Goldman Envy

"We believe we’re #1, but we’ll leave that for others to decide."

When co-chairman John Whitehead made that statement to a reporter for New York magazine in late 1983, Goldman Sachs & Co. was already one of Wall Street’s iconic firms.  That reputation was burnished further over the next quarter of a century as Goldman Sachs rode out various market storms, from the 1987 market crash to the bursting of the dot.com bubble, only becoming stronger in the process. Everything the investment bank touched seemed to turn to gold; its rivals, made increasingly irritable by frequent demands by their own shareholders to generate returns of the kind that Goldman’s bankers routinely delivered for the firm’s investors, resorted to doing whatever they could to play "catch-up."

Now, the very strategies that made Goldman Sachs the envy of Wall Street are under scrutiny. Every successful initiative the firm has undertaken — Goldman’s creativity in devising and structuring new products, the insight displayed by its proprietary traders making money for the firm’s own account, the firm’s success in developing relationships with Wall Street’s new power players — is being placed under a microscope by regulators and legislators, a fact made plain in Tuesday’s hearings on Capitol Hill, when CEO Lloyd Blankfein and several other top executives were hauled in front of a Senate panel for a painful public drubbing.

The transaction at the heart of this scrutiny shows just what happens when Wall Street firms focus more on battling their rivals for market share, fees and profits than they do on serving all their clients and keeping the financial system itself on an even keel. The Securities and Exchange Commission alleges in a lawsuit filed earlier this month that Goldman’s dealmakers crossed the line by failing to disclose to potential investors in a new issue of synthetic mortgage-based securities that a hedge fund manager who wanted to bet against the new product — John Paulson, now a multibillionaire — had helped pick the specific securities it contained. Even at the time this "Abacus" deal was structured, it created a buzz on Wall Street, a rival hedge fund manager recalls. "Everyone heard about it and we were all amazed that John Paulson had actually been able to convince Goldman to create something in order for him to bet that it would fail," he said.

Where Goldman led, other firms almost certainly followed — or at least tried to follow. Ironically, Goldman’s reputation as a blue-chip firm may have left it sitting alone in the hot seat by default. No executives from Deutsche Bank or the now-defunct Bear Stearns were sitting alongside Blankfein as he struggled to explain to his congressional inquisitors just why he didn’t believe his firm had an obligation to tell potential investors that the securities it was selling were those it was itself betting against. (One former Goldman head of sales and trading applauded the efforts of his team for transforming some "big old lemons" of mortgage securities into lemonade to sell to the firm’s clients, one senator said, citing internal Goldman Sachs e-mails; other transactions subsequently sold to clients included those that some Goldmanites called "shitty" or "crap" at the time.)

Blankfein, who characterized the firm’s actions as prudent risk management and declared that clients "don’t care about our views," was alone precisely because of Goldman’s success. If Bear Stearns, Deutsche Bank, or Citigroup or Merrill Lynch — didn’t pull together the same kind of transactions for other hedge fund clients, it probably wasn’t because they didn’t want to, but because they couldn’t. These other big Wall Street players simply might not have been able to convince investors that investing in subprime mortgages — transformed into investment-grade collateralized debt obligations through the alchemy of structured finance — was a good idea in early 2007, when the Abacus deal was structured and mortgage defaults were on the rise. Ironically, their inability to catch up with Goldman Sachs may have saved them from the same kind of public hostility to which Goldman itself is now being subjected.

The problem for Wall Street doesn’t lie just in what Goldman was doing — what it did or didn’t tell its clients about its proprietary trading or its views of the products it was selling — but in Wall Street’s propensity to try to mimic whatever its most successful member is up to. For the last two or three decades, chasing Goldman Sachs has been the game on Wall Street. The firm has consistently been one of the top securities underwriters and advisors on mergers and acquisitions; its success has produced billions of dollars in profit, including $3.46 billion for the first three months of this year, and billions more in salaries and bonuses for its senior bankers, about 1,000 of whom are rumored to have received bonus payouts of $1 million or more last year.

Inspired by what it saw as a "competitive gap" between it and Goldman, Swiss banking giant UBS even hired a consulting firm in 2005 advise it on the best way to generate higher profits. Alas, following the consultants’ recommendations produced more risks that UBS couldn’t or didn’t manage, leaving it with billions of dollars in losses and writedowns. Stanley O’Neal, the former CEO of Merrill Lynch, was notoriously cranky on the days Goldman’s quarterly profit statements were released; attempts by his top executives to replicate Goldman’s profitability succeeded instead in erasing a decade’s worth of profits and forced Merrill into a merger with Bank of America to avoid bankruptcy.

Regardless of what happens to Goldman Sachs itself, the phenomenon of Goldman envy is here to stay. Blankfein himself, asked by members of the Senate subcommittee whether Goldman’s competitors were taking the same approach to their business that Goldman was, responded without hesitation or equivocation. "Yes, and to a greater extent than us," he replied.

The SEC lawsuit, as well as the marathon grilling of the Goldman executives by the Senate subcommittee, highlight an issue that is bigger than any single transaction: What will a Wall Street firm do in pursuit of profits? What did Goldman Sachs do to preserve its place at the top of the heap, and what might other Wall Street firms have done in their scramble to keep up with the much-envied Goldman Sachs? And what might they do in the future, whether it is still Goldman Sachs’s performance that they are trying to replicate, or that of the next great winner among Wall Street’s financial institutions? Perhaps the biggest question of all is whether, finally, chasing Goldman Sachs will become yesterday’s game.