The U.S. Senate has never been a bastion of financial genius. But last Tuesday’s Senate subcommittee hearings on Goldman Sachs revealed a disturbing degree of misconception in the senators’ minds about how the nation’s finance and banking systems function. If there is any hope for a financial-reform bill to be effective and protect the country from a repeat of the 2008 meltdown, then our lawmakers must recognize that in its capacity as the nation’s market maker, the financial sector plays a fundamentally different role from all others in our economy, and that consequently the products and services it supplies must be regulated on their own terms, not those of standard everyday goods.
The senators at Tuesday’s hearing spoke almost exclusively in what they believed to be the language of Main Street, an effort that could have been eminently reasonable were its purpose to clarify the often opaque language of finance for the benefit of the American people. But the senators instead used this language barrier to distort rather than to elucidate, quickly revealing that their priorities lay more in political theater than in problem-solving. Characterizing the Goldman securities in question as “good” deals, “bad” deals, or, as Sen. Carl Levin (D., Mich.), the chairman of the investigations subcommittee, was fond of putting it, “sh***y” deals, the senators drew comparisons between these complex financial instruments and common consumer products like cars. These are false parallels that apply an inappropriate economic and ethical framework to thinking about financial reform.
There is a basic and very important difference between what financial institutions do and what every other sector of the economy does. Unlike firms in the rest of the economy, financial institutions do not produce actual, tangible goods. They operate on a level once removed from goods-producing firms, creating and trading on the markets that allocate capital and credit to those firms and to the consumers who buy their products. For every such allocation, there is potential for a high return on the investment and potential for a low or even negative return. In other words, there is risk and there is reward. Financial institutions act first and foremost as middlemen between sellers of these risk-return packages (companies, governments, mortgage borrowers, etc.) and buyers (retail investors, pension funds, insurance companies, etc.). In this world, the investment banks are market makers. The “products” they create, buy, and sell are packages of various combinations of risk and return.
There is no such thing as a financial package or instrument that is inherently “good” or “bad,” “better” or “worse” than any other. These packages simply offer different profiles of risk and return. They can be “better” or “worse” only for a particular client, based on what the rest of the client’s portfolio looks like and thus what kind of additional exposure to risk and return is optimal for that portfolio. The exact same financial instrument could be a very good investment for one party and a very bad investment for another. It all depends on the desired risk exposure.
It was thus meaningless for the senators on the subcommittee to talk about these financial instruments as if they were everyday goods that can come with a manufacturer’s guarantee. Senator Levin repeatedly asked Goldman CEO Lloyd Blankfein and his colleagues whether a “customer has a right to assume that you [Goldman Sachs] would like to see that security succeed.” Mr. Blankfein explained that the term “succeed” has no solid definition in this context. While most of the senators saw this defense as obfuscation, it was in fact an accurate statement that goes to the heart of the problem: Success depends on the customers’ preferences and what they seek in their portfolios. A tranche of mortgage-backed securities could nosedive in value but be very successful for its holder if, for example, that holder had large stock holdings in counter-cyclical businesses like fast food and discount shopping centers, which generally do better when the rest of the economy does worse. Because mortgage values are strongly pro-cyclical, these risk-opposite positions would smooth out the effects of large booms and busts in the holder’s portfolio.
The obligation on market makers in this context is not to give their clients securities they believe will be “successful” — a term without real meaning — but to make sure the financial product in question delivers the risk exposure (and potential return) that the client is seeking. That is the duty of an investment bank in this context, and it is what Goldman argues it did for its clients, who were not workaday retail investors, as many of the senators seemed to intimate, but rather some of the biggest and most sophisticated investors in this asset class, who clearly understood — or at least whose very well-paid job it was supposed to be to understand — the types and degrees of risk they were taking on.
Many of the senators had difficulty comprehending the concept of market making. Even after hours of testimony, for example, Sen. Jon Tester (D. Mont.) had to be reminded by Mr. Blankfein that the word following “market” in that phrase is “makers.” The closest most of the senators got to understanding this concept was in making another everyday comparison — to a casino. Sens. Levin, Tester, and Claire McCaskill (D., Mo.) were particularly fond of making this accusation, characterizing the investment bankers as nothing more than overdressed sports bookies, and asserting that consequently they “do not serve a social purpose” in the U.S. economy. In particular, they heaped criticism on the use of synthetic CDOs (collateralized debt obligations), an instrument in which neither party actually owns the underlying asset (in this case mortgage claims), labeling them as nothing more than a “scam” concocted by nefarious speculators betting on the misfortune of hardworking Americans.
This argument fails two logical tests. Firstly, this old diatribe ignores the essential role that speculators play in any market. By definition, every market transaction requires two equal and opposite sides. For every farmer or truck driver trying to hedge against volatility in crop or oil prices — the kind of betting these senators endorse as wholly just — there must be someone willing to take the opposite bet: namely, a speculator. And without the activity of speculators in these transactions, the price of these assets would not accurately reflect the best information available in the market.
Secondly, and even more fundamentally, this line of argument misses the point of what investing is all about: that, in most cases, the underlying asset itself in any given security does not matter — only the specific combination of market risk and return that it embodies. It is the market risk linked to that asset’s performance that gives it value to the investor. While some investors and speculators make one-time bets on particular assets that they believe to be under- or over-valued, the great majority of investors — especially large institutional investors, which deploy the vast majority of capital in all world markets — have a large portfolio of investments, for which the decision to invest in any particular security is made in order to diversify holdings across different asset types and risk profiles so as to hedge against concurrent movements in the entire portfolio — in other words, to achieve the lowest level of volatility for any target rate of return.
