Saturday, July 18, 2009

Of Goldman, bubbles, and hype

If you haven't already read this widely distributed story on Goldman, it's worth a read, particularly on a Sunday night.

It's called The Great American Bubble Machine, by Matt Taibbi, first published by the Rolling Stone.

Illustration by Victor Juhasz (RS)

Reading the article will make you mad. But before you go out to lynch Goldman employees (as many Sober Look readers have suggested), think about the wise old statement "He that is without sin among you, let him first cast a stone..." (John 8:7). Our discussion here is not about defending Goldman or it's practices. It's about a much broader shared blame that goes way beyond the aggressive and profitable firm called Goldman Sachs.

On a personal note and for the purposes of disclosure, I have never worked for Goldman nor do I own GS shares. But some years back a recruiter called to tell me he wanted me to interview for a job at that firm. I told him thanks, but no thanks. He said "are you crazy? People would kill their grandmother to work there". My answer was "that's exactly why I DON'T want to work there."

I have however dealt with Goldman as a client (or a potential client) on numerous occasions. Goldman employees exude professionalism and creativity. They always have the latest twist on an existing product or a unique solution to a problem. In general they will be more expensive than others - they don't want to win on price. They also don't want to win on providing balance sheet (if they provide credit, they will unload the risk somewhere else). They generally want to win on innovation. If you've done a transaction with them, more likely than not they've made good money. And unless you have the sophistication to match theirs, you won't know how they made money on you.

Per Taibbi's story (as well as thousands of other conspiracy theories), Goldman alums are everywhere. They are particularly prevalent in government posts - from Corzine to Paulson. But think about these types of jobs. It takes a polished, smart, yet a ruthless and driven workaholic to have these government posts or to run for a major political office. It also takes much money and connections. Well, ex-Goldman guys have the perfect combination of these traits. That's why they are in these roles. Not because somehow the US government is controlled by Goldman (sorry to disappoint many of you).

This by the way is no different than the Skull and Bones society at Yale. Workaholic qualities, intelligence (sometimes), polished presentation, money, connections (in this case it's family connections vs. Goldman alums network) gives one a real advantage in politics.

With this backdrop, let's take a look at how Goldman "caused" or is about to cause all the financial bubbles, one at a time.
BUBBLE #1 The Great Depression

...Goldman ... sponsored a new trust, the Shenandoah Corporation, issuing millions more in shares in that fund — which in turn sponsored yet another trust called the Blue Ridge Corporation. In this way, each investment trust served as a front for an endless investment pyramid: Goldman hiding behind Goldman hiding behind Goldman. Of the 7,250,000 initial shares of Blue Ridge, 6,250,000 were actually owned by Shenandoah — which, of course, was in large part owned by Goldman Trading.

The product he is discussing here is basically a mutual fund on steroids - a stock portfolio with leverage. These actually exist today in another form: many ETFs have leverage. Goldman was by no means the first to set one of these up. The Foreign & Colonial Government Trust, the first investment trust, was set up in the UK in in 1868 and is still open to investors today (known as The Foreign & Colonial Investment Trust).

Share Investment Trust, launched in 1872, was the first to use leverage (also in the UK). By the time Goldman's Shenandoah came along, funds with leverage and ponzi schemes were everywhere. Goldman just did it in size, marketed these aggressively, and used tons of leverage. This ultimately nearly destroyed the firm.

In terms of the asset bubble, JPMorgan was probably more to blame than Goldman, as John Pierpont Morgan had been providing support for the stock market for years prior to the crash (similar to the Fed in the last 20 years), creating the ultimate in "moral hazard". William Durant and the Rockefeller family did their part as well. But the "get rich fast" mentality permeating the nation was the key driver for the bubble.

BUBBLE #2 Tech Stocks

... The basic scam in the Internet Age is pretty easy even for the financially illiterate to grasp. Companies that weren't much more than potfueled ideas scrawled on napkins by uptoolate bongsmokers were taken public via IPOs, hyped in the media and sold to the public for mega-millions. It was as if banks like Goldman were wrapping ribbons around watermelons, tossing them out 50-story windows and opening the phones for bids. In this game you were a winner only if you took your money out before the melon hit the pavement.

All true. Goldman was on the forefront of the tech IPO mania. But let's get some perspective here. Does anyone remember CSFB's role? Maybe not. How about Frank Quattrone? Ring any bells? Well it was actually not Goldman who was the top IPO banker, but CSFB's Quattrone (he took public Netscape, Cisco, and, earning $160 million a year. All investment banks who could get into the IPO game got in - large and small. Somehow Taibbi doesn't want to discuss this, as it may dilute his story.

Let's bring in a quick example from history: the great California Gold Rush. Many gave up their land and occupations to go to California. However, remember that very few miners actually made money. Instead it was all the service providers who got rich - in fact that's how San Francisco was built. Taibbi would probably argue that bubble was Goldman's fault as well.

In the 90s so much was made on a few successful IPOs that it became the new gold rush. Remember FNN getting into the game and spreading the IPO gospel, helping the mania? Remember the stay-home moms watching FNN all day and trading stocks? Remember 19-year-old kids taking out student loans to buy Yahoo! shares like it was a drug? How about people quitting their jobs and college in droves to start tech companies, hoping to become the next Bill Gates?

Goldman as well as CSFB and numerous others were riding the wave, ready to accommodate. It's absolutely true, these firms had deployed unethical and sometimes illegal practices, but just as the service providers in the Gold Rush, they didn't cause the bubble.

