As of this morning I counted five separate threatened criminal investigations and one civil fraud suit targeting Wall Street’s best-known firms, ranging from the formidable Goldman Sachs to the hapless Moody’s. Sure, Wall Street is a convenient scapegoat, and the populists demand a villain. But is that all there is to this? Or is there something inherently wrong with the industry?
Bear with me on this. It’s pretty clear now that for all the greed, laziness and dunderheadedness that blew up in 2008, what put the match to the fuse was fraud. That’s not unique to this bubble. Fraud has been part of every crisis from junk bonds to savings and loans to dotcoms to liar loans and toxic CDOs. I doubt that financiers start out more dishonest than the rest of us, any more than, say, Tiger Woods was born more sex-addled than the average male. It’s just that, like Tiger, Wall Streeters face more temptation than the rest of us, and they do so in an entitled culture that makes cutting ethical corners not just worth the risk but also weirdly justifiable.
Too much temptation. Because Wall Street competes for a share of people’s accumulated wealth, rather than a share of their salaries, the sums available for skimming are orders of magnitude larger than in other businesses. And that’s before you add leverage, which only multiplies the stakes. So Wall Street starts with a condition that you rarely find in other industries: the ability to get really, really rich quickly without excessive effort. That alone changes the equation.
What then makes it so easy to separate people from their wealth is complexity. Complexity in financial products assures that a sales person will always know more than his customer — it’s called asymmetric knowledge, according to economists. A desire to preserve a firm’s reputation, backed by legally mandated disclosure, is supposed to control the temptation to exploit asymmetric knowledge. How well did that work? Not too well. If there was any theme in this crisis, from overextended homeowners to Goldman Sachs’ Abacus CDO (collateralized debt obligation) to Bernie Madoff’s investors, it was that no one understood what they were buying. And sellers stood to get very, very rich if they kept it that way.
Too permissive a culture. Goldman’s defense in its SEC suit is that its customers were sophisticated institutions that should not have expected the bank to act in their best interest. Steve Randy Waldman devastates this claim, pointing out that the victims had every reason to believe that Goldman thought the CDO they had created would succeed. Regardless, the buyer-beware argument is still a favorite on Wall Street. “Goldman’s customers were consenting adults,” as one hedge fund manager put it to me. “They should have done their homework.” True, any institution lazy enough to invest other people’s money without understanding what they’re buying is not a very sympathetic victim. But that doesn’t disguise the emptiness of Goldman’s defense. Preying on institutions is still predatory. And ultimately, it’s ordinary people’s wealth that’s destroyed when institutions are suckered.
Since Goldman will probably settle, the issue of whether the company’s behavior was actually fraudulent will go undecided. And it hardly matters. But being just this side of illegal is a pathetically low standard for America’s financial institutions to set for themselves.
Too entitled a culture. “We’re compensated in line with our contribution,” said the investment bank recruiters in Liar’s Poker to Michael Lewis, when the author was a young Princeton grad applying for a job. Really? The average bonus at Goldman Sachs last year was 10 times the total household income of the middle-of-the-pack American family. Most economists would say the reasons for astronomical salaries on Wall Street have less to do with “contribution” and more to do with leverage and habit. Levered 12 to 1 (or 30 to 1, which is what many firms were carrying before the crash), a sliver of a profit quickly gets magnified into investment genius.
As for habit, most Wall Street firms have their origin as partnerships, and they kept their profit-sharing practices when they went public. (And hedge funds, where the real money is, remain partnerships). That’s largely why financial services firms traditionally devote a larger share of their cash flow to compensation than other industries. According to a March 2010 survey by the Society for Human Resource Management, for example, salaries accounted for 46 percent of operating costs in financial services last year. In all other industries the average was 38 percent.
If you work in finance, however, it’s much more satisfying to explain your outsized pay as just desserts for outsized service to society. We are doing God’s work,” said Lloyd Blankfein in his revealing interview with the Sunday Times of London. If you earn 10 times what everyone else does, you have to be more than usually mature not to conclude that you are 10 times more valuable.
And once you’ve decided that your 10x pay is “in line with your contribution,” a great many convenient corollaries fall into place. If your contribution is so important compared to other people, why should you be subject to oversight by the lesser mortals who populate Congress and the SEC? Any interference with your pursuit of profit becomes a net loss for society.
Or for that matter, why should you be subject to the same taxes? You hear that argument in hedge funds’ opposition to the American Jobs and Closing Tax Loopholes Act of 2010, which the House passed last Friday and which proposes to tax hedge fund partners more like other money managers. (At the moment, partners’ fees are taxed at lower capital gains tax rates.) In essence, hedge fund capitalists argue that their labors are so important to the economy that they deserve lower taxes than everyone else. The argument is breathtaking in its sense of privilege, but it is delivered in all apparent seriousness by Wall Streeters in forums from the New York Times’ op-ed page to congressional testimony.
But we ordinary people deserve some blame. Wall Street gets away with acting above the law because we kind of like it that way. The most successful hedge fund manager before John Paulson and the few others who shorted real estate in 2007 was Steve Cohen, head of SAC Capital. SAC’s trades alone accounted for some 3 percent the volume on the New York Stock Exchange at one time, and rumors flew that he achieved his returns on the back of illegal inside information. The rumors were never proved — nor did they keep Cohen from attracting customers who might have wanted his returns but didn’t want to look too closely at his methods.
Or take Bernie Madoff. Surely some of his victims suspected that no one earns 10 to 12 percent returns year in and year out the old fashioned way. Maybe, they might have told themselves, Madoff was exploiting some trading anomaly in a legally gray area. Maybe he occasionally crossed the line. But who cared, as long as you were getting rich along with him?
Reporter: Temma Ehrenfeld
Eric Schurenberg is editor-in-chief of CBS MoneyWatch.
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