GS Fraud (continued)

http://www.latimes.com/business/la-fi-hiltzik-20100516,0,770128.column
latimes.com

Investment banks aren't required to act in clients' best interest

Goldman Sachs' conflict of interest might have been evident to buyers if they had been dealing in plain-vanilla securities, rather than the tutti-frutti mishmash Goldman helped concoct.

Michael Hiltzik

May 16, 2010


At a congressional hearing a couple of weeks ago, Sen. Susan Collins of Maine asked a lineup of current and former Goldman Sachs executives a simple question: Did they have a duty to act in their clients', not their firm's, best interest?

The query elicited some impressive verbal contortions. "I believe we have a duty to serve our clients well," one witness replied to the Republican senator. "It's our responsibility . . . in helping them transact at levels that are fair market prices and help meet their needs," said another. "Conceptually it seems like an interesting idea," said a third.

The witnesses could have avoided their discomfiture by sticking to the simple truth. The correct answer to the question of whether investment bankers have a duty to act in their clients' best interest is "no."

We may have put our finger here on one of the major problems with the state of our financial rules and regulations. Investment bankers and their professional cousins, broker-dealers, don't generally owe what's known as a "fiduciary duty" to their clients under federal or state laws (New York's state law is what normally applies).

Efforts in Washington to expand the fiduciary rule beyond its existing application to registered investment advisors have been consistently fought off by Wall Street and the insurance industry. But a new effort to add it to the financial reform bill now being debated by Congress is being mounted by Sen. Ted Kaufman (D-Del.), among others.

Acting in a client's best interest wasn't a burning issue in simpler times, when investment bankers raised capital for their clients through stock or bond offerings, and brokers brought buyers and sellers together for deals in conventional securities. Everyone knew where the dividing line ran between the client's interest and the firm's interest, and how to stay on the right side.

Those days are past. In 2001, Goldman Sachs reported pre-tax earnings of $719 million from investment banking (helping clients raise capital), $2.1 billion from providing brokerage services and $1.2 billion from trading.

Last year, it reported $1.3 billion from investment banking, $1.3 billion from brokerage and $17.3 billion from trading. Anyone detect a trend line there?

A great deal of that trading involved derivatives, which are financial instruments so esoteric that their buyers' and sellers' investment goals, and even the size of their holdings, can be concealed.

"Conflicts of interest have been exponentially exacerbated by the rise of derivatives trading," says John C. Coffee Jr., a Columbia University law professor who recently testified before Congress on the need to tighten fiduciary rules on Wall Street. "Investment banks are no longer in the old world of raising capital. Now you can have a party in a transaction who wants the price to go down."

There's nothing wrong with taking a negative view of the market. Nor, when you're buying or selling, is there anything wrong with obscuring what you really think an asset is worth — skill in doing so is what makes some people better dealmakers, or salespersons, than others.

The problem arises when the broker or banker is the creator of the asset or the deal, and misleads clients about what he thinks is its true nature or true value. This is the sort of thing the Securities and Exchange Commission has accused Goldman Sachs of doing when it marketed a billion-dollar investment linked to subprime mortgage securities without divulging that the deal had been partially crafted by a client who wanted the package to fail.

In that case, the SEC said in its lawsuit over the so-called Abacus deal, Goldman yoked its fortunes to one client at the expense of another. The firm's conflict of interest might have been evident to the buyers if they had been dealing in plain-vanilla securities, an SEC official said, rather than the tutti-frutti mishmash Goldman helped concoct.

That's just the latest example. In 2008, New York Atty. Gen. Andrew Cuomo and the SEC extracted settlements worth more than $50 billion from Bank of America, Goldman Sachs and other institutions over their sales of auction-rate securities. These were investments the banks suggested were as liquid as cash or money-market funds, until the banks pulled the rug out from under the auction-rate market, rendering the securities about as liquid as concrete.

There's no dearth of evidence that Wall Street's definition of "conflict of interest" has gotten looser over the years, like an old sweater stretched hopelessly out of shape. Investment firms' growth strategies call for them to be in so many businesses at once that it's almost inevitable that one department is undermining the interests of the clients of another.

Sometimes the firms admit this is troubling, sometimes they say it's progress. In his testimony, Coffee cited a famous observation by Jack Grubman — who played the dual role of telecom dealmaker and "independent" telecom stock analyst at Salomon Smith Barney during the go-go 1990s — that "what used to be a conflict is now a synergy."

Advocates of extending the fiduciary rule to brokers and investment bankers say the goal is to reacquaint them with traditional morality. Fiduciary duty is not always easy to define, but lawyers often cite the words of Supreme Court Justice Benjamin Cardozo, who described it in 1928 as "not honesty alone, but the punctilio of an honor the most sensitive."

They also maintain that the "suitability" or "know your customer" standard customarily applied to brokers and bankers isn't enough anymore. That rule is designed to keep brokers from putting customers into deals they can't afford or can't understand — like selling an options straddle to an elderly widow, say.

The suitability rule wouldn't stop Goldman Sachs from selling a bucket of subprime mortgage investments to a supposedly sophisticated major European bank with billions in assets, as it did in the Abacus deal. But a fiduciary standard might lead the firm to think twice before forgetting to mention that some of the securities involved in the deal might have been picked because they were expected to lose money.

