A Defense of Goldman Sachs

Question: I must take exception to your two pieces on Goldman Sachs (Part I and Part II). Let us concede up front that Mr. Blankfein’s formulation of Goldman doing “God’s work” was a bit ham-handed at best, but rather than just endlessly making sport of that, you might have more thoughtfully addressed the key point that he was trying to make: that Goldman was playing an important and constructive role in the distressed financial markets of late 2008 and early 2009.

This role goes well beyond just the investment banking/new issue business, which, it is true, accounts for only a small portion of the companies total revenues. Goldman, as well as the other major investment banks, plays an important role in making markets in a vast variety of financial instruments that is vitally needed to maintain the liquidity in the markets. All the revenues generated in these activities shows up as “trading” income in their financial statements. Your report thoroughly conflated all these revenues with “proprietary trading for their own account,” which is at best a gross misrepresentation of what goes on. To be sure, there is proprietary trading that goes on at Goldman Sachs, but a good deal of what shows up as “trading” income is really what the English commonly refer to as “dealing” income, which results from making markets.

Unlike equity markets, with which you are perhaps more familiar and are traded on an “agency basis,” almost all fixed-income trading is done on a “principle” basis, which means that it passes through a broker/dealer’s balance sheet on its way from the seller to the buyer. This is because the fixed-income markets are much more highly fragmented than the equity markets and thus there is not necessarily a matched trade there at exactly one single moment in time. That is why dealers buy a position from a seller and then look around for a buyer to take that position off their hands.

It works the exact same way in many markets for things of great value. Think of dealers in antiques, art, rare coins, collectible automobiles and so on. If you inherited a rare stamp collection from a great aunt, you would probably take it to a dealer, or better yet, several dealers to see what it is worth and who would make what kind of bid on it. That dealer, is of course very likely to be more knowledgeable about the value of the collection than you would be. Before making you an offer he would probably think of clients who had expressed an interest in such and such a specimen and auction records for this or that other piece. Would that stamp dealer be “front running” you just because he made you an offer that was lower than where he thought he could sell the collection? Of course not, that is his business.

In the same way, though on a vastly larger scale, it is with fixed-income markets. In the United States alone, there are about $34 trillion of fixed income investments, which come from literally hundreds of thousands of separate issues, many of which are very difficult to understand, are infrequently traded, and difficult to value. To maintain liquidity in these markets — and remember it was illiquidity more than anything else that turned a “problem” into a “crisis” — you need dealers like Goldman to stand in the middle of the trade.

I understand that many people are angry about the financial crisis. I am a taxpayer too and am angry as well. But the road to finding a solution to prevent, mitigate, and resolve future crises needs to be driven by some clear analytical thinking about what went wrong. By personalizing the issue, and demonizing one of the most critically important market makers in the markets, you do nothing to further the dialogue about what went wrong and what we should do about it in the future.

Paul Solman: This is an extraordinarily sophisticated response and I thank you for it, Mr. Kotowski. It will give readers the very best possible defense of Goldman and its actions.

That said, I would ask them and you to consider David Stockman’s point: that Goldman, like all investment banks that make their money by “trading” (broadly defined), do so PRIMARILY by something akin to “front-running”: trading ahead of the very clients whose business you detail above. Every investment banker and finance professor I know (and I know plenty) acknowledges that this is how Goldman makes most of its money.

Brokerage? Sure, it can be a profitable business, especially if key rivals like Bear Stearns and Lehman have bought the farm. But why is Goldman so FANTASTICALLY profitable? All I can report is what’s been told to me, again and again: mainly because they trade for their own account (like a hedge fund), mainly with money they can raise cheaply because of the Fed and the implicit government TBTF guarantee, mainly on the basis of more information they are privy than ever before, mainly because they were saved when others weren’t.

Did the government NEED to save Goldman to keep the markets functioning during the crisis? I imagine so, though no one can ever know for sure. But should they be allowed to keep the game going now and pay their employees most of the profits they’re making? Those are the policy questions of the moment.