Value at Risk, Models, and Risk Management

Models are widely used in risk management to synthesize risk and help analysts, investors, and company boards determine acceptable trading parameters under different scenarios. Value at risk (VaR) is a widely used measure of the risk of loss on a specific portfolio of financial assets, expressed in terms of a probability of losing a given percentage of the value of a portfolio—in mark-to-market value—over a certain time. For example, if a portfolio of stocks has a one-day 5 percent VaR of $1 million, there is a 0.05 probability that the portfolio will fall in value by more than $1 million over a one-day period. Informally, a loss of $1 million or more on this portfolio is expected on one day in twenty. Typically, banks report the VaR by risk type (e.g., interest rates, equity prices, currency rates, and commodity prices).

VaR may be an unsatisfactory risk metric, but it has become an industry standard. Wall Street equity analysts expect banks to provide risk (VaR) calculations quarterly, and they talk about risk increasing, or decreasing, depending on the output of the models. The models and VaR calculations, however, make numerous assumptions, some of which proved over time to be invalid, making it dangerous to rely on or extrapolate too much on VaR. Analysts and investors (and boards of directors) overrely on VAR as a measurement of risk, and therefore management teams do also, one of the external influences of being a public company. Yet the overreliance on VaR, one of the key measures employed in risk management, is controversial. Some of the claims made about it include that it “[ignores] 2,500 years of experience in favor of untested models built by non-traders; was charlatanism because it claimed to estimate the risks of rare events, which is impossible; gave false confidence; would be exploited by traders.”⁶ Comparing VaR to “an airbag that works all the time, except when you have a car accident,” David Einhorn, the hedge fund manager who profited from shorting Lehman stock, charged that VaR also led to excessive risk-taking and leverage at financial institutions before the crisis and is “potentially catastrophic when its use creates a false sense of security among senior executives and watchdogs.”⁷

Leading up to the crisis most of Wall Street essentially used the same models and metrics for risk management, particularly VaR (an effect of being public—analysts and investors compare VaR between firms in analyzing performance). But Goldman did not rely as heavily on it. Interviews confirmed the level of dissonance at Goldman, even as a publicly traded firm, in discussing and understanding that the output of the models was and is unique to Goldman, which meant the firm was not as dependent on the models as were other firms, and that, combined with what sociologists call a “heterarchical structure” (less hierarchy in the chain of command than in many firms) and the trading experience of its top executives, gave Goldman an edge.⁸ The more intense scrutiny of the models and risk factors led Goldman’s top executives to pick up on market signals that other firms’ executives missed.⁹ As Emanuel Derman, the former head of the quantitative risk strategies group at Goldman and now a professor at Columbia, wrote, at Goldman, “Even if you insist on representing risk with a single number, VaR isn’t the best one … As a result, though we [Goldman] used VaR, we didn’t make it our religion.”¹⁰ (Meanwhile, at other firms, measures like “VaR [value at risk] … became institutionalized,” as the New York Times’ Joe Nocera put it. “Corporate chieftains like Stanley O’Neal at Merrill Lynch and Charles Prince at Citigroup pushed their divisions to take more risk because they were being left behind in the race for trading profits. All over Wall Street, VaR numbers increased.”¹¹)

Even though VaR has flaws, it is the only relatively consistent risk data that is publicly reported from the various banks, which is why I analyzed it. When analyzing the publicly reported data from 2000 to 2010 for Goldman and its peers, what stands out is that Goldman’s standard deviation of VaR is higher (meaning that the level of the total VaR was more varied) than most other firms, implying that Goldman more dynamically managed risk than its peers over the time period.

Goldman also had the organizational structure and environment to complement and support risk management systems and procedures. During an interview for this book, an executive at a competing firm (who had earlier worked at Goldman) explained that his firm simply did not give the same attention to risk management. He did not think his firm had the capability to aggregate risk at a level similar to Goldman and said the top executives neither had the capability nor dedicated the time to interpret, discuss, and debate risk. He said that Goldman’s focus on proprietary trading and its profits had caused the firm to invest in systems and groom future leaders who understand it. He explained that Goldman’s biggest advantage was that its top people were real traders and risk takers or had access to and dialogue with such traders, as well as the culture to support investment in the systems and the dialogue. He explained that this was why he hadn’t been surprised when Hank Paulson and the board had bypassed John Thornton and John Thain (to whom Paulson allegedly had verbally promised the CEO position) and picked Blankfein to succeed him as CEO. Thornton and Thain did not have as much real time and extensive expertise in trading and risk. The firm gained trading expertise at its top with Blankfein, and that helped it navigate the credit crisis.¹²

One executive at a competitor speculated that although his firm had people running around doing lots of things related to risk, including analyzing lots of models, no one knew how it all added up and, more important, what it meant. He questioned whether it was even possible to understand risk management in such large, complex organizations. But he said if one firm could, it was probably Goldman, which seemed to prioritize risk management because of its dependence on proprietary trading and because it had the cultural heritage of teamwork, as well as its near-death experience in 1994.

