The New York Times published an op-ed by Greg Smith, a Goldman Sachs' Executive Director who is resigning from his job after almost 12 years with the firm because, as he puts it, the firm's culture has veered far from what it was when he first joined the firm. He says in spite of the firm's recent scandals "the interests of the client continue to be sidelined in the way the firm operates and thinks about making money." At SLCG, we have come across many examples of the issues raised by Mr. Smith. We think that the marketing of investments aimed at maximizing financial firms' profits without regard to their clients' investment objectives or bottom lines transcends any single firm and is a common characteristic of many financial firms.
Mr. Smith lists three ways to become a leader in today's Goldman Sachs. We have come across examples of these same three practices.
The first way to become a leader according to Mr. Smith is to persuade clients to buy products your firm wants to unload. Until 2007, big brokerage firms occasionally placed bids on ARS (which we discuss in a blog post and a research paper) to prevent auctions from failing. In late 2007, as demand for ARS declined and banks' ARS inventories increased considerably, brokers aggressively marketed ARS to small investors in an effort to reduce their inventories, according to a Congressional Research Service Report. Court documents describe how, for example, UBS management discussed withdrawing their support from bids, allowing auctions to fail, while at the same time encouraging its brokers to market ARS to UBS's clients (see Summons and Complaint, Cuomo v. UBS Securities LLC). By mid-February many auctions failed leaving investors with illiquid, devalued securities.
According to Mr. Smith, the second way to become a leader is to push securities that produce the highest profits to the financial advisor's employer. For example, we've blogged about non-traded REITs and distributed a significant research paper. Traditional mutual funds and ETFs provide exposure to real estate with transparent pricing, ready liquidity, and low fees yet non-traded and private REITs are often marketed to investors even though their expected returns do not compensate for their risk and their illiquidity. It is doubly hard to justify such investment recommendations considering the high fees advisors and dealer managers are able to collect, which may be as high as 15% of the investment.
The third way of becoming a leader according to Mr. Smith is to trade "any illiquid, opaque product with a three-letter acronym." Bank of America's LCM VII CLO is a spectacular example of such a product (see our blog post on LCM VII). In July 2007 Banc of America Securities transferred $35 million of previous losses to unsuspecting investors in its LCM VII and Bryn Mawr II CLO offerings. Investors ultimately lost nearly $150 million in October 2008 when these two CLOs backed by leveraged loans were liquidated. After we issued our report, Gretchen Morgenson of the NY Times wrote an article about LCM VII and William Galvin, Secretary of the Commonwealth of Massachusetts, subpoenaed Bank of America over these two CLOs.
Our casework can sometimes provide a pessimistic view of modern finance. Regulatory reform and changes in enforcement policy alone will not eliminate the problem. We think Mr. Smith has part of the story right when he appeals to corporate culture and the "moral fiber" of financial firms as a way to turn the tide. We would add that another key ingredient is investor education, which is the main purpose of this blog.