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From Now On Goldman Will Only Sell A Product To Clients If Some Goldman Partners Understand It

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I can't find the quote but I recently read someone arguing that you should never worry about anything you see on the news. By definition, the argument goes, horrible things that make the news are newsworthy, and they are newsworthy because they are rare, and so the odds of you dying in a terrorist attack, bridge collapse, Ebola outbreak, or anything else you see on TV are basically nil.

Financial news is endearing because it's the opposite of that: it consists mostly of pointing at perfectly unexceptional market-standard practices that happen every day and saying "holy fuck, did everyone know about that? That's messed up." As Matthew Klein has said, "many things that are considered normal in finance look like fraud to almost everyone else,” so the vein is rich. Libor manipulation, Apple's taxes, really take your pick. Or today's Times article "Banks’ Lobbyists Help in Drafting Financial Bills"; my impression is that an article titled "Financial Bill Written Without Drafting Help From Banks' Lobbyists" would, for sheer unlikeliness, be the financial-regulatory equivalent of a news report about terrorists blowing up a bridge using the Ebola virus.

Closest to my heart among these scandals of differing perceptions might be the "you built me a CDO designed to fail" cases. For starters: the fact that they come out of market-standard practices is reflected in the fact that pretty much everybankhasoneofthem.1

But while every other bank seems to have come out of the CDO scandals with a reaction along the lines of "it's a fair cop, here is a pile of money," Goldman, who sort of originated the idea,2 has spent the last few years putting together increasingly convoluted committee structures and online animations to make sure it'll never happen again, for some "it." Here is the latest 26-page report on Goldman's business standards improvement, and here is a genuinely delightful "lifecycle of a transaction" animation that I am tempted to replace with this:

Though you should still click over to Goldman's version, their use of flowchart symbols (and colors) is far more sophisticated than mine.3

The whole thing is ... I mean, it seems perfectly reasonable and well-intentioned and probably best practices and sure why not. But here you can read Kevin Roose gently make fun of it, and it's hard to disagree:

There's probably no Business Standards Committee in the world that could both completely reassure Goldman's clients they won't be taken advantage of while also allowing Goldman to perform its core business functions profitably.

That is the key conflict, isn't it? It's telling, for instance, to note that the client is absent from the flowcharts, except at the very beginning and the very end; in my diagram above everything in the mush occurs entirely within Goldman Sachs. That just makes good sense, of course; if Goldman's salespeople are any good then the client will want to transact and will be annoyed at being held up and pestered by a bunch of paternalistic committees. On the other hand, if your intent really is to make sure that a client understands the risks and fees and conflicts of interest involved in a trade, why would your process consist of:

  • devil's advocate on humorless overprotective committee identifies risks and conflicts,
  • committee communicates those risks to salesperson, and
  • salesperson, who is basically paid for printing transactions, is sent off to communicate them to client?

I mean! Not to pick on Goldman, who actually have some pretty thoughtful answers to that question;4 and it's not like other banks' approval processes have covered themselves in glory. Consider Deutsche Bank's repeated insistence that its horrible trade that blew up Monte dei Paschi "was subject to rigorous internal approval processes." Still, it's hard to shake the sense that the goal of these internal-approval committees can't really be to make sure that the client understands all the risks and fees and conflicts as well as Goldman does itself.

Really, how could it be? Is it crazy or shocking or scandalous or cynical to say that complex structured transactions tend to derive a lot of their value (to their sellers) from their opacity (to their buyers)?5 That if every customer knew of every risk in every such transaction, they would on balance demand that Goldman shoulder more of those risks? That if every customer fully understood the edge embedded in every such transaction, they would on balance demand that Goldman take less edge? That that would be bad, for Goldman, and probably worse than the occasional scandal? What's the point of having better models if you share the answers with your counterparties? What's the point of being right about mortgages if you're not allowed to short them to someone? There are many things that investment banks do that are not zero-sum, and whose economics don't depend on outsmarting customers; broadly speaking those are not the things that go to suitability committees for approval.

