Why You Should Thank Goldman Sachs
A lot has been written, reported, blogged, talked, and argued about lately regarding Goldman Sachs.
Most of this talk has been negative, blaming them for the recent financial crisis, criticizing their executive compensation, and making public vendettas against the culture of the firm, as Greg Smith did in a recent op-ed for the New York Times.
However, despite all of this criticism, Goldman Sachs remains one of the largest investment banks in the world, and is not going anywhere.
Now, while you can make a moral argument about whether or not a company should have their clients best interest at heart, the fact remains that for most large investment banks and brokerage houses, there is no legal requirement to do so.
And what’s more, this is the right way for Goldman to conduct business.
Let’s look at a real world hypothetical:
- A mortgage company, between the years of 2000 and 2005, makes loans to 100 consumers who purchased houses. The total loan value of these homes equals $10,000,000.
Let’s say Goldman Sachs helped this company obtain the financing to make these loans. They charged a fee for this service, as any firm would, but have no further stake in the company.
But Goldman Sachs does not use its own money to finance these loans, they have clients who are investors, who are looking to make investments in different asset classes, and in this case choose to do so investing in mortgages.
When these investment are initially made, the housing market is booming, asset prices are going through the roof, and people are banging down the door to invest in these mortgages.
At this point, Goldman Sachs has clients (individuals) who have made an investment to finance the loans, and a separate client (the mortgage issuer) who has actually made the loans to consumers.
Now, jump ahead to 2006.
- The real estate bubble is coming to a head, and Goldman is worried that these asset prices may start to fall.
What does Goldman Sachs do?
Your first reaction: Well, they should immediately tell all of the investors that they think the market is going to crash and they should stop making investments.
Sounds reasonable, right?
Well what about the investments they have already made?
Well they should recommend the investors sell them, right? They are going to decrease in value.
So Goldman, doing what is in the best interests of its client, finds investors to purchase the mortgages, before they decrease in value.
But wait, these new investors are purchasing an asset that Goldman believes will decrease in value.
Does Goldman tell them that?
If they do, the initial investors in the mortgages, who are clients of Goldman, will be stuck, because no one will want to buy the mortgages.
If they don’t tell them, then they are condemned for selling an asset they believed would decrease in value (which is one of the major reasons they were criticized in the media).
Either way, if Goldman offers its opinion, it is, for lack of a better word, screwed.
Damned if you do, damned if you don’t.
The only way to avoid this situation is to take a neutral stance.
While Goldman is entitled to its opinion, it is inappropriate to offer that opinion to clients.
If they did, they would inherently be shunning one side of the table in favor of the other.
Goldman’s role is to create the opportunity for one investor, with one point of view, to conduct business with another investor, with a different point of view.
That’s it. No more, no less.
So while you can sit hear and complain about the big evil corporation ripping off the little guy, Goldman’s role is what makes markets work.
Without them, business would not transact, investors would not invest, and most assets would cost significantly more than they do today.
Thank you, Goldman Sachs.