What lies behind the history of Goldman Sachs and the Bear Stearns failure?
How have the Goldman Sachs history and other banking scandals affected Wall Street today?
William Cohan is the bestselling author of the book Money and Power: How Goldman Sachs Came to Rule the World as well as other books. He has a 17-year history on Wall Street. He worked with Lazard Frères and with Merrill Lynch and was a managing director at JP Morgan. With all of his experience on Wall Street, he has now become an investigative journalist and has written a lot about Wall Street.
Douglas Goldstein, financial planner & investment advisor, interviewed Cohan on the Goldstein on Gelt show to hear his ideas on the current financial situation.
William Cohan: Before I went to Wall Street, I had been an investigative journalist in Raleigh, North Carolina. I’m a proud graduate of the Columbia Graduate School of Journalism in New York. Journalism was in my DNA and it was only a sidetrack for 17 years of going to Wall Street that took me away from that. Then I decided to come back to it and see what I could do writing about Wall Street.
Douglas Goldstein: In your newest book, Money and Power, which is about Goldman Sachs and its huge power as a bank, you described the history of how the bank grew, but a lot of times people talk about the banks that are too big to sell with such a negative tone to their voice. Is it a negative thing?
William Cohan: You have to think about what the history of Wall Street firms is all about. Originally, when they came into being, they did well and they benefited by providing what their clients wanted, which by and large was capital. You can’t have capitalism without capital, and Wall Street firms provided capital to their clients 24/7 anywhere in the world and what they needed, and that is an incredibly valuable function. That’s why Wall Street has so much power. Metaphorically, Wall Street and any firms that provide this kind of access to capital for corporate clients is really the whole nature of the world economy nowadays. That aspect is usually an important function that Wall Street plays. They also provide advice on mergers and acquisitions. They also provide investment advice and those basic functions, which is what Wall Street did per se the first 200 years of its existence, which is very valuable and probably are what they get paid to do.
What’s happened in the last 25 years or so since these firms started going public, which began in 1970 making it 40 years ago, is that they got access to much more capital. They started using the public’s money, not their own partner’s money, and they began taking more and more risk with other people’s money. What happened is that they got much bigger with thousands and thousands of employees. Goldman Sachs has something like 32,000 or 33,000 employees now, when once upon time it was 5, 10 or 200. Now, these firms are huge and they have a huge amount of capital.
In 1970, Goldman Sachs’ capital was 45 million and today it is 72 billion dollars. The difference is that they get paid nowadays to take risks with other people’s money and that leads to unfortunately a lot of bad behavior that requires regulators to be vigilant. It requires the market to be vigilant and unfortunately when that doesn’t happen, we get into the trouble that we had in the last financial crisis.
Douglas Goldstein: Do you think the regulators are capable of overseeing this business?
William Cohan: I think they are certainly capable of regulating Wall Street more than they have done in the past 25 years, as Reagan’s mantra of deregulation became the gospel. I think that there’s no question that they fell down on the job during the last 10 years between the internet bubble and real estate bubble. It’s just frankly unconscionable what they allowed to happen on Wall Street, and more and more of their poor behavior comes out all the time.
On the other hand, it’s never been a particularly fair fight. The Securities and Exchange Commission is constantly fighting for every dollar that it can get from Congress. They are understaffed compared to Wall Street firms. They clearly have very many talented people, but it’s not in the same league as the people on Wall Street who get paid millions of dollars. The regulators get paid tens of thousands of dollars to do their job and to attract a different kind of person. The Wall Street firms basically are in existence to avoid or evade the regulators’ grasps. It’s never been a particularly fair fight, but that doesn’t mean the SEC and its ilk need to advocate what they did in the last 10 years.
Douglas Goldstein: The previous book you wrote was called House of Cards, which talks about the excess on Wall Street and how the recent economic situation came about and all the problems that we had over the past few years. Do you think that situation really could’ve been avoided given the power of the banks?
William Cohan: It absolutely could’ve been avoided. People like to think of Wall Street as monolithic and a collection of bad guys who are evil and want to take over the world and things like that. Naturally, that is a gross exaggeration of what Wall Street is really like. It is a collection of people just like everybody else who do what they are rewarded to do, which is to take risks with other people’s money, to make as big a bonus as they possibly can in any given year and they make decisions all the time.
