Ben Stein on Goldman's Hatzius: Chinese Walls and Wall Street

In his missive in Sunday's New York Times, Ben Stein does what many would like to do: call out Goldman Sachs (GS) and introduce some tarnish to its shiny reputation. The thrust of Mr. Stein's argument is that one of Goldman Sachs' leading economic analysts, Jan Hatzius, basically put out a puffy "fear piece" that would ultimately benefit the firm's proprietary short positions in the housing sector. And he suspects even greater bad behaviors but you get the gist.

Now I don't have a problem with Ben or anyone else trying to expose misdeeds or shady dealing, but I do have a problem with an analysis that is economical with the truth and detached from the realities of a business model that is both heavily regulated and under constant scrutiny. Either Mr. Stein doesn't understand how Wall Street and the securities market work (unlikely) or he has a clear agenda and was in desperate need of a column for today's paper (somewhat more likely). Whichever it is, I believe he is way, way off, and trying to concoct conspiracy theories directed at Goldman is somewhat similar to those he is creating with his own puffy fear piece. Those who throw stones... right?

As I interpret it, Dr. Hatzius was saying that the financial system would possibly not be able to adjust to a level of financial losses that are large on an absolute scale but small compared with aggregate credit or the gross domestic product. He is also postulating that lenders would have to retrench so deeply that lending would stall and growth would falter — an event that, again, has not happened on any scale in the postwar world, except when planned by the central bank.

In other words, with the greatest possible respect to Dr. Hatzius, his paper is not really what I would call a serious overview of the situation. It is more a call to be afraid and cautious based on general principles that he embraces and not on the lessons of history. (In this respect, he is much like many economic journalists and commentators who sell newsprint by selling fear. The common cause of journalists and Wall Streeters in this regard is a subject I will address in the future.)

Ok, so Dr. Hatzius has a view, and given his credentials and his perch I'd say his view is probably worth considering. Just because his paper doesn't comport with Mr. Stein's view of the world doesn't make it wrong or its methodology flawed - it's just that Mr. Stein doesn't like it. That's fine. But one need not intuit evil intent because of it. Anyway, Ben goes on to ask the following question:

Why, then, is his document circulating? Perhaps as a token of Dr. Hatzius’s genuine intelligence, which is fine. But to me, his paper seemed like a selling document in the real Wall Street sense of selling — namely, selling short. (Dr. Hatzius notes that he has long been bearish on housing, since faraway 2006, but I respectfully note that that is a lot different from predicting a credit catastrophe. The spokesman for Goldman also noted the company’s bearishness on housing since 2006. He also noted that in the recent past, Goldman Sachs has moved to a considerably larger short posture and that the firm is net short.)

More thoughts came to me as I read a recent piece in Fortune by my colleague Allan Sloan, a veteran financial writer. Mr. Sloan traces the life and death throes of a Goldman Sachs-arranged collateralized mortgage obligation. He shows how truly toxic waste was sold to overly eager investors who now have major charge-offs, and he also points out that some parts of the C.M.O. were indeed safe and were either current or had been paid off.

But what leaps out at me from this story is that Goldman Sachs was injecting dangerous financial products into the world’s commercial bloodstream for years.

Ben, come on, you've got to be kidding me. He's setting the table for his conspiracy theory, the foundation of which is that not only that Dr. Hatzius is biased in his view because of his firm's trading book but that the firm itself has been engaging in destructive behaviors. Mr. Stein, CMOs, CBOs and all forms of ABSs have their place in the capital markets, increasing liquidity, re-allocating risk to those best able to accept it and supporting economic growth. The sub-prime mess does not, in and of itself, mean that pooled assets where participations are sold off to investors are bad. And his use of language and populist rhetoric severely dulls the strength of any argument he is likely to make from this point forward.

Further, there are walls between groups that underwrite securities and those that issue research, for the reasons we all now know so well (read: Blodget-gate). So the likelihood that a senior economist is putting out reports that would knowingly benefit the firm's positions and get paid for it is somewhat far-fetched, especially when the firm in question is Goldman Sachs. What firm would have more to lose from such a thinly-veiled ploy? I think they're a little smarter than that.

