Should we criminalize Wall Street?

Not surprisingly, the populist blog Naked Capitalism cheers the release of a report authored by the staff of the Senate Committee on Permanent Investigations into the causes of the financial crisis.

Senator Carl Levin (D-MI), the Committee Chairman, has been the most aggressive in attacking the behavior of major investment banks like Goldman Sachs for their alleged role in taking advantage of the crisis. Levin has said he is sending the report to the Department of Justice for a possible criminal investigation of the big Wall Street banks.

Yet once again it is clear in reading through the report that Levin is intent on misleading the public on what it is that investment banks do, exactly. Behind the report, in fact, is an ideological position that drives the mistaken views expressed openly in the report. That ideological position is one that suggests that the source of the crisis is the increasing “financialization” of our economy carried out by large Wall Street banks and hedge funds over the last 20 years or so. This same meme lies at the heart of popular films about the crisis such as the sequel to Wall Street directed by Oliver Stone called, apropos, Wall Street: Money Never Sleeps, and the Oscar winning documentary Inside Job directed by Charles Ferguson.

The giveaway of this world view can be found in the early pages of the Report’s so-called “case study” of Goldman Sachs. The Report says it relied on just four sources, including news items in the Wall Street Journal, Reuters, Vanity Fair, and Hoovers, to determine what it was Goldman Sachs did from its founding in 1869 until the 1999 repeal of the Banking Act of 1933 (commonly but mistakenly known as the Glass-Steagall Act), which forced commercial banks to divest their investment banking activities.

From this “in depth” research – and with no attempt to ask Goldman employees or former employees as they did for other aspects of the Report – the Senate staff concluded that until 1999 Goldman Sachs “operated exclusively as an investment bank, providing investment advice to corporate clients, arranging and executing mergers and acquisitions, and arranging financing for customers through stock and bond offerings.” (Emphasis added.)

In other words, Goldman was basically a neutral arbiter of its client’s needs, bringing together savers and entrepreneurs to engage in productive expansion of the real economy.

Really? That’s what bankers did? How quaint. It’s as if Carl Levin thinks that Goldman Sachs became the world’s leading investment bank by operating like Jimmy Stewart in It’s a Wonderful Life!

This is, in fact, a stereotype of what investment banks did that aims to make the reader wistful for the Eden that “financialization” theorists argue existed before Adam and Eve (aka “Gramm Leach Bliley”) bit into the apple in 1999 and unleashed the whirlwind.

One person Senator Levin could have told his staff to test this Jimmy Stewart thesis with would have been his colleague in the Democratic Party, former Treasury Secretary and former head of Goldman itself during that Edenic era, Bob Rubin.

How would Rubin have responded?

Well, after he stopped laughing he might have asked, if he was in a generous mood, do you know how I got to the top of Goldman Sachs? It wasn’t because I brought together “savers and entrepreneurs,” Senator. It was because I was a razor sharp trader of bonds, including US government bonds, on behalf of Goldman Sachs as well as its clients.

In fact, Senator, Goldman has long had at the very heart of its operations a trading operation both for its own account and as a broker and market maker.

And over the years, many many years before “1999” we made lots of money for ourselves engaged in precisely the same kind of trading – though perhaps with not quite the same bells and whistles that today’s derivative instruments entail – that you are now suggesting is so inappropriate for an investment bank.

And if he had had the patience he might have explained to the Senate staff that if he and his fellow “masters of the universe” (as novelist Tom Wolfe described bond traders in his novel of the Rubin era) had not engaged in that kind of aggressive trading Goldman would not have had the asset base and institutional experience to engage in the kind of IPO and M&A advisory work that the Senate committee celebrates as the heart of the “good” investment banking of those bygone days before (TAH DUM) “1999”.

Forget a meeting with Rubin, just ask Lloyd Blankfein how he became a Goldman banker. He was at J. Aron, a commodities trading firm that Goldman acquired in the early 80s. Another indication of the importance of trading activities to the firm. Heck, even a cursory review of the history of Goldman Sachs on the Wikipedia website would have sufficed to correct the staffers.

The Senate Report then compounds its mistake by contending that Glass-Steagall “had restricted the activities that could be engaged in by investment banks,” and thus its repeal enabled Goldman to “expand…its operations” in the direction of what the Senate staff claims were manipulative trading practices.

But that, too, is wrong.

Glass-Steagall forced banks that were members of the Federal Reserve system to divest themselves of investment banking activities, but it did not place any restrictions on the trading activity of those investment banks once they were spun off. The Banking Act of 1933 aimed to prevent commercial banks from dipping into the funds of retail depositors and invest them in the capital markets. But that did not prevent investment banks – which of course were not backed up by the Federal Reserve system – from engaging in precisely the kind of proprietary trading and hedging activities that are at the heart of the Committee Report.

