Good Honest Dollar $$

After the events of the recent years, news of the SEC action against Goldman Sachs has not done much to help public perceptions of either the investment bank itself or of Wall Street in general.

(On April 16, the SEC announced its intention to charge the investment bank with ‘Fraud in Structuring and Marketing of CDO Tied to Subprime Mortgages.’ For a detailed background, read the SEC media release and Goldman’s response)

Here’s my two bob’s worth on all of this:

 
• Goldman are not (yet) guilty.

In the court of public opinion, it appears that some have made up their minds – guilty.

This viewpoint does have some logic. The SEC investigation ran for more than a year, and charges would not been have bought about in absence of a plausible case.

Nonetheless, these types of conclusions are pre-mature. For one thing, the SEC proceeded only reluctantly [apparently they were split three-two on whether to proceed (refer article)], inferring that the case is not watertight. Moreover, the case is genuinely in dispute, and only those close to the transaction in question have any idea what really went on.

Suspicion about the big end of town is natural. But by itself, it is a weak basis on which to infer guilt.

Goldman are only guilty if and when they are proven to be so in court.

 
• Goldman are not necessarily morally guilty.

Legally guilty or not, weren’t their actions immoral?

Not necessarily. At least not with regard to the transaction to which the SEC action relates.

It is true that Goldman did arrange a transaction whereby one of their clients (hedge fund Paulson & Co) would profit from a deterioration in the US housing market.  To many, this seems galling – Paulson stood to gain from the pain of ordinary Americans.

But there is nothing inherently wrong about this, nor are there any problems with Goldman facilitating the efforts of their client in this regard. Investors are well within their rights to bet for or against the market as they please. That’s simply part of the normal, healthy functioning of the market.

 
• The real problem is disclosure.

But there might be a problem in the area of disclosure.

Was information Goldman provided to ACA and IKB entirely truthful and accurate? If so, they have done nothing wrong. If not (as the SEC alleges), then their conduct was unprofessional, unethical and almost certainly illegal.

That’s what it boils down to – disclosure. Nothing more, nothing less.

(Along with Paulson and Goldman itself, ACA Capital Management and IKB were the other investors involved in the transaction to which the charges relate)

 
• Goldman will bounce back.

In spite of all its troubles, the $3.5 billion profit which they announced on April 20 provided a fair bit of comfort for management – profits of this magnitude tend to do that.

The announcement served to underscore an important point: for Goldman, problems associated with the allegations are manageable, serious though they are.

With around $73 billion in shareholder funds (refer article), Goldman should be able to handle any financial penalties associated with the case (investor losses totaled around $1 billion).

And damage associated with the ‘guilty’ verdict in the court of public opinion may be overstated. Provided Goldman continues to deliver the goods for clients, they won’t go away – nor will the firm’s top talent.

Therein lies the biggest danger: a loss of confidence in the firm on the part of clients themselves. But even this should be manageable and a mass exodus seems unlikely.

Goldman seems to have a history of being able to bounce back after the storms.

Though it may suffer a few bumps and scratches, it will almost certainly ride out this one pretty much intact.

Fund managers are paid to manage client funds in a manner which reflects a thorough level of diligence and care.

The same applies to senior executives of financial institutions with respect to the way in which they invest shareholder funds.

Neither are paid to simply hand client or shareholder money over to scam artists, and their behavior with regards to the Madoff fraud, in which many did just that, represented a serious breach of their duty of care.

 
What the scandal involved
The scandal, committed by Bernard Madoff, a former chairman of NASDAQ, appears to have worked as follows:

Mr. Madoff ran a financial services firm, which he started in 1960. As part of its offering, the firm ran an investment management and advisory division, which essentially managed client funds in brokerage accounts within his firm.

The division (whose clientele consisted predominately of banks, investment funds and wealthy individuals) appeared to deliver exceptionally consistent results, recording returns on investment in the vicinity of ten per cent every year, year in, year out, even throughout periods of unfavorable market conditions.

One problem – in reality, such results were not in fact being achieved, a fact which Mr. Madoff was hiding by running an illegal pyramid, or Ponzi type of scheme, whereby the payment of returns to existing shareholders was being funded out of contributions from new investors rather than out of profit.

The scheme unraveled during the financial crises, with fresh contributions from new investors drying up combined with an abnormally high demand for withdrawals.

 
They should have been suspicious
A number of warning signs pointed to the fact that something wasn’t right, and bankers and fund managers who invested shareholder/client money with Mr. Madoff have no excuse for their lack of diligence.

Briefly speaking, the warning signs included:

• An unrealistic degree of consistency in investor returns;

• Claiming to use hedging strategies in the S&P 100 options market, which one independent research firm concluded was too small to handle a portfolio of his size;

• Lack of transparency, including refusal to allow clients online access to their accounts, and ejecting from meetings investors who asked difficult questions;

• Lack of accountability – including the practice of clearing his own trades, (highly unusual within the industry) and using a firm with just one qualified accountant as an auditor.

(See Wikipedia article and The Economist report for details)

The consistency of returns was a giveaway, and Madoff’s claims (which included the achievement of consistent returns of around ten per cent per year, year in/year out, and at one point, recording seventy two months of gains in a row) should have been seen for the lie that they were. 

Simple common sense dictates that regardless of the effectiveness with which hedging techniques are used, returns of that level of consistency are not achievable in fluctuating financial markets.

Any banker or fund manager who conducted any diligence at all would not have worked out that something was amiss, and the haphazard way in which some invested with Mr. Madoff was simply astounding.

 
 “It’s all the SEC’s fault”
Equally astounding is the readiness of some clients to blame the SEC, as opposed to taking responsibility for their own lack of diligence.

This lame excuse is blamed being touted by Union Bancaire Priv’ee, a Swiss private asset management company, who claims that the exposure of its clients (estimated at $USD 1.1 billion) is the result of failure on the part of the SEC to effectively monitor Mr. Madoff’s firm. (refer article)

That’s ridiculous. UBP manages approximately $USD124.5 billion in funds, and a firm of this size surely has an obligation to its clients to conduct proper due diligence with respect to any hedge funds or money managers with whom it invests substantial amounts of client funds.

Any mistakes made by the SEC do not in any way absolve UBP or any other fund manager or bank of responsibility for their own failure to fulfill their duty of care.

 
Just admit to your mistakes
Clients and shareholders have every right to be livid about the way in which fund managers and banks simply handed their money over to a scam artist.

Those banks and fund managers who invested with Madoff should just own up and acknowledge that they breached their duty of care.

They are not paid to be sheep. They are paid to be diligent with client/shareholder funds.