Thursday, December 20, 2012

Inside the Great Vampire Squid

Review of Why I Left Goldman Sachs: A Wall Street Story, by Greg Smith (New York: Grand Central Publishing, 2012)

Earlier this year, Greg Smith, a young financial industry executive, announced his resignation from the giant Wall Street firm Goldman Sachs, where he had worked for twelve years, mostly in New York. But he didn’t send his Goldman supervisors a standard resignation letter.

Instead, he worked secretly for months on an essay “to distill into simple terms exactly what I felt was wrong” (p. 236). After confirming Smith’s story, The New York Times published the essay just days after he cleaned out his desk late on a Saturday night. (Readers of this blog might recall this posting about the op-ed on the same day it came out.)

Smith writes that “Goldman would later tell me they had surveillance video of me walking out the front lobby with my box and backpack. They thought I had larceny in my heart, when all I had was freedom” (p. 243).

Smith’s ticket to freedom--the op-ed piece explaining why he was leaving Goldman--attracted so much attention that he was reportedly offered a $1.5 million advance to publish a book.

But reviews of his quickly published memoir have been mixed. The New York Times’ James Stewart complained that it “was curiously short on facts.” Not surprisingly, The Wall Street Journal sided with Goldman Sachs and said that Smith deluded himself into “taking his dissatisfaction [with his pay] as a betrayal by the firm he loved”—something that Smith explicitly denies (p. 241). Forbes said that his “story just doesn’t add up” or “make any sense.” These judgments, as I’ll show, are unfair and miss the point.

Instead, I think this book is an interesting glimpse inside a company that Rolling Stone magazine’s Matt Taibbi famously called “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.”

BusinessWeek’s reviewer, Bryant Urstadt, offers a more sympathetic reading, comparing this Wall Street memoir to Michael LewisLiar’s Poker, a tell-all story of Lewis’ time at the former Salomon Brothers company that I described last year as “a hilarious send-up of the big shots who ran Salomon by someone who saw their greed and recklessness firsthand. Lewis was close enough to be on the inside, but critical enough to keep his distance; his account turns out to be a readable introduction to Wall Street, specifically the bond market, in the 1980s.”

Like Lewis, who was an art history major at Princeton, Smith was recruited out of an elite school (Stanford). But Smith was an economics major who was passionate about comparative advantage and about making money. Lewis, the liberal arts student, by contrast, seemed unimpressed with money and bemused by investment bankers.

Lewis was also modest about his own ambitions as a twenty-something young person. Greg Smith, however, comes across as an earnest over-achiever who was proud of making it in the competitive world of Goldman Sachs. To cite one example, he stresses how rigorous the recruitment process was, pointing out that only 2.2 percent of people who apply for internships or full-time positions get an offer (p. 9). He was clearly pleased to be in the 2.2 percent. By contrast, Lewis “takes his own advancement as a sign that something’s not right at Salomon Brothers” (to quote Urstadt's review). A little humility would have helped Smith’s case.

And he’s not nearly as entertaining a writer as Lewis. Smith narrates at least two brief conversations with Goldman big-shots happening at urinals, and it just sounds weird. Lewis, a born storyteller, would have made more of this material.

Whereas Lewis quits after seeing the absurdity of Wall Street’s bond market, Smith only gradually sees Goldman’s greed and ethical shortcomings. For years, he doesn’t ponder the absurdity of profiting from complex financial instruments that few people understood. Instead, he was so gung-ho about Goldman that he did corporate recruiting for them.

Still, even if it lacks drama, Smith’s story of growing disenchantment with an employer he loved does tell us something about Wall Street's role in the global financial crisis. We can profitably read Why I Left Goldman Sachs as an accurate picture of a typical young person who entered Wall Street in the early 2000s. And we should read the details, while not bombshells, as significant indicators of the corrupted culture of Wall Street, from a highly sympathetic source. 

What follows are a few glimpses inside the “great vampire squid’s” way of doing business, by one who was there and saw how it contributed to the global financial crisis.

Goldman Sachs became a hedge fund rather than a trustworthy adviser. A number of reviewers have glossed over this important point, but it seems central to Smith’s departure. As he puts it, “a fiduciary stood in a special position of trust and obligation where the client was concerned. This role was applicable when the firm was advising the client about how the client should best invest its money versus pushing the client into investments that generated the largest fees. . . . This ideal of doing what is right for the client, and not just what is right for the firm, was there, prescribed in the 1970s by former senior partner John Whitehead in his set of 14 Principles” (p. 111).

