Goldman Sachs ... came out looking good!

Dear Colleagues

Yesterday (April 27, 2010) present and former executives from Goldman Sachs (GS) were grilled by US Senators on Capital Hill. My take on the day was that Goldman Sachs showed very clearly why they are good ... why they did not lose really badly when the housing market went sour while everyone else did.

Personally, I thought the CFO was the most impressive ... simply because he seemed to have a deep understanding of what his job was ... to preserve the assets of the organization while allowing the organization to earn money. The CEO was way better than I expected ... again, exhibiting a great clarity about why Goldman Sachs existed, to serve global customers, and make money doing it.

The Senators preoccupation with a series of issues that bother Main Street, but are the core of any working capital market was, in my view counterproductive. The GS people clearly knew how their markets worked ... and the Senators, it seemed, either did not get it, or did not want to get it.

In due course the US legislators are going to pass some legislation that will complicate the life of the capital markets, make things more difficult to work within the rules, and essentially make things worse.

The hearings made it abundantly clear that the behavior of the Wall Street Banks was not what messed up the US economy ... but the behavior of the whole value chain of wage and fee earners in the sub-prime housing boom. This was not addressed on Tuesday, but was in a previous hearing. The house building industry grew as fast as it could and made substantial profits ... more than was reasonable. Land owners sold land to builders ... and profited more than was reasonable. All the professional actors did their paperwork, collected fees, but probably did not do what they really should have been doing to identify the stupidity of what was going on. The community bankers and others did the mortgage origination and collected the fees. All of these steps were done in a way that created a huge fee machine ... and this system never ran out of gas, simply because all of the mortgage paper was able to be sold out of the local system into a national and international capital market that had also figured out how to make money out of this paper.

Capital markets are all about monetizing a real transaction using paper ... it is called, I think, securitization. It is a very convenient process, and on balance very valuable for a sane society.

GS, it seems, figured out early on that the sub-prime securitization process had gotten out of hand, so they changed direction and reduced risk in this segment of the capital market pretty early on. Others who did not identify the need for direction change, either failed, or are struggling and are on taxpayer funded life support. GS got it right ... and they balanced their book ... reduced exposure ... very rapidly. Their clients ... were still in the buy mode for these securities a long time after GS had changed direction. Their clients still saw gold in these complex securities, though GS itself had moved on. Seems smart to me ... and nothing here should be illegal.

In my view, the question of the rating agencies and how they do their rating is much more problematic. I used to do risk management as the CFO of a company ... and we reduced risk by making sure we operated safely. This was a physical idea, not merely papering over potential problems. My cost of insurance was reduced by around 67% ... and my exposure to risk reduced at the same time. Real risk reduction produced real cost savings. But the rating agencies seem to be doing risk reduction simply by playing statistical games ... and not surprising they got it wrong.

But the big takeaway from all of this was that the profit metric is a totally inadequate measure of performance for economic actors in society. There absolutely has to be a measure of social impact in the internal management metrics and in the reporting to stakeholders. My take is that GS performed exactly as it was meant to perform ... and did not lose huge amounts of money in the process, while almost every other actor in the economy lost money. All the "little guys" on Main Street were happy when they were earning fees from the economic activities that would end up in the crash ... and set the stage for the crash. Most of Wall Street crashed ... most of Main Street crashed. All this profit ... and no solid socio-economic benefit from very much of it. The metrics were inadequate!

The capital market is needed ... the capital market ought to be an efficient tool for getting the allocation of capital right. But clearly the simple "profit only" capital market is not getting funds allocated to important things in a way that works efficiently. A hybrid capital market where both profit and social value are in play will change the market in ways that are important ... and in my view can set the stage for a sane, smart society.

Peter Burgess