While some analysts of the crisis have pointed to the failure of the boards of directors at the banks to question risk-taking, most of the people I interviewed said that those on the boards of the banks had limited trading and risk expertise and that it would be almost impossible, anyway, for an outside, independent director who has an important full-time job and attends monthly or quarterly meetings to be able to take the time to understand and question such complex risks.¹³ That made having executives at the top of the firm with trading and risk management experience all the more important, especially when there wasn’t a mechanism like financial interdependence of a partnership.

Communicating the Signals

Goldman’s relatively flat organizational structure and the relative strength of its social network are exemplified in a series of e-mails and memos from as early as the end of 2006 that were sent to top Goldman executives by traders. They discussed the firm’s exposure to mortgages and the top executives’ ability to understand the issues, concluding that Goldman should reduce risk as quickly as possible. There are e-mails from Blankfein and Viniar giving direct guidance related to risk.¹⁴

In one e-mail, CFO Viniar wrote, “Let’s be aggressive distributing things because there will be very good opportunities as the markets [go] into what is likely to be even greater distress, and we want to be in a position to take advantage of them.” Blankfein wrote in one e-mail, “Could/should we have cleaned up these books before … and are we doing enough right now to sell off cats and dogs in other books throughout the division?” The communications show how involved the leaders were. (They also raise serious questions and concerns about what Goldman leaders knew, did, and instructed others to do, and the impact of these actions on the firm’s culture.)

Meanwhile, even as Goldman reversed course and tried to reduce risk in mortgages—and even allegedly shorted the market—its competitors were adding risk. For example, Chuck Prince at Citi was, as described and paraphrased in an interview, “dancing with elephants.”¹⁵ A former Citi executive I talked to at the time expressed doubt that Prince (whose professional background was more legal and administrative in nature) had the same sort of direct communication, knowledge, and discussion that Viniar and Blankfein were having or the expertise to do so. One could argue that, at the time, Citi’s structure may have been more hierarchical and more complex than Goldman’s (Citi had more than 300,000 people in more than one hundred countries), making it harder for information to get to the top. Other elements, such as dissonance, may also have been missing, adding to structural secrecy and restricting information flow.

Goldman, by contrast, encourages the discussion and disagreement needed to arrive at the best answer. For example, when I was in proprietary trading in the early 2000s, I participated in meetings wherein the portfolio managers of proprietary trading groups presented their ideas and strategies to other proprietary portfolio managers in other groups. Once, a manager presented a trade that appeared to be a good investment based on models, but the other proprietary traders quickly ferreted out a weakness in the model: it was not properly accounting for the illiquidity and the severe downside that would happen in selected, albeit low-probability, scenarios. It is hard to believe that a risk management department or accountant expected to value the investment would be able to identify all the issues raised in that room of traders.

Taking Action, Continuous Adjustment: Risk Management Systems

Before the heavy trading losses Goldman experienced in 1994, the firm’s risk management system was informal; traders made their own decisions with little intervention from management, and risk was often assessed “with a series of phone calls and a quick tally on a scratch pad.”¹⁶ By 1995, it had implemented an “interdisciplinary, firm-wide risk management system, a risk committee that [met] weekly, and a loss limit on every trading seat.”¹⁷ Current risks became instantaneously visible through the new computer-based system, which enabled managers to “aggregate the firm’s market and credit risks across the entire organization [despite any organizational silos] at any point during the day.”¹⁸

One Goldman partner I talked to pointed out that most of the heads of the other firms had not gone through what happened to Goldman in 1994 when so much of the capital of the firm and of Blankfein, Viniar, and other partners was put at serious risk. The other heads had been working in organizations that had worked with other people’s capital with different incentives for a longer time. So, the partner told me, Goldman was much more aggressive with regard to building risk management systems.

The computer system was only one aspect of the overall risk management system. Traders no longer operated with little oversight. A risk committee, composed of partners from around the world, met by teleconference to examine “all of the firm’s major exposures, including the risks related to the market, individual operations, credit, new products and businesses, and the firm’s reputation.”¹⁹ The committee members had the expertise to question and challenge each other and the organizational structure and culture to support the dissonance.

