One-and-a-half cheers for Goldman
Sachs By Spengler
The
poison drip never stops. Last week, regulators in
the United States fined Goldman Sachs US$22
million for failing to prevent research analysts
from feloniously advising favored clients of
changes to stock recommendations. And federal
prosecutors reportedly will offer immunity against
a back-office manager of the busted commodities
firm MF Global in return for testimony
against its former chief, Jon
Corzine, who ran Goldman Sachs before becoming
senator and governor in New Jersey.
Corzine allegedly signed off on the
improper transfer (that is, theft) of customer
funds to meet margin calls for the firm's own
account.
A $22 million fine for research
violations sounds like a slap on the wrist for a
technical violation, to be sure, but it points to
a red thread which, if we follow it carefully,
will illuminate flaws in the American economy that
are no fault of Goldman Sachs. The Corzine case is
straightforward: either he stole the money or he
didn't, and either the Justice Department will
press the matter upon a former Democratic senator
and governor, or it won't.
The Wall Street
research business is another matter. I ran a
couple of large Wall Street research departments,
and sat on the Security Industry Association's
committee that wrote the rules for bond research.
In this case, Goldman Sachs identified 180
preferred clients, mainly hedge funds, who would
get extra attention from research analysts under
an "Asymmetric Service" program. Traders and
analysts held weekly "huddles", as the firm
quaintly called its meetings, and the analysts
then called their best customers with their best
ideas. The Securities and Exchange Commission
alleges that the likes of George Soros and John
Paulson might have known when Goldman would change
its recommendation on a stock before you and I
did, and could make money that we couldn't make
trading in front of a research report.
Goldman Sachs, to be sure, isn't charged
with any specific acts of fraud, only with failing
to impose adequate safeguards. Even if we assume
the worst, though, there's fraud and then again
there's fraud. Americans love to be duped about
certain things. They want to be duped so badly
that they elevate con men into heroes. The iconic
example is "Professor" Harold Hill in the 1957
musical The Music Man. Goldman Sachs serves
an indispensable function as facilitator in a
grand national self-deception that the vast
majority of Americans want to perpetuate as long
as possible.
Just who were these
"preferred clients", and why did they have such
pull with Goldman Sachs? The answer is that hedge
funds who engage in high-frequency trading
generate far higher commissions than old-fashioned
buy-and-hold investors like insurance companies or
mutual funds.
The putative geniuses with
computer trading strategies or outsized market
savvy produced returns that the rest of us could
only dream of (and took enormous fees for so
doing).
Except they didn't.
If you
had put your money into hedge funds in 2005 and
distributed it across the whole universe of hedge
funds, you would have roughly the same amount of
money today. By contrast, if you had simply bought
the existing universe of publicly traded stocks
and bonds and reinvested interest and dividends,
your portfolio would have grown by half.
Hedge funds underperform stock and
bond indices by a huge margin
Source:
Bloomberg
If the hedge funds performed
much worse than either stock or bond index funds,
what were they doing there in the first place?
There are a few authentic geniuses in the hedge
fund business, to be sure, who throw off
spectacular returns regularly; there are a larger
number of clever fellows who have a great idea one
year (like John Paulson, who foresaw the housing
collapse) and then lose just as spectacularly the
next year. And there are a very large number of
Ivy-educated herd-followers in pink shirts and
suspenders with no particularly notion of what
they should do, some of whom take every
opportunity to chisel out a speck of income by
nefarious means.
If they are such duds,
who hires these managers? For the most part, hedge
funds get their money from the same pension funds
and insurance companies who manage money for the
small investors who feel so badly used by Goldman
Sachs. Despite the hedges' miserable performance,
institutional investors will continue to invest
with them. Reuters reported last February that
hedge fund assets "could hit $2.13 trillion this
year": [1]
This news comes from the opinions of
600 surveyed institutional investors with $1.04
trillion in hedge fund assets, according to
Reuters. The respondents also believed their
hedge fund portfolios will bring 8.6 percent
returns in 2012 and hedge funds could expand by
around 12 percent from an additional $200
billion in assets.
