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Goldman Sachs woes worry Wall Street

What most worries the big guns of Wall Street about the Goldman Sachs blowup is the light it sheds on their operations and the consequences for their business models.

Warren Buffett last week said there was nothing “unique” about The Goldman Sachs Group Inc.’s behavior in structuring and selling a synthetic collateralized mortgage obligation that the Securities and Exchange Commission claims defrauded some institutional clients and favored another. The Sage of Omaha meant to defend Goldman’s approach to facilitating trades, but his support for a company in which he owns $5 billion of preferred stock could backfire if he’s right that “everybody does it.”

The issue goes beyond the particular deal cited by the SEC and could filter down to such sources of profit as proprietary trading and investing, market making and investment banking.

It’s difficult to defend the often simplistic scapegoating that Goldman executives have endured, but the probes by regulators, politicians and the press have exposed the multifarious and sometimes conflicting roles that Goldman and other Wall Street powerhouses perform.

The backlash has already started.

Last week, Sen. Ted Kaufman, D-Del., and Sen. Arlen Specter, D-Pa., proposed amending the Senate’s regulatory-reform bill with a fiduciary requirement for institutional broker-dealers when advising on stock or swap transactions (see story on Page 4).

“As we saw in the recent Goldman Sachs hearing, Congress needs to ensure that broker-dealers have a clear duty to act in the best interests of their clients,” Mr. Kaufman said as he introduced the amendment.

Coming on top of the so-called Volcker proposals, which would prohibit bank holding companies from owning hedge funds, making private-equity investments or trading for their own accounts, the proposed restrictions could seriously erode revenue at Goldman, Morgan Stanley and other behemoths. Goldman, for example, booked more than 80% of its $12.8 billion in revenue last quarter from trading and principal investing.

Just where do the conflicts lie?

The big banks make markets for clients across a spectrum of stocks, bonds and structured financial products. They also trade those instruments for their own accounts. Sophisticated investors know that in pure investment banking, firms advise some corporate clients on the most efficient ways to raise capital, while advising other clients — pension funds and other institutional investors, for example — on whether to buy those capital-raising products.

There are strict “Chinese walls,” of course, that restrict sales representatives, traders and investment bankers who work directly with clients from sharing information with co-workers on proprietary trading desks, and it’s hard to prove that such barriers have been crossed. The Holy Grail of regulators is evidence of a leak that let a proprietary desk trade ahead of its clients or take positions in anticipation of their moves.

If that is what the Justice Department’s reported criminal investigation of Goldman is focusing on, the shivers going down Wall Street’s spine are justified.

Many of Goldman’s best clients have said in recent days that its ability to trade for itself, whether hedging positions on its book as a result of accommodating clients’ trades or for speculative purposes, makes it a more secure partner.

York Capital Management kept “billions and billions of dollars” at Goldman during the 2008-09 credit crisis, and nothing at less agile rivals such as Lehman Brothers Holdings Inc. and Merrill Lynch & Co. Inc., because “at the end of the day, you really want strong counterparties,” James Dinan, founder and chief executive of the hedge fund, said at the Milken Institute’s Global Conference two weeks ago.

“The more financially solvent these organizations are, the more comfortable you are using them,” he said.

Goldman chairman and chief executive Lloyd Blankfein, to be sure, hasn’t helped his cause with breast-beating explanations of why the firm has no obligation as a market maker to disclose to clients its view of what they are buying or selling — let alone what other clients think. He may be right that such disclosures are irrelevant to market making, but he would have done better to parse his different businesses and spell out what kinds of disclosures are appropriate in each.

“Investment banks have done a poor job articulating what they do,” said Daniel Loeb, chief executive of activist hedge fund Third Point LLC. “I support financial reform, but I just want to make sure that we don’t lose sight of the importance of Wall Street.”

Israel Englander, a veteran Wall Street trader who runs the hedge fund Millennium Partners LP, was more plaintive in giving his views of financial reform at the Milken conference. “I would like to leave things the way they are,” he said.

It’s unlikely, however, that testimonials from hedge funds — which have replaced conventional institutional investors such as pension funds as Wall Street’s best clients — will carry much weight with regulators or legislators. And if a fiduciary standard were to be adopted for sales to institutional as well as retail investors, it would create conundrums about how to treat vastly different clients.

“There will always be market participants who are more meaningful than others,” Kenneth Griffin, founder of Citadel Investment Group LLC, said in an interview at the Milken conference, in which he offered full support for Goldman.

That’s in sharp contrast to more traditional Wall Street leaders. David Komansky, the former chief executive and chairman of Merrill Lynch, told Bloomberg News last week that he “regrets” his role in helping to repeal the Glass-Steagall Act.

Goldman, for its part, is now requiring clients to sign documents verifying that they’ve been informed of risks in buying certain securities, according to published reports. That’s reminiscent of rules it laid out in 2004 prohibiting sales representatives from offering hot initial public offerings to clients willing to pay high commissions or give the firm ancillary business. The rules were issued days after Frank Quattrone, a prominent banker at Credit Suisse Group, was convicted of obstructing a probe into the way Wall Street distributed IPOs (a conviction that was ultimately overturned). By that point, the dot-com boom that inspired such practices was over.

The big question today is whether, once again, the rules of disclosure are coming too late.

E-mail Jed Horowitz at [email protected].