The traders were not always happy about being subjected to more oversight: “There was, in fact, a vigorous debate within Goldman about the right level, just as there was over the firm’s overall risk levels,” William Cohan writes. “Angry at being reined in by its powerful risk managers, traders dubbed them the ‘VaR Police.’”²⁰

Crisis Leadership

Often, leaders get too much credit or blame, with too little emphasis on the organizational elements that leaders inherit or are a product of. Lloyd Blankfein has been blamed for a “J Aron/FICC takeover” of the firm, which has resulted in a change in culture.²¹ Yet, he also is credited with saving the firm in the crisis. The role of the organizational elements received a lot less consideration or publicity.

Blankfein’s career took off as a sales trader and a manager of traders. He has been described as having “a sixth sense about when to push them to take more risk and when to take their collective feet off the accelerator.”²² According to interviews, Blankfein thought the best traders were quick adjusters, a trait he, too, possessed. He was not a trader per se, although many people have the impression that he was, and yet he gained credibility with his traders by managing a small trading account that could be monitored. A former partner of Blankfein’s said that Blankfein knew he could lose credibility if he lost money, but he thought “even if he lost money he would get credibility because the credibility of being right isn’t so important. The credibility of knowing what a trader experiences when they lose might even be more valuable, so maybe he figured out that either way it was good to show that he was learning.”²³ An executive at a competitor that I interviewed pointed out, this is precisely what outside boards of directors at banks typically lack.

Blankfein’s background in trading made him a wholehearted supporter of a strategic move toward proprietary trading. He acknowledged the challenges of balancing agency business with a growing proprietary business but viewed the move as not only a “momentous strategic opportunity” but also a necessity that had been deferred to maximize profits and should be deferred no longer.²⁴ Blankfein did not propose making the proprietary (or principal) investing business dominant but rather talked about combining the two businesses, agency and principal, in an “unbeatable whole.”²⁵ He actively promoted this theme as he gained authority and reputation within the organization, even though clients continued to express concern about whether, in any given situation, Goldman was acting as their agent or as a competitor.²⁶ Blankfein’s argument raises questions about Goldman executives’ argument that in certain trades the firm was simply acting as a market maker.

Blankfein gained professional respect from peers and senior partners for his ability to evaluate possible ramifications of alternative courses of action. He has been described as “original in his perceptions and analysis … accessible to others” and as having “a detached rationality.”²⁷ His personal style and actions reflected and modeled for others some of the best aspects of the firm’s partnership culture as it had been at its strongest. He asked many questions of the very smart people with whom he surrounded himself, until he was satisfied that he had gotten the right answer. He tapped in to the expertise and vast experience of retired partners, who many times (and in my experience) had been treated almost as outsiders after they became inactive. He used his extensive global social network to promote the firm’s goals, something that became critical to the firm’s survival during the credit crisis.

Any discussion of Goldman’s leadership during the crisis must also acknowledge the role of David Viniar, Goldman’s chief financial officer from 1999 to January 2013, a man who, many of my interviewees said, was the key person responsible for the firm’s survival. A former investment banker working specifically in structured finance, Viniar worked on several credit and risk committees before becoming CFO. He understood structured products, which were at the heart of the crisis. He had the expertise to question traders or have a dialogue with them; he had their respect, unlike most CFOs, who would not have worked directly in structuring such complex products. Viniar also took advantage of a culture in which an element of dissonance was still alive, one that supported playing devil’s advocate, collecting and channeling information that challenged taken-for-granted assumptions in the organization, when it came to trading risk.

Viniar’s rotation through various assignments was crucial to his ability to help guide Goldman through the crisis. These rotations were the result of an organizational design that served to improve understanding and strengthen social networks.²⁸ One Goldman partner told me something to this effect (I am paraphrasing): “You can’t BS David. He has a lot of experience and knows more than you. He may not be smarter than you in your area of expertise, but he knows more about risk than you do because of his training and experiences. What makes him particularly effective is his ability to check out what you tell him. He and his group have the contacts and know the people—internally and externally.”²⁹

A Goldman partner credited Blankfein with retaining Viniar when Blankfein became CEO and not replacing him with those he considered loyal to him, as the partner said Blankfein did in many other important areas. He elaborated that for Goldman’s board, Blankfein, Viniar, and Gary Cohn were not only the top three from a reporting perspective but also the top three authorities on risk; no other firm had that much talent and expertise in their top three working so closely together during the crisis. However, in many ways their active involvement in risk management—supported by the remarkable number of e-mails and other communication, and knowing what they knew and directing people to reduce risk—put them closer to the actions and behavior of those at Goldman prior to and during the financial crisis. This, therefore, raises the issue of their personal role in, at the very least, the change of meaning of putting the clients’ interest first.

