The investment bank is, among other things, an underwriter. That means it buys securities from an issuing company and sells them. Goldman is also a "market-maker." That means it facilitates trading by offering to buy and sell securities from investors at set prices.
A key question emerging from yesterday's testy Senate hearing on the investment bank's role in the financial crisis is whether these functions are fundamentally at odds.
From the outset of the 10-hour session, Goldman officials and lawmakers frequently talked past one another. "It's like we're speaking a different language here," Sen. Jon Tester, D.-Mont., told Goldman CEO Lloyd Blankfein.
Partly, it was the occasion. The banking firm is, of course, in hot water with the SEC. Blankfein, Fabrice Tourre, and the other current and former bank execs who testified were understandably guarded in their answers. For their part, the senators on the panel were understandably aggressive in their questions (and not averse to creating a headline or two). Sparks were bound to fly.
But the fencing stemmed from something deeper -- disagreement, misunderstanding and distrust over what Goldman does and how it does it. Here's a telling exchange between Blankfein and Michigan Democrat Carl Levin:
Levin: "When you sell something to a client, they have a right to believe that you want that security to work for them. In example after example, we're talking about betting against the very thing you're selling, without disclosing that to that client.... Is it not a conflict when you sell something to someone, and then are determined to bet against that same security, and you don't disclose that to the person you're selling to?"Levin is accusing Goldman of hawking a product it had allegedly designed to fail, the infamous Abacus CDO, so that the bank and a preferred client (hedge fund manager John Paulson) could cash in by shorting it. For his part, Blankfein is arguing that Goldman simply acted as a merchant in giving investors what they wanted -- a stake in the future of the housing market and a chance to profit if home prices rose. As such, Goldman wasn't interested in whether the mortgage-backed securities in Abacus were going north or south.
Blankfein: "In the context of market-making, that is not a conflict. What clients are buying is they're buying an exposure. The thing that we are selling to them is supposed to give them the risk they want. They are not coming to us to represent what our views are. They probably, the institutional clients we have, wouldn't care what our views are, they shouldn't care."
Levin thinks Goldman should have cared; Blankfein doesn't see that at all -- in his view, all Goldman was doing was providing a marketplace.
Goldman got into the underwriting game in the early 20th century. Its first big splash came in 1906 when it joined Lehman Brothers in taking Sears Roebuck public (offering price: $50 per share). For years, much of Goldman's revenue came from underwriting, along with selling commercial paper and providing traditional investment banking services, such as advising on mergers and acquisitions.
Goldman's push into market-making dates only to 2000 (the year after it went public) when it bought "specialist" firm Spear, Leeds & Kellog for $7 billion. The deal instantly turned Goldman into one of the biggest providers of these services on the NYSE and Nasdaq. Other Wall Street players, such as Deutsche Bank and Merrill Lynch, were also diving into the business.
For Levin and other lawmakers yesterday, the issue is whether Goldman has the same fiduciary duty to investors it does business with in making markets as it does, say, to underwriting or M&A clients. Are market-makers under any legal or ethical obligation to tell customers everything they know about a given security that could affect its value? And should an investor care if someone like Tourre, whose opinion on the real estate market may not be worth a nickel, thinks home prices are set to collapse?
The Senators clearly thought so. Blankfein and the Goldman executives seemed dumbfounded by the idea.
Frankly, I don't know who's right. But intuitively, having the same requirements for both underwriting and market-making seems impractical. It would turn providing liquidity to the market into a disclosure nightmare.
Of course, Goldman's reputation could suffer among investors who are shocked (shocked!) that bank employees might sling products that are, to borrow Levin's turn of phrase, "shitty." But probably not: Somehow I suspect there are employees all around the land who have a similarly low opinion of their companies' offerings. On Wall Street, this will not exactly come as a surprise.
And finally, investors don't deal with Goldman because of the firm's reputation for being ethical. They go to the company because of its reputation for knowing something other banks don't. What would hurt Goldman is if clients stopped trusting it to share what it knows.
Attacking Goldman's business model might well be warranted. But Congress would be better off following the SEC's lead and focusing on more concrete questions, like whether the bank lied about Abacus.
Tower of Babel image by Tobey C. Anderson