In House of Cards, I wrote about the decision-making at the top of Bear Stearns, which led to the collapse of that firm. They made a series of decisions and kept to them, and that ended up being fatal to that firm and I’m not out with those decisions. Any one of these decisions could’ve been reversed at anytime and could’ve been changed. If people only had the motivation or the foresight to make decisions that were less greedy than the ones that they made.
I contrast that with what Goldman Sachs did, and now everybody loves to criticize Goldman Sachs, which is everybody’s favorite whipping boy and punch-line at the moment. In fact, as I outlined in the book, Goldman Sachs made a whole series of other decisions that led to its huge amount of success during the crisis. I know it gets lumped together with all the other firms, but if you actually look at the facts, the same year that Bear Stearns was going out of business, which is essentially the end of 2007, Goldman Sachs made $17.2 billion in pre-tax profit. These firms are very different and they’re very different in terms of decision-making at the top, and that’s the difference between success and failure.
Douglas Goldstein: Could you say that the banks are all making very big debts because they were planning with the huge pot of gold, and some of them won and some of them lost the bets?
William Cohan: Yes that is good shorthand for it, but I think it’s far more complicated than that because of the theories of many, many decisions that I think are hugely correlated to the incentive system that each firm has. Like for instance at Bear Stearns, they had a bonus system or a bonus culture, but the executive committee, the top five guys who run that firm were compensated based on a return on equity calculation, which is just Wall Street speak for a ratio between the profit the firm makes in any given year and the amount of capital they have in the firm at any given time.
At Bear Stearns, they were highly motivated to maximize profits with the minimum amount of equity capital. Bear Stearns went public in 1985. It did a secondary offering in 1986 and never raised capital again. Goldman Sachs was constantly raising capital throughout its existence and had a very different incentive system. The top 400 people who run that firm got paid based on the pre-tax profits of the firm made, not based on return on equity calculation although that’s something that the board certainly look at, but pre-tax profit so that when they sensed that the firm was losing money in 2006 trading mortgage tax security, they decided to do a complete 180 and they ended up going from being long on the mortgage market to shorting the mortgage market. As a result, they made billions of dollars while the rest of Wall Street went down the tubes.
That was the decision made by individual people at each of these firms. To say that this could’ve been prevented or could’ve come out otherwise is being utterly naïve and dismissive. I think one of the great things that this report by the financial crisis inquiry commission in the United States did was that it made the point that this was a man-made disaster that could’ve been prevented.
Douglas Goldstein: Regular people invest their regular money with these big bangs at the end of the day and I think they’ve lost a lot of faith. They felt the investment companies with whom they entrust their money don’t really have their best interest in mind. Is that true? Is there something that people can do about it?
William Cohan: Once upon a time, when these firms were all private partnerships with their partners’ private capital in these firms, which is the way it was from the existence of Wall Street until 1970, I think the incentives of the firm and its clients were completely aligned. As these firms went public and the public’s money was substituted for partners’ money, and the incentive system changed from being one with a shared pre-tax profit to one of getting a portion of the revenue that they generated, all the incentives changed and the conflict became larger and larger. There became a conflict between what was in the firm’s interest and what was in these clients’ and customers’ interest. We saw that play out to a hugely detrimental degree during this financial crisis.
For individuals who have their money at these firms, I think you have to be very careful. Anybody who is in the business of selling new products for a living knows that you have to take what they tell you with a grain of salt even though they may explain it in terms that make them seen like an expert and authoritative. I think you are better off perhaps finding somebody to manage your money who works at a small independent firm who you can trust and you can get access to on the phone who is not in the business of selling the products that the firm manufactures. We saw hugely the danger of that during this financial crisis.
Douglas Goldstein: Could you tell people how they could follow the work that you’re doing?
William Cohan: You can follow me at Twitter at William Cohan. My books were all available of course on Amazon and bookstores everywhere. I write for Vanity Fair, Bloomberg View, New York Times, Fortune Magazine and The Atlantic. I’m around.
Disclaimer: This article is for educational purposes and is not a substitute for investment advice that takes into account each individual’s special position and needs. Past performance is no guarantee of future returns.