BUBBLE #3 The Housing Craze

... Take one $494 million issue that year, GSAMP Trust 2006S3. Many of the mortgages belonged to secondmortgage borrowers, and the average equity they had in their homes was 0.71 percent. Moreover, 58 percent of the loans included little or no documentation — no names of the borrowers, no addresses of the homes, just zip codes. Yet both of the major ratings agencies, Moody's and Standard & Poor's, rated 93 percent of the issue as investment grade. Moody's projected that less than 10 percent of the loans would default. In reality, 18 percent of the mortgages were in default within 18 months.

This is true. However Goldman was not the largest player in this market. This was in part because Goldman never liked committing balance sheet. Citi on the other hand was more than willing to commit balance sheet (via CP conduits), pushing sub-prime ABS product out the door in billions. Bear Stearns used it's internal hedge funds to buy (on leverage) sub-prime paper they (as well as others) structured. Lehman, Morgan Stanley, Merrill were all big players as well, and the list goes on. And just to help some remember, it was UBS that was the buyer of same of that paper (folks in Zurich felt that if it's real estate, it's got to be good) and always wanted more (in fact their internal hedge fund Dillon Read did the same thing that Bear Stearns was doing). Citi was right there to sell them more. Wachovia (remember that bank?) was a large scale buyer and structurer of sub-prime ABS as well.

Taibbi argues that Goldman shorted the paper it sold. At least Goldman publicly said they are negative on the asset class. Morgan Stanley was shorting sub-prime (though not enough to avoid huge losses). The firm known to short sub-prime on a large scale and tell clients about it was actually Deutsche Bank. Good for them.

And what was the Fed doing? Pumping more liquidity into the system to get the bubble nice and big. Sorry Mr. Taibbi, it wasn't Goldman that caused the housing bubble either. Everybody had a hand in it - from mortgage brokers, to house speculators, regional banks, investment banks, monolines, the rating agencies, the BIS and the Fed.

BUBBLE #4 $4 a Gallon

... With the public reluctant to put money in anything that felt like a paper investment, the Street quietly moved the casino to the physical-commodities market — stuff you could touch: corn, coffee, cocoa, wheat and, above all, energy commodities, especially oil. In conjunction with a decline in the dollar, the credit crunch and the housing crash caused a "flight to commodities." Oil futures in particular skyrocketed, as the price of a single barrel went from around $60 in the middle of 2007 to a high of $147 in the summer of 2008.

Put yourself into the environment of the early 2008. The supply/demand chart for oil looked ugly. As China/India demand was forecast to grow, the supply was predicted to shrink. The dollar was collapsing. Geopolitical situation looked terrible: from belligerent Iran and Venezuela, to newly aggressive Russia, to unstable Nigeria. Rice hoarding and shortages were popping up all over the globe. Think about it - Goldman or not - as a pension or an endowment, what would would you be investing in? Yes, Goldman economists were bullish oil to the last minute, but so was the rest of the world.

BUBBLE #5 Rigging the Bailout

... Once the bailouts were in place, Goldman went right back to business as usual, dreaming up impossibly convoluted schemes to pick the American carcass clean of its loose capital. One of its first moves in the postbailout era was to quietly push forward the calendar it uses to report its earnings, essentially wiping December 2008 — with its $1.3 billion in pretax losses — off the books. At the same time, the bank announced a highly suspicious $1.8 billion profit for the first quarter of 2009 — which apparently included a large chunk of money funneled to it by taxpayers via the AIG bailout. "They cooked those firstquarter results six ways from Sunday," says one hedgefund manager. "They hid the losses in the orphan month and called the bailout money profit.

That's right, Goldman did that. It made their 09 performance look better than it was. Must be that PwC is in on this as well - they are the auditor. Unlike Citi, UBS, Merrill, Wachovia, etc. however, Goldman did not rely on TARP to survive - they raised equity from Buffett. With regard to AIG, Goldman actually bought protection on AIG, fully prepared for it to go under. But all that aside, the bailout wasn't a "bubble", so Taibbi's bubble theme doesn't apply here.

BUBBLE #6 Global Warming

... Here's how it works: If the bill passes, there will be limits for coal plants, utilities, natural-gas distributors and numerous other industries on the amount of carbon emissions (a.k.a. greenhouse gases) they can produce per year. If the companies go over their allotment, they will be able to buy "allocations" or credits from other companies that have managed to produce fewer emissions. President Obama conservatively estimates that about $646 billion worth of carbon credits will be auctioned in the first seven years; one of his top economic aides speculates that the real number might be twice or even three times that amount.

This one is completely absurd. Goldman knows that carbon credit trading in the US is happening sooner or later. It's been in place in Europe for years. Any good business, when presented with a huge new market will invest to get ready for it.

With regard to the Chicago Climate Exchange (CCX), nobody will benefit more from carbon trading than it's founder, Richard Sandor. Sandor (not Goldman) is the inventor of carbon trading (he's worked on it for 20 years or so.) He owns the bulk of CCX, and he is the one who got Goldman to take a share in order to create liquidity in the fledgling market.

Carbon trading is in fact an implicit tax. This is probably not the right time to implement it, given the fragile economy. It's also unfair to push it on the US, while China continues to pump massive amounts of carbon into the atmosphere. But if one had a choice between "carbon cap" and "cap & trade", the latter is always preferable. Cap and trade will stimulate clean air technologies and create carbon offsets (such as farmers planting trees). The reason it will work is that people stand to make money doing it (from farmers, to biofuels manufacturers, to utilities). And investors/traders (including Goldman) stand to make money as well.

Just as many other large US corporations, from GE (dumping PCBs into the Hudson river) to Exxon (a little spill in Alaska), Goldman is guilty of a number of unethical and illegal practices over the years. But to say that Goldman caused the various bubbles throughout history is a bit of a stretch, wouldn't you agree Mr. Taibbi?
Related Posts Plugin for WordPress, Blogger...
Bookmark this post:
Share on StockTwits