One year ago in this
same survey, respondents had estimated a 2011
hedge fund increase to 11 percent while
incorrectly forecasting hedge fund assets would
increase to $2.3 trillion by year's end.
From concerns about the European debt
crisis and declining economic growth, US hedge
funds lost an average of 5.2% in 2011. This
represented the second lowest in annual returns
since 1990 when industry data had first been
tracked. But this hasn't deterred investors and
pension funds from looking to hedge funds for
protection, according to Credit
Suisse.
The pension funds expected to
earn 11% last year but lost 5.2% instead. Now they
expect to earn 8.6% and will continue to invest.
It sounds insane, but it really isn't. The
institutional investors are up against it and
might as well be hanged for a sheep as for a lamb.
The anemic American economy simply doesn't
produce enough financial returns to meet the
requirements of pension plans. Most pension plans
need an 8%-9% return on assets to meet their
obligations. But 10-year Treasuries pay 2%, and
investment-grade corporate bonds pay 3% to 4%.
Equities promise higher returns, but they are
volatile: a pension plan that owns stocks during a
big market dip will have to sell at the bottom to
meet current obligations, and may never catch up.
Because market returns undershoot the
requirements of pension funds, they will come up
short as obligations to pay retirees kick in.
According to an American Enterprise Institute
study [2], state and municipal pension funds are
short $3 trillion. The 100 largest US corporate
pension funds had a combined deficit of $326
billion last year, and are borrowing money to
paper over the shortfall. If corporations come up
short, they either must divert profits into
pensions or, like General Motors, use the
bankruptcy courts to reduce pensions.
As
the American population ages during the next 20
years, the proportion of Americans over 60 years
of age will jump from about 18% today to 26% in
2030. The pension problem (and the Social Security
and Medicare problems only will get worse).
Proportion of Americans over 60
No
one wants to admit this. To address the matter
directly risks political suicide, as Governor
Scott Walker of Wisconsin discovered when he took
on the government unions in his state. Americans
never have been asked to give back benefits that
they previously were promised, and will fight
bitterly to maintain them.
Never mind that
there isn't enough money to fund government
employee pensions, not if they confiscate the
whole net worth of all the millionaires in the
country. So in order to maintain the pretense,
pension funds "expect" (which is to say include in
their budgets) high expected returns from hedge
funds.
The unions are lying to their
members. Prospective pensioners are lying to
themselves. Politicians (except for a very few
brave individuals like Walker) are lying to their
constituents. Corporate accountants are lying to
their shareholders. Pension fund managers are
lying to their sponsors. Hedge fund managers are
lying to the pension funds.
In this circle
of deceit, the least damaging form of deception
comes from Wall Street, which helps a few favored
hedge customers to earn the extra dollar by
not-quite-legal means. "I say - is this table
honest?" "Honest? As the day is long!" Everybody
is lying, but only Goldman Sachs will pay a fine.
It hardly seems fair.
So here are
one-and-a-half cheers for Goldman Sachs. The firm
serves one of the most characteristically American
of all functions: to help the public believe its
own bunkum. Every kid is above average in Lake
Woebegone, and every hedge fund will earn excess
returns, and every pension fund will beat the
market, so that every prospective retiree will
avoid the squeeze that confronts all of us not
very far down the road.
Spengler is channeled by David P
Goldman, president of Macrostrategy LLC. His
bookHow
Civilizations Die (and why Islam is Dying,
Too) was published by Regnery Press in
September 2011. A volume of his essays on culture,
religion and economics,It's
Not the End of the World - It's Just the End of
You, also appeared this autumn, from Van
Praag Press. He resigned as Bank of America's bond
research chief in 2005 due to philosophical
differences with management.
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