Goldman’s Gain, America’s Risk

Goldman’s Gain, America’s Risk
July 14, 2009, 4:57 pm
By The Editors

http://roomfordebate.blogs.nytimes.com/2009/07/14/goldmans-gain-americas-risk/


The headquarters of Goldman Sachs in Lower Manhattan.

Updated, July 14, 8:30 p.m. | Jeffrey A. Miron, an economist at Harvard, says this situation shows why governments should not be in the bailout business.

Having earned $3.44 billion in the second quarter, Goldman Sachs announced that it would be setting aside a compensation pool of $11.36 billion for the first half of 2009, or nearly $400,000 each, on average, for its roughly 29,400 employees and temporary workers. That level of per-worker compensation is close to what it was in mid-2007, when Wall Street was booming.

Many taxpayers might find the comeback of fat pay packages perplexing, especially since the federal government was throwing cash into the bank not that long ago. Is it reasonable to be critical of this kind of largess at Goldman when the rest of the economy is still floundering? Or is this a sign that the financial industry is stabilizing and that government aid is doing what it was supposed to do?

* William K. Black, economist, the University of Missouri
* Yves Smith, financial analyst
* Mark Thoma, economist, University of Oregon
* David Merkel, financial analyst
* Charles Geisst, author
* Jeffrey A. Miron, economist, Harvard University


A Poster Child for Financial Insanity
William K. Black

William K. Black, associate professor of economics and law at the University of Missouri, Kansas City, is a former financial regulator. His book, “The Best Way to Rob a Bank is to Own One,” focuses on the role of “control fraud” in financial crises.

It’s difficult to decide which is more insane: the efforts of the Bush and Obama administrations to recreate the failed financial markets, e.g., collateralized debt obligations that produced the worst global financial crisis in three generations, or continuing to make obscenely wealthy the financial idiot-savants that caused the crisis.

Goldman Sachs is the poster child for both forms of insanity. The news that Goldman has purportedly earned astonishingly large profits in the latest quarter and plans to pay many billions of dollars in “bonuses” to people who are already in the top 1 percent of the wealth distribution raises issues in two categories: performance and pay.

Personally, I’m more concerned by the performance. I care about pay primarily because it creates perverse incentives to engage in accounting/securities fraud and other forms of abuse. There are two possible explanations of Goldman’s performance — and they are both frightening. “Economic recovery” is not a possible explanation. Reports of “green shoots” simply means that things are getting worse at a slower rate than six months ago. The recession, already our worst in modern history, is getting worse.

Goldman is the textbook case of “moral hazard.” It recognizes that both administrations have guaranteed that it will not be allowed to fail no matter how badly it is run. (Treasury Secretary Geithner, in a portion of a speech ignored by the media, twice used the phrase “capital insurance” to describe our new policy. The taxpayers no longer insure only depositors — we insure the shareholders, or more precisely, the senior officers.)

“Moral hazard” is well known in insurance and economics. If there is little downside to the senior officers and if they can capture the upside, e.g., through massive bonuses, then it pays to either engage in ultra high-risk gambles, or the sure thing, accounting fraud. Either explanation is frightening because it is simply a matter of time before this strategy causes an even bigger financial crisis than this one.

Of course, you can’t send out a memo to 10,000 employees and tell them explicitly to engage in either ultra high-risk strategies or accounting fraud. That’s the genius of bonus systems — you can send the same message without risk of prosecution. When the Business Roundtable was looking to respond to the Enron and WorldCom wave of “control frauds,” they choose as their spokesman Franklin Raines, then chief executive of Fannie Mae. A reporter asked him why there were so many scandals on Wall Street. Mr. Raines replied:

“Don’t just say: ‘If you hit this revenue number, your bonus is going to be this.’ It sets up an incentive that’s overwhelming. You wave enough money in front of people, and good people will do bad things.”

Goldman’s profits should teach us (1) that our policies are maximizing moral hazard, (2) at firms that pose a systemic risk to the entire economic system, and (3) changing executive compensation to minimize the perverse incentives is not “merely” a matter of fairness — but essential to protecting ourselves from future crises.

A Benefit for the Few
Yves Smith has written the blog Naked Capitalism since 2006. She has spent more than 25 years in the financial services industry and currently is head of Aurora Advisors, a management consulting firm.