But these committees do serve an important purpose, which is to double-check that the customer understands, not necessarily the trade, but the overall context of how these things work. Clients who understand that context don't, y'know, sue. You don't necessarily want a customer who can model up how much edge you're taking in a trade, but you do want a customer who understands that such a thing is possible and that the harder it is to model the more edge you're probably taking. You don't necessarily want a customer who knows John Paulson is on the short side of your synthetic CDO, but you certainly want a customer who knows that there's gotta be someone on the short side. What you want, ultimately, is a customer who, when things go wrong for him in a normal way, says, "yeah, sucks, but I guess this is pretty normal." Not one who says "wait, this is a normal way for things to go wrong? That's messed up."

Banks’ Lobbyists Help in Drafting Financial Bills [DealBook]
Business Standards Committee Impact Report [GS]
Lifecycle of a Transaction [GS]
Goldman Sachs Unveils Huge New Muppet-Appeasement Plan [DI / Kevin Roose]

1.Also, everyone can find something in these cases to feel good about. If you work in finance, you can feel snidely superior when you hear the most popular criticism, "how could you be selling me something when you were on the other side of the trade?" Because: how could you not? If you're a critic of the industry, though, there's plenty of genuine dishonesty for you to get mad about; the fact that "John Paulson chose the securities in Abacus and was shorting it" may not have been that material an omission doesn't detract from the fact that Goldman really does seem to have covered it up.

2.Of getting sued over CDO scandals, I mean. Not the idea of CDOs themselves.

3.The compulsion to quote at length is too strong. Here:

Or here:

I submit to you that what makes those graphics so wonderful is that they convey no information. "We'll look at some things harder than others, depending." "We can either approve or not approve or do something else." I also love this one though:

I hope someone counted the members of each committee to draw in the boxes.

4.For one thing, when committees tell client coverage teams to warn clients about things, now they follow up to make sure the coverage teams actually do it:

Our Business Selection and Conflict Resolution Group implemented new procedures to monitor when our IBD teams have been instructed to deliver a specific communication to clients about conflicts. This new communication management system tracks whether the required communications have been delivered by our IBD professionals. The ability to systematically track and monitor communications regarding conflicts helps us ensure that clients are receiving the information they need to make timely and informed decisions.

And the "conditional approval" process, where the committees basically tell salespeople they can do trades but only if they change their structure or tell the client stuff, seems to have some bite:

The conditional approval discipline represents a rigorous approach to the identification of critical issues – many of which are reputational in nature – that are seen by committees as outright barriers to approving a transaction as proposed. There are many transactions that committees approve only after important changes are made to the way the transactions were originally contemplated. During 2012, approximately two-thirds of transactions reviewed by the Firmwide Capital Committee, almost half of transactions reviewed by the Firmwide Commitments Committee and approximately one-third of transactions reviewed by the Firmwide Suitability Committee were “conditionally approved.”

Also, supposedly the salespeople won't just be paid for printing trades, not any more:

The BSC also recommended increasing the emphasis on client focus in our annual performance review process. Now, as part of the review questionnaire for all professionals, reviewers are asked to rate the reviewee with regard to their focus on trust, transparency and long-term orientation in connection with client relationships.3 These changes have reinforced four key messages to all of our employees regarding (1) the importance of serving our clients, (2) the importance of protecting the firm’s reputation and upholding our culture and values, (3) the link between “cultural” behavior and how people are recognized and rewarded in our organization and (4) individual and collective accountability.

Accountability for clients is one of the factors considered in compensation determinations for client relationship professionals. For example, senior bankers in IBD are required to prepare client relationship summaries that are considered in compensation determinations. Leadership, culture and values (including client focus) have also been reemphasized as part of the criteria for evaluating candidates for promotion to partner and managing director.

5.A pseudo-exception is when the trade derives its value to both buyer and seller from its opacity to some third party: a tax trade where the tax savings pay for the fee and then some, or an accounting/regulatory capital/etc. arbitrage trades where the client thinks the third-party bamboozlement is well worth the fees. These raise their own issues for committees to mull over, as Goldman is keenly aware.