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What Did Goldman Sachs Do Wrong?

On April 16, 2010, the U.S. Securities and Exchange Commission (SEC) filed civil fraud charges against investment bank Goldman Sachs, alleging that the company misled investors by withholding material information regarding an investment portfolio named “Abacus.”

The story was big news – and remains big news two weeks later.

In a nutshell, a hedge fund manager named John Paulson believed – correctly, as it turned out – that the U.S. housing market and especially the subprime housing market would soon collapse. He asked Goldman Sachs to put together a portfolio of subprime mortgage bonds into something called a synthetic collateralized debt obligation (CDO), which he planned to “sell short.” If the CDO went up, he would lose money; if it went down, he would profit handsomely. Paulson wouldn’t actually be buying or selling any mortgages; he would in essence be placing a side bet that a lot of the mortgages identified in the portfolio were about to plummet in value. Other investors would need to be found to take the other side of the bet, investors who believed that the housing bubble wasn’t going to burst any time soon.

Eventually, a company called ACA Capital Management picked the contents of the portfolio, and backed its picks by insuring the portfolio and investing itself. Goldman Sachs found other investors besides ACA to buy into the portfolio, particularly a large German bank, IKB. Paulson and his company shorted the portfolio, and when the housing bubble did in fact burst they ended up making a profit of around a billion dollars.

The SEC charge against Goldman Sachs results from the undisputed fact that Paulson put together a list of mortgage instruments he wanted to see in the portfolio – presumably ones he thought were especially likely to fail. ACA considered this list as it put together the portfolio, and some of Paulson’s recommendations were accepted. IKB wasn’t told that Paulson (or anyone on the short side of the investment) had played a role in choosing its contents.

The key legal question is whether this was a “material” fact that Goldman Sachs was obligated to tell IKB and other prospective investors. There are of course broader questions in play: the wisdom of “derivative” financial instruments that are side bets rather than actual investments; the failure to regulate such instruments aggressively in the past and the question of how they should be regulated now; the extent to which investment banks in general and Goldman Sachs in particular can be blamed for the financial meltdown of 2008-2009; the culture of investment banks like Goldman Sachs and why that culture led first to their lionization and then to their demonization.

In the days after the story broke on April 16, I tried to follow it carefully, as did my wife and colleague Jody Lanard. Our initial impression was that the SEC case against Goldman Sachs was weak; that the news coverage was even weaker; and that the calumny being heaped on the company by commentators, politicians, and the public was a stunning example of the dynamics of outrage. People were angry that the economy had tanked, were reluctant to acknowledge their own role in the debacle, and were looking for scapegoats … especially scapegoats that had managed to earn astronomical profits while everyone else was suffering. If the scapegoat happened to be an arrogant, self-congratulatory, and largely Jewish-run company with incestuous ties to the federal government, so much the better.

To celebrate my 65th birthday on April 18, 2010, my daughter Jennifer and her fiancé Daniel took Jody and me to dinner and a show in New York City. Daniel works for Deutsche Bank, and we naturally spent some time over dinner discussing the Goldman Sachs case.

A spate of emails followed, written mostly by Daniel and me, as we tried to figure out what had happened, and what we thought about it.

Daniel, Jody, and Jennifer all urged me to post these emails on my website. I resisted, arguing that the Goldman Sachs controversy isn’t really about risk communication – except in the literal sense that the company is accused of failing to communicate honestly about the risk of Abacus.

In a larger sense, though, the controversy really is about risk communication. It raises an extremely difficult outrage management question: How should a company like Goldman Sachs respond when massive public outrage leads people, politicians, and even prosecutors to willfully misperceive a pretty ordinary piece of business as a serious legal breach?

The emails that are reprinted below (lightly edited) don’t address that question until the very end, when they address it only very briefly. We were busy figuring out whether we thought what had happened was in fact a pretty ordinary piece of business or a serious legal breach.

But that’s arguably part of risk communication too. These emails exemplify an essential step that has to precede any risk communication effort. Before figuring out what to say, you have to figure out what happened. When a client calls on me for risk communication advice, the client tells me what happened. But the client’s initial story (even the internal, confidential story) is often one-sided and self-deceptive. So I try to ask tough questions, and I go online and see what journalists and activists (and the client) are saying publicly. Through a process of successive approximations I start getting a handle on the actual facts.

When there is no client – as is the case here – Jody and I do pretty much the same thing, relying entirely on publicly available information. We do it for practice. We do it for fun. It’s what we do.

I have another reason for deciding to post this email dialogue. For more than a decade, I have been aghast at what I see as the public’s increasing misunderstanding of the nature of corporate capitalism. Love it or hate it, corporate capitalism is fundamentally amoral. Companies promise their shareholders that they will maximize long-term, sustainable profitability. Except in extraordinary circumstances (a Hitler asks you to manufacture gas for the ovens), corporate managers are not supposed to interpose their personal values in ways that redound to the disadvantage of their shareholders.

