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Too Cute By Half

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April 29, 2010

On April 15, I discussed the disappointing performance of the Financial Crisis Inquiry Commission (FCIC).  The vapid FCIC hearings have featured softball questions with no follow-up to the self-serving answers provided by the CEOs of those too-big–to-fail financial institutions.

In stark contrast to the FCIC hearings, Tuesday brought us the bipartisan assault on Goldman Sachs by the Senate Permanent Subcommittee on Investigations.  Goldman’s most memorable representatives from that event were the four men described by Steven Pearlstein of The Washington Post as “The Fab Four”, apparently because the group’s most notorious member, Fabrice “Fabulous Fab” Tourre, has become the central focus of the SEC’s fraud suit against Goldman.   Tourre’s fellow panel members were Daniel Sparks (former partner in charge of the mortgage department), Joshua Birnbaum (former managing director of Structured Products Group trading) and Michael Swenson (current managing director of Structured Products Group trading).  The panel members were obviously over-prepared by their attorneys.  Their obvious efforts at obfuscation turned the hearing into a public relations disaster for Goldman, destined to become a Saturday Night Live sketch.  Although these guys were proud of their evasiveness, most commentators considered them too cute by half.  The viewing public could not have been favorably impressed.  Both The Washington Post’s Steven Pearlstein as well as Tunku Varadarajan of The Daily Beast provided negative critiques of the group’s testimony.  On the other hand, it was a pleasure to see the Senators on the Subcommittee doing their job so well, cross-examining the hell out of those guys and not letting them get away with their rehearsed non-answers.

A frequently-repeated theme from all the Goldman witnesses who testified on Tuesday (including CEO Lloyd Bankfiend and CFO David Viniar) was that Goldman had been acting only as a “market maker” and therefore had no duty to inform its customers that Goldman had short positions on its own products, such as the Abacus-2007AC1 CDO.  This assertion is completely disingenuous.  When Goldman creates a product and sells it to its own customers, its role is not limited to that of  “market-maker”.  The “market-maker defense” was apparently created last summer, when Goldman was defending its “high-frequency trading” (HFT) activities on stock exchanges.  In those situations, Goldman would be paid a small “rebate” (approximately one-half cent per trade) by the exchanges themselves to buy and sell stocks.  The purpose of paying Goldman to make such trades (often selling a stock for the same price they paid for it) was to provide liquidity for the markets.  As a result, retail (Ma and Pa) investors would not have to worry about getting stuck in a “roach motel” – not being able to get out once they got in – after buying a stock.  That type of market-making bears no resemblance to the situations which were the focus of Tuesday’s hearing.

Coincidentally, Goldman’s involvement in high-frequency trading resulted in allegations that the firm was “front-running” its own customers.   It was claimed that when a Goldman customer would send out a limit order, Goldman’s proprietary trading desk would buy the stock first, then resell it to the client at the high limit of the order.  (Of course, Goldman denied front-running its clients.)  The Zero Hedge website focused on the language of the disclaimer Goldman posted on its “GS360” portal.  Zero Hedge found some language in the GS360 disclaimer which could arguably have been exploited to support an argument that the customer consented to Goldman’s front-running of the customer’s orders.

At Tuesday’s hearing, the Goldman witnesses were repeatedly questioned as to what, if any, duty the firm owed its clients who bought synthetic CDOs, such as Abacus.  Alistair Barr of MarketWatch contended that the contradictory answers provided by the witnesses on that issue exposed internal disagreement at Goldman as to what duty the firm owed its customers.  Kurt Brouwer of MarketWatch looked at the problem this way :

This distinction is of fundamental importance to anyone who is a client of a Wall Street firm.  These are often very large and diverse financial services firms that have — wittingly or unwittingly — blurred the distinction between the standard of responsibility a firm has as a broker versus the requirements of an investment advisor.  These firms like to tout their brilliant and objective advisory capabilities in marketing brochures, but when pressed in a hearing, they tend to fall back on the much looser standards required of a brokerage firm, which could be expressed like this:

Well, the firm made money and the traders made money.  Two out of three ain’t bad, right?

The third party referred to indirectly would be the clients who, all too frequently, are left out of the equation.

A more useful approach could involve looking at the language of the brokerage agreements in effect between Goldman and its clients.  How did those contracts define Goldman’s duty to its own customers who purchased the synthetic CDOs that Goldman itself created?  The answer to that question could reveal that Goldman Sachs might have more lawsuits to fear than the one brought by the SEC.



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