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Many Shades of Gray: the Goldman Sachs Standard

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Many Shades of Gray: The Goldman Sachs Standard Are there ethics in big business? Or does big business answer to a different power? This can be a rather gray area. The problem to be investigated is the Goldman Sachs Standard and the ethics (or lack thereof) that exist in the company. The original market strategy was to provide loans for small businesses and then sell these loans as commercial paper. (Jennings, 2012) In the 1920s, this became a tough market in which to make a profit. So, to borrow a phrase, when the going gets tough, the tough change strategies. In the late 1920s, Goldman changed its investment strategy to layered investments. This strategy involves creating a company and then personally purchasing a large amount of the shares. Goldman would generally purchase approximately 90 percent of these shares. The public, unaware of the original purchase, only saw a profitable company so they eagerly purchased not only the remaining initial shares, but also purchased shares sold by Goldman at a higher rate. Goldman would also purchase some of these to artificially inflate the market even further. This enabled Goldman to make money off of the secondary sales.
Goldman was lying to its clients because the company it created was not truly as profitable as the inflated share price would indicate. It was fully aware of this and continued to layer additional companies into the strategy that would appear successful only as long as the market continued to grow. Goldman was lying through both commission and omission; and its lies not only affected its clients, but the market as a whole. This strategy was one of the factors of the market crash in 1929. (Jennings, 2012) Goldman did not promote ethical stewardship in this strategy as it pertains to its clients and the market as a whole. There needed to be more transparency in the trades even though this may have meant less of a profit for Goldman.
In the 1990s, within the market, there had existed a standard underwriting practice that required a private company to demonstrate a 3-year profit before going public. What was not known by most investors was that this standard was no longer being enforced. (Jennings, 2012) Goldman realized this and went as far as underwriting companies that had not shown any profit and even had business plans showing they were not expecting a profit anytime soon. Although Goldman was doing nothing illegal, they were capitalizing on the position that investors would be unaware that the profitability standard had been relaxed, thus placing more risk on the investors.
Goldman added to its strategy a practice known as laddering as it underwrote the initial public offerings (IPOs) of Internet companies. Laddering is when an investment company inflates IPO prices of shares for the sake of obtaining a greater allotment of the offering. The underwriter will offer initial pre-IPO shares to its best customers with the agreement that these customers will also purchase additional shares at the inflated price. Once the price increases a certain level, "insiders" then sell their shares at substantial profits. Laddering is illegal, but Goldman took this practice to a new level. They used the opaque nature of the scheme to hide the synthetic nature of the high demand which led to greater profits.
One example of this is the eToys IPO that Goldman underwrote in 2000. (Jennings, 2012) The stock for eToys was priced at $20 for the IPO. “Goldman had laddered the shares and the price climbed to $75 per share by the end of the first day of trading. By March 2001, eToys was in bankruptcy.” (Jennings, 2012, p. 76) The investors were not aware of the inflated share value or the additional risk they were assuming by investing in this IPO. Goldman received an SEC Wells notice for laddering. Goldman avoided a civil hearing by settling and agreeing to pay a $40-million fine. Once again, Goldman failed to display ethical stewardship by not being an “honest broker” for all clients. It refused to recognize its responsibility to make clients aware of their risk in order to ensure a higher rate of return for its better clients.
Goldman Sachs’ next venture delved into mortgage-backed securities; specifically collateralized debt obligations (CDOs). By this time in its history, Goldman had acquired such success that it began showing a “toes to the line” posture in which it would go right to the edge of legality. In 2007, Goldman reflected a change from investing in CDOs to investing in short sales. With this change, Goldman positioned itself to gain when CDOs fell in value. At the same time, it continued to sell CDOs to investors thus allowing the company to play both ends against the middle. In either scenario, Goldman would make money while a certain percentage of its investors would lose. There was no apparent effort from Goldman to keep its investors informed of any of these transactions. By filing its position change in the SEC Form 10Q, Goldman met the letter of the law even though they were aware that these quarterly reports are seldom audited by the SEC or reviewed by investors.
Goldman’s investment strategy for CDOs greatly resembled its strategy for layering from the 1920s. (Jennings, 2012) When Goldman changed its status from an investment bank to a bank holding company it became eligible to receive loans from the Federal Reserve that carried no interest rate for repayment and had no time limit for repayment. With these funds, Goldman was able to invest substantially in the layering model resulting in large personal profits.
It was during this period that Goldman began holding trading huddles. These were meetings between Goldman analysts and Goldman traders to discuss the forecasted success or failure of different investments. Contrary to SEC provisions of transparency, Goldman would only share the results of these meeting with its employees and select larger clients. These results were generally different than the information Goldman shared publically. Goldman circumvented the SEC requirement of analysts issuing reports contrary to their actual beliefs by only including in its huddles the type of analyst that did not fall under the purview of the SEC regulation. This practice once again gave an unfair advantage to certain larger investors as Goldman traders followed the letter of the law, but failed to adhere to the spirit of the law.