The size of the Goldman bonuses masks a more important issue, namely that the firm was in very dire shape not long ago and was saved from collapse by official intervention, not merely the Troubled Asset Relief Program, but a host of special facilities created by the Fed to direct liquidity to the very markets that firms like Goldman are deeply exposed to and depend upon for their business to be viable, let alone profitable.

Goldman was in such acute distress that, as The Financial Times reports today, Goldman senior officers sold nearly $700 million of equity from when Lehman failed through April, with the heaviest selling occurring when the firm was on TARP life support and while it was selling stock to the public. Put more bluntly, the executives were being cashed out by outside money.

Lest you have any doubts, the insiders sold far more shares than in the comparable period the year prior, when the firm’s stock was priced much higher. Goldman also received a capital injection from Warren Buffet’s Berkshire Hathaway shortly prior to the TARP funding. Needless to say, the terms Buffett got were vastly superior to the ones the taxpayer received.

The logic of these programs is that the big capital markets players have become such crucial parts of the economic infrastructure that they cannot be permitted to fail. Yet they continue to enjoy a grossly asymmetric deal, socialized losses versus privatized gains. The stunning magnitude of the Goldman bonuses shows whom this arrangement benefits, not the public at large, but a privileged few.


Returning to High-Risk Strategies
Mark Thoma is an economics professor at the University of Oregon and blogs at Economist’s View.

What does the size of Goldman’s compensation pool tell us? It gives some indication that the financial sector is improving, and that is good news. There’s no guarantee, however, that the recovery of the overall economy will follow anytime soon. Even with improvements in the financial sector, the recovery of the broader economy is likely to be a slow process.

That’s because the economy cannot go back to where it was before the crisis hit. The financial and housing sectors need to shrink, too many economic resources were used unproductively in support of these activities, and the automobile sector is also in transition.

But getting smaller isn’t enough. The financial sector also needs to change its ways so that accumulated risk does not threaten the financial system and the broader economy. As Robert Reich notes today, Goldman’s chief financial officer tells Bloomberg News, “Our model really never changed, we’ve said very consistently that our business model remained the same.”

That thinking is worrisome. Goldman’s unexpectedly large earnings is a signal that some firms are returning to the same high-risk strategies — backed by “too big to fail” government guarantees — that got us into trouble in the first place. Apparently, the excesses that led to the high incomes of financial executives have not ended.

Are the profits and the bonuses justifiable compensation of executives for superior talent? That’s a legitimate question. Goldman was helped by bailout funds. There’s some debate about whether it actually needed a direct infusion of funds, but it certainly benefited when its counterparties such as A.I.G. were bailed out. It is also benefiting from its early escape from government constraints that still inhibit the ability of other firms to compete on equal footing.

The executive compensation structures provided bad incentives that were a big factor in the financial crisis. The size of Goldman’s compensation pool shows this problem hasn’t been fixed.

CONTINUED BELOW

 

CONTINUED FROM ABOVE


They Earned the Bonuses
David Merkel
David Merkel is the director of research for Finacorp Securities and the founder of The Aleph Blog.

All mature industries are cyclical, even finance. And if a company wants to survive in a cyclical industry, it needs to keep total leverage low, have excess high-quality assets ready, avoid risks that competitors are embracing as a group and hire smart people.

Goldman Sachs has survived the crisis in the brokerage space by doing essentially that. They kept leverage lower than their competitors; they salted away quality assets at Bank of New York; they raised capital when they needed to, paying Warren Buffett a pretty yield; they were quick to lay off risks; and they hired bright people who avoided taking underpriced risks that competitors did, like nonprime mortgages.

Companies that survive an industry crisis gain a disproportionate amount of the profits as they gain market share. Because of reduced competition, bid-ask spreads are wider, and a well-capitalized firm like Goldman earns more.

Some help from the government, through TARP, was forced on Goldman. Other help from the government was available to all; the government took the risk that healthy firms would benefit in order to avoid panic regarding unhealthy firms.

Is Goldman connected with the government? Too much so. Indeed, I fear we have regulatory capture of the U.S. Treasury by Wall Street, but before the crisis that was true also.

There is nothing new about Goldman employees getting large bonuses from profits. They earned the bonuses. Let them be paid lest there be negative ramifications in other areas of contract law.