That doesn’t mean that corporate avarice is unconstrained. It is supposed to be constrained by two powerful forces.

• Regulation and regulatory enforcement. Corporate behavior that is profitable for the company but harmful to the society should be illegal, and enforcement should be strict enough that illegal behavior isn’t profitable. Wise companies stay within the law.
• Public opinion (outrage). Corporate behavior that is profitable for the company but harmful to the society should arouse outrage on the part of stakeholders and the general public. Wise companies know that arousing other people’s outrage isn’t profitable either.

Because of the way I see capitalism, I have long advised my corporate clients that they should both aim to be and claim to be “responsive” rather than “responsible.” See for example my 2006 column on “Giving Away the Credit: Managing Risk Controversies by Claiming You're Responsive (though maybe not responsible)” – especially Reason #4 in that column, “To Save Capitalism.” See also a 1999 exchange of letters I had with John Elkington and Chris Marsden, posted on this website under the title “Responsible or Responsive?”

So if it turns out that Goldman Sachs did things that were unequivocally illegal, it should be punished by the government. And if it did things that arouse outrage in stakeholders and the public, even if only in hindsight, it should be punished by the zeitgeist.

But three things trouble me about the Goldman Sachs controversy as it has evolved so far.

First, something is badly awry when the government instrumentalities charged with deciding what corporate behavior is to be illegal (e.g. Congress and the SEC) start looking for ways to punish companies for “violating” laws and regulations they neglected to promulgate in the first place. It may turn out that Goldman Sachs did some illegal things in recent years. But I don’t see much of a smoking gun in the charge that it failed to tell a big German bank that a hedge fund manager suggested some of the investments in the Abacus portfolio while planning to short-sell that portfolio. The SEC spent more than a year looking for something to punish the Wall Street banks for, and that’s the worst infraction it could come up with?

Second, something is badly awry when the government instrumentalities charged with deciding what corporate behavior is to be illegal become cheerleaders for post hoc public outrage – pandering to the public’s desire for scapegoats instead of trying to foster understanding of what really went wrong with our economic system. Not that I’m clear myself on what really went wrong. But I am clear that the blame should be shared: Wall Street banks ran amuck, the government let them, and a very large percentage of the public participated and applauded.

Third and most important, something is badly awry when the public is encouraged to believe that a corporation can be expected to possess a moral anchor. People have moral anchors. Corporations go where the economic incentives take them. When the incentives take them to a bad place, we need to change the incentives, through regulation and through outrage. If we don’t understand that – if we expect corporations to be unilaterally responsible – we will fail to send clear signals to which they can be responsive.

I’m not unhappy that many people are outraged at Wall Street in general and Goldman Sachs in particular. But we need a much sounder understanding of what we’re outraged about. If we’re outraged that investment banking focuses too much on side bets rather than actual investments in actual assets, fine. That will serve as a useful corrective. If we’re outraged that investment banking is arrogant, overpaid, and soaking up too much of the nation’s best and brightest in largely unproductive work, also fine – another good corrective. But what’s the point in being outraged about what so many politicians seemed to be outraged about last week – that investment banking serves buyers and sellers at the same time, always knowing that if one of them makes money the other is bound to lose money, and sometimes guessing which is which and making its own investments based on those guesses? That’s not a useful corrective. It is simply a misunderstanding of how modern capitalism works.

I have noticed over the past few days that I am more interested in the Goldman Sachs controversy than the huge BP oil spill in the Gulf of Mexico. How to talk about oil spills and the like has been my stock-in-trade for decades. Now as I approach retirement (but I’m not there yet!), I’m more and more interested in how to talk about capitalism. That could be a fascinating retirement project: figuring out how to talk about capitalism.

If you decide to read these emails, I’d like you to do so with four questions in mind:

• Do you think Goldman Sachs did anything illegal here? Do you think it did anything wrong?
• Do you find yourself wanting Goldman Sachs to be guilty of something because of your own outrage (and the company’s arrogance)?
• If in fact Goldman Sachs is being scapegoated, what could it do to manage the outrage more effectively?
• What lessons does the Goldman Sachs controversy teach about the nature of capitalism? Is the public learning the right lessons?

If you feel impelled to enter the conversation, please do so.

1. Peter M. Sandman to Daniel and Jody Lanard
    April 19, 11:25 a.m.

In the car this morning … I heard a radio talk show host railing about how awful it was that Goldman Sachs “defrauded” pension plans and banks by selling them a product it knew that somebody else intended to short, especially because that somebody else “hand-picked” the package and Goldman Sachs kept that information “secret.” He didn’t mention that ACA did the actual picking; that ACA turned down more than half the mortgage instruments Paulson had picked; that Paulson was basically a relatively little guy (at the time), betting against the establishment financial experts at the banks that wanted to buy the package; or that Goldman Sachs’s job in this case was to make a market by providing a package that some experts (most, in this case) would want to buy and some (Paulson) would want to sell or short.