Several large Wall Street firms, to include Goldman Sachs, participated in auction-rate markets. (Jennings, 2012) These securities instruments were advertised as mutual-fund grade with higher returns. The firms would offer these securities monthly and their clients would be invited to bid on them. What investors did not realize was that the firms would also be bidding on the securities, thus inflating the price of the securities. The firms would artificially increase demand and reset the price of these securities weekly. They did not worry about the risk of inflating the demand because they were betting on the greed of their investors to outbid them. This growth gave the illusion of a thriving market even though it was being artificially influenced by the investment firms. When Goldman pulled out of the operation the market collapsed. Legal action was initiated by the New York Attorney General which was averted by the investment firms agreeing to buy back their investors’ securities. This incident was touted as one of the largest contributions to shaking public confidence in the integrity of the market. Goldman once again failed to show ethical stewardship by not revealing their participation in inflating the value of the securities instruments. This action had a significant impact on Goldman’s larger clients financially as they were left holding significant numbers of unsellable funds.
The CDO market seemed to afford Goldman Sachs plenty of opportunity to practice their “toes to the line” strategy. In 2010 Goldman was involved in a CDO deal known as ABACUS. In this deal, a Goldman employee put together a CDO group from the mortgage pool that had been identified by a financial analyst as substandard. This analyst and Goldman positioned themselves short on these securities so they would make money when the securities instrument failed to deliver. Goldman entered into this arrangement with full knowledge and even used a third party to structure the deal so they would be distanced from the actual activity. The SEC filed a civil action against Goldman Sachs for this venture and Goldman Sachs agreed to pay $550 million in penalties and client reimbursements. As Christine Harper (2011) states: “While Goldman Sachs didn’t admit or deny wrongdoing under the SEC settlement, the largest ever by a Wall Street firm, the company said it made a “mistake” in its marketing materials about the investment.”
Goldman Sachs leadership has influenced the actions of all with whom it does business. Analysts and sales staff are encouraged to be aggressive in their trading actions. One of Goldman’s management mantras is “Filthy rich by forty”. (Jennings, 2012) Young, impressionable analysts and sales staff were able to observe upper management’s disregard for SEC sanctions and took this as a cue to stretch the limits when structuring offerings. To borrow a line from the movie Wall Street, “Greed is good”. Upper management and executives were doing all they could to keep the margins as high as possible. They felt insulated from civil action because they knew that their size and their influence over the market would make it nearly impossible for significant sanctions to be levied against them without risking a market collapse.
Was Goldman Sachs bluffing during its participation in the CDO market? Definitely not. Bluffing is lying in risk. The bluffer may have a week hand, but he also does not know what is in his opponent’s hand. In the CDO market participation, Goldman was never at risk. Goldman knew what the market would do because it was able to manipulate the market in the direction it wanted the market to go. Goldman then hedged its bet by playing both sides against the middle.
When Goldman CEO, Lloyd Blankfein, made the contention that Goldman’s investors were qualified and/or sophisticated investors to whom the company was not required to provide detailed information, he was saying that these investors should have known the risks in the market and performed their own research if they wanted more information.
According to Jennings (2012): “Howard Chen, a banking analyst, issued these observations on the Goldman settlement: (1) He observed that there would be no management changes at Goldman; and, (2) “We do not anticipate any material long-term impact to the firm’s client franchise.”” Both of these statements are disturbingly true. Why should Goldman replace any of its leaders? It still is one of the largest firms on Wall Street. It has over 32,000 employees. It has assets over $1 trillion and annual revenues are steadily growing even in a depressed market. Currently Goldman is not even accepting clients with less than $10 million to invest. (Jennings, 2012) The fines that have been levied against Goldman do not even reach one percent of its assets. What is truly disturbing is that Goldman seems to be beyond the reach of its governing body, the SEC. Is it that the SEC does not possess the power to control these “monster” companies? Or is the SEC concerned that if fines are levied in the amounts that would cause discomfort to the firms, it could inadvertently cause a serious dip in an already unstable market? Todd Baker, the former executive vice president for corporate strategy and development at Washington Mutual stated, “We always need to worry a little about Goldman because we need them more than they need us, and the firm is run by traders” (Harper, 2011) References
Harper, C, (2011). Goldman Model Championed by Blankfein Planted Seeds of Distress.
Bloomberg Businessweek, July 22, 2011. Retrieved from http://www.businessweek.com/news/2011-07-21/goldman-model-championed-by-blankfein-planted-seeds-of-distress.html#p1

Jennings, M. (2012). Business ethics: Case studies and selected readings 7th Ed. Mason, OH:
South-Western Cengage Learning. ISBN: 9780538473538

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