The Wrong Message
Charles Geisst
Charles Geisst is the author of 18 books, including the forthcoming “Collateral Damaged: The Marketing of Consumer Debt to America.”

Whether Goldman Sachs’ bonus pool is too large given the current condition of the economy is debatable and will undoubtedly engender much more discussion over the coming months. Being free of the Troubled Asset Relief Program’s money allows them to pay bonuses as they please, in keeping with Wall Street tradition. The move is opportunistic but given the size of their recently declared profits, it can be argued that it is justified unless Wall Street tradition actually changes, which seems unlikely at the moment.

A profitable quarter or two are better than losses but they are no excuse for ignoring the serious financial reforms the U.S. needs.

Much more important is the political side of the economic decision about bonuses. The enormous profits give the impression the economy is on the road to recovery, which does not seem to be the case. The fact that this has all played out while the Obama financial reforms are still in their early stages of debate should not be lost on anyone. It is generally agreed, outside Wall Street, that stringent financial regulations are needed to prevent this crisis from repeating itself again. Goldman sends a signal that their profits suggest the worst of the crisis is behind us and that the markets are returning to normal.

By the end of this year, when the administration’s reform proposals finally come up for a vote, the idea of regulating profitable firms will again be playing to an old Wall Street refrain. Why regulate and dampen the entrepreneurial spirit? The markets “self-corrected” and returned to normal. Meddle with them and further economic recovery will only be hindered.

The implications of all this seem very disingenuous. But the serious, embedded political message Goldman is trying to send should be ignored. A profitable quarter or two are better than losses or treading water but they are no excuse for ignoring the serious financial reforms the U.S. currently needs. In the past, large amounts of money like Goldman’s profits were compared to other values in society. This is no longer fashionable. But it is not unfashionable to ask how many furloughed California workers could go back to work if Goldman dedicated half that money for bonuses to a good cause. That TARP money got the Goldman ball rolling in the first place.

No Exit for Government
Jeffrey Miron

Jeffrey A. Miron is a senior lecturer on economics at Harvard University.


Is a generous bonus pool an acceptable use of Goldman’s profits, given that it recently benefited from a government bailout? There are arguments on both sides.

A defender of the bonuses would say that Goldman has paid back the $10 billion capital injection it received in October, 2008. And after doing so, it should be free to direct its own business practices.

After all, financial firms like Goldman have long relied on bonuses as a key component of compensation, and arguably, this compensation structure provides good incentives for their employees to take profitable risks on behalf of the company. And despite recent events, which might seem to throw into question how well these incentives work, it is extreme hubris for political leaders to assume they can run financial firms better than the financial firms themselves.

A critic of the bonuses, however, would point out that Goldman has benefited from taxpayer largess and continues to benefit by far more than the $10 billion capital injection it returned. The F.D.I.C. has been guaranteeing some of Goldman’s debt, and Goldman dodged its counterparty exposure to A.I.G. (valued in the billions of dollars) because the government bailed out A.I.G. Thus Goldman is still a major beneficiary of taxpayer funds, which suggests it should pay the rest of this bailout back before paying itself bonuses.

Can these conflicting views be reconciled?

Goldman might argue that the bonuses are necessary to retain its top employees and promote future profitability, so that these bonuses are a good investment for taxpayers. Yet without being privy to Goldman’s books, and without knowing exactly how the government’s involvement will unwind, it is impossible for taxpayers to know whether they will see a return on their investment or get stiffed to a substantial degree.

The lesson to be learned, therefore, is that this kind of dilemma is one reason governments should not provide bailouts in the first place. Once a bailout occurs, the government is inevitably drawn into the day-to-day business decisions of the companies and forced to resolve issues with no good resolution.

More generally, the bonus issue raises a crucial unanswered question going forward: how will the federal government be able to exit its huge role in managing the financial sector?