A Goldman spokesperson told Rolling Stone that “its behavior throughout the period covered in the Levin report was consistent with responsible business practice, and that its machinations in the mortgage market were simply an attempt to manage risk.”³⁰ The question here is whether its behavior is consistent with the original meaning of the business principles, not if these were responsible business practices. In my interviews, most of the current and former partners who believe there has been a change in culture strongly stated that in this instance the behavior was not consistent with those principles. In my interviews with clients, I asked them what they think when Goldman tells them about the business principles, even today, based on what they have learned about its behavior. Most told me Goldman’s behavior does not reflect how clients interpret the principles, which is based in part on how Goldman itself portrays them externally. However, most people I interviewed said that does not necessarily make the firm’s behavior criminal or illegal.

More Concentration of Trading Experience at the Top

David Viniar retired in January 2013 and was replaced with Harvey Schwartz. Like Viniar, Schwartz worked in various areas of the firm, including banking for a short time, which should give him a more nuanced view and access to more information. But Schwartz got his start in the J. Aron area at Goldman, similar to Cohn and Blankfein, as well as the person who is head of human resources (the head of human resources would typically interact with the board on matters like compensation and performance). Many current and former banking partners that I spoke to pointed to this J. Aron concentration at the top. From a sociological perspective, it does raise the risk of changing the element of dissonance and increasing structural secrecy.

Some partners also raised the concern that Blankfein has put people loyal to him in key positions throughout the firm and/or lateral hires who may not have as good an understanding of the original meaning of the principles. Once again, this is interesting from a sociological perspective in terms of raising the risk of a change in dissonance and increase in structural secrecy. Some current and former banking partners speculated that they believe that Blankfein learned from Paulson’s coup of Corzine and wanted to consolidate power. From an organizational perspective, the fact that this could happen reflects the changes. The fact that a board would allow this also reflects the changes. And with the passage of time and Blankfein and Goldman’s many successes, who is to question it?

Does Outperformance Signal a Shift from Principles?

The tricky issue about the residual dissonance that represents a degree of preservation of Goldman’s culture at the time the principles were codified is that Goldman does not consider that, in some instances, it has an obligation to share the benefit of this wisdom with its clients. In late 2006, Goldman recognized the need to de-risk and moved swiftly to do so without warning clients or the government. This is one of the things about Goldman that spurred the vitriol of Matt Taibbi and many others. After a period of mounting concern about Goldman’s overexposure to mortgages, in late 2006 Viniar and a group of executives drafted a memo describing their course of action for reducing that exposure. Goldman’s critics are quick to point to this statement: “Distribute as much as possible on bonds created from new loan securitizations and clean previous positions.”³¹ Taibbi translates this to, “Find suckers to buy as much of [the] risky inventory as possible.” Taibbi then provides an apt analogy: “Goldman was like a car dealership that realized it had a whole lot full of cars with faulty brakes. Instead of announcing a recall, it surged ahead with a two-fold plan to make a fortune: first, by dumping the dangerous products on other people, and second, by taking out life insurance against the fools who bought the deadly cars.”³² According to Taibbi, within two months of the memo, Goldman had gone “from betting $6 billion on mortgages to betting $10 billion against them—a shift of $16 billion.”

As a public company, Goldman has a fiduciary responsibility to its shareholders, which confers the highest standard of legal care and loyalty.³³ Therefore, if Goldman thought that it was in the best interests of shareholders to de-risk immediately, it had a duty to do so. But to de-risk, Goldman sold the risk to clients. Many current partners at Goldman whom I interviewed (corroborated by congressional testimony by Goldman executives) pointed out that the “sophisticated, institutional clients” wanted the risk, and Goldman sourced it for them. The partners argue Goldman did not defraud its clients. However, the SEC charged Goldman and an employee with fraud on a specific deal for its role as an underwriter (which has different legal obligations than those of a market marker). Goldman settled the charges for $550 million, and the employee is fighting the civil case.

Legal experts I interviewed explained that Goldman has no legal fiduciary responsibility to clients when it is acting as a broker on their behalf. Investment banks are not held to a “fiduciary standard” in their dealing with these clients, but rather a “suitability standard,” which is less stringent.³⁴ Under a suitability standard, Goldman is not required to put the client’s interests first and is not obligated to disclose its own proprietary views or positions. A suitability standard instead requires the firm to ask whether the product is suitable for the client (for example, whether it meets the investment objectives) and to disclose the risks.³⁵

The impression of Blankfein’s testimony at the Levin hearings, in response to accusