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Why I left Goldman Sachs – oh please
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By now you've probably read Greg Smith OpEd at the NY Times on why he left Goldman Sachs. At first I read it and I thought "good, someone is daring to bring ethics into the discussion". But upon re-reading it I ended up thinking "what bullshit".
Mr Smith , thirteen years is long to realize what an investment bank is for. Investment banks (assuming they don't use their own balance sheet for a minute) mediate between those who need capital and people who have money to invest, between those who need to hedge risk and those who seek it, and between those who buy companies and those who build it. Their profitability is predicated on how well they do this reliably, and how much margin they can take by being in the middle. To attack them for optimizing profits (and thinking of customers as sources of profits) is misunderstanding their nature. Mr Smith woke up and smelled the coffee.
The employees of investment banks are incentivized purely on the annual net margin they can generate. Think about it : have a great year, kill it, get $2M or $10M and be made for life. No one else is tooled like they are to optimize profit everywhere it can be made. They have better mathematicians, better systems and better salesmen. They have no incentive to care about any of the externalities that they create.
In that sense Darth Vader's hilarious "Why I left the Empire" is the best possible response.
What happened in the run-up to the financial crisis is that EVERYONE thought they could create value out of thin air and forgot the basics. Financial engineering does not generate value that was not there to start with.
- As an asset manager, you can invest in bonds, equities, commodities, hedge funds and so on. What you cannot do is invest in a structured note that links the payout to a basket of commodity options and hope somehow you will make more money, when what you are clearly doing is enabling your investment bank to fudge the returns profile and make a higher margin. Greed makes you buy things you don't understand.
- As a bank you cannot hope that selling off all your risk through securitization but keeping the equity portion (i.e. the toxic piece) really releases capital. What you're doing is playing with the capital adequacy regulations so you can be more leveraged. And driving more margin to your investment bank.
- As an individual you cannot do continuous equity release on your mortgage and buy plasma screens. What you're doing is speculating on the housing market with the place where you want your kids to grow.
Investment banks are what they are. They are not and will never be aligned with their clients. They want to maximize their margin by being the most inventive middleman they can be. That is their M.O. and there is nothing moral or immoral about it : it simply does not enter into the equation. It's what they do and by the way they are a necessary and important cog in efficient financials markets. What with have today is the tail wagging the dog, but don't blame them for being good at what they do.
I left investment banking after seven years and pretty much as soon as I understood this. I wrote about some of the shit we used to do to give you a sense of how everything can be arbitraged if people let you. Why did I leave ? Because it's hardly aspirational, because it was clear we were going to destroy value and because I subscribe to notion of sustainability and, to use Umair Haque, Betterness. I subscribe to the Manifesto.
If you want to change the system, and we should, here what needs to happen:
- The industry as a whole should accept Behavioural Economics and Chaos Finance and stop trying to be so smart in devising increasingly complex instruments that cannot be understood / modelled / controlled.
- Every asset manager (the guys who invest your pension money) should be compensated on a long-term incentive package and assets held should be fully understood and manageable by the investor. Most should have long-term buy and hold strategies instead of constantly trading on results.
- Every market (e.g. credit derivatives) should be standardized, made transparent and disintermediated by technology. Take margins out, bring transparency in.
- Commercial banks who deal with people's life savings should be heavily regulated and treated for what they are, utilities. I don't want the people providing my mortgage to have expertise in anything other than whether I am a good credit risk or not.
- As for investment banks, they should continue to do what they do best: raise capital, run M&A, and so forth. How profitable they are depends on how profitable you want them to be.
- What happened in the wake of the financial crisis is one of the great swindles of all time. To take a leaf out of J.P. Rangaswami's awesome LIFT talk on "Tech Vs People" (@jobsworth), the losses that came out of the financial crisis were socialized and the profits were privatized, in the exact opposite manner in which the open source community functions, where successes are shared with the community that then improves and propagates the gains whilst losses remain private (you project tanks, you just wasted your time).
Amongst investment banks, Goldman Sachs is a well run firm that stays (usually) on the right side of the law. They are better than many of their competitors and insanely good at what they do. Asking them to be agents of change in building a better world is misplaced - they are just not designed for that. However how much power and money you decide to give them is mostly down to you.