In fact, Glass-Steagall and numerous administrative decisions and regulatory reforms years before its repeal allowed commercial banks to operate directly in the capital markets. According to one summary of how the Act operated before 1999:

“Commercial banks are not forbidden from underwriting and dealing in securities outside of the United States. The larger money center banks, against whom the prohibitions of the Glass-Steagall Act were directed, are particularly active in these markets. Five of the top 30 leading underwriters in the Eurobond market in 1985 were affiliates of U.S. Banks, with 11 per cent of the total market. These affiliates include 11 of the top 50 underwriters of Euronotes. Citicorp, for example, has membership in some 17 major foreign stock exchanges, and it offers investment banking services in over 35 countries….In summary, commercial banks can offer some aspects of investment advisory services, brokerage activities, securities underwriting, mutual fund activities, investment and trading activities, asset securitization, joint ventures, and commodities dealing, and they can offer deposit instruments that are similar to securities.

As I suggested, Goldman – and all other investment banks – were and have always been simultaneously brokers or market makers who act merely as middlemen between buyers and sellers as well as dealers trading for their own account. Is the Committee really unaware of the licensing procedures that the SEC has overseen for many decades that allow firms like Goldman to trade for their own account? Here is a guide to the Securities Exchange Act of 1934 (!) in case they need a primer.

It was this simultaneous role as market maker and dealer that led the Senate committee staff to conclude that Goldman inappropriately entered into the so-called “Big Short” against the longterm prospects of the housing market.  Far from being a heinous act undermining our economy, what Goldman did was critical to the financial survival of the bank itself and entirely consistent with the nature of modern capitalism. When Goldman conducts an IPO for a firm like Sears, Roebuck or Microsoft it commits to that firm that it will “underwrite” the offering. This means Goldman is contractually obligated to buy the shares from the firm and resell them to the public. If it fails to resell them – a constant risk – Goldman is stuck holding them.

Thus, Goldman has to go long in a sense on any business it agrees to underwrite in a securities offering. It would be utterly mindless and irresponsible of the bank to not hedge against those risks. It is forced to borrow at significant expense in order to engage in the underwriting and it has to make sure it is protected against the possibility of a failed IPO. More, if it did not have a regular institutionalized knowledge of how to protect against those risks it would quickly go out of business. And our financial markets would lose the services of the very financial intermediaries that the Senate staff suggested were so critical in its Jimmy Stewart view of the world. One would have thought that the collapse of Lehman and Bear Stearns would have been reminder enough of this possibility

In fact, the Report explains this to a certain extent though they try to divert the reader from drawing the logical conclusion. On page 388 the Senate staff describes the overall impact of the so-called “Big Short” thusly:

“The $3.7 billion in net revenues from the SPG’s short positions helped to offset other mortgage related losses, and, at year’s end, at a time when mortgage departments at other large financial institutions were reporting record losses, Goldman’s Mortgage Department reported overall net revenues of $1.2 billion.”

In other words, Goldman suffered $2.5 billion in losses somewhere else in the mortgage assets it invested – presumably because of failed long positions – which had to be offset, or hedged, by these short positions.

Goldman had no inside knowledge of when or how or even if the housing market would fail. The most knowledgeable critic in the world of the bull market in housing was not, in fact, a Goldman banker. He was a rather bookish economist at Yale – Robert Shiller – who was more than willing to share all that he knew about the housing market with anyone willing to listen. Heck, he practically screamed it from the mountain top.

In fact, a review of the offering documents prepared by the investment banking side of Goldman for the long positions it sold to investors in the controversial synthetic CDOs that the Report also spends considerable time discussing were filled with pages of explanation to those investors of the downward trends that Goldman saw in the housing market.

Goldman, in other words, shared its knowledge of the risks in the market with those investors, like the German bank IKB that bought the Abacus CDO long position across from the short counter party in the trade, the hedge fund run by John Paulson. The “risk factors” section in the Abacus offering circular takes up 14 single spaced pages, including a page and a half of warnings like the following that are specific to the the housing market:

“Recent Developments in Subprime Residential Mortgage Lending. Recently, delinquencies, defaults and losses on residential mortgage loans have increased and may continue to increase, which may affect the performance of RMBS, in particular RMBS Residential B/C Mortgage Securities which are backed by subprime mortgage loans. Subprime mortgage loans are generally made to borrowers with lower credit scores. Accordingly, mortgage loans backing RMBS Residential B/C Mortgage Securities are more sensitive to economic factors that could affect the ability of borrowers to pay their obligations under the mortgage loans backing these securities. Market interest rates have been increasing and accordingly, with respect to adjustable rate mortgage loans and hybrid mortgage loans that have or will enter their adjustable-rate period, borrowers are likely to experience increases in their monthly payments and become increasingly likely to default on their payment obligations. Discovery of fraudulent mortgage loan applications in connection with rising default rates with respect to subprime mortgage loans may indicate that the risks with respect to these mortgage loans are particularly acute at this time. Such risks may result in further increases in default rates by subprime borrowers as it becomes more difficult for them to obtain refinancing.”