Then the host almost acknowledged that the “fraud” perpetrated by Goldman Sachs might actually not be illegal, and added something along these lines: “That’s the real problem. These guys actually think they have a fiduciary responsibility to their shareholders to maximize profits as long as it isn’t actually illegal.”

Well, yeah. All three of the participants in these transactions had that fiduciary responsibility; Paulson did a superb job of legally making money for his investors; Goldman Sachs did a pretty good job; the banks that bought the package did a crappy job. And the government did perhaps the crappiest job, by failing to make harmful actions illegal. (Of course Goldman Sachs did let down its shareholders to some extent by failing to predict that it was likely to end up a scapegoat.)

I don’t quite understand exactly what the government should have been regulating. Not the mere existence of CDOs, or the fact that some institutions wanted to bet that the subprime housing market was going to keep rising while others (Paulson) wanted to bet that it was going to tank, or the decision of Goldman Sachs to satisfy both markets. Maybe it’s just letting institutions get simultaneously overleveraged and too big to fail. Maybe it’s not making it easier for participants in the CDO market to assess the true value of what they’re buying (or selling). Pretty obviously something went wrong. And pretty obviously it wasn’t Goldman Sachs facilitating a trade between a willing seller and a willing buyer, both of whom had access to the same information.

The wonderful end to the radio talk show story: After his diatribe, the host segued to a commercial for a homeopathic prostate remedy. As he read the commercial, I wonder if he noticed that he too was making money by legally facilitating commerce between a willing seller and a willing buyer by extolling the virtues of something he personally thought was probably crap.

Daniel, if you learn anything from colleagues at Deutsche Bank that leads you to believe there’s some real misbehavior here, not just a witch hunt, please let me know!

2. Daniel to Peter M. Sandman and Jody Lanard
    April 19, 12:58 p.m.

I’m yet to chat with a colleague who understands this fully, so this is just my own take on it. When I read more about this, I have to say that the whole thing does seem to stink a bit of making GS a scapegoat, but I can’t say that I agree with you.

If one is to believe the SEC Complaint:

• Firstly, my natural instinct is that GS and Tourre [Fabrice Tourre, the highly paid Goldman Sachs employee who managed the Abacus project] acted unethically – it just doesn’t feel right, and by this I mean it doesn’t feel right even to those around me in banking who understand the complaint, the products and the parties involved. I know this is not an argument for taking them to court, but I think it’s a good starting point.
• The SEC Complaint is not based on a vague sentiment that GS should be punished for previous profitable actions that may have been a part of the process leading to the financial crisis – rather, the SEC specifically says that GS and Tourre broke certain parts of the Securities Act and the Securities Exchange Act. So while it may be that the SEC is trying to regain some face and punish Wall Street banks for being greedy, I don’t think it means they have come up with a frivolous claim.

As I understand it, these pieces below seem worthy of making an issue of (I’m sure you’ve read the full complaint, so I’ll be interested in your opinion):

So, what are your thoughts on the things I would say are “not OK”?

There’s the argument that if one were to consider the flip side, we would all think nothing of this. In other words, it’s only because of the fact that Paulson was going short (and going short seems inherently wrong or shady) that we’re even considering Goldman’s actions as a crime.

But the “flip side” has only been described this way: a group of parties put together a portfolio that they expect to succeed, then experienced investors decide whether to buy it or short it. No one would have a problem with short investors losing money when the portfolio does in fact succeed.

But if the flip side were described as “a group of parties put together a portfolio they expect to succeed, but build the product, distribute misleading information and market it in such a way that your average institutional investor is going to think it likely to fail,” then I would have the same issues with it.

3. Peter M. Sandman to Daniel and Jody Lanard
    April 19, 1:32 p.m.

Comments below in red sans-serif font:

I’m yet to chat with a colleague who understands this fully, so this is just my own take on it. When I read more about this, I have to say that the whole thing does seem to stink a bit of making GS a scapegoat, but I can’t say that I agree with you.

If one is to believe the SEC Complaint:

• Firstly, my natural instinct is that GS and Tourre acted unethically – it just doesn’t feel right, and by this I mean it doesn’t feel right even to those around me in banking who understand the complaint, the products and the parties involved. I know this is not an argument for taking them to court, but I think it’s a good starting point.
• The SEC Complaint is not based on a vague sentiment that GS should be punished for previous profitable actions that may have been a part of the process leading to the financial crisis – rather, the SEC specifically says that GS and Tourre broke certain parts of the Securities Act and the Securities Exchange Act. So while it may be that the SEC is trying to regain some face and punish Wall Street banks for being greedy, I don’t think it means they have come up with a frivolous claim. I agree. Nothing wrong with getting Al Capone for tax evasion because you can’t get him for the racketeering you’re really mad at him for … as long as he’s genuinely guilty of non-trivial sorts of tax evasion.

