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Goldman Sachs and the Art of Ripping Your Clients' Faces Off

By Morgan Housel – Updated Apr 6, 2017 at 1:30PM

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Where we go from here.

"Traders and salesmen would boast about 'ripping the face off' their clients -- structuring and selling complicated deals that clients did not understand but that generated huge profits for the bank that was brokering the trade."
-- From the book 13 Bankers

That quote actually refers to how banks operated in the 1990s. But some things never change on Wall Street.

Goldman Sachs (NYSE: GS) was charged with fraud on Friday, but you probably already know that. The story has been reported relentlessly. Just to cover the bases, here's the deal:

  • Collateralized debt obligations (CDO) are packages of mortgage-backed securities (MBS). The CDO are diced up into different risk slices and sold to investors.
  • In a specific deal put together by Goldman, hedge fund manager John Paulson was allowed to help pick the MBS that were included in the CDO. Paulson ostensibly picked the most wretched MBS he could find because his hedge fund was short (betting against) these same securities through credit default swaps (CDS). Paulson paid Goldman $15 million to throw the deal together.
  • All of this was unbeknownst to the clients purchasing the CDO. In fact, they were told otherwise: That the MBS were independently selected by a company called ACA Management, LLC. (You can download the dealbook investors were given here.)
  • According to the SEC's fraud charge: "The deal closed on April 26, 2007 ... By January 29, 2008, 99% of the portfolio had been downgraded. As a result, investors ... lost over $1 billion. Paulson's opposite CDS positions yielded a profit of approximately $1 billion."

"God's work," baby!
To be blunt, Goldman fibbed, rigged the game, and "ripped the faces off" its clients. Or at least that's what it's being accused of.

What's curious is that, despite the media frenzy, most of this story has been known for some time. Wall Street Journal reporter Greg Zuckerman explained the bulk of it in his 2009 book The Greatest Trade Ever, which details Paulson's bet:

Paulson didn't think there was anything wrong with working with various bankers to create more toxic investments ... After all, those who would buy the pieces of any CDO likely would be hedge funds, banks, pension plans, or other sophisticated investors ...

However, at least one banker smelled trouble and rejected the idea. Paulson didn't come out and say it, but the banker suspected that Paulson would push for combustible mortgages and debt to go into any CDO, making it more likely that it would go up in flames ... other bankers, including those at Deutsche Bank and Goldman Sachs, didn't see anything wrong with Paulson's request and agreed to work with his team.

So to be clear here, that Paulson had a hand in helping Goldman create CDO isn't news, nor was it a crime. The only charge (and it's a big one) is that Goldman didn't disclose this fact to the CDO buyers. What's it all mean for the bank?

What this means for Goldman
In the late 1970s, John Whitehead, a former Goldman senior partner and co-chairman, wrote down a list of 14 "business principles" the bank should strive to follow. To this day, the list is paraded on Goldman's website and in its annual reports as a practical bible.

Nos. 1 and 2 on the list are:

  1. Our clients' interests always come first. Our experience shows that if we serve our clients well, our own success will follow.
  2. Our assets are people, capital, and reputation. If any of these are ever lost, the last is the most difficult to regain.

Assuming the charges against Goldman are legit, rule No. 1 has been thoroughly spat on, and the latter part of rule No. 2 is about to become the bank's worst nightmare.

The biggest threat Goldman faces are not fines. It's that clients will come to terms with what's long been suspected: That a good number of Goldman bankers are well-dressed Ivy League carnies. Not wanting its face ripped off again, business could turn elsewhere.

Think that's being dramatic? In the mid-1990s, a tape recording caught employees from Bankers Trust bragging that the goal was "to lure people into the calm and then just totally [$%@#] 'em." The bank never fully recovered from its reputational blow and was eventually taken over by Deutsche Bank. If you were a pension manager, or the head of finance for a municipality, and a Goldman salesman came to your door tomorrow offering to sell something fancy and lucrative, would you take him seriously after learning of these fraud charges? Think about it.

And although Goldman is the only bank implicated, suspicion of investment bankers is pretty universal these days. After learning of Goldman's mischief, client protest may very well wander over to the other big shops -- Citigroup (NYSE: C), Bank of America (NYSE: BAC), JPMorgan Chase (NYSE: JPM), and Morgan Stanley (NYSE: MS).

Maybe ... maybe not
There are a few counterarguments here. One is that only one Goldman banker was named in the fraud charges, and the entire franchise shouldn't be lumped in with his misbehavior. This sounds fair, but I don't think this holds much water. When business is based solely on character, you're only as strong as your most morally bankrupt idiot.

Enron's auditor, Arthur Anderson, wasn't engaged in companywide fraud, but its reputation was pretty well wrecked after Enron collapsed. That's why when Warren Buffett stepped in as Salomon Brothers CEO in the early 1990s amid a scandal, he told Congress his attitude was, "Lose money for the firm, and I will be understanding. Lose a shred of reputation for the firm, and I will be ruthless."  

Another why-worry argument is that this has all happened before. After the dot-com bust, a mess of Wall Street banks were accused of hyping Internet stocks to clients while privately acknowledging otherwise. Some thought Wall Street was ruined. Yet just a year or two later, it was successfully peddling mortgages that could make look conservative. Investors have short memories, especially when they get a new bubble to play with.

I certainly don't think this will be fatal for Goldman. But I'm hoping -- really, truly hoping -- this wake-up call will defang some of the power and influence banks wield. Maybe that's being naive. Fingers crossed.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article, and realizes his chances of ever getting a job with Goldman Sachs have pretty much been shattered after writing this article. A member of The Motley Fool's board of directors is the chief operating officer of Paulson & Co. The Fool has a disclosure policy.

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