 

Reader Comments (quite revealing)

From 1 to 25 of 351 Comments
1 2 3 ... 15 Next »
1.
1. July 14, 2009 5:32 pm Link
The Senate should be pursuing Goldman’s conflicts of interest with current government officials.
— Ethan Bair
2.
2. July 14, 2009 5:35 pm Link
$600,000 per employee profits in one quarter. thought goldman was on the brink and thrown the federally chartered bank status. now we all pay — again and again and again and again.
— joe blow
3.
3. July 14, 2009 5:37 pm Link
those grasping evil people of companies like goldman and AIG screwed our economy by creating complex risky financial markets, then they got saved by us the taxpayers, and now they are straight back to their old evil greedy ways.
wall this when unemployment is reaching 10%.
people are losing their homes, can’t find jobs, havng trouble buying food.
and these people are paying themsleves millions after we bailed them out!
its scandalous!
the government learnt nothing.
they should be ashamed of themselves.
— mikeymanhattan
4.
4. July 14, 2009 5:53 pm Link
Is Goldman still benefiting from ANY taxpayer funded facility? If so, they need to share the profits with the taxpayers BEFORE sharing them with their employees.
Next time they come asking for a TARP loan, let’s jack up the rates!
— andrew
5.
5. July 14, 2009 5:59 pm Link
One cannot say definitely that “Golden Sacks” has been behaving badly - just unethically. And of course they are not alone.
The notion that multi-thousand if not million dollar paychecks is justifiable in terms of societal value added is ludicrous. Value is added, no doubt, when all is done honestly, but much more is added when it is done ethically
The time has come, young masters of the universe, to look clearly in the mirror and ask if what you see is something your fellow humans would respect and like.
— Robert Robinson
6.
6. July 14, 2009 5:59 pm Link
Can they create cost-of-living sustaining jobs without cheating someone else out of their life savings?
If so, great.
Or are they simply taking a little from lots of outsiders, to pay a selective group of insiders.
— show me
7.
7. July 14, 2009 6:20 pm Link
They didn’t just get 10 billion from TARP, which they finally returned. They haven’t returned 12.9 billion from TARP which they got from AIG. And nearly 30 billion through the FDIC.
If I had 50 billion from the government, I would hope that I would have a return along the lines of a few billion, which is all they’ve achieved.
Can anyone tell us what Goldman paid in taxes last year? I heard it was between 10-15 million. With an M, million. Compared to billions from the government.
— eva
8.
8. July 14, 2009 6:25 pm Link
I read Matt Taibbi’s article “The Great American Bubble Machine” in Rolling Stone. His piece was mentioned by the Times in “For Goldman, a Swift Return to Lofty Profits” (07/13/09) and was quickly dismissed as “the ramblings of conspiracy theorists” by an unknown Sach’s representative.
I did not get this impression. In fact it made me suspect of any article about Sach’s that is not even slightly critical of the company’s obscene bonus scheme.
I am a firefighter/paramedic by trade. There is a saying out there that says “you wouldn’t risk your life for a million bucks, we do it daily for less.” Why not steer that money set aside for these alleged “too-big-to-fail” financial institutions into those that are really “too essential” to fail like public safety and education?
If anyone deserves a average $600,000 salary it is my colleagues and my daughter’s teacher, all of whom had to tighten their belts during this recession.
— Jay
9.
9. July 14, 2009 6:31 pm Link
Great news for me.
— Debra Garson
10.
10. July 14, 2009 6:48 pm Link
The above commentary is interesting, but until things are reformed, how about using the tools that are available in the current environment. I would specifically reference capital requirements. Regulators should review Goldman and given their profits vis a vis risk exposure require an increase in their capital requirements. They are a bank now, they should be regulated accordingly.
PS: Congress should consider applying a windfall tax to Goldman, single handedly gaining revenues, decreasing risk, and scoring political points.
— Julie Steinberg
11.
11. July 14, 2009 6:50 pm Link
This is exactly why the government should have gotten equity stakes in return for their support of financial institutions. Then it would have been heads WE win, tails we lose. Instead we gave the support, the shareholders won and the American people got no upside.
— Sam
12.
12. July 14, 2009 6:51 pm Link
Even though they returned TARP dollars Goldman received additional taxpayer money through the AIG takeover/bailout. How much of our money did Goldman get through that “too big to fail” funnel, and is there any way that we can get them to repay THAT money?
— Dan
13.
13. July 14, 2009 6:53 pm Link
