Goldman Sachs is the bank everyone loves to hate. In the first of our two-part investigation into the bank, we ask why they emerged as the biggest winners in the financial crisis. We also look at how they lobbied the US Government to reduce banking regulations, how they acquired massive fortunes by selling sub-prime mortgages, and how they deceived their clients by betting against the products they sold.
Don't Forget To Read The Second Part Of Our Feature: Into The Belly Of The Beast (Part II – Goldman Sachs & The European Crisis)
Goldman Sachs was not always the investment bank everyone affects to despise. Its bankers were once dubbed “billionaire boy scouts” because of their talent for making fortunes while maintaining a guilt-free, cherubic image.
But Goldman’s bankers are now far more likely to be compared to squids than boy scouts and have become the favourite target of anti-bank protestors. A week before Christmas, 300 protesters in the Occupy Movement dressed up in squid costumes and carried a giant puppet squid on a march to Goldman Sachs’ offices in New York.
The action was inspired by a Rolling Stone article which compared Goldman Sachs to: “a great vampire squid, wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money”. The protesters shouted: “We fry calamari”, and “everyone pays their tax. Everyone, but Goldman Sachs.”
Public hatred of Goldman, fuelled by modern mass media, has intensified, but it would be naive to believe the banks’ character has fundamentally changed. Although there was nothing on the same scale as its nefarious role in the 2007 Financial Crisis, Goldman has been involved in controversy ever since it was founded by the German-born Jew Marcus Goldman in 1869. In 1929 for example, Goldman sponsored a pyramid scheme disguised as a mutual fund, which collapsed causing 42,000 investors to lose US$300 million. Then, in 1970, came the Penn Central catastrophe in which a default on short-term paper marketed by Goldman produced damage claims exceeding the bank’s net worth. In the late 1980s, Goldman’s head of risk arbitrage, Robert Freeman, was sent to jail for insider trading. And during the same period, Goldman was implicated in an illegal scheme to prop up insolvent businesses operated by the corrupt Czech-born newspaper tycoon Robert Maxwell.
“The reality is that the firm has been in and out of trouble throughout its whole existence and has constantly been pushing the edge of the envelope,” said William D. Cohan, a former investment banker and the author of Money and Power: How Goldman Sachs Came to Rule The World.
Cohan marvels at the hypocrisy embedded in Goldman Sachs’ 14 Business Principles, which were codified in the 1970s and are still being drummed into brainwashed employees’ heads today.
“They make the general public think they believe in them, but the most important principle is ‘putting the client first’, whereas the reality is they are in business to make money and will do it any way they have to,” he said.
Cohan believes the 14 principles are at the heart of what he calls Goldman’s ‘holier-than-thou attitude’.
“At Merrill Lynch, we had principles scratched into the wall, but never gave them a moment’s thought. But at Goldman they write them down, distribute them and reinforce them regularly. There’s an element of ‘drinking the Kool-Aid’ when you join Goldman and most of them fall for the brainwashing. They get people young so they can mould their thinking. “
“To give an example of the Goldman mindset, I was giving a talk recently to 250 New Yorkers and a Goldman Sachs banker stood up and loudly berated me for daring to suggest they were not all saints.”
Suzanne McGee, a journalist and author of Chasing Goldman Sachs, believes there was a change in the bank’s status in the 1970s.
“For most of its 200-year history Goldman wasn’t the force it is today. It transformed itself in the 1970s, which was a turbulent period when some firms thrived and others withered on the vine. Goldman was one of the most innovative banks and by the mid-1980s it was positioned to be a power house,” she said.
“What interests me historically is how Goldman changed from being the firm everyone might not like, but admires, to the firm everyone affects to despise. Up to the 1990s, their reputation was very high. In that period, if an IPO was underwritten by Goldman Sachs that was akin to Good Housekeeping’s sales approval. They were believed to have the X-factor, which meant they could outperform everyone else in every way. This reputation was so strong that in the late 1990s their bankers were banned from carrying bags with Goldman Sachs logos on when they took flights to conferences. The bosses were afraid they’d tip off rival traders.”
“But that mainly positive reputation has gone since the financial crisis. Goldman Sachs’ workers still don’t carry bags with logos, but now it’s because they might get beers poured on their heads, or someone might pick a fight with them!”
While McGee expresses a grudging admiration for the financial acumen of the Goldman elite, she is under no illusion that they follow the ‘do what’s best for the client’ principle to the letter.
