Fiduciary Duty

A federally licensed “investment advisor” is both tested (to be certified) and required to apply a higher standard of care (which among other things requires the advisor to put the interest of the client ahead of that of the advisor) – called a fiduciary duty. A federally licensed stock broker (trader) is tested but is not a fiduciary acting on behalf of a client. See a problem? As long as a licensed trader is following trading rules – like not acting on inside information or engaging in stock manipulation – he/she can sell his/her clients whatever they like, recommending along the way, without fear that perhaps someone in that broker’s company is making opposite recommendations and selling instruments that actually are betting the original broker’s recommendations to his/her client are wrong.

While touting that the firm has millions of satisfied customers, Goldman Sachs is beginning to generate an aura of mistrust among a growing cadre of existing and potential clients. It is interesting to note that while the firm has traditionally been built under the leadership of corporate financial advisors (mergers and acquisitions specialists with an eye for raising capital of all forms) – investment bankers – today that leadership (and the direction of the company) has moved dramatically towards trading (CEO Lloyd Blankfein comes from that world, not investment banking), particularly trading on the firm’s own accounts. With access to exceptionally cheap money, since Goldman has established a commercial banking operation (they prefer to access Fed funds for their own benefit rather than deploy that capital into the traditional lending markets to their customers), the emphasis on the company’s own portfolio appears to trump any other operation or any other value.

In a lengthy article on the subject, the May 19^th New York Times speaks to this shift of values: “When new hires begin working at Goldman, they are told to follow 14 principles that outline the firm’s best practices. ‘Our clients’ interests always come first’ is principle No. 1. The 14th principle is: ‘Integrity and honesty are at the heart of our business.’… But some former insiders, who requested anonymity because of concerns about retribution from the firm, say Goldman has a 15th, unwritten principle that employees openly discuss… It urges Goldman workers to embrace conflicts and argues that they are evidence of a healthy tension between the firm and its customers. If you are not embracing conflicts, the argument holds, you are not being aggressive enough in generating business.

“But a former Goldman partner, who spoke on condition of anonymity, said that the company’s view of customers had changed in recent years. Under Lloyd C. Blankfein, Goldman’s chief executive, and a cadre of top lieutenants who have ramped up the firm’s trading operation, conflict avoidance had shifted to conflict management, this person said. Along the way, he said, the firm’s executives have come to see customers more as competitors they trade against than as clients… In fact, Mr. Blankfein and Goldman are quick to remind critics that Wall Street deals with sophisticated investors, who they say can protect themselves. At the bank’s shareholder meeting earlier this month, Mr. Blankfein said, ‘We deal with the most demanding and, in some cases, cynical clients.’… Even Goldman’s mortgage department compliance training manual from 2007 acknowledges the challenges posed by the firm’s clients-come-first rule. Loyalty to customers ‘is not always straightforward’ given the multiple financial hats Goldman wears in the market, the manual notes.”

Markets change; that’s the real world. And sometimes the big trading firms have inventory and deals based on past assumptions even as the winds blow in another direction. In 2007, the subprime housing market was showing clear signs of deteriorating with related derivatives – bundles of such loans – evidencing higher-than-projected overall default rates. Unfortunately, even as Goldman analysts were projecting this erosion of subprime bundle values and as traders created new derivatives that actually bet on further erosion (appreciating in value as the subprime default rate climbed), other Goldman traders were still selling the failing subprime derivatives.

One such example, according to the Times: “As the housing crisis mounted in early 2007, Goldman Sachs was busy selling risky, mortgage-related securities issued by its longtime client, Washington Mutual, a major bank based in Seattle… Although Goldman had decided months earlier that the mortgage market was headed for a fall, it continued to sell the WaMu securities to investors. While Goldman put its i mprimatur on that offering, traders in the same Goldman unit were not so sanguine about WaMu’s prospects: they were betting that the value of WaMu’s stock and other securities would decline… Goldman’s wager against its customer’s stock — a position known as a ‘short’ — was large enough that it would have generated at least $10 million in profits if WaMu collapsed, according to documents recently released by Congress. And by mid-May, Goldman’s bet against other WaMu securities had made Goldman $2.5 million, the documents show.” The original WaMu did collapse; it was taken over by federal regulators in the fall of 2008 and is now a part of the Chase banking group.

As we look for obvious rule changes, it would seem clear that, just based on the above, two additional regulations need to be added to control such failures: 1. Fed funds should not be available for the relevant commercial bank (or its affiliates) for use directly or indirectly for trading on their own accounts (it makes self-trading too easy) and 2. A clear fiduciary duty should be imposed both on the individual brokers and the company that employs them (including all affiliates). Or you could simply allow rogue conflicts of interest to continue to infect our economy. Pick one or do nothing.

I’m Peter Dekom, and sometimes we really need to take the stick out of the hand of the guy who keeps poking us in the eye with it.