And then, 2/3 of the way into his discussion, Mr. Stein drops the bomb:

Here is my humble hypothesis, even after talking to Goldman: Is it possible that Dr. Hatzius’s paper was a device to help along the goal of success at bearish trades in this sector and in the market generally? His firm says his paper, like all of its economists’ work, was not written to support any larger short-trading strategy. But economists, like accountants, are artists. They have a tendency to paint what their patrons, who pay them, want to see.

If I were Dr. Hatzius, I'd be making a little Ben Stein voodoo doll and sticking it like a pincushion. And just when you thought Ben had only gone off the reservation, be took an express trip to another galaxy far, far away. Check out this line of argument:

Doesn’t this bear some slight resemblance to  Merrill selling tech stocks during the bubble while its analyst Henry Blodget was reportedly telling his friends what garbage they were? How different would it be from selling short the junky stock that your firm is underwriting? And if a top economist at Goldman Sachs was saying housing was in trouble, why did Goldman continue to underwrite junk mortgage issues into the market?

HERE is a query, as we used to say in law school: Should Henry M. Paulson Jr., who formerly ran a firm that engaged in this kind of conduct, be serving as Treasury secretary? Should there not be some inquiry into what the invisible government of Goldman (and the rest of Wall Street) did to create this disaster, which has caught up with some Wall Street firms but not the nimble Goldman?

Ok, now here is where my disbelief comes in. Wall Street firms are made up of separate groups. Walls are established among these groups where appropriate, particularly keeping those areas that touch clients separate from those that trade proprietary capital. So at any one time a firm may well have someone in research put out a "buy" rating (grounded in the logic and belief of the research team) on a security, while a prop trading desk elsewhere in the firm is already long a boatload of the issue.

Does this mean that because research issues a buy that no desk in the firm can own the shares? That is absurd. Contrary positions across large, complex firms abound, and Chinese Walls exist to specifically protect against the inappropriate flow of information. And in my experience, these walls tend to work quite well. Further, during my time at both Citi and Deutsche our economists and securities analysts' took positions that were either been helpful or hurtful to the positioning of our books, and it was what it was. There was no tip, no nod, no communication prior to the issuance of a report whatsoever.

So I find Mr. Stein's hypothesis both fascinating and fanciful, considering how smart he is yet how deranged his position happens to be.

And then further extending the witch-hunt to Mr. Paulson? Now, if both he and Dr. Hatzius are in on the scam to secretly help out Goldman, then why is Mr. Paulson trying to help the mortgage market with his support of the Super SIV, freezing ARM rates, etc., while his Goldman colleague is on the opposite side of the trade? Doesn't this logically run counter to Mr. Stein's contention? Maybe its me, but I feel like my affair with mainstream media is having a bad-hair week.

Comments

[c2]

You are missing the point.

Take the Stein piece out of the equation. Make it disappear, if you will. Then ask yourwself how would you justify GS selling toxic mortgage based crud at the same time that it shorted it?

Stein muddied the picture by discussing the Hartzius memo. The conflict of interest is the one I described.

The proper disclosure in an honest financial world [I fully know tht I am engaging in fantasy here] would requitre GS to sell the crud only after disclosing at the time of the sale or (even later, when it does go short on it], that it has taken a position directly contrary to its clients' interests.

You may well argue with me, but I believe that any party who got shafted by GS in this manner will remember and not ever do busines with it again. If I were an asset manager, I would definitely strike them off my list.

The market will take care of them. You cannt screw your clients and expect them to come back for more of the same.

[jswede]

What you describe as "crud" and "toxic" would be - at a different (lower) price - be called "speculative"... and to many a "good value". The market sets the price, GS is one player on one side of the market - it can't have any real effect on the price the market is willing to pay for securities that had rating agencys' independent opinions on its quality.

So a part of Goldman thinks the market was mispricing the securities -- and it acted upon that thought by shorting. The part that was securitizing and selling CMOs was only giving the market what it wanted - the best performing mortgage funds of the last 5 years were full of this stuff, and no one was complaining then.

The only thing GS did "wrong" was to be right on its shorts -- that was a propriatary trade and also involved risk - who is GS, or anyone else for that matter, to tell investors who supposedly know what they are doing that they (the investors willing to pay the price they did for securities), AND the rating agencies, are wrong?

What if GS was wrong on its shorts? What would Ben Stein's column say then? (I can bet who'd he be accusing.)

[c2]

I don't think you get my point.

There is an inherent conflict of interest in selling stuff to a client which is also being shorted. The client is bound to become resentful and will forever wonder whether there was manipulation involved. At the end of the day, a bad business practice because that client will no longer trust you.

There is always an element of trust involved in these transactions. Imagine that you are a client who takes the advice of your broker. You will be incredibly upset if you determine that he was taking a contrary position - and profiting mightily from it - at the same time.

At the end of the day, the only thing we have is our credibility. Goldman's has taken a hit for the sake of short term profits. I don't think that blithely suggesting that "one part" of Goldman's was doing doing this is going to correct the suspicion that it was doing something improper.

The fact that GS was in fact not wrong on its shorts says more about the acrid taste in the mouths of its clients than anything else. They were not wrong, and the speculation at the end of your message is therefore irrelevant as the perception will forever be that they were right because they knew something they did not disclose to their clients.

[c2]

I don't think you get my point.

There is an inherent conflict of interest in selling stuff to a client which is also being shorted. The client is bound to become resentful and will forever wonder whether there was manipulation involved. At the end of the day, a bad business practice because that client will no longer trust you.

There is always an element of trust involved in these transactions. Imagine that you are a client who takes the advice of your broker. You will be incredibly upset if you determine that he was taking a contrary position - and profiting mightily from it - at the same time.

At the end of the day, the only thing we have is our credibility. Goldman's has taken a hit for the sake of short term profits. I don't think that blithely suggesting that "one part" of Goldman's was doing doing this is going to correct the suspicion that it was doing something improper.

The fact that GS was in fact not wrong on its shorts says more about the acrid taste in the mouths of its clients than anything else. They were not wrong, and the speculation at the end of your message is therefore irrelevant as the perception will forever be that they were right because they knew something they did not disclose to their clients.

[huangjin]

I think it is more a question of groupthink. As Bernard Goldberg pointed out in his book on the media, the bias isn't conscious—it's just that everyone thinks the same way.

[RUGOLF]

The fact that you think Chinese Walls work removes all of your legitimacy. You must have been asleep at the wheel during your stated tours of Citi and DB (historically second rate ibanking firms I must say). When money is flowing, regulation gets weaker/goes away. (Read history my friend.) Follow the money and you can generally find your answer. Let's look at what happened post 2001 (after getting caught with hand in cookie jar). 2001 Operating Income: Ibanking $719 MM, Prop Investing $1,215MM....2006 Ibanking $1,576MM, Prop Investing $10,600MM Hmmm....which area has grown the most? GS realized that risk/reward profile of the research analyst conflict with ibanking clients could be dwarfed by moving up the chain. It is simple math.

[kurt walter]

Who gives a rip what Goldman Sachs says? I don't listen to any stock analysts. That crook, Blodget, showed what stock analysts are all about. With underwriting deals, the conflicts of interest are massive. Do your own research and ignore the hype from brokerage firms.

[hedgie1]

Everyone on wall street knows that Goldman's proprietary trading operarations really push the envelope when it comes to ethics. How else do you think Goldman has amassed huge short positions in the RMBS and CMBS markets they sold synthetic CDO's to customers (which don't require ownership of the underlying) and simply took the other side of the trade. I guarantee that their salesman were told to push these very complicated products hard to stupid plain vanilla managers. I have been trading derivatives for 15 years and I have no idea how to price these things, furthermore the data required to price them accurately is very hard to come by and virtually inaccessible for a medium sized manager (of course Goldman has the data). My experience with Goldman is whenever possible they will pursue the less transparent more complicated solution that ultimately screws over the customer. Once some more knowledgeable folks on Capital Hill figure out what is going on there is going to be hell to pay.