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According to the Collins English Dictionary 10th Edition fraud can be defined as: "deceit, trickery, sharp practice, or breach of confidence, perpetrated for profit or to gain some unfair or dishonest advantage".[1] In the broadest sense, a fraud is an intentional deception made for personal gain or to damage another individual; the related adjective is fraudulent. The specific legal definition varies by legal jurisdiction. Fraud is a crime, and also a civil law violation. Defrauding people or entities of money or valuables is a common purpose of fraud, but there have also been fraudulent "discoveries", e.g. in science, to gain prestige rather than immediate monetary gain
*As defined in Wikipedia

Tuesday, October 9, 2012

Goldman Sachs--You Should Have Remained a Partnership

Goldman Sachs is doing again what it does best:  paying millions to settle claims with regulators.  This time Goldman is paying eight US exchanges $6.75 million over mislabeled options.  Of course, they "neither admitted nor denied wrongdoing."

How can such a bank which claims to be a class act not know how to properly conduct its own affairs?

You can catch a glimpse of the answer in a September 27, 2012, working paper by Mark Adelson called, The Deeper Causes of the Financial Crisis--Mortgages Alone Cannot Explain It.

On pages 17 and 18 of this paper there is a description of actions of banks that also caused the financial meltdown and, not coincidentally, these actions exactly describe how Goldman Sachs conducted business that led to the crisis:
The Deeper Causes of the Financial Crisis--Mortgages Alone Cannot Explain It
By Mark Adelson -
. . . .

55. Another Interpretation: This article adds another interpretation to the mix. In contrast to other studies, this article attempts to differentiate immediate causes from deeper causes. Doing so recognizes that there can be a chain of causation leading up to an event. Although every link in the chain may bear investigation, the ones at the very start of the process generally are the most important.56.
56. In this writer's view, there are at least five deeper causes that potentially can explain why many financial firms had embraced high leverage and strong risk appetites in the years leading up to the crisis: 
i. securities firms converting from partnerships to corporations, 
ii. deregulation over the past 30 years, 
iii. the quant movement, 
iv. the spread of risk-taking culture through the financial industry, and 
v. globalization57.
57. Although each one might deserve an entire book, it receives just a brief discussion below:58.
58. Securities Firms Converting from Partnerships to Corporations: The first deeper cause is the conversion of securities firms from partnerships to corporations. The change in organizational form explains the change in incentives and risk-taking behavior at those firms. After the change, non-owner employees became responsible for key risk decisions but had skewed incentives.Instead of taking risks with their own money, the employees could take risks with shareholders' money.59.
59. Securities dealers started converting from partnerships to corporations in the 1970s. The trend continued through 1999, when Goldman Sachs, the last major securities firm in partnership form, converted to corporate status. The conversion meant that managers were no longer necessarily owners of the firm. The separation of management from ownership gave rise to the classic  "principal-agent problem," especially as the firms came to have employees with responsibility for risk-taking who did not have substantial pre-existing equity stakes. The employees could take risk with other peoples' (shareholders') money. If the outcomes were positive, the employees could reap huge gains through incentive compensation schemes. If the outcomes were negative, their downside was limited--they might get fired and have to get a new job, but their accumulated personal wealth was generally not at risk. Michael Lewis embraces this point in the epilogue of The Big Short, where he asserts that the former CEO of Salomon had done violence to the Wall Street social order--and got himself dubbed the King of Wall Street--when, in 1981, he'd turned Salomon Brothers from a private partnership into Wall Street's first public corporation. 

See the entire working paper here


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