“Someone at another bank said that when Goldman comes with a deal the first question you ask should not be ‘will they screw me’? It should be ‘in which way will they try to screw me’? Other banks are the same, but Goldman is far better at it than anyone else”.
Just how much better became evident in 2007, when the US housing bubble burst and the nation was plunged into its biggest financial crisis since the Great Depression. The fall-out for America’s financial sector was huge. Lehman Brothers filed for bankruptcy, IndyMac bank collapsed, Bear Stearns was acquired by JP Morgan Chase, Merrill Lynch was sold to Bank of America, and mortgage giants Fannie Mae and Freddie Mac were put under government control. Meanwhile, although Goldman helped to provoke the crisis, it made billions of dollars out of it by taking out huge bets that the mortgage market was about to crash. The firm went on to earn US$11.6 billion in 2007, more than Morgan Stanley, Lehman Brothers, Bear Stearns and Citigroup combined. Merrill Lynch lost US$7.8 billion that year.
The United States Senate’s 2011 Levin–Coburn Report found:
“The crisis was not a natural disaster, but the result of high risk, complex financial products; undisclosed conflicts of interest; and the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street.”
Goldman Sachs CEO Lloyd Blankfein even apologized in 2008 for his bank’s role. “We participated in things that were clearly wrong and have reason to regret,” he confessed.
But the apology was meaningless, according to William K. Black, an American lawyer, author and former bank regulator, who has testified against the banks. Black believes Goldman knew precisely what it was doing and was operating according to a well-known formula in the financial world. If he had his way, Black says he would send Goldman’s bankers into the fourth circle of Hell – which is reserved for the avaricious - in Dante’s inferno.
“Goldman, and other investment banks, behaved fraudulently in order to earn massive amounts of money,” Black said. “There were four ingredients in their foolproof fraud recipe. 1. Grow like crazy. 2. Make really crappy loans at a premium yield. 3. Have extraordinary leverage. 4. Make virtually no allowances for future losses.”
“If you do those four things, you are virtually guaranteed to report record off-the-chart short-term profits. We’ve known this in economics since a 1993 paper by Akerlof and Rohmer called Looting The Economic Underworld of Bankruptcy for Profit. Even if a firm fails, the CEO and all the other folks will walk away wealthy. It’s maths; a sure thing!”
The first two elements of the formula, Black says, are related. A bank grows like crazy by making “crappy loans”. Good loans would not work because a bank would have to buy market share, cutting its yields.
“But there are tens of millions in the US who cannot afford to repay a loan to buy a house. Precisely because they can’t, the bankers can charge a premium yield and can grow like crazy. Into the teeth of this glut, they created the largest bubble in the history of the world.”
The Largest Bubble In The History Of The World
“There’s a saying in the trade that ‘a rolling loan gathers no loss’. Saving the firm is not the issue. It’s about individualised profit opportunities. With massive executive compensation, you can become fabulously wealthy in two years. But if you get the bubble to hyperinflate, you can keep it running for six or seven years,” said Black.
Black argues that this fraud recipe has been facilitated by the neo-classical view of economics prevalent in the US and Europe. “Unsurprisingly, these were the epicentres of the global crisis. We have created a criminogenic environment through the three Ds – deregulation, de-supervision and de facto decriminalisation through executive compensation.”
The deregulation and de-supervision of the banks is largely a story of Goldman Sachs – and its allies – lobbying government to win the competition in laxity with the world’s other great financial centres.
Related: Does Wall Street Own Obama?
“In the US, they argue that jobs will go to the City of London unless we let the banks have their way. It’s manipulative bullshit and as soon as you accept it as a framing you’ve lost as a regulator. They will do everything they can to reinforce it. They will say ‘There is no alternative, you are naive if you think anything else’.”
Goldman lobbied for decades to regulate itself and gradually the restraints on banks were loosened. Banks used to be monitored by the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Office of Thrift Supervision. Officials probed bank loans and referred suspicious behaviour to the Justice Department.
William K. Black was senior deputy chief counsel at the Office of Thrift Supervision in 1991 and 1992, the last years of the Savings & Loans crisis, which was like the 2007 crisis but smaller. At that time, there were thousands of criminal referrals and hundreds of convictions.
The regulatory controls began to slacken in the mid-nineties when former Goldman co-chairman Bob Rubin served as Bill Clinton’s senior economic-policy adviser. Gradually, the US moved toward a system of voluntary compliance by banks. As a result, referrals by regulators dropped from 1,837 in 1995 to 72 in 2007.
