Elephant Tears

Of all the Wall Street firms that have been attacked and hated since the financial crisis began, the one that has consistently provoked the most opprobrium is Goldman Sachs. Long before Occupy Wall Street, in July 2009, Matt Taibbi of Rolling Stone called it ‘a great vampire squid wrapped around the face of humanity’. He not only blamed Goldman for the housing bubble, but implied that it had survived the crash only because of its undue influence in high places: Henry Paulson, its former CEO, was Bush’s treasury secretary. Since then the firm has suffered one public relations disaster after another, culminating in a $550 million out-of-court settlement to avoid prosecution for fraud by the Securities and Exchange Commission. William Cohan’s Money and Power: How Goldman Sachs Came to Rule the World is the most substantial of several recent books about the company. Perhaps out of fear of more bad publicity, Goldman thought it wise to co-operate with him, and Cohan has interviewed many company executives, past and present. The result is a history that, unusually, avoids both hysteria and adulation.

The story of the rise of Goldman Sachs is at once remarkable and commonplace. It is certainly an achievement for a banking firm to grow over a century and a half from a one-man operation set up by an immigrant German-Jewish cloth trader into a multinational which employs 35,000 people and made a profit of almost $40 billion in 2006. Yet a similar story could be told about many very successful businesses. One of the more striking aspects of Goldman Sachs is that for most of its history it barely featured in the news. It was a successful Wall Street institution, but its clout didn’t compare to that of J.P. Morgan or its successor in investment banking, Morgan Stanley. In 1947, Goldman’s partners were perversely pleased to be included in the massive antitrust lawsuit brought by the US government against 17 major Wall Street firms for colluding to maintain high fees for securities underwriting. Not to have been on the list would have implied that the firm was of little significance. Very occasionally, Goldman Sachs made a splash by landing some extraordinary coup, as in 1956, when it managed the first public offering of Ford Motor Company shares. But most of the time its business activities were well below the threshold of public interest.

In 1929, however, seduced by the mirage of ever rising stock prices, Goldman strayed from its traditional underwriting business and was among the worst culprits in inflating the Wall Street bubble. Its investment fund, the Goldman Sachs Trading Corporation, was a masterpiece of leverage applied to irrational exuberance. In a period of just nine months an original investment of $1 million had become a pyramid of funds with a market value of $1.7 billion. As J.K. Galbraith wrote, the Goldman creation ‘was to stand as the pinnacle of new era finance. It is difficult not to marvel at the imagination which was implicit in this gargantuan insanity.’

The Trading Corporation collapsed, its share price falling from $326 to $1.75. The firm’s own losses ran to $13 million, and it faced a spate of lawsuits from investors who had lost hundreds of millions; it’s remarkable that it did not go the way of Lehman Brothers in 2008. That it survived is due to the fact that in those days Goldman Sachs, like other Wall Street firms, was a partnership in which the partners assumed unlimited liability for all the business’s debts.

After the Crash, the Sachs brothers, who had been in charge after Henry Goldman’s retirement, reasserted control to get rid of their discredited senior partner, Waddill Catchings. The firm gradually regained its reputation, mostly because its new senior partner, Sidney Weinberg, focused strictly and successfully on investment banking services for the US’s largest companies. The Ford share offering of 1956, the largest yet in history, was the high point of his reign. He was succeeded in the 1960s by Gus Levy, a trader by background, who represented a new and in hindsight disturbing trend on Wall Street: firms began to derive most of their profits from taking risks with their balance sheets rather than providing investment banking services.

Under Levy, a second crisis threatened to destroy the firm. In 1969, Goldman started placing short-term debt for Penn Central, which had just been formed through the merger of two loss-making railroads. As an SEC investigation later revealed, Goldman learned early in 1970 that Penn Central’s financial position was deteriorating. It reduced its own exposure to the company to zero, while it continued selling Penn debt to investors without letting them know its true opinion of the risks. Penn Central filed for bankruptcy in the summer of 1970, and the disclosure of Goldman’s behaviour resulted in a wave of lawsuits by furious investors. Goldman denied that it had any legal obligation to vouch for the soundness of the paper it sold, but this did not stop it losing a number of court cases and coming to expensive out-of-court settlements with other clients. Given that the amount of defaulted paper was nearly twice Goldman’s capital, the firm’s survival was once again at risk. This time it was saved by the huge real estate assets of the railroad, which yielded a decent return to creditors when they were sold.

Levy died suddenly in 1976, and Sidney Weinberg’s son John took over as senior partner with John Whitehead. Both were investment bankers rather than traders, and it was Whitehead who attempted to carve in stone the firm’s code of business practice with his 12 (later 14) principles: the Goldman Way, as it came to be called. His first rule, still present on the company’s website, was: ‘Our clients’ interests always come first.’ In the light of the Penn Central scandal, this principle looked as if it had been mostly honoured in the breach.

