Thursday, January 6, 2011

Goldman Sachs: is the fundamental concept flawed?

Today in the New York Times, Simon Johnson writes a piece entitled "Why Are Taxpayers Subsidizing Facebook, and the Next Bubble?". The central thesis of the piece is whether it is appropriate for an institution like Goldman that is "too big to fail" and therefore effectively has a government guarantee that it will not default on its debt, be an equity investor in Facebook.

It is one thing to invest money on behalf of your clients. Thats the core of what an investment bank does. No problem there. But we heard today that the division of Goldman that does just that, passed on the $450 million dollar investment in Facebook. As a result, Goldman itself did the investment, putting the deal directly on the company's balance sheet.

Simon argues that this is problematic because the Goldman balance sheet is effectively guaranteed by the government, and because Goldman is an actual bank (as opposed to an investment bank) it gets to borrow from the fed freely at essentially no cost. So, in essence the government is backing what one must admit is a risky investment in a private internet company.

I fundamentally agree with Johnson's assessment, but it seems to me the problem is much bigger than this Facebook investment. One really interesting question is whether an investment bank can reasonably also be a bank holding company. Allowing a firm like Goldman to become a bank creates all sorts of problems and I suspect this is just the tip of the iceberg. Banks should operate in a fundamentally risk averse manner. Investment banks can't. It seems to me that not only is the current structure of Goldman a problem, but the *concept* of Goldman is a problem.

We cannot allow any institution to be both secured by the government, and in the business of taking large risks. Of course defining "large risk" is problematic in that no one would have thought mortgages could, in any context, be defined as high risk. But while there may be gray areas where valuable collateral turns out to be not so valuable, an investment in Facebook ain't gray. And obviously much of Goldman's other investment banking related endeavors couldn't be defined as low risk either.

My point here is that I think Goldman needs to be clearly free to fail. That means we need to regulate them in such a way that we can guarantee that failure *is* an acceptable option. Regulators suck (see Bernie Maddoff) but in this case the not so free market sucks even more.


  1. Although your main point is good, you need to rework this line: "Of course defining "large risk" is problematic in that no one would have thought mortgages could, in any context, be defined as high risk."

    Plenty of people thought that; they have been consistently ignored before and after the fact. My senses were tingling as early as 2007 that the impending doom was finally imminent, and as the crash unfolded in slow motion until everyone finally noticed and recession ensued, I began to wonder what the point of prediction was if I couldn't change the course of events.

    Recently, I picked up "The Black Swan" by Nassim Taleb on the Kindle, and among many other things, he notes that the Fannie Mae of 2006 was sitting on a pile of dynamite that they believed safe because of the Power of Math. The risk was there for everyone to see, even beforehand as Taleb did, but the actors who mattered in the market were (at best) not looking.

  2. @sapphirepaw, yes you are right. Certainly there were many people predicting that the mortgage backed securities were indeed risky. But regulation and laws move much more slowly than market dynamics (hence my argument that regulators suck) and historically mortgages were thought to be a relatively safe place for banks to provide money. Clearly financial engineering changed mortgages from something safe to something that could be incredibly risky.