The casino and sports-bookie comparisons fall apart here because they fail to encompass the idea of portfolio building in a world in which all economic and asset price behavior is interconnected. A single horse race is a pure speculative gamble because it is an independent event that has no correlation to any other bet. But if the performance of different horses had statistically significant correlations to economic factors as various as crop production and manufacturing growth, mortgage rates and technology stocks — as the Goldman securities in question most certainly did — then a wager on them would not be a speculative bet but rather an informed investment engineered to hedge risk and optimize an investment portfolio.
Some of the subcommittee’s more thoughtful members, such as Sen. Ted Kaufman (D., Del.), rightly recognized that the real problem in the system lay not in the supposed worthlessness of the services Goldman provided, but in the potential for a conflict of interest when the firm trades in the markets it creates. Could it be gaming the system and fleecing its clients? The implication, and flat-out accusation lodged by Senator Levin, was that Goldman’s trading desk purposefully created bad securities that it fooled clients into buying, and then had its own proprietary desk bet against them to make a mint.
There are two reasons this argument does not hold water. The first is that Goldman Sachs, like all investment banks, separates its trading and proprietary investment divisions with an array of rules and safeguards. Any information passed between them is monitored by a cadre of lawyers in the legal-compliance division to make sure no material and publicly undisclosed information that could constitute insider trading is passed back and forth. There are as yet no official charges (aside from Senator Levin’s intimations) that Goldman breached this wall of separation. The SEC’s case against Goldman alleges that it committed a legally and ethically equivalent violation in allowing a hedge-fund client to help construct a synthetic CDO without revealing its potential conflict of interest to the other parties involved in the transaction. But whether or not there was such a breach in this particular instance, or in others that have yet to be investigated, the problem presented is one of enforcing existing rules and regulations, not of inherent flaws in the system that necessitate massive reform measures.
The second, and perhaps more fundamental, point is that it should not matter to the customers buying these securities what the proprietary desk at Goldman or its hedge fund client (or any other financial institution, for that matter) thinks of it. Whether Goldman’s proprietary division bought into the security or not should have made no difference. The customers in question were not lowly retail investors hiring Goldman in a fiduciary capacity to advise on or handle their investments; they were large and sophisticated financial firms asking Goldman to supply a specific type of (very complex and rare) security with a very specific risk profile. They knew the contents of this security, the risk involved, and the rating given to it by an independent agency. To create that security, Goldman by definition had to create a market with a buyer and a seller. In the end, Goldman actually ended up buying the security itself to balance out the buy and sell sides of the market (resulting in a loss of roughly $90 million for the firm itself). But again, whether other parties in the transaction (Goldman or some other firm) viewed that security as desirable should be of no importance to the customers. If they were going long on the security, then by definition someone else was going short. Each side, by definition, must have seen advantage for its own portfolio position in making the transaction, or else neither would have executed the trade and the security would never have come into existence.
The real problems behind the financial crisis, sadly, were barely touched on in the hearings. The over-subsidization of the mortgage market by government-sponsored entities like Fannie Mae and Freddie Mac, the loose monetary policy of the Fed, the influx of capital from Chinese savings and the sovereign wealth funds of oil states: save some efforts by Sen. Tom Coburn (R., Okla.), none of these factors behind the financial meltdown came up. Even more disturbingly, in hearings supposedly focused on investment banks’ role in the crisis, the true flaws in these firms’ operations were not discussed.
The real problem on Wall Street was not that Goldman or other banks were acting illegally or immorally or even greedily in executing transactions of the kind discussed; the problem was that all the investment banks were executing the same kinds of complex and opaque deals using similar financial models without taking each other’s effect on market movements into account. Taken on its own, any transaction like the one under SEC investigation would have been economically sound and without adverse impact on financial markets or the general economy. It became a problem because all the investment banks were running similar deals in massive numbers, not taking into account that these self-replicating processes were amplifying upward moves — and therefore the inevitable downward fall — in the market. This phenomenon changed the underlying market behavior that the banks’ financial models were built on, and, combined with shortsighted incentive pay structures at many firms, led nearly everyone to jump aboard the bandwagon right up until it crashed. This is the definition of systemic risk, and it is a classic case of a collective-action problem. It implies collective, not individual, guilt, and it requires a collective solution. This is why Mr. Blankfein was accurate in claiming that Goldman itself was not guilty of bringing on the crisis, but that “the financial institutions let the public down and we [Goldman Sachs] are a very important and influential financial institution so we bear our share.”
Rather than trying to pin individual blame on particular firms or investors, as so much of the Senate seems intent on doing, the right thing to do for the country and for its financial system is to enact financial reform that acknowledges the collective nature of the problem and applies collective solutions. Through tougher rules on transparency and reserve requirements, greater restrictions on certain types of trading, and smarter guidelines for incentive pay, well-designed financial regulations could keep banks from driving each other into making the kinds of deals that, while on their own are beneficial to each, as a whole put everyone in danger. Understanding these real issues, rather than pursuing moral grandstanding and scapegoating, is the route to meaningful reform.
– Daniel Krauthammer is a writer in Los Angeles. He holds a Master of Science degree in financial economics from Oxford University