By Darwin Bond-Graham
Goldman Sachs employee Greg Smith’s very public resignation, replete with a pointed letter published in the New York Times yesterday, has landed upon the investment bank like a bomb. Slamming a “toxic and destructive environment” within Goldman Sachs, Smith says the firm’s internal culture has devolved to the point where the entire staff not only tolerates, but expects workers at all levels, from senior partners to associates, to pursue nothing but ever-more sophisticated means of “ripping their clients off.”
Apologists for the financial sector —including the editors of the major business newspapers and television networks— predictably have shot back with a flurry columns and reports, mostly designed to discredit the former vice president by making fun of Smith and his concerns. If you strip away the ad hominem layers to these responses though, the core problems raised by Smith remain, and the reaction of the business press seems all the more absurd, for Goldman’s pesky turncoat isn’t saying anything that’s news to the public: Goldman Sachs is characterized by a toxic culture of greed? Stop the presses!
There is much more to be said about Goldman Sachs’ derivatives operation, however, and Smith’s provocative resignation provides an opportunity because he was working in the belly of it.
At the center of Smith’s critique are derivatives, the arcane financial instruments that transformed the world’s splintered national economies and regional banking systems into a single, if complicated, global system. Evangelists of derivatives claim they have made new heights of economic growth, trade, and prosperity possible. Critics have pointed out since the beginning of the derivatives boom in the 1980s how perfectly suited they are to fraud and systemic catastrophe via the greed of the few and the powerful.
Derivatives, many close observers have reminded us, were at the center the Enron meltdown, the demise of Long Term Capital Management, the Asian Financial Crisis, and most recently the Great Recession and its various flares, from the housing bubble that exploded from junked collateralized debt obligations, to the current Greek debt imbroglio and the credit default swaps haunting the background. In each case, and many less-known fiascos, derivatives traders in Wall Street’s leading banks played key roles either as the major villains, or enabling partners in vast crimes of information, leverage, and risk. Time and again we find derivatives at the center of scandalous greed. Now we have a high-profile banker denouncing not just some bad apples in his firm, but the firm’s entire culture.
There’s a deeper and more disturbing truth still further below the surface though. To get there it’s instructive to know a little more about Goldman’s derivatives operation, and the wider industry of which Goldman is a small part.
Who are the clients on the receiving end of Goldman’s “toxic and destructive” tendencies? Many times the victims have been other corporations, industrial firms with less sophisticated and perhaps naive financial officers. Quite often though the victims of Goldman’s derivatives operation have been cities, counties, and local government agencies. A key client category for derivatives has been large local governments and agencies that issue hefty sums of long-term debt.
Goldman, and the handful of other global banks that dominate the derivatives industry, sold local governments on the idea that a particular set of derivative products could provide wondrous solutions to hedge against the risks inherent in issuing long term debt. The banks claimed that interest rate swaps could shield counties, cities, and agencies from possible spikes in floating interest rates attached to their bonds. Thus many governments agreed to complex, multi-decade deals involving the swapping of payments on fictive amounts of money associated with real debt. In no time at all interest rate swaps became the single largest category of derivatives, dwarfing all others.
Today interest rate swaps make up 82% of the total market in derivatives, measured by total notional amounts. This is partly the result of governments all over the world entering into interest rate swaps, agreeing to tie cash flows to trillions of notional dollars. What’s key is that none of this has required duplicity or reckless greed on the part of bankers at Goldman Sachs or other firms. Let’s be clear; this is a structural transformation of capitalism on a global scale, and it has sucked up all corporate and government entities into the new logic of hedging and efficiency. That a few powerful financial corporations have placed themselves in strategic positions to benefit from this structural shift should come as no surprise.
In California’s Bay Area multiple governments have come to find themselves on the paying end Goldman’s derivatives department where apparently traders referred to clients as “muppets.” The most obvious example is the city of Oakland where a chronic budget crisis has led to the shuttering of schools and cuts to elder services, housing, and public safety. Oakland signed an interest rate swap with Goldman in 1997. The terms of the deal, revised once in 2003, were typical of interest rate swaps except that Oakland’s financial officers, based on this author’s research and impressions, seem to have agreed to a somewhat higher fixed rate obligation than most other cities that signed swap deals for similar amounts of debt with comparable ratings. Oakland partly did this, I am guessing, to receive upfront payments of roughly $5 and $10 million from Goldman Sachs, cash that the city wished to have on hand immediately. The bank seemed eager to do this because the original terms, and renegotiated terms in 2003, were much to its favor. It would earn the $15 million back, and then some over the twenty-four year life of the swap.
Across the Bay, Goldman Sachs signed an interest rate swap agreement with the San Francisco International Airport in 2007 to hedge $143 million in debt. Today this agreement has a negative value to the Airpot of about $22 million, even though its terms were much better than those Oakland agreed to. The Airport, like Oakland, must now pay millions each year to Goldman Sachs until the agreement expires, or until the floating LIBOR interest rate rises enough to offset the net balance of payments. Goldman sold derivatives up and down California and across the United States to cities, counties, and agencies, promising them a means of reducing debt payments over the long haul.
Business press pundits who are now slamming Smith say it’s absurd to expect that Goldman Sachs was doing anything less than trying to make money off these deals, and that counter-parties to the firm’s dealings knew well what they were signing up for. This mischaracterizes the entire problem, however, and threatens to steer the conversation into a narrow, and politically irrelevant one about whether Goldman Sachs is or isn’t a den of fraud.