So what had changed? Goldman had been privately held until 1999, and its partners could maintain control of the firm. Once Goldman went public, issuing stock in 1999, the pressure to generate ever-higher profits increased, and the partners lost control. Instead of investment banking, “proprietary trading” became the profitable service to sell. And sometimes Goldman would become a co-investor in such trades. “In the old days,” writes Smith, “the firm would advise a client to invest its own money in something; in the new universe, the firm could now invest its money in the same thing” (p. 113). The problem, however, was “when the firm changed its mind (or masked its intentions) and made a bet in the other direction from the client’s” (p. 113).

In other words, Goldman might advise a client to buy into a complicated scheme and then turn around and bet against that scheme. Such conflicts of interest became more common, but Smith trusted his bosses “for a long time” (p. 114).

By the end of 2008, however, Smith says that he was growing wary of a corporate culture that promoted a trader to managing director who was gouging clients (pp. 154-55).

When Senator Carl Levin of Michigan held public hearings in 2010 on a famously “shitty deal” that Goldman advised its clients to buy—the perfect example of a conflict of interest and what Goldman called an “axe” (see below)—Smith watched them on TV in Asia, where he met with a client the next day. When the client said that he couldn’t trust Goldman, Smith’s instinct was to think of how to fix the problem (p. 186). But the high-level Goldman partner working with him didn’t seem to care and was only interested in making money in the short-run. “Maybe this was an isolated example, but it was not what I expected from a partner” (p. 187).

However, other evidence from the book suggests that this was not an isolated example.

PATC meetings or Bonus Day
Smith explains how a ten-minute meeting each December would decide each employee’s Per Annum Total Compensation (PATC). Informally, Goldman people called the ritual Bonus Day. As he puts it, “there was an absurd amount of emphasis placed on these meetings. For many people, the session determined a person’s entire self-worth” (p. 119).

On Bonus Day 2006, when he was in his mid-20s, Smith was told that he would make “close to half a million dollars” (p. 119). And, even though he had also been promoted to becoming one of thousands of vice presidents, he was disappointed!

Later, he describes how the compensation system became “largely mathematical: you were paid a percentage of the amount of revenue next to your name” (p. 233). Naturally, “the problem with the new system was that people would now do anything—anything—to pump up the number next to their name,” which poisoned “young minds” (p. 233).

An excessive focus on individual compensation, regardless of how well you served your clients, surely helps to explain the problem, even at Goldman, which was widely considered to be the best-run, most ethical Wall Street firm. No less than authority than Nouriel Roubini contends that compensation was a root problem in the crisis (Crisis Economics, pp. 68-69, 184-91).

Even if Smith is motivated by sour grapes, which he denies, the problem of compensation, attached to booking profits without regard to consequences, remains.

Elephant Trades and GCs
Amid growing uncertainty in 2007, Smith also explains a growing emphasis on making huge “elephant trades” that made Goldman a million dollars or more in profit. “When you executed one of these trades, the revenue would go next to your name in the form of a gross credit, or GC” (p. 126). Later in the book, he describes the focus on GCs as corrupting Goldman’s culture (pp. 190, 229, 234). He tells how his supervisor, Georgette, came to his desk and said, “The only time I want to hear from you is in the form of a one-line email that states how the big trade was and what the GCs were” (p. 225). This emphasis confirms the impression that profit crowded out care for clients and corroded Goldman’s organizational culture (Smith’s primary grievance).

While others think Smith is naïve to complain about this—we are talking about Wall Street after all—he is documenting an important shift in Goldman’s culture. And it’s a story connected to larger cultural shifts (from Enron to professional sports and beyond). As profit becomes everything—or the only thing—communal trust is corroded. 

“Structured derivatives” and selling tuna
Smith describes how the complex financial products called derivatives could harm real people. For example, the city of Oakland bought a swap from Goldman that was designed to hedge against interest rate increases. “The product ultimately backfired, and is now costing the city millions of dollars” (p. 152). He likens Goldman’s sales of derivatives to a company that sells tuna:

The can clearly says, “Bumble Bee tuna,” and features a cute little logo. You go home, and most of the time you enjoy some delicious tuna. But let’s say you get home one day and find dog food inside the can. How can this be? you wonder. They told me it was tuna. But then you look at the back of the can. There, in print so tiny as to be almost unreadable, is printed something like “Contents may not be tuna. May contain dog food.” (p. 153).

Unfortunately, “most clients pay as close attention” to “the fine print of the ten-page disclaimer at the end of the contract” as “you do when you hit the Accept button before downloading music from iTunes”(p. 153).

Clients beware?
A reasonable person might therefore counter that buyers should be aware of what they are buying, especially when they are investing millions of dollars in pension (or other) funds for someone else. But Smith contends that Goldman preyed on the “Client Who Doesn’t Know How to Ask Questions.” Such clients were “the perfect target to sell a type of derivative known as an exotic—a very complex product that could be made to look much simpler for the client when dressed up with enough bells and whistles as a structured product” (p. 163). In other words, they were buying tuna cans that might have dog food in them, but they had no idea.

Smith says that some of these clients would end up on Goldman’s top 25 clients list, as ranked by the fees they paid to Goldman. “There is something highly disconcerting,” he writes, “about seeing a global charity or philanthropic organization or teacher’s pension fund in the top twenty-five of a firm’s clients” (pp. 163-64). In other words, Goldman profited from the naïveté of these non-profit clients.

Selling Axes
Smith says that he was bothered by pressure to sell risky investments or positions that Goldman wanted to axe from its books, even though it knew that these investments would harm clients. Here’s how Smith nicely describes the problem:

The firm believes, deep down, that one outcome is going to transpire, yet it advises the client to do the opposite, so the firm can take the other side of the trade and implement its own proprietary bet. One way to understand this is to think of selling donuts. Say you own a Krispy Kreme doughnut store, and you have too many doughnuts in stock and need to sell them before they go bad. In order to drive up sales, you could say “Our doughnuts are fat-free!” That would technically be a lie, but it wouldn’t get you sent to jail. It might open you up to legal action, but who really wants to go to court? Suddenly people would be rushing in to buy these delicious Krispy Kreme doughnuts, convincing themselves that if a brand as reputable as Krispy Kreme is saying the doughnuts are fat-free, then it must be true. Axes are something like surplus Krispy Kreme doughnuts that Goldman wants to clear from its inventory, making a compelling, but not always completely accurate, case for clients to buy them. (pp. 230-31).

The most famous axe of all was the notorious Abacus/Timberwolf deal made famous by Senator Carl Levin in the following interchange with Goldman witnesses.

The problem with this deal was that Goldman could “see what both buyers and sellers [were] doing” (p. 185). It knew that the Timberwolf investment was a bad one, and advised clients to buy it, yet at the same time that it was also betting its own money that Timberwolf would crash in value.

This problem of “asymmetric information” means that Wall Street firms like Goldman are like casinos that can “effectively see everyone’s cards” and even determine which cards you get (in complex, unregulated derivatives. “Certainly not much scope for the casino to lose in this scenario” (p. 248).

Working in London, Smith was involved in selling dubious products akin to the “fat-free” Krispy Kreme donuts to “the national banks of sovereign nations, countries with millions of citizens who were depending on their governments to get their shit together” (p. 232).

Goldman Sachs’ behavior had terrible real-world consequences for governments in Europe and around the world. Ripping off these central banks is hardly ethical business, and Smith is right to be upset about this.

A whitewashing self-study
Smith describes how Goldman went through a year-long Business Practices Study, ending in January 2011, which appeared to be more of an exercise in PR and spin than a genuine attempt to learn lessons from the crisis, dashing his hopes (pp. 192, 218-19). In a follow-up seminar to discuss the study a few months later, Smith says that he suggested to a high-level partner that managing directors needed “to be held accountable” and reforms be put into practice, but the partner “looked at me with a blank stare and nodded wordlessly, almost robotically” (p. 230).

We shouldn’t be shocked that Goldman failed to police itself as it ripped off its own clients. “This was happening all over Wall Street,” writes Smith, “but Goldman Sachs was supposed to be a leader” (p. 241).

Or maybe it really was just a huge vampire squid.

Either way, Greg Smith is free now.

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