The next significant year in the loosening of regulations was 2004, when the banks persuaded the US Government to create a voluntary approach to regulation called Consolidated Supervised Entities. One of the most influential figures behind the move was Hank Paulson, Goldman’s then CEO. The banks won the right to lend virtually unlimited amounts regardless of cash reserves. This lax approach led directly to the financial crisis as get-rich-quick investment banks recklessly lent 35 dollars for every one in their vaults.
The Achilles heel to the fraud recipe Black describes is that no one really knows when the bubble will burst. Some of the banks which bet heavy, such as Lehman Brothers, paid the price. But Goldman Sachs - demonstrating once again that its bankers are the most highly skilled on Wall Street - saw the dangers and bailed out in time, making billions of dollars in the process.
In 2005, Goldman began using swaps to limit its exposure to risky sub-prime mortgages. The details of its swaps trades are secret, except for US$20 billion it bought from AIG in 2005 and 2006 to cover mortgage defaults, or ratings downgrades on subprime-related securities.
Goldman’s mortgage traders also bet heavily against the housing market on a sub-prime index in London and by February 2007, Goldman had veered from betting US$6 billion on mortgages to betting US$10 billion against them.
The swaps contracts, especially the ones with AIG, would net massive profits. When Goldman’s securities lost value in 2007 and early 2008, the firm demanded US$10 billion, of which AIG paid $7.5 billion. AIG suffered an enormous drain on its finances, which led to the taxpayer bailout in 2008 to prevent worldwide losses. Goldman’s payout from AIG’s taxpayers’ money was more than US$8 billion.
But there were massive conflicts of interest as Goldman continued to sell junk sub-prime bonds to clients as AAA rated products despite taking out massive bets against them. The names of the deals Goldman used to clean its books — such as Hudson and Timberwolf — have gone down in banking history.
In the Hudson deal, Goldman claimed to have aligned its interests with its client after buying a US$6 million, but that was a paltry sum compared to its secret US$2 billion bet against the market. In the Timberwolf deal, Goldman kept an Australian hedge fund called Basis Capital in the dark about its counter bets. The fund invested US$100 million in 2007, and almost immediately fell apart financially.
The most famous example of conflict came when Goldman was paid US$15 million to construct a security but did not disclose that the person paying them, John Paulson, was betting against it. Investors in this Collateralized Debt Obligation (CDO) lost US$1 billion, while billionaire investor John Paulson made US$1 billion.
William K. Black regards Goldman’s behaviour as fraudulent. “The Levin report said they misled their clients and misled Congress. Mislead is another word for deception which is the core principle distinguishing fraud from other crimes. It’s a betrayal of trust, but selling mistakes to customers is actually the standard policy of investment banks. It’s actively pushed from the top.”
A huge bullhorn comes on and tells them ‘shift the following crap onto your customers’,” he said.
Cohan disagrees with Black, however.
“The Levin report was damning, but the problem is not what’s illegal, but what’s legal. It was really unethical to continue selling the mortgage- backed securities throughout 2007 whilst making huge bets against the market. But they didn’t do anything illegal, and the reason they didn’t is because they wrote the rules and laws by which they lived.”
”They are a perfect embodiment of the values of American society – of freewheeling Darwinian capitalism,” he said.
The consequences of investing in Goldman’s trashy products were drastic for many funds. One of the worst hit was California’s public employees’ retirement system, known as CALPERS, which bought US$64.4 million in sub-prime mortgage-backed bonds from Goldman in March, 2007, by which time Goldman was busy betting the other way. By July, CALPERS listed the bonds’ value at US$16.6 million, a drop of nearly 75 percent.
“Goldman would argue they were not betting against clients, but that these funds are counterparties,” said Suzanne McGee.
“Goldman would say ‘they know the game and we don’t have the same fiduciary duty to maximise profits as we do to our shareholders, or to clients who ask us to invest their money’. It’s important to understand that Goldman Sachs’ best customer at the end of the day is itself.”
Read Part Two Of Our Feature On Goldman Sachs where we look at Goldman’s networks of power in Europe. We consider the ways in which Goldman is using the same dangerous financial products, which caused the 2007 crisis to bet against Europe’s floundering economies whilst at the same time governing, or advising those countries. Finally, we ask what can be done to reduce Goldman’s power.
Get more special features from the world's top economists in your inbox. Subscribe to our newsletter for alerts and daily updates.