Again borrowing from JP, "you don't get a medal for critizing, you get a medal for how constructive your criticism can be". Mr Smith woke up to the reality of investment banks -- instead of demonizing them, he should think about how you redefine their importance and take power away from them.
Let's attack the cause, and not the symptom.
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Instead of humbly acknowledging that he was a part of the machine, and pointing out ways in which to improve the bank, he tries to absolve himself with a giant disingenuous F You to his ex-colleagues. That’s why his piece is so pathetic: it smacks of cowardice, betrayal, a false sense of superiority and washing dirty laundry in public. This is the opposite of whistleblowing. I wonder what his agenda is.
Re banks: Either advisory or principal. That’s the issue. You can’t have it both ways and the system doesn’t need you to have it both ways.
Re banks: couldn’t agree more. Might add that the billing mechanisms on the advisory side could also be improved. Banks should earn in proportion to utility provided to client rather than transactional volume which just incentivises them to sell unnecessary (and potentially dangerous) products.
Great post Fred. I considered I banking early on and shadowed some folks in it to get an inside scoop. I quickly determined it wasn’t for me for a variety of reasons many of which you outline. This author is a whistle blower and a blow hard.
The Darth post was awesome.
And nice blog redesign BTW.
Ah thanks will soon write a post about the design work :-)
This is a compelling takedown. But it makes me wonder: do you believe that without Mr. Smith’s op-ed *this* conversation would be happening today? Is the common wealth enriched (by any degree) by folks stopping to consider how an investment bank could/should be?
Oh I liked very much that the Op Ed was published — we need more of this soul searching going on for sure and it has to come from the inside.
It really is amazing to me how seemingly smart people really don’t know anything. Indeed what we should do, in fact what society is beginning to demand is that investment banks and every other business become agents of change as well as agents of profit. To suggest that profit maximization is all that I Banks can do because they are “designed” that way is not only a ridiculous statement but a misinformed one at that. The public, those who give these places a license to operate are not going to continue to stand for the corporatists view of the world. The future of capitalism is about building businesses based on societal purpose, shared humanity as well as profit. If the guys at Goldman aren’t smart enough to find a way to do that they will go out of business….or at least be diminished significantly….just wait and see.
Jeff I think we are generally agreeing, I just think I Banks have the least natural incentive to be agents of change. I am interested in understanding your comment: To suggest that profit maximization is all that I Banks can do because they are “designed” that way is not only a ridiculous statement but a misinformed one at that.
Fred: What I meant by that is I think we feed ourselves and society at large a false choice when we default to the either / or argument: “Either you can make money or you can be an agent of good to society” My friend Raj Sisodia and the late David Wolfe wrote a book entitled: Firms of Endearment; How World Class Companies Profit from Passion and Purpose. In the book we posit that it is not only possible but as society ages and information explodes all around us it is imperative that businesses find a way to do both, make money and operate with a sense of purpose to society. People at Goldman like people anywhere only leave their humanity at the door if, like Greg suggests, that’s what their leaders tell them they must do to get ahead. Those same leaders could of course change the culture of GS and make it acceptable to leave some money on the table if that would indeed be in the best interest of the client. The funny thing is when you start operating that way, you end up with more clients, more loyal clients and clients willing to pay a premium for your services because they believe you have their best interest at heart. It’s what we call ironic management. As soon as you stop focusing on quarterly earnings and focus on building an ethical and enduring organization….your quarterly earnings start to explode. I think its also important to note that I’m not speaking just theoretically here. My partners and I started a hedge fund a few years back aimed at investing in “Firms of Endearment” Don’t invest in companies like Goldman, or JPM or BP or McDonalds because we analyze corporate culture and invest accordingly. Our performance has been so spectacular that at times it’s difficult for potential investors to believe. The take away being, not only can you operate like this in any field, if you do you will outperform your competition. It’s simply a better business model than what we mostly have today.
I agree fully and I look at it through the lens of sustainability. I cited Umair Haque so people would not be mistaken about my position and beliefs in this and in fact have been wanting to write a post about the alignment of profit and the creation of sustainable businesses. It’s just that I have lived inside an investment bank, they will be the LAST to change and kicking and screaming be dragged there by the rest of the market. The NY Times OpEd is either naive or disingenuous. And that was my point : you can demonize them all you want but it’s a shared responsibility that even allows them to operate the way they do.