Obama was elected to rescue the middle class. Instead, he hired Tim Geithner and Larry Summers to rescue the Wall Street fat cats who got us into this mess. How wonderful that he is succeeding.
— lydgate
14.
14. July 14, 2009 7:01 pm Link
God Bless America
— John Suriano
15.
15. July 14, 2009 7:03 pm Link
Come on, people. Just because some other banks screwed up does not mean ALL banks screwed up.
I don’t work for Goldman, but just because they posted huge profit does not automatically make them evil.
As for the TARP money, before jumping the gun, did you even try to find out if they paid back the money? If they have, they have all the right to compensate people working for them which made them earn profit in the first place.
Smart does not necessary equate to evil.
— Gary
16.
16. July 14, 2009 7:21 pm Link
My experience in the industry has taught me that the time to worry on Wall Street is when their is a profit bonanza. Such periods of excess always suggest a monumental disaster is on the horizon.
The blowups with Long Term Capital Management. and our latest financial debacles in 2008 were all proceeded by periods of obscene financial profit.
The lesson to be learned here is the the screws need to be tightened when times are good . Where is Fed Chairman Martin who said when the party gets too lively it is time to take away the punch bowl?
— Len
17.
17. July 14, 2009 7:24 pm Link
i hope that in the future if a goldman fails, it is permitted to fail.
goldman is privy to opportunities — they are also linked in a symbiotic way with the top officials. saving goldman is fine — but if it is ever deemed too big to fail again — and is saved again, G-d help us.
privatizing profit and socializing losses is just simply not right.
it is not fair. people understand fair, and this is not fair. it needs to be fixed — i truly will applaud a violent revolution if unfairness becomes the norm.
— Todd S
18.
18. July 14, 2009 7:25 pm Link
Goldman Sachs took a $11 billion loan from the taxpayers, and then received untold billions more funneled through AIG (the government gave money to AIG, who simply passed it along to other companies, Goldman Sachs included). Meanwhile, Goldman deferred their profits until after the TARP loan was repaid, meaning that the company was out from under the restrictions on that money. They can now give six-figure and seven-figure bonuses to whomever they want and are answerable to no one.
Meanwhile, too Goldman Sachs has been profiting off of the economic downfall, making money off of the fire sales of companies and emergency sales of stock by banks needing to raise capital. If Goldman had the ability to make $736 billion from this underwriting in a single quarter, did they really need any taxpayer loans in the first place?
It’s no surprise, of course, that most of Obama’s top economic gurus all come from Goldman Sachs. Given the close ties, is there really any doubt why Goldman has made such a quick reversal in fortunes? Let’s be completely honest with ourselves: Obama’s administration works for Goldman Sachs.
— blert
19.
19. July 14, 2009 7:32 pm Link
I guess Americans now think that people should work for modest sums of money at companies that are only marginally profitable.
How dare Goldman make big profits and reward the people that made them.
Shameful. Don’t they realize that profits are un-American now?
— BT
20.
20. July 14, 2009 8:01 pm Link
I agree with #13. Obama and his economic whiz kids could NOT be more disappointing in this regard. Never mind how smug each of them seems.
— Mary in Seattle
21.
21. July 14, 2009 8:02 pm Link
This is just one further step in what will likely end up being the largest transfer of wealth from the taxpayers to private investors in the history of any democracy.
— Luis B.
22.
22. July 14, 2009 8:06 pm Link
Obama help keep this insanity going by supported and insuring the TARP got through congress. I am not suprised at all.
There are two Americas and there always will be. One for the rich and connected and one for the rest of us.
Now stop whinning and go back to drinking your beer.
— Michael H.

 

GS is a PARASITIC PLAGUE sucking every drop of blood out of the middle class taxpayer.


While it's competition LEH, ML, BSC were effectively decapitated. GS pocketed taxpayer funds using AIG as the conduit without taking the prerequisite haircut like its competitors. using these free funds, it then drives up oil prices setting a hidden tax on the taxpayer that bailed them out.

This Goul needs to be forcibly detached from its corrupt hosts inside the govt. and put to rest. Forcibly if needed. Same treatment goes for its apologists.

 

I would have no problems with those huge bonuses if they had a downside risk on their personal wealth, even a lot smaller than the upside potential. Introducing personal financial responsibility is enough to stop that kind of frightening behaviour, we just have to introduce maluses for people claiming bonuses...

Even maluses of 1-2 % of losses made would change the map tremendously. We would see who have balls...