When governments signed up for interest rate swap deals with Goldman Sachs they certainly did know that the bank would be making money off the agreement, first in the form of up-front fees, and then off of savings produced by the pairing of comparative advantages in debt markets that interest rate swaps are designed to achieve. If you don’t understand that last point, don’t worry. What it means simply is that Goldman Sachs sold interest rate swap products to governments by promising to both protect a government against interest rate volatility, and to also likely reduce the overall long-term cost of borrowing money. It was supposed to be a win-win game.
The truly impressive thing about the whole derivatives market is that it is supposed to ratchet up the efficiency of the entire global economy, making dollars go much further, protecting all parties from volatility, transcending previous market barriers and smoothening flows of cash… at least in theory. The theory seemed to be working in the 1990s and through most of the 2000s. Goldman didn’t have to convince anyone of this for the results were plain to see.
That is hasn’t panned out in practice, that the whole derivatives-based economy nearly collapsed in 2008 and continues to falter, isn’t so much the result of Goldman’s toxic culture of greed as it is the outcome of a much more troubling feature of our economic system. While I agree with Smith’s observation —which is important because it’s based on insider knowledge— that Goldman Sachs is an especially predatory corporation, I see a larger pattern of power relations embodied in the new economy, structured as it is by derivatives, that isn’t based on any specific firm’s internal culture or corruption, or the supposed naivety and stupidity of financial officers in government and less profitable sectors of the economy.
Consider the fact that Goldman Sachs isn’t even the biggest fish in the pond, nor is it profiting the most from the blizzard of derivative products that structure the capitalist economy today. Of the five financial corporations that “dominate in derivatives,” as the U.S. Office of the Comptroller of the Currency puts it, Goldman Sachs ranks fourth, behind by Bank of America, Citibank, and far behind the absolute king of derivatives, JP Morgan Chase.
In February JP Morgan Chase let slip that it cleared $1.4 billion in revenue on trading interest rate swaps in 2011, making these instruments one of the bank’s biggest sources of profit. According to some reports, JP Morgan Chase made billions more in 2008 and 2009 when the financial crisis and federal response combined to make floating-to-fixed interest rate swaps into extremely profitable assets for the banks on the floating side of the deal. Similar things can be said for Mogan Stanley, HSBC, Wells Fargo, Bank of America, Bank of New York, and the dozens of smaller interest rate swap peddlers currently profiting from direct transfers of public dollars.
Are all these banks poisoned by toxic cultures of greed? Surely there are similarities in the internal cultures of large banks, and greed and a little sociopathic ability to profit from another’s loss is a professional asset in these sorts of organizations. In contemporary corporate culture the euphemism for this is “competition.”
Toxic culture and greed, or “competitiveness” if you prefer, in the investment banks isn’t a sufficient answer to why derivatives have become the foundation of today’s global economy, however. The criminal activities of some bankers driven by these more pervasive cultures can’t explain the economic crisis and the vast injustices that are being perpetrated still in the name of “economic recovery.” The interest rate swap crisis stinging local governments and enriching the banks is a case in point.
The windfall of revenue accruing to JP Morgan, Goldman Sachs, and their peers from interest rate swap derivatives is due to nothing other than political decisions that have been made at the federal level to allow these deals to run their course, even while benchmark interest rates, influenced by the Federal Reserve’s rate setting, and determined many of these same banks (the London Interbank Offered Rate, LIBOR) linger close to zero. These political decisions have determined that virtually all interest rate swaps between local and state governments and the largest banks have turned into perverse contracts whereby cities, counties, school districts, water agencies, airports, transit authorities, and hospitals pay millions yearly to the few elite banks that run the global financial system, for nothing meaningful in return. These perfectly legal cash flows measuring globally in the hundreds of billions, from the public to the banks, dwarf anything that is the result to fraud.
Back when the economy was in a “normal” stasis of growth, the early and mid-2000s, interest rate swaps and other derivatives promised security against risk, and a new vista for capitalism and public finance. Tellingly, when the crisis struck, swaps were allowed to become a one way flow of funds from the public to the banks. This shadow bailout for the banks has done considerable damage to already cash-strapped local governments suffering from declines in tax revenues and federal aid.
Whether Goldman Sachs is or isn’t an organization gripped by a toxic culture isn’t all that important when one considers the destructive impact that derivatives have had, and continue to have upon society. Capitalism as it functions today is completely dependent upon derivatives. Interest rates swaps are the single largest type of derivative, measured by notional amount, because they achieve an integration of different national, regional, and sectoral financial markets into one global financial system. It’s in the genetics of the project of financial globalization, fueled by derivatives, that the real problem lies, not in the internal culture of Goldman Sachs, or the illegal behaviors of some bankers across many firms. The real crime lies in perfectly legal and legitimated activities whereby a few powerful corporations design a system that puts the welfare of the world’s vast majority at grave risk. It’s the system that’s toxic. Goldman Sachs merely operates well within the toxicity.
Nevertheless, Greg Smith’s effort to pull back the curtain on one of the most nefarious and powerful corporations in history is most welcomed, especially for the deeper conversations it can stoke about the origins of the current crisis.
