Are Clients Really Worried About Goldman?

In the wake of a lawsuit by the SEC and a day-long grilling by the Senate, Goldman Sachs is feeling pretty battered. The New York Times piled it on yesterday, with a sprawling front page article that claims Goldman's clients are questioning whether to continue doing business with the bank. There's little doubt that Goldman's bankers and traders have thick enough skin to handle some criticism from Washington, but if they start losing business, then that's a real problem. A bank is only as strong as its relationships. Does Goldman really have reason to fear? Probably not.

The Times article uses nearly 3,500 words to argue that Goldman's clients have lost trust. But it really boils down to four criticisms of the firm. Let's consider each, then the broader claim that Goldman's business might be hurt due to its actions over the past few years.

Washington Mutual and New Jersey

Two of the article's sections make essentially the same argument. First, Goldman underwrote securities for failed bank Washington Mutual and the state of New Jersey. Ultimately, however, Goldman bet against Washington Mutual once it realized the retail bank's problems. Goldman also advised clients to buy protection against New Jersey's potential default as the state's fiscal problems became clearer. Should we be outraged at Goldman treating its clients this way?

There are two points here. First, of course these clients were angry at Goldman: the bank exposed their problems. But wouldn't it have been worse to recognize their issues and ignore them? Then Goldman would have done a disservice to its hundreds of other clients who it advises, as well as its shareholders.

Second, the division of the firm that underwrites securities is completely separate from its proprietary trading desk and municipal research team. Some years ago, banks were required to put "Chinese walls" up to prevent these groups from colluding. It's irrelevant to the prop traders and muni researchers who the firm underwrites for -- that's not supposed to affect their actions or opinions.

Auction Rate Securities

Next, the article faults Goldman for its involvement with auction rate securities. Yes, Goldman was wrong to think that these securities would be okay. But then, so was every other investment bank. Virtually all were advising clients to sell auction-rate securities, and all got out as quickly as possible when they realized how poorly the securities would perform as liquidity was drying up.

But the article also blames Goldman for not breaking a contract so to treat one client more favorably regarding its auction rate securities. So the bank should have ignored a contract in order to voluntarily endure losses due to the risk a client agreed to take on? How do you think Goldman shareholders would feel about that decision? Goldman has a fiduciary duty to maximize their profit, which arguably outweighs any desire it has to protect clients form themselves.

Collateral Calls

Is Goldman responsible for the fall of AIG? The article appears to make that utterly wild implication. It criticizes Goldman for requesting collateral to cover mortgage-related losses on assets backing loans it provided to AIG and other firms. Goldman -- rightly -- recognized the deterioration of these assets. So what exactly was the bank guilty of? Again, it was just hedging its own risk, so to protect its shareholders and profits. Ignoring a bad loan when you can guard against its losses isn't good customer service: it's stupid business.

Its Unwritten Principle

This point sort of relates to the last one. The article complains that Goldman has an unwritten 15th principle:

any business in any industry, has potential conflicts and we all have an obligation to manage them effectively

In other words, even though your clients are important, you should not lose sight of the big picture. This isn't just good business sense; it's basic common sense. Let's say you loan your brother your car from time to time. He's family, arguably the strongest relationship bond possible. But if he develops an alcohol problem and wants to borrow your car to drive to a bar one night, would you let him? Of course not. Similarly, if Goldman realizes a client could cause its shareholders a grave loss, then it must do what it can to prevent that, despite the relationship.

Are Customers Really Growing Weary of Goldman?

The Times piece manages to find five or so past clients of Goldman that no longer wish to work with the bank. But what about the other thousand or so? Is it plausible that all of the bad press will lead the others to question doing business with the firm? Warren Buffett doesn't think so. He argues that Goldman's clients understand the bank wears many hats, and that could sometimes conflict with a client's interest.

The industry sources I spoke with also agreed. One equity analyst at a fund that deals with Goldman in its market-making capacity said his firm has no intention of changing its relationship with the bank due to recent allegations. He doesn't believe many other firms the bank trades with will either.

The analyst has also observed little impact to Goldman's underwriting so far. Goldman continues to play a prominent role in recent new issue equity offerings that hit the market, he says. He imagined a worst-case scenario being that Goldman goes from lead manager to co-manager on some deals until Washington turns its microscope off.

Sophisticated clients know what they're getting when they do business with Goldman: a highly skilled market maker that always keeps its own interest in mind. And that's okay -- every bank that hopes to remain in business is ultimately out for its own interest. But the fact that it cares about its own well being doesn't mean it can't also provide excellent service to its clients.

Note: I received an e-mail that contended that some of Goldman's bets against the mortgage market were done by its mortgage desk -- not its prop trading. That's a good point, but those were hedges on its mortgage market exposure. It's baffling that people expected Goldman to just smile and take losses instead of protect its shareholders by hedging its risk when it foresaw a problem in the mortgage market. Certainly, most Goldman clients wouldn't blame the bank for this action.