The Innovations Frauds of Goldman Sachs

Goldman Sachs is big on innovation. What does financial innovation mean for a bank like Goldman? Das parses the real meanings behind innovation in finance, innovations that The Economist magazine finds so positive.

We have no doubt that the biggest benefits of innovation lie in lining the pockets of bank executives with huge amounts of other people's money which is then used to influence the policies of politicians and government officials. Recent financial innovations discussed include securitization, CDSs, CDOs squared, ETFs and HTF.

Here's an excerpt from Das's essay:

Satyajit Das: Pravda The Economist's Take on Financial Innovation
By Satyajit Das - Naked Capitalism

Super Smarts…

The Economist fails to understand the real motivations of financial innovation. They believe that: “Products … mutate constantly, in part because patenting is not common”. Citing Franklin Allen of the Wharton School at the University of Pennsylvania and Glenn Yago of the Milken Institute, wholesale financial innovation, they argue, is the creation of new capital structures that align the interests of lots of different parties.

In practice, the major alignment of interests relates to getting a deal done to enable the bankers to receive substantial bonuses based on mark-to-market values of the product. The profit frequently does not fully recognise the long term consequences or risks to either the client or the financial institution.

Confusing bankers with saintly figures in line for beatification, the Report approvingly cites Goldman Sach’s Martin Chavez who explains that innovation is in response to the “clients call”… We can’t tell them ‘no thanks’.” This, undoubtedly, is “doing God’s work”, which the head of the firm once stated was its primary mission.

It is difficult to reconcile this position with statements by another Goldman Sachs’ employee Fabrice Tourre, who sold the Abacus deals to unwitting “widows and orphans”. Among tender emails to his girlfriend Serres, the self-styled “Fabulous Fab” observed in January 2007: “More and more leverage in the system. The whole building is about to collapse anytime now?.?.?.? Only potential survivor, the fabulous Fab[rice Tourre] standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstrosities!!!”

Tourre stated that Abacus was “pure intellectual masturbation”, “a ‘thing’ which has no
purpose, which is absolutely conceptual and highly theoretical and which nobody knows how to price”. But Tourre was not assailed by self-doubt: “Anyway, not feeling too guilty about this, the real purpose of my job is to make capital markets more efficient and ultimately provide the U.S. consumer with more efficient ways to leverage and finance himself, so there is a humble, noble, and ethical reason for my job :) amazing how good I am in convincing myself!!!”

Stéphane Mattatia, Société Générale’s global head of equity flow engineering and advisory, told The Economist of a hedge based on the Euro falling and gold rising for a client worried about French CDSs. Of course, SG managed to lose Euro 5.9 billion through its inability to hedge its own risk on positions taken by rogue trader Jerome Kerviel. If the client was concerned about positions in French CDS, wouldn’t it have been just easier to close out its existing position rather than enter into a complex, potentially expensive and illiquid instrument?

There is no acknowledgement that much of what is called financial innovation is economic rent extraction, exploiting lack of transparency as well as information and knowledge asymmetries. There is no discussion of the destructive bonus culture which encourages certain behaviours in financial institutions. Thomas Philippon and Ariel Reshef have estimated that around 30-50% of the extra pay bankers received compared to similar professionals is attributable to economic rents.

In a January 2009 speech, Lord Adair Turner, chairman of UK’s Financial Services Authority, observed that: “Much of the structuring and trading activity involved in the complex version of securitized credit was not required to deliver credit intermediation efficiently, but achieved an economic rent extraction made possible by the opacity of margins and the asymmetry of information and knowledge between…users of financial services and producers…financial innovation which delivers no fundamental economic benefit, can for a time flourish and earn for the individuals and institutions which innovated very large returns.”

The unpalatable reality that few, self interested industry participants and their cheerleaders are prepared to admit is that much of what passes for financial innovation is specifically designed to conceal risk, obfuscate investors and reduce transparency. The process is entirely deliberate. Efficiency and transparency is not consistent with the high profit margins on Wall Street and the City. Financial products need to be opaque and priced inefficiently to produce excessive profits. The Report does not canvas this issue.

It is very worthwhile to read the whole article here