Survival of fittest on Wall Street
What IS a disaster for America’s Wall Street (actually 50th and Park) and London’s City (actually Canary Wharf) and deep trouble for the economy of jobs, factories and stores has a (very small) silver lining for Charles D. Ellis and his publisher: “The Partnership: The Making of Goldman Sachs” will probably sell as many copies as they can print. Everyone interested in finance and economics will spend several months trawling for information to understand our current mess. Many know (or will soon know) that, of all the investment banks, commercial banks, shadow banks, hedge funds, investment vehicles, etc., in our economy, only two seem capable of withstanding current financial upheavals: James Dimond’s JPMorgan Chase and Lloyd Blankfein’s Goldman Sachs.
As of this writing, the rest of Wall Street’s large institutions appear likely to vanish completely, become nationalized or be gravely weakened if they manage to survive intact. The financial markets are reacting to the news of Treasury Secretary (and former Goldman Sachs head) Henry M. Paulson’s $700-billion relief plan without the slightest sign of the crisis easing. JPMorgan Chase and Goldman Sachs may not survive either, but they have much better odds of emerging stronger and of profiting from today’s stock market chaos -- it would take a near-Great Depression to drag them under.
For the last two generations, Goldman Sachs has been the rising firm to watch on Wall Street. For at least the last generation, the consensus judgment of those who work in the financial system has been that Goldman Sachs is the “best” large-scale Wall Street firm. As Ellis writes, the firm “recruited more intriguing people” and “people who cared more about [the long-term welfare of] their firm” than in other firms. Its leaders “took a longer-horizon view” and “were more alert to [operational] details.” They “worked harder” and “were more modest” -- that’s what Ellis says, but I don’t believe it.
The saying is that B-grade people hire C-grade people to work for them, and A-grade people hire A-grade people to work for them. The Goldman Sachs mathematics, however, has been that A+-grade people hire A+++-grade people -- the best in the world -- to work for them. That is many things, but it is not “modesty.”
Since the end of World War II, Goldman Sachs has grown from being a 250-employee firm that sold mostly commercial paper at low margins to a firm of tens of thousands able to enter and make a credible play to dominate any market it wishes. The firm’s analytical abilities to make guesses about where asset prices should be (and will be) are at least as good as, and usually better than, those of anybody else. Testifying before Congress early in the 20th century, then-dominant financier J.P. Morgan said that the most important asset in finance was character -- that one’s analytical judgments and long-term desires for the business are so strong that what one says does in fact happen. Goldman Sachs is seen by the consensus to have that character.
According to Ellis, the firm’s nadir occurred during the Roaring ‘20s, when it was known as the Goldman Sachs Trading Co., a firm that was the most overleveraged and catastrophic, bubble-based investment vehicle of that era. And yet, by a long, slow process, various Goldman Sachs heads created an institutional culture in which it has dominated in so many ways. The firm is trusted by outsiders, makes use of the information it gathers to make itself more profitable without making clients feel cheated, and places great value on intelligence and analysis as it takes large but calculated risks.
In the last generation, Goldman Sachs has grown to its current position as a financial juggernaut playing in every single sector of modern finance. And that is what most of Ellis’ book is about -- the creation of, in current head Blankfein’s words, “an interesting blend of . . . confidence and commitment to excellence . . . [coupled with] insecurity that drives people to keep working and producing long after they need to. We cringe at the prospect of not being liked by a client. . . . Alumni take a lot of pride in having worked here.”
With the current market crisis, however, readers may be more interested in how, in the early 2000s, 16 Goldman Sachs traders invested the firm’s own capital in residential mortgage-backed collateralized-debt obligations while also being responsible for making a market for clients who were speculating in the same securities. At the end of 2006, Goldman Sachs Chief Financial Officer David Viniar ordered the traders to reduce their exposure to mortgage-security risk. As Ellis tells the story, the traders complained that they did not know how to do that: They didn’t know what would be a fair or good price at which to sell. And Blankfein intervened, ordering them “to sell 10 percent of every position: ‘That’s the market price. Mark to that.’ Since the market was so large, it took months to completely hedge the firm’s exposure. By February 2007, the firm would have a large short position focused on the riskiest part of the ABX [index] . . . [which] would rapidly drop from about 90 to nearly 60.”
By the summer of 2007, Goldman Sachs was making additional large bets against the ABX index and was out of the business of making new collateralized debt obligations -- all this was happening while Citigroup head Charles Prince was saying that you had to keep dancing as long as the music was playing. If you stopped and prices kept going up, Prince said, your profits would lag far behind those of your competitors and the stock market would punish you. Prince echoed an apocalyptic judgment by John Maynard Keynes on a previous generation of bankers: that government intervention and economic management were required because high financiers were people who thought it better to fail conventionally -- in the company of their fellows -- than to succeed unconventionally by breaking from long-held strategies and positions.
The end result of what is happening on Wall Street is unclear. Organizations that bet significantly that mortgage-backed securities and their derivative collateralized-debt obligations had a future may not have much of a future of their own. Other firms that implicitly bet that these shaky organizations would not be forced to dump assets onto the market at fire-sale prices may not have much of a future either. And Goldman Sachs has reincorporated itself as a bank holding company to get inside the Federal Reserve system’s protection and is hunting for commercial bank assets to buy.
Like all financial institutions, Goldman Sachs is fundamentally a bank and is equally vulnerable to a bank run. In today’s world, the financial institutions with large commercial-bank businesses -- Bank of America, JPMorgan Chase -- appear to have an easier time maintaining confidence than those without. In retrospect, Goldman Sachs’ failure to acquire large-scale commercial bank assets once Glass-Steagall was repealed in the late 1990s was a mistake. But that appears not to have been a fatal mistake. Its competitors have made bigger mistakes, and Warren Buffett just invested $5 billion of Berkshire Hathaway’s money in Goldman Sachs. He wouldn’t do that unless he expected to make a lot of money.
J. Bradford DeLong, a former deputy assistant U.S. Treasury secretary, is a professor of economics at UC Berkeley.