It was in the 1980s that the profitable but relatively staid world of investment banking began to take off. In 1970, Goldman had $49 million in capital. Now it has in excess of $70 billion – an increase of more than 1400 times. In the meantime, the GDP of the United States has risen by 14 times. The reasons for the exponential growth of finance are disputed. It has been claimed that the increasing use of borrowing is an inevitable part of economic growth, and that the rise of global finance is necessary to sustain a globalised world economy. A more sceptical view is that much of the recent economic growth in the West is illusory, since it is based on the higher and higher levels of debt made possible by ill-conceived deregulation and financial experimentation.

Goldman Sachs grew extraordinarily fast while retaining its partnership structure, which prevented it from raising outside equity and left it with the constant threat of loss of capital through the withdrawal or death of its partners. By the late 1990s it was the only major partnership left on Wall Street: its rivals had either gone public or been absorbed by larger banks. By the time Goldman itself went public in 1999, its capital had swelled to more than $6 billion, almost exclusively through internal growth. Going public allowed a further exponential leap in capital and profits. But such growth could not be fuelled simply through the traditional business of investment banking: it involved taking ever greater risks with the firm’s own capital. In 1970, Goldman’s assets were 6.5 times its capital. By the 2000s this had risen to 30 times, and like most other investment banks, Goldman was essentially operating as a hedge fund for its own account, while simultaneously providing services for its clients.

There were two problems with this model, both of which became apparent in the financial crisis. The first was that so much leverage meant that banks were highly vulnerable to any fall in the value of their assets. It was this that sank Lehman Brothers, Bear Stearns and Merrill Lynch. Goldman survived not because it hadn’t been part of the bubble but because its risk management department, considered the best on Wall Street, woke up to the looming crisis just in time. The company was able to hedge or sell off its bulging portfolio of subprime loans just before the crash.

In order to do so, Goldman had to operate in secret, since it would otherwise have provoked the market collapse it was attempting to pre-empt. But this secrecy inevitably created a conflict of interest with its customers, to whom it was still attempting to sell its portfolio of dodgy mortgages. Goldman continued to package and sell mortgage-backed securities until the summer of 2007, when the collapse of two Bear Stearns funds finally set the whole subprime house of cards tumbling. The lawsuit brought by the SEC in 2010 accused Goldman of selling securities that they knew would fail and then betting against them. It attracted enormous public attention, not just because of Goldman’s name but also because of the emails exchanged between ‘Fabulous’ Fabrice Tourre and his girlfriend, in which he alternated between denigration of the ‘monstrosities’ he was selling and titillating intimacies. Goldman’s defence was that its customers weren’t widows and orphans but sophisticated institutions that simply took a different view of the market. Nonetheless, it thought it best to settle out of court for a record sum, part of which, at least, trickled back to RBS, whose ill-fated acquisition of ABN AMRO, which had provided credit insurance to Goldman, had landed it with losses of $840 million.

The most immediate question that arises from this story is whether it’s possible to combine trading and investment banking operations on such a scale without running into insoluble conflicts of interest. Goldman claims that it ‘manages’ conflicts by erecting ‘Chinese walls’ between departments, but Cohan quotes several bankers and investors who think this is nonsense. ‘A lot of their basic business model should be illegal,’ one of them said. ‘They view information gathered from their client businesses as free to them to trade on … against the client [or] against other clients.’ Given that Goldman’s income from trading now averages more than four times its income from investment banking, it is easy to see the size of the problem. It’s also easy to understand the highly vocal opposition of bankers to the prohibition of all trading except on behalf of clients, as proposed by Paul Volcker, the former chairman of the Federal Reserve.

Cohan gives plenty of space to Goldman employees to justify (or incriminate) themselves, as well as to outsiders. His extensive interviews with most of the major players convey a vivid and not always appealing impression of life in the firm. We learn that in emails Goldman employees use ‘$$$’ to mean money, and that ‘LDL’ means ‘let’s discuss live’ when an issue is too sensitive to leave a digital trace. The company emphasises the importance of team spirit and has a low-key, almost puritan style. Yet the competition is ruthless and emotions run high. When John Corzine was replaced as chief executive by Paulson in a palace coup in 1998, one colleague said, ‘there were elephant tears and vomiting and things like that. But he got the message. He was very unhappy, but he took it like a man.’

The book fails, however, to address the issue raised by its subtitle: ‘How Goldman Sachs Came to Rule the World’. Cohan mentions the substantial number of former Goldman executives who have gone on to high places in government since the mid-1980s. But apart from the unresolved question of whether Paulson favoured his old firm when he bailed out AIG – which passed $14 billion of the money it got on to Goldman – while letting Lehman Brothers fail, Cohan doesn’t discuss any other example where Goldman can be seen to have gained anything more than improved access to the corridors of power through its alumni network, which also included such figures as Robert Rubin, Clinton’s treasury secretary. If Goldman Sachs’s omnipotence is more than a piece of marketing hyperbole, he should have looked a lot harder at this issue. As it is, there is some reason to believe that Goldman’s heyday may be over. Higher capital requirements and restrictions on trading activities, combined with anaemic economic growth are denting its profitability: in the last three months it lost money for only the second time since going public, and its share price is back to crisis levels. Lawsuits against the company abound, and it seems unlikely that another Goldman executive will be appointed treasury secretary any time soon.