On Cohan's Goldman Op-Ed: Bankers vs. Traders

Includes: GS, KBE, KRE, XLF
by: John Lounsbury

William D. Cohan has an op-ed in The New York Times that discusses the decades-long transformation of Goldman Sachs from a banking firm to a trading firm. All the current and former Goldman executives, including CEO Lloyd Blankfein testifying this week before the Senate Permanent Subcommittee on Investigations, were traders.

Cohan points out that the Goldman executives were unable to define what their responsibilities were toward their clients. I heard answers like: “Our responsibility is to ‘serve’ our clients well.”

I would ask if they were thinking of ‘serving’ up a pig roast.

Cohan quotes Blankfein to emphasize how grotesque the testimony became:

"There are parts of the business where you’re a money manager, where you owe a duty to the client,” Blankfein said. “There are parts of the business where you are a principal and you are giving the client what it wants and it’s understood — where you have to know that they’re suitable, you have to know that the product you do delivers what they expect to have. But the markets couldn’t work if you had to make sure it was good for them.”

Cohan’s retort: Say what?

Goldman is a Hedge Fund

Here is the problem: Goldman is primarily a hedge fund, not a bank. In the quarter ended March 31 (results released April 20) net revenues for investment banking (financial advisory, equity and debt underwriting) totaled $1.18 billion. Net revenues for trading and principal investment totaled $10.25 billion. Goldman is 10% investment banking and 90% hedge fund. As a Federal Reserve member bank (since the autumn of 2008) it is a hedge fund with access to the ZIRP (zero interest rate policy) largess of the Fed via the member bank discount window. The broker-dealer (B-D) function for Goldman is a small corner of the trading and investment business. Goldman also has a larger global business known as Goldman Sachs Prime Brokerage.

Broker-Dealer Potential Conflicts of Interest

The broker-dealer position is rife with potential conflicts of interest, but failing to disclose these is not illegal. The standard required by law is that broker-dealers (B-Ds) must assure that the investment sold is suitable for the client's circumstances. There is no fiduciary responsibility for B-Ds by law. Therefore, there are few disclosure requirements by the B-D.

There are disclosure requirements for the client because the B-D is required to justify suitability for each investment. The B-D is required to ask the client for information about assets, liabilities, net worth, expenses and income. Sanctions of the B-D can and do occur when there is not diligence in asking for client information or for selling investments that are not “suitable” based on client information obtained.

The B-D can be held responsible, using a hypothetical example, if it puts a pension fund in speculative stocks with no dividends when the fund has monthly pension cash flow requirements. The B-D has no legal liability if it puts the same pension fund in a CDO investment like Abacus 2007 AC-1 which has more than enough cash flow to support the pension cash flow requirements. The B-D has no liability because the vehicle is AAA at the time of sale, even if the B-D is 100% short the position sold.

If the B-D had a fiduciary responsibility, all positions held in a security sold would need to be disclosed. Fiduciary responsibility is a much more client friendly condition than is suitability responsibility. Of course, it also constrains the activities and profit opportunities of the firm. FINRA (Financial Industry Regulatory Authority, an industry self-regulatory organization) has resisted for years the imposition of a fiduciary responsibility on its members, all the way down to the registered representatives who deal with individual retail investors.

Goldman Doesn’t Hide

The following is from Goldman’s Brokerage disclaimer statement:

Many of the products described herein involve significant risks, and the user should not enter into any transactions unless the user has fully understood all such risks and has independently determined that such transactions are appropriate for the user. Any discussion of risks contained herein with respect to any product should not be considered to be a disclosure of all risks or a complete discussion of the risks which are mentioned. The user should not construe any of the material contained herein as business, financial, investment, hedging, trading, legal, regulatory, tax or accounting advice, and the user should not act on any information in this service without consulting its independent business advisor, attorney, and tax and accounting advisors concerning any contemplated transactions.

The disclaimer is much briefer in Latin: Caveat Emptor.

Possible Legislative Action

There is now a renewed effort in Congress to impose a fiduciary standard on broker-dealers. Fawn Johnson, of Dow Jones Newswires reports at Nasdaq.com that Sen. Robert Menendez (D., N.J.) wants to offer an amendment to a financial overhaul measure that would raise broker-dealer standards to match those for investment advisers. Johnson also writes that SEC Chairman Mary Schapiro has been pressing lawmakers to mandate a uniform fiduciary standard of conduct for all financial services professionals who provide securities investment advice to investors. FINRA (Financial Industry Regulatory Authority), the industry self-regulatory organization for broker-dealers, has long fought to support the right of their representatives to provide investment advice while being exempt from the requirements for fiduciary responsibility of investment advisors as required by the Investment Advisors Act of 1940. To date FINRA has been successful, in spite of being strongly opposed by other organizations such as the Certified Financial Planner Board of Standards.

One reason for lack of action in the past may have been because the public has had little understanding of the different standards applied to registered representatives with broker-dealers and registered investment advisors. Perhaps the current spotlight will change that.

Disclosure: No positions