Daniel Krauthammer, who holds a Master of Science degree in financial economics from Oxford University, demonstrates how wide-of-the-mark Democratic Senators were when they cross-examined Goldman Sachs executives last week. The questioning by such Senators as Carl Levin, Claire McCaskill, and Jon Tester betrayed ignorance — feigned, willful, or otherwise — of what financial markets are all about.
Characterizing the Goldman securities in question as “good” deals, “bad” deals, or, as Sen. Carl Levin (D., Mich.), the chairman of the investigations subcommittee, was fond of putting it, “sh***y” deals, the senators drew comparisons between these complex financial instruments and common consumer products like cars. These are false parallels that apply an inappropriate economic and ethical framework to thinking about financial reform.
There is a basic and very important difference between what financial institutions do and what every other sector of the economy does. Unlike firms in the rest of the economy, financial institutions do not produce actual, tangible goods. They operate on a level once removed from goods-producing firms, creating and trading on the markets that allocate capital and credit to those firms and to the consumers who buy their products. For every such allocation, there is potential for a high return on the investment and potential for a low or even negative return. In other words, there is risk and there is reward. Financial institutions act first and foremost as middlemen between sellers of these risk-return packages (companies, governments, mortgage borrowers, etc.) and buyers (retail investors, pension funds, insurance companies, etc.). In this world, the investment banks are market makers. The “products” they create, buy, and sell are packages of various combinations of risk and return.
There is no such thing as a financial package or instrument that is inherently “good” or “bad,” “better” or “worse” than any other. These packages simply offer different profiles of risk and return. They can be “better” or “worse” only for a particular client, based on what the rest of the client’s portfolio looks like and thus what kind of additional exposure to risk and return is optimal for that portfolio. The exact same financial instrument could be a very good investment for one party and a very bad investment for another. It all depends on the desired risk exposure.
It was thus meaningless for the senators on the subcommittee to talk about these financial instruments as if they were everyday goods that can come with a manufacturer’s guarantee. Senator Levin repeatedly asked Goldman CEO Lloyd Blankfein and his colleagues whether a “customer has a right to assume that you [Goldman Sachs] would like to see that security succeed.” Mr. Blankfein explained that the term “succeed” has no solid definition in this context. While most of the senators saw this defense as obfuscation, it was in fact an accurate statement that goes to the heart of the problem: Success depends on the customers’ preferences and what they seek in their portfolios. A tranche of mortgage-backed securities could nosedive in value but be very successful for its holder if, for example, that holder had large stock holdings in counter-cyclical businesses like fast food and discount shopping centers, which generally do better when the rest of the economy does worse. Because mortgage values are strongly pro-cyclical, these risk-opposite positions would smooth out the effects of large booms and busts in the holder’s portfolio.
The obligation on market makers in this context is not to give their clients securities they believe will be “successful” — a term without real meaning — but to make sure the financial product in question delivers the risk exposure (and potential return) that the client is seeking. That is the duty of an investment bank in this context, and it is what Goldman argues it did for its clients, who were not workaday retail investors, as many of the senators seemed to intimate, but rather some of the biggest and most sophisticated investors in this asset class, who clearly understood — or at least whose very well-paid job it was supposed to be to understand — the types and degrees of risk they were taking on.
To the extent that the Democrats on the Committee acknowledged any difference between selling securities and selling cars, it was only by way of claiming that investment bankers are essentially “bookies,” or a casino, who serve no worthwhile social purpose. Krauthammer explodes this claim too:
The casino and sports-bookie comparisons fall apart. . .because they fail to encompass the idea of portfolio building in a world in which all economic and asset price behavior is interconnected. A single horse race is a pure speculative gamble because it is an independent event that has no correlation to any other bet. But if the performance of different horses had statistically significant correlations to economic factors as various as crop production and manufacturing growth, mortgage rates and technology stocks — as the Goldman securities in question most certainly did — then a wager on them would not be a speculative bet but rather an informed investment.
The real problem, according to Krauthammer, was not illegal, immoral, or even greedy conduct, but rather the fact that “all the investment banks were executing the same kinds of complex and opaque deals using similar financial models without taking each other’s effect on market movements into account.” But because the showboating Senators have missed this point so badly, they also are missing the proper approach to solving the problem.
Rather than trying to pin individual blame on particular firms or investors, as so much of the Senate seems intent on doing, the right thing to do for the country and for its financial system is to enact financial reform that acknowledges the collective nature of the problem and applies collective solutions. Through tougher rules on transparency and reserve requirements, greater restrictions on certain types of trading, and smarter guidelines for incentive pay, well-designed financial regulations could keep banks from driving each other into making the kinds of deals that, while on their own are beneficial to each, as a whole put everyone in danger. Understanding these real issues, rather than pursuing moral grandstanding and scapegoating, is the route to meaningful reform.