As I understand it, these pieces below seem worthy of making an issue of (I’m sure you’ve read the full complaint, so I’ll be interested in your opinion): I haven’t read the complaint itself, just excerpts and descriptions in news stories and blogs.

So, what are your thoughts on the things I would say are “not OK”?

There’s the argument that if one were to consider the flip side, we would all think nothing of this. In other words, it’s only because of the fact that Paulson was going short (and going short seems inherently wrong or shady) that we’re even considering Goldman’s actions as a crime.

But the “flip side” has only been described this way: a group of parties put together a portfolio that they expect to succeed, then experienced investors decide whether to buy it or short it. No one would have a problem with short investors losing money when the portfolio does in fact succeed.

But if the flip side were described as “a group of parties put together a portfolio they expect to succeed, but build the product, distribute misleading information and market it in such a way that your average institutional investor is going to think it likely to fail,” then I would have the same issues with it. I agree. If Paulson put together a portfolio meant to fail and GS told investors it was put together by someone who meant it to succeed, that’s fraud. It’s clear that Paulson did indeed mean the portfolio to fail. But it’s not clear to me that Paulson put together the portfolio; ACA put it together. And it’s not clear to me that ACA meant the portfolio to succeed or to fail; I would have thought it meant it to be a portfolio that would attract rational buyers and rational sellers/short-sellers … and it apparently succeeded in that goal. {footnote: Once again, I wrote this before I understood that ACA went long on the portfolio.}

4. Daniel to Peter M. Sandman and Jody Lanard
    April 19, 3:10 p.m.

I think our main point of difference would be our view on the statement “ACA selected the portfolio.” If that is an acceptable statement, then my feeling would be that the process was distasteful, and that ACA and IKB were cleverly conned, but nothing illegal happened – it was essentially a case of “Let the buyer beware.”

If on the other hand one believes that the statement “ACA selected the portfolio” is essentially untrue, then one sides with the SEC. This is my position, as ACA was chosen only because this removed Paulson from the picture, thus giving his picks the illusion of being selected by an independent party. Paulson’s picks made up the majority of the portfolio, and ACA sought his approval when suggesting replacements (some of which Paulson vetoed). To me, the omission of this information could be considered criminal.

Incidentally, GS denies my point No. 5. They deny that Tourre in any way indicated that Paulson would be going long on the portfolio.

Hope you don't mind the long replies - you've certainly raised my interest in this debate!

5. Peter M. Sandman to Daniel and Jody Lanard
    April 19, 3:36 p.m.

Your responses are admirably short!

Did ACA think it wasn’t selecting the portfolio? Did ACA object to GS claiming that it had selected the portfolio? Did ACA sell its reputation without actually selecting the portfolio?

I have trouble picturing any scenario here in which Goldman Sachs misbehaved and ACA did not.

6. Peter M. Sandman to Daniel and Jody Lanard
    April 19, 3:52 p.m.

Addendum:

Apparently ACA was itself a major long investor in the portfolio – so ACA did have the same economic interests as those who were buying the portfolio from GS, just as GS told them it did. And clearly ACA knew about Paulson’s role when it decided to be a long investor. So a short investor recommended some components of the portfolio and then a long investor made the final picks. That sounds okay to me. In fact, it sounds fairer than if Paulson and ACA had both been long investors, putting together a portfolio that favored the buyer side, which GS then had to try to sell to some poor schnook of a short-seller.

There must be basic stuff I don’t understand. Why doesn’t Paulson have a grievance that ACA chose the portfolio and then went long on it, whereas IKB does have a grievance that Paulson helped choose the portfolio and then shorted it? Well, yes, I understand that Paulson knew about ACA and IKB didn’t know about Paulson. Still, I would have thought ACA’s reputation as a bond insurer and portfolio packager would have required it not to have a stake on either side….

I need to go back and read some kind of basic text. (But I probably won’t. I’ll just keep expressing ignorant opinions as I try to understand better.)

7. Daniel to Peter M. Sandman and Jody Lanard
    April 19, 4:01 p.m.

I think there are two questions:

• Was ACA illegally conned? No, as your questions highlight. They (obviously) knew the degree to which Paulson influenced the construction of the portfolio.
• Were the other investors illegally conned? Yes. I think so.

8. Jody Lanard to Daniel and Peter M. Sandman
    April 19, 4:09 p.m.

I think it is a little bit important to try to see “who was John Paulson” in the minds of relevant players, before this enormously successful (for him) event.

From the articles below, he seems to have been perceived as basically a nobody – not much of a player:

• http://nymag.com/daily/intel/2009/11/bad_news_bears_2.html
• http://nymag.com/daily/intel/2009/12/john_paulson_2.html

The articles could be misleading. I have no way of knowing.

