There is widespread popular sentiment against the alleged indiscretions of Goldman Sachs in structuring and selling a complex mortgage-based derivative security, Abacus 2007-AC1. It will take a while to determine whether there was a deliberate attempt to deceive on the part of the investment banking giant or whether this was the result of the individual actions of a rogue trader (named in the US SEC civil suit) or of a small group operating around him. We emphasise that the article does not seek to justify, or even explain, specific transactions at Goldman Sachs, but to lay out the operating environment in which banks, particularly investment banks, structure complex securities. It is a coincidence that this comes barely a couple of days after no less an august person than Warren Buffet, the oracle of Omaha, chose to defend the transaction.
The vaunted investment bank?s reputation has unquestionably been dented. First came the bad press on account of the structuring in 2002 of an unusual, if perfectly legal, currency swap transaction that allowed Greece to shove back into the future part of its then current borrowing requirements. Close on its heels came the unexpected news of the SEC suit. The antagonism to the Abacus transaction is remarkable, given the academic and professional interest, even envy, that Goldman and a handful of other banks had generated in the early days of the unfolding financial crisis following news accounts of their standout success in recognising the risks of the looming crisis and the subsequent alacrity in hedging their balance sheets.
While it is easy to be critical of the Abacus deal, particularly after the leaked e-mails of the risible commentaries of its chief architect, there are larger issues?regulation, governance, accounting and disclosure?whose regulatory implementation will be influenced by the outcome of these investigations. We highlight two of these issues here. One, who bears the larger responsibility for appropriate due diligence of financial products designed for investors? And two, how should banks manage their enterprise risk, balancing the investment needs of their diverse set of stakeholders?
The short answer to the first issue is: both seller and buyer. The crux of the argument for the seller in the Abacus deal will be this: the counterparties were large sophisticated institutional investors. In the case of the Abacus transaction, the largest investors in the transaction were IKG (a large German specialist bank for corporate lending) and ACA Capital Partners (an independent securities selection agency). We cannot do better than quote from a defence document submitted by Goldman Sachs to the SEC (now available on the Internet), commenting on the principle of the deal: ?The bottom line is that no amount of disclosure would change that the very sophisticated investors already knew that some entity or entities by necessity had to take a short position?regardless of who selected them, the offering documents for each of the reference securities disclosed detailed information on their underlying assets, as required by Regulation AB. It is this concrete information on the assets?not the economic interest of the entity that selected them?that investors could analyse and use to inform their decisions.? In addition, a significant function of large banks is as ?market makers?, giving both buy and sell quotes to match demand and supply of complex securities.
As to the second issue, banks cater to the financial needs of diverse classes of investors and clients, ranging from the retail investor looking for a safe haven to park her savings to high net-worth families who are savvier about their investment options; from sophisticated corporations to even more alert institutional investors, including hedge funds. They have vastly different risk appetites, investment horizons and financial targets.
In structuring products to meet these multiple aspirations, banks are often confronted with potentially conflicting decisions. It is a legal, moral and ethical axiom that the primary responsibility of banks is their fiduciary responsibility to depositors, to ensure that their savings remain safe. This is the task of the risk managers and CFO, and this de-risking is what Goldman and some other banks actually achieved, progressively into the run-up to the crisis. However, banks are also accountable to their shareholders, who expect a reasonable return on their risk equity capital. Higher returns can only come about with higher levels of risk. This is the core trade-off that banks continually have to manage.
However strong the risk control systems in banks, occasional mis-sells will invariably fall through the cracks; these might not be indicative of systemic negligence. The best regulatory antidote to these potential conflicts of interest are stringent, albeit appropriate, disclosures and associated standardised accounting norms.
The author is vice-president, business & economic research, Axis Bank. Views are personal