Other warnings included:

1) “These economic trends have been accompanied by a recent downward trend or stabilization of property values after a sustained period of increase in property values.”


2) “Recently, a number of originators and servicers of mortgage loans have experienced serious financial difficulties and, in some cases, have entered bankruptcy proceedings. These difficulties have resulted in part from declining markets for their mortgage loans….Such financial difficulties may have a negative effect on the ability of servicers to pursue collection on mortgage loans that are experiencing increased delinquencies and defaults and to maximize recoveries on sale of underlying properties following foreclosure. The inability of the originator to repurchase such mortgage loans in the event of early payment defaults and other loan representation breaches may also affect the performance of RMBS backed by those mortgage loans.”


3) “These adverse changes in market conditions may reduce the cashflow which the Issuer receives from RMBS held by the Issuer (or a Credit Default Swap that reference RMBS), decrease the market value of such RMBS and increase the incidence and severity of Credit Events under the Credit Default Swap.”

These are what experts in the financial markets would call “red flags” – you ignore them at your peril.  They are ignored, in fact, by the Senate Committee staffers in their report, presumably because of the inconvenience they cause in their argument. Instead the staff remains obsessed, as was the SEC, with the fact that Goldman did not disclose to the purchasers of the long position in Abacus the role of a short investor in the transaction. While Goldman has now admitted it should have done so, it remains inexplicable to me why this is the case. The transaction would not have taken place without a short on the other side and may not have taken place unless a short investor helped put the deal together. The long investor, including the German industrial bank IKB, was happy that there was such a deal on offer given their bias to the long side on housing.

And by the way IKB – which manages assets as of the end of 2010 valued at $50 billion – was no newcomer to financial engineering. It financed its position in the Abacus deal by selling commercial paper to small investors in the state of Washington, bilking them of millions apparently and leading to a huge lawsuit. As I wrote about their role in the deal here some months ago:

“IKB thought they had found a money machine – raise millions through the commercial paper sales to unsophisticated small investors while investing it through Goldman on the other side of what they thought were dumb “shorts” who fantasized about the collapse of the housing market.”

(See the LA Times story about the IKB money machine called “Main Street paid for Wall Street maneuvers” here.)

So some people, like those portrayed by Michael Lewis in his book The Big Short, listened to people like Bob Shiller. Others, like many of Goldman’s own bankers who had built those losing long positions, did not. In fact, what is fascinating about the Senate report is the description of the intense debate inside Goldman itself about whether or not to be long or short on housing. One comes away with the feeling that it was hit or miss whether Goldman, too, ended up like Bear and Lehman – road kill in the housing collapse.

And somehow we are to think Goldman was engaged in a devious effort to profit from the failing housing market.

Does the Senate staff not realize the $1.2 billion they walked away with would be chump change if Goldman were serious about using inside knowledge of an industry to profit at the expense of its clients? Does the staff not understand that there were Goldman clients that made many times more than this from the very same mortgage-related assets? Certainly many consumers and working people and small institutional investors were unfairly lured into housing related investments. But are we really to cry tears for the IKB’s of the world? If they lose and Paulson wins, where is the net social loss? Because Goldman, as intermediary collects a hefty fee? C’mon.

There is, of course, a very serious problem in our economy exposed by the housing collapse and the behavior of the many players in that collapse. Some of the behavior was fraudulent and those who engaged in fraud should, indeed, be pursued by the appropriate authority. But it makes no sense to attempt to criminalize the core institutions of capitalism. We should, I think, be considering major changes to those structures – changes that channel surplus generated by our labor force into socially responsible development of our economy and that of the world. This would mean a shift away from the chaotic and volatile features that are so prominent in capitalism today.

But it is naive and even disingenuous to suggest that the ex post criminalization of what was long and widely accepted capitalist practice is any kind of solution. It smacks of another kind of “short termism” – one aimed not at making a fast buck but of generating short term enthusiasm for ineffectual liberal politicians who need votes in 2012.


In the interest of full disclosure, I have been involved in several transactions, on both sides of the table, with Goldman Sachs.

1 thought on “Should we criminalize Wall Street?”

  1. Thank you Stephen! I see there is an “inside job” inside the “Inside Job” and other so called critiques.

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