But the news that “John Paulson thinks these bonds are going to lose value” seems like it would have fallen pretty flat. Why would anyone have cared what the pre-bubble-bursting John Paulson thought? ACA certainly wouldn’t have wanted to take his word for anything, I think. “So what if some nobody loser jerk-off like John Paulson thinks these bonds are gonna tank. Who the hell is he? Who cares what he thinks? Let’s buy!”

9. Daniel to Jody Lanard and Peter M. Sandman
    April 19, 4:45 p.m.

I think that’s a good point. Lots of Monday morning quarterbacks like myself are throwing around the notion that Paulson was a known shorter of stocks – but as you say, he was basically a nobody, and only now we’re attributing more influence to him than he probably had.

And I’m a bit stuck now on Peter's points. ACA, a reputed expert in financial instruments, built the portfolio (and any such institution would naturally receive advice, possibly conflicting, from any number of parties on the value prospects – no problem there), invested in it and sold it, and ultimately was ruined by it. So why is Goldman to blame (especially as Goldman lost USD90m too)?

To your last email, Peter, it seems to hang on whether not informing IKB of Paulson’s involvement would constitute (and this is from the Securities Act) “omission to state a material fact,” or any “deceit upon the purchaser” – and, if there was an omission, whether this responsibility falls on Goldman Sachs.

So I see your points and don't have good answers, but something does not feel right. (From here on in, I’m going to lose a bit of logical ground, and speak more emotionally.) When you look at what happened, and how this was constructed (the timeline, the emails from Goldman/ACA etc. that the SEC got hold of), you feel like you would want to make sure this didn’t happen again. The way we do that is by punishing someone.

I also think that a financial product (or any product) should not be built to lose value. I get that people bet whether something will lose value or gain value, and that seems fine to me, but to build something in order for it to lose value seems destructive and wrong.

Back tomorrow, hopefully better armed.…

10. Peter M. Sandman to Daniel and Jody Lanard
    April 19, 4:51 p.m.

I accept that something feels wrong … though I wonder if it would still feel wrong if Paulson had lost his shirt and IKB (and the housing market) had made out just fine. The way to test for outcome-biased thinking is to postulate the same behavior but the opposite outcome and see how that feels. (What if governments had bought a lot of flu vaccine and actually needed it….) Still, something does feel wrong.

But I don’t think punishment is how you deal with things that feel wrong. Punishment is how you deal with things that were plainly illegal. New regulation is how you deal with things that feel wrong.

I’m fine with figuring out how best to regulate the conflicting interests of buyers, sellers, long-investors, short-investors, market-makers, insurers, and the rest.

I’ll let you go now. For now.

11. Daniel to Peter M. Sandman and Jody Lanard
    April 20, 9:14 a.m.

One GS argument which may be irrelevant (that they are trying to make relevant) is the fact they lost USD90m on the transaction. One article points out that “people familiar with the deal” said GS didn’t want to invest long at all, but as ACA couldn’t sell the entire deal (and GS thought they would be able to), GS had to pick up the rest with their own money.

This happens reasonably often. If we’re trying to syndicate out a big loan, for example, we don’t actually want to be stuck with any of it ourselves (we just want to be the arranger, and be paid for that role), but sometimes we have to take a piece as well. If this is true, then the GS assertion that they didn’t make a bundle on this, and in fact made a loss, is not impressive.

12. Peter M. Sandman to Daniel and Jody Lanard
    April 20, 10:09 a.m.

I fully agree. It’s the sort of easily understood but easily rebutted argument that makes their harder-to-understand but sounder arguments less effective. They are getting bad communication advice, I think.

13. Jody Lanard to Daniel and Peter M. Sandman
    April 20, 10:15 a.m.

VERY stupid of GS to argue (by implication) that their loss of $90m validates their confidence in the deal, if in reality they lost the $90m because they couldn’t sell it – and if this is ultimately knowable.

14. Peter M. Sandman to Daniel and Jody Lanard
    April 20, 10:33 a.m.

Jody and I have been picturing a scenario something like this.

Comments?

15. Daniel to Peter M. Sandman and Jody Lanard
    April 20, 5:56 p.m.

The scenario you describe appears reasonable and unproblematic.

Here are my additional thoughts. (Some are not my own. I listened to the Goldman earnings call today, and analysts grilled them at the end on the SEC case.)

Another thought about this:

The common argument is that during the sale of a financial instrument, there are parties who think the value will go up, and parties who think it will go down; this is what makes the market work. The argument continues: “Of course there will be short investors, and so why should IKB care about the disclosure of Paulson. If not him, then others must short the portfolio, otherwise there is no market.”

I don't agree with this as an argument in this case. If I buy stocks, I believe the value will go up, but if I sell them, it’s not necessarily because I believe the value will go down. It’s because I need liquidity, or because I feel I can use my money in a better way. I may still believe that the stock value will go up – in fact, 100% of the people in an active market could believe that the value of the stock will go up. Shorting to me is entirely different.

