Banking: Lessons From Goldman

It’s a slow day for economic news, especially since I think we’re all waiting for the GDP announcement later this week when we’ll learn the extent of the recovery now underway. With that in mind I want to extend my recent run of comments on banking by taking a very quick look at Goldman Sachs, the bete noir of progressive bloggers.

First off: in my dealings with investment banks I would always rank Goldman as the class of the group. They invariably were brighter and more innovative than the others. So I consider myself to be a Goldman Sachs fan.

Having said that they are currently behaving badly and need to be boxed in. And that’s me being kind.

How do I square these two statements?

Easily: the Goldman Sachs I dealt with was the one that existed before it went public in 1999. The whole nature of Goldman’s business changed after the initial public offering. The two organizations share very little in common other than the name.

For instance: back before going public Goldman was owned by a fairly large number of partners – between 200 and 250 of them. The personal wealth of these partners was predominantly locked up in Goldman’s equity and was available as a distribution usually only at retirement. Partners were expected to keep their cash in the company to help fund its activities. This is a very familiar situation for a partnership. A natural consequence of this practice was that the bank’s activities were heavily monitored and administered by the partners – they stood to lose their own wealth if the bank lost money. Thus the bank’s income streams were varied and balanced to prevent catastrophic losses. A good example is the income from securities trading which provided about one third of total income in the years just before the banks went public.

So the bankers who I was dealing with had their own money at stake. That meant their advice had a weighty feel to it: you could trust the fiduciary responsibility embedded within it since it flowed from the partner’s own position.

After the IPO the bank changed totally.

It is now about 80% owned by retirement funds and other investment managers who are not necessarily long term investors and do not have day to day control over risky decisions.

The consequence of this passive management is entirely predictable – except if you’re a fan of neo-classical economics and its ‘agency’ theory variations.

The income from riskier businesses like trading has ballooned and now accounts for almost 80% of all income – up from that 33% I mentioned before. The entire bank is now much more dependent upon the vicissitudes of volatile financial markets than it ever was when it was a true partnership.

So the loss of personal oversight has unleashed a willingness to take more risk and indulge in more leverage than was conceivable when the people managing the bank were at personal risk of loss. Goldman is significantly diminished a as result.

The problem is that the bank’s pay structure was not altered. It is a fine thing for partners to pay themselves whatever they want from the profits of their business – it’s belongs to them after all. It is absolutely not fine for a public company to persist in that same habit. The cost of management in a partnership is no one’s business but the partners. They can pay out the entire profit to themselves if they want. There is no public or external constraint in a private company like the old Goldman Sachs. But after going public that scenario changes completely. The cost of managing the company – including the cost of paying the employees – is now a burden on the shareholders who have a right to expect that burden to be minimized. In my own theories of management that’s why I focus on what I call ‘management cost’.

Allow me to explain.

Economic theory tells us that firms should not exist at all. This is because all transactions should be mediated – conceived and executed – within the ambit of a ‘free market’. And, as I have said here before, a ‘free market’ is one where no one has any long term advantages over anyone else. There can be no profits under these circumstancesand no firms – production is undertaken in the open market through the cooperation of equally skilled and funded partners.

Obviously this is a utopian vision. That’s the problem with economic theory – it simply doesn’t speak to real world economies.

But there is a kernel of truth in that vision: any cost associated with setting up and running a company has to come out of someone’s pocket. Rational people only tolerate that expense if they are going to get something they otherwise would not.

In the case of the average customer the benefit of that expense is the availability of products too complex or rare for the consumer to construct or locate for themselves. In this case the expense adds value.

For the shareholders there is a different benefit: the profits from a set of activities that they do not have the expertise to oversee themselves. There are very few investors who have the know-how to run their own bank or to build automobiles, so they hire managers to oversee the process, and those managers acquire the workers and machines etc to get the job done. This is the ‘agency’ I mentioned earlier: the managers act as agents for the shareholders. These agents cost money and must be governed correctly so as to prevent them defrauding the shareholders, that’s why businesses have boards of directors and so on.

So both customers and shareholders, for different reasons, look at the cost of running a firm as a burden they’d like to minimize. For customers that minimization should bring lower prices for the firm’s products. For the shareholders it should produce higher profits. Either way management has a duty to lower the cost of its own existence.

This is patently not occurring at Goldman Sachs. On the contrary: management cost is proudly inflated as if it were a sign of success.

The bank acts as if it were still a private company. It sets aside an obscene portion of its revenues for the benefit of its employees – either as base pay or as bonuses. The employees act as if the shareholders and customers did no exist. In fact they openly divert money from those two groups into their own pockets. This is called rent seeking in polite circles. In less polite circles it is dammed near fraud. The employees who owe their jobs to the capital invested by the shareholders and to the ongoing business thrown their way by customers skim an inordinate amount of the cash flow from their activities and hoard it for themselves. To the tune of about 50% of gross revenues. That is obscene.

And it reflects the extraordinarily twisted and self-serving sense of entitlement that pervades modern finance.

No self-respecting business analyst would advocate buying the stock of a company whose management cost was as inflated as Goldman Sachs is. We ridicule GM for having fallen into a situation where its employee costs are as high as they have become: that’s called bad management and is the subject of mirth amongst the traders who consequently sell GM short all the time. Yet they think nothing of their own excessive pay. Apparently its OK to pay a banker ridiculous amounts, but not a car worker.

The odd thing is that the investors who own Goldman’s stock don’t resist this open pillaging of their profits. Passive investors are the bane of capitalism. By overlooking the theft of their profits they diminish the returns they could be offering to the participants in their products – usually retirees. So the ludicrous pay structures of Wall Street end up impoverishing Main Street folks via the back door represented by passive investment managers.

Why would these investment managers tolerate this situation?

Because they’re in on the act. The Wall Street pay structure is mimicked by the pension managers, insurance companies, and other ‘fiduciary’ businesses. The top executives of these firms are extremely well compensated and want to keep it that way. they see nothing wrong with skimming half of a firm’s revenues for a bonus pool – as long as that firm is in finance. In manufacturing … not so much.

The common thread running through all this is that once clever people start to play with other folk’s money they need to be boxed in quickly. Otherwise they’ll rob you blind.

The old Goldman knew this. The partners were active and relatively risk averse. It is only in the last ten years or so that robbery became respectable – the current Goldman Sachs is flat out robbing its customers and shareholders.

We will never fix wall Street as long as this goes on.

If Wall Street types – and those pension managers – want to be paid like capitalists of yore, let them act the same way. Put your own capital at risk: all of it, every day. No cash bonuses. Just a lifetime stake in the capital of the company you work for.

I have said this before: one of the characteristics of old time recessions, and especially the Great Depression, was the frequency of bankruptcy amongst bankers. Those folks lost their own wealth: when the bank went bankrupt so did they. It was personal. Today’s yahoos are a far different crowd: they can run the ship aground and still expect to get paid. That’s why they’re a joke.

But the joke’s on us while we tolerate it.