Having worked on the management committee at Morgan Stanley in NY, I could not agree more with your perspective. Plus, if he really believed what he was saying — why did he run away with his tail between his “spilt milk” legs. Uber naive.
BTW – he could attach the entire VC world exactly the same way.
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Thank YOU! Greg Smith is a CLOWN!
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So Fred, I largely agree here, however there is a larger picture. You and I may know all this, but given that, as you say, ”the losses that came out of the financial crisis were socialized and the profits were privatized” – do the general public? Do the members of Congress that approved the financial bailout?
So while I do think you are right, I view this like I do web analytics: they are never absolutely accurate, but they are directionally accurate. This Op-ed may in its specifics be BS, but directionally it points to something more important and interesting.
Good point. I am glad the piece came out too. Now let’s do something meaningful with it : not change the investment banks (that horse bolted a long time ago) but rethink the fundamentals of investing, borrowing and finance. It is good if it drives awareness of motives and methods, I agree with you. I-banks are not the Great Squid, they are what they are. We let finance become a huge part of GDP, we all drank the Kool Aid of too much leverage, of thinking that financial engineering delivered value, instead of thinking about the fundamentals and keeping things simple.
This axiom kills me very time i read it. Fully subscribing to pretty much everything Fred says:
‘Profits’ that piled up until then where always socialized, either by the buying Plasma screens out of home equity crowd in Nevada or the conservative German citizen choosing the stupid pension fund in Dusseldorf. As painful as it is to watch, it is for many reasons the better choice to bail out the banks instead of society at large. The banks knew it, they gambled for it, and for the right reasons they got it. When the game is who is using more moral hazard to their own gain, they will always win in the end.
As long as we incentivize a group of people to make as much money as possible, some will get really good at their job, and some will do really stupid things aspiring to do the same. While hating self-righteous cynics, there is a great scene in “Margin Call” in which one of the bankers talks about how they put their hand on the other side of the scale while riding out to the loathed Brooklyn in his Continental GT, past the building of the people he thinks “Na, they’re all fucked”.
The discussion happening now, as interesting as it is to see how the Times/Dealbook does reporting around it, it’s confined in the ‘old’ system and reactions to it. The optimistic assumption: Looking at eg what the Pirates are doing in Berlin at the moment, or some other stuff boiling somewhere and not heard of by any of us yet, will come out of leftfield and hopefully fill the increasing vacuum with something new and pretty awesome.
“Financial engineering does not generate value that was not there to start with” – Do we take this to mean that derivatives are a zero sum game? Surely there are many simple examples of how financial instruments can create real world value that wouldn’t have otherwise been possible. Problem is risk was underestimated & they were traded by people who didn’t fully understand them but derivatives do have inherent utility.
I would love for you to expand on that.
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Fred, your post rings true. However, if it took you 7 years to really understand what the investment banking business was about why can’t it have taken this Greg dude 12 years? I mean, if he’s 58.3% as smart as you it might just have taken him that much longer to “get” it, right?
The other place that we can ascribe guilt on the traditional ibanking side is the clients (I’m not talking about the use of a bank’s balance sheet to trade against a client, I’m talking about the traditional “old school” advisory business that used to be a big part of a banks raison d’etre.) I started out as a baby banker working for a MD who would tell clients when he thought a deal they were trying to do was a bad idea. Most of the time the clients either fired him, didn’t give him the deal, etc. The clients wanted to do deals just as badly as the bankers – either because they were incorrectly incentivized by their board or because they thought it was fun/sexy. He did land and keep a few really big clients with his “tell it like it is” strategy, and for him the revenue impact was likely slightly more positive than negative, but the amount of headache and effort required was intense.
It’s a great point and that’s why I am focused on changing the incentive of the consumer of investment banking services first — that’s where the musical chairs game starts.
I’m very hopeful that the Atlas portfolio does well enough that you can start to really influence some bankers as you look to big time exits Fred!!! :)
Excellent comment. Thanks. Karl
Mr Smith , seven years in venture capital is long to realize how to spell entrepreneur.
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