Why is this relevant? Because I think it’s an important fact that the prevailing investor belief is that values will go up, and the existence of a market doesn’t mean 50% of people think the value will go down. So if there is an aggressive short seller present who has been involved in building the product, then this is material and disclosable information. At least, it’s wrong to indicate that “the economic interests of those selecting the portfolio are aligned with investors.” (I know, we’re back to the point that ACA selected the portfolio.)

16. Peter M. Sandman to Daniel and Jody Lanard
    April 20, 7:08 p.m.

A few miscellaneous reactions:

17. Daniel to Peter M. Sandman and Jody Lanard
    April 20, 7:18 p.m.

One thing I did mean to say, and this has surprised me, is that I’ve come to the conclusion that you, Jody and I are at least as well informed as any other outsider looking in, including those in the banking industry. I’ve asked a bunch of people what they think (people who I thought would have real expertise in answering my questions), and all of their points seem to be things well known to us or anyone reading the paper. Disappointingly, I’ve received no additional insights to claim as my own in order to stump you.

So yes, Goldman should hire you. On the earnings call, they sounded arrogant, annoyed, and dismissive. It didn't come across well.

18. Jody Lanard to Daniel and Peter M. Sandman
    April 20, 8:58 p.m.

It is such a gift to us to know you, Daniel.

You gently provoke us to think anew about notions we thought we already understood.

You integrate the valid emotional and ethical aspects with the intellectual and “factual” aspects of situations.

And you express all this so articulately, and in a way that doesn’t cause me to react defensively, but to consider your viewpoint at all times, and to reconsider my own.

Maybe you know lots of people with whom to have these kinds of interchanges, but for us (Peter and me) we mostly have each other, and it is so LIMITING sometimes, since our own knowledge of the world is rather narrow.

So I just want to tell you what a joy it is to have watched, and slightly participated in, the interchanges between you and Peter as I try to form my opinions and understandings about the Goldman Sachs situation.

19. Daniel to Jody Lanard and Peter M. Sandman
    April 20, 10:21 p.m.

What a lovely email, thank you so much. It really made my day.

I did get encouragement from Jen [Jennifer Sandman – my daughter, Jody’s stepdaughter, and Daniel’s fiancée] before engaging in this debate – she assured me that it would not be an imposition on your time. I’ve thoroughly enjoyed myself, though I’m slightly disappointed as I look back over my emails to Peter to find that I haven’t been entirely consistent in my arguments. Oh well, they developed as they went along, and you and Peter were to make sure I was properly thinking things through!

I can tell you that Jen would not necessarily agree that I always remain an articulate and reasonable adult during our debates. So the next time I feel she’s getting the upper hand, I will just bring out your email and read it to her.

20. Peter M. Sandman to Daniel and Jody Lanard
    April 21, 9:16 a.m.

I often disagree with Wall Street Journal editorials; I find its editorials a lot less well-informed than its news coverage. But here’s a link to one from two days ago that I like – especially the notion that if the SEC looked for 18 months and this was the worst legal violation it could find, then illegality wasn’t the problem….

http://online.wsj.com/article/SB10001424052702303491304575188352960427106.html?mod=WSJ_latestheadlines

21. Daniel to Peter M. Sandman and Jody Lanard
    April 21, 10:41 a.m.

Yes, I like this article too. The only point I disagree with is that Goldman’s loss of $90m is somehow a plus for the defense.

And, per the last paragraph, I keep thinking that the SEC must have more evidence or that I'm missing something. But I’m now coming to the reluctant conclusion that maybe I actually understand the case reasonably well, and that the SEC’s complaints are rather thin. But I’m not giving up yet on my original position.

22. Daniel to Peter M. Sandman and Jody Lanard
    April 21, 12:13 p.m.

I am curious where you stand.

I think there are three positions:

1. You agree with the SEC’s case, and Goldman should be punished.
2. You don’t believe that SEC has any case at all, but you feel that future regulation should be put in place to stop this happening again.
3. You don’t believe that the SEC has any case, and you see no good reason why additional regulation should be in place for this situation.

I’ve moved from a 1 to a 2. Are you a 3?

23. Peter M. Sandman to Daniel and Jody Lanard
    April 21, 12:50 p.m.

I’m certainly a 2 with regard to merchant banking generally, and especially CDOs and the like.

I don’t know if I’m a 2 or a 3 with regard to the narrower question of transparency in prospectuses.

There are surely things that led to the market collapse that should have been illegal and weren’t. I’m not sure if there were things GS did with regard to the Abacus portfolio that should have been illegal and weren’t – but I’m entirely open to that possibility. I am not open to trumping up a case against GS to cover our failure to regulate adequately; I have no clear view on whether that failure had anything to do with transparency in prospectuses or not.