Not everybody thinks a fiduciary standard will work. "Fiduciary rules are much too vague to have a deterrent effect," says Larry Ribstein, a law professor at the University of Illinois, who testified at the same hearing as Coffee. "They're too nebulous to apply across the board in a statute that applies to the spectrum of relationships" in the financial industry. He says that's particularly true if, as Congress is contemplating, you're going to impose criminal penalties for violations. "There you have a special need to be clear."

Ribstein also contends that applying fiduciary standards to investment bankers would be solving a problem that doesn't exist. If Goldman Sachs withheld from its Abacus clients information it should have disclosed (as the SEC contends), that's fraud, and laws exist to punish it.

Coffee responds that any new law can give financial regulators the power to define how fiduciary rules should apply in any given category of transactions. "Any time you come up with a new statutory scheme you can imagine problems," he told me. "But this is a way for the SEC to get a handle on the growing problem of conflicts of interest."

Banks make a profit trading 61 days in a row

http://www.nytimes.com/2010/05/12/business/12bank.html?ref=business
4 Big Banks Score Perfect 61-Day Run
By ERIC DASH
It is the Wall Street equivalent of a perfect game of baseball — 27 up, 27 down, the final score measured in millions of dollars a day.

Despite the running unease in world markets, four giants of American finance managed to make money from trading every single day during the first three months of the year.

Their remarkable 61-day streak is one for the record books. Perfect trading quarters on Wall Street are about as rare as perfect games in Major League Baseball. On Sunday, Dallas Braden of the Oakland Athletics pitched what was only the 19th perfect game in baseball history.

But Bank of America, Citigroup, Goldman Sachs and JPMorgan Chase & Company produced the equivalent of four perfect games during the first quarter. Each one finished the period without losing money for even one day.

Their showing, disclosed in quarterly financial filings, underscored the outsize — and controversial — role that trading has assumed at major financial institutions. It also drives home the widening lead that a handful of big banks are enjoying over lesser rivals on post-bailout Wall Street.

Experts said it would be difficult to repeat such a remarkable feat this quarter. Even so, the performance could feed the debate in Washington over the role of proprietary trading at banks, as well as sometimes conflicted roles banks play as market makers in matching buy and sell orders.

Risk management experts said the four banks, as well as other Wall Street players, reaped big rewards without necessarily placing big bets that stocks or bonds would go up or down. Instead, they mostly played matchmaker, profiting from the difference between the prices at which clients were willing to buy and sell. Banks said that customer order flows were particularly strong during the period.

“This is not about hitting home runs,” said Jaidev Iyer, who runs his own risk management consulting firm, J-Risk Advisors. “This is just, as we call it, milking the market and your captive client base.”

Still, the quarterly showing was highly unusual. Bank of America said that its trading revenue surpassed $100 million on 26 days, or almost 43 percent of the 61 trading days in the first quarter. It was the first time Bank of America had a perfect quarter since acquiring Merrill Lynch in early 2009.

JPMorgan said that its trading revenue hit $90 million on 39 days during the first quarter, and exceeded $180 million on nine days, or about 14 percent of the time.

A JPMorgan spokesman said the last time the bank had a perfect run was the first quarter of 2003. “The high level of trading and securities gains in the first quarter of 2010 is not likely to continue throughout 2010,” Morgan said in a regular filing with the Securities and Exchange Commission this week.

Goldman Sachs — which is fighting an S.E.C. suit claiming the bank defrauded customers on a complex mortgage investment — posted its first perfect quarter ever. Goldman made at least $100 million on 35 days during the quarter, and at least $25 million on the remaining trading days.

In the wake of the S.E.C. suit, Goldman’s role as a market maker has come under scrutiny on Capitol Hill. It has staunchly defended its business practices and said it had done nothing wrong.

Gary D. Cohn, Goldman’s president, said Tuesday that the standout quarter highlighted the strength of the trading that Goldman executed for its customers, particularly its fixed income, currency and commodities unit, known as FICC. “Our FICC and equities businesses are largely global market-making businesses where we intermediate flows and commit capital and liquidity and in the process generate revenue including bid-offer spreads,” Mr. Cohn said at a UBS conference in New York. “These franchises create numerous opportunities for the firm.”

Citigroup also had a loss-free first quarter, according to a person briefed on the situation. The bank discloses its trading performance on an annual basis, but big daily losses have been a regular occurrence over the last few years. In 2008, it lost $400 million on 21 of its 260 trading days.

This year, even those that lost money from time to time, performed very well during the quarter. Morgan Stanley said its losses reached as much as $30 million only four days in an otherwise profitable quarter. A Morgan Stanley spokesman said the firm’s last perfect run was the second quarter of 2007.

Given the recent turmoil, last quarter’s strong showing will be hard to replicate. In 2009, the banks posted losses on less than 20 percent of the trading days; during the turmoil of 2008, losses occurred as much as 40 percent of the time.

“It was pretty smooth sailing last quarter,” said William Tanona, an analyst at Collins Stewart. “I would be very surprised to see history repeat.”