24. Peter M. Sandman to Daniel and Jody Lanard
    April 21, 1:30 p.m.

This brief article makes one of the points I made more tentatively in my response to your earlier email: that a synthetic CDO always has somebody shorting it. It remains true that the short-seller isn’t always involved in choosing the portfolio – but as the article says, why should that matter to a sophisticated buyer that has examined the portfolio itself?

http://www.theatlantic.com/business/archive/2010/04/any-sympathy-for-the-investors-goldman-allegedly-misled/39282/

25. Daniel to Peter M. Sandman and Jody Lanard
    April 21, 2:08 p.m.

Yes, I like his example about selling a lemon to a mechanic. But even as I was starting to think, well, that doesn’t really matter if there were omissions of material information, I read the next paragraph, which basically refutes that.

And I may have to give up on the value of my nice long speech on buying vs. selling vs. shorting. As you (and he) point out, this product was made for buyers and shorters, and everyone knew it.

26. Jody Lanard to Peter M. Sandman and Daniel
    April 24, 4:23 p.m.

This article talks about Goldman Sachs emails showing the bank “sought to profit from housing downturn.”

http://www.washingtonpost.com/wp-dyn/content/article/2010/04/24/AR2010042401049_pf.html

It still doesn’t look to ME like they did anything wrong. They were debating internally about which way the market was going to go; they had divergent opinions at various times; they placed divergent bets at different times.

27. Peter M. Sandman to Daniel and Jody Lanard
    April 27, 8:46 a.m.

The first of the two articles linked below says the GS spin is evil but is working. The second one says it’s evil and will backfire.

• http://www.thestreet.com/story/10736379/1/goldmans-public-relations-efforts-are-paying-off.html?cm_ven=GOOGLEN
• http://www.forbes.com/2010/04/26/goldman-sachs-spin-personal-finance-public-relations.html?boxes=financechannellatest

I agree with the second article that contrition, not counterattack, is the best response to outrage. But how do you express contrition with regard to false charges that are widely believed?

The answer, I think, is to diagnose the outrage and apologize for what people are actually outraged about, not for the things they’re falsely accusing you of because they’re outraged (about other things). In this case, GS needs to apologize for its role in the financial catastrophe – and, more broadly, for its arrogance and self-indulgence, for its “masters of the universe” mentality that pretended what it was doing was incredibly important and incredibly difficult and worth paying incredible salaries and bonuses for (not to mention pretending it knew what it was doing) … for all the things that made people enthusiastic about blaming it for whatever was available to blame it for. (GS can’t apologize for being Jewish, though that is surely part of the picture.)

I tell clients to find things they can honestly apologize for, and to “correct the record” about things they’re unfairly accused of only in the context of a larger effort to reduce stakeholder outrage.

28. Daniel to Peter M. Sandman and Jody Lanard
    April 27, 9:23 a.m.

Yes, I like the second article – it is quite perceptive in outlining how the public’s view changed over time. And in fact, how my view shifted: first indignant and anti-Goldman, then (during emails with you) a shift to “what-a-ridiculous-charge,” and now back to “Goldman-must-pay.” Just ask Jen, I change my mind very easily, depending on what article I read, or who I speak to!

There was another very anti-Goldman article in the WSJ this morning: http://online.wsj.com/article/SB10001424052748704464704575208590634609592.html?mod=WSJ_hps_LEFTTopStories

It does contain a note of contrition from Blankfein [Lloyd Blankfein, CEO of Goldman Sachs]: “I recognize, however, that many Americans are skeptical about the contribution of investment banking to our economy and understandably angry about how Wall Street contributed to the financial crisis….” “…What we and other banks, rating agencies and regulators failed to do was sound the alarm that there was too much lending and too much leverage in the system – that credit had become too cheap.”

In my mind, it’s weak. It says “We’re all to blame” – they are sorry that this all happened, but this is more of a problem in the financial system in general. It’s a typical offer of generic contrition in exchange for zero contrition on the main issue (Abacus). I'm left feeling that they are being weaselly.

I'm sure you also feel this falls short, but I don’t know that I would go as far with contrition as you would. Is it not a matter of finding a balance? If you eloquently express in words the outrage of the people, and take it all on yourself, surely you risk severely damaging your competitive prospects relative to your peers.

For example, if GS says that one of their key unwritten missions was “the pure pursuit of profits at the expense of the greater economic good of the country,” this might be an honest statement, but I don’t think they would be wise to say it.

29. Peter M. Sandman to Daniel and Jody Lanard
    April 27, 9:50 a.m.

I would like to see GS concede that capitalism requires companies to maximize shareholder ROI in any way that’s legal and sustainable, and that shareholders have a legitimate claim of malfeasance if a company puts the welfare of the world ahead of that requirement. To concede that it must also concede:

1. that this aspect of capitalism is something normal people find offensive if not incomprehensible;
2. that this aspect of capitalism is why aggressive government regulation is essential, especially in the case of investment banking; and
3. that even by this standard GS and its peers failed, insofar as the binge of subprime lending was not sustainable – and in fact profiting at the expense of your customers’ welfare in ways that ultimately damage the world and outrage the public is rarely sustainable.

More generally, I am convinced that in a high-outrage environment being more contrite than peer companies is a competitive advantage, not a competitive disadvantage. There are lots of cases where the public had a choice of whom to blame for a crisis, and in almost every case the institution that was blamed most was the one that blamed itself least. See www.psandman.com/gst2003.htm#ritterhoff, for example.

30. Daniel to Peter M. Sandman and Jody Lanard
    April 27, 10:30 a.m.

Given that the highest level of outrage is coming from the general public, the communication task seems to me to be even harder. I don’t mean to imply that a bank should talk down to the public, or not treat them as intelligent (I’m sure this would be a mistake, and would like to read an article on this if you’ve written one), but would GS need to carefully tailor its message to someone who lost their home (but isn’t quite sure why)? And is their real task here to apologize for the financial crisis, rather than for the Abacus issue?

Or maybe Goldman doesn't have to worry about what Joe Public thinks about them, and should just make sure their apologetic message resonates with clients, regulators, investors, institutional buyers, etc.?

31. Peter M. Sandman to Daniel and Jody Lanard
    April 27, 12:50 p.m.

I’m not sure if GS would agree, but I think it has two main audiences: (a) investors, regulators, and others who understand the realities of high finance; and (b) the general public. Congress will be responsive to both, but ultimately more to the general public. And of course the jury pool will be absorbing whatever it is absorbing from the zeitgeist – again, the attitudes of the general public. Even activists (and prosecutors) will be monitoring whether the general public’s appetite for GS’s blood waxes or wanes.

The individual victims of financial disaster aren’t a key audience. But they’re players. If GS is wise it will speak directly to them … because the general public wants to hear what it has to say to them.

As for the intelligence issue, I think people are enormously capable of learning what they really want to know, and enormously capable of resisting learning what they’d really rather not know. So we are, as a species, willfully stupid in the service of many goals, several of which are relevant here: outrage, certainly; and also guilt – our preference to blame somebody other than ourselves for our own unwise actions.

I tell my clients that the information that X is true is almost totally worthless up against people’s preference to believe Y. But if you can get people to want to believe X, they are capable of mastering surprisingly complex information proving that X is true.

P.S. Another article on GS public relations: http://www.latimes.com/business/nationworld/wire/sns-ap-us-goldman-sachs-damage-control,0,5335089,full.story

32. Peter M. Sandman to Daniel and Jody Lanard
    April 28, 9:01 a.m.

Did you follow the Senate hearings on GS yesterday? Jody and I found them really disgusting – political leaders who know better pandering to the public’s desire for a scapegoat. I’d love to have heard an answer like this:

Senator, there are five options.

1. Either we did something that was illegal, in which case we should be prosecuted.
2. Or we did something that was legal but harmful to our shareholders, in which case we should be fired.
3. Or we did something that was legal and good for our shareholders but harmful to our customers, in which case they should take their business elsewhere.
4. Or we did something that was legal, good for our shareholders, and good for our customers, but harmful to the society as a whole, in which case it should have been illegal, and you should be investigating regulatory failures, not us.
5. Or we didn’t do anything wrong, in which case you should be trying to figure out what really made the economy tank instead of using us as a distraction and a scapegoat.

Take your pick.

I’m still tentatively picking the last option. (Jody is leaning toward 4.) I’m much too ignorant about the financial role of things like synthetic collateral debt obligations to know how they should be regulated. But I do know that there’s nothing wrong with an investment bank creating financial instruments that some investors want to buy and others want to short.

Sometimes the bank has no opinion on which of the two clients is right.

Sometimes the bank has an opinion, and thinks one of the two clients is investing foolishly; that does not create an obligation to tell the client so, as long as all the relevant information is on the table – especially if the client is a professional investor presumed to be savvy.

Sometimes the bank even acts on its opinion and buys or shorts that particular instrument itself.

Investors must be told that all these possibilities happen sometimes; they needn’t be told which one is happening this time.

Nothing I have read or heard so far persuades me that GS did anything wrong in the Abacus transaction. But I do see endless evidence that GS fostered a culture of arrogance – that it built a cadre of young, shallow, self-indulgent, smart-but-not-wise assholes who thought their incredible incomes really meant they were something special. I’d like to see GS (and the whole industry) acknowledge this, apologize for it, and do something about it. I don’t mind that in the meantime the public holds those über-punks in contempt. But I mind enormously that the Senate and the SEC are capitalizing on that contempt to mislead the public about the very nature of capitalism.

33. Daniel to Peter M. Sandman and Jody Lanard
    April 28, 9:28 a.m.

I’ve only read the commentary and articles today. I agree – it does seem like the politicians were striving for who could get the best quotable comment of condemnation. I really liked your 1-2-3-4-5 summary answer. I guess I would put myself at 4, except this creates the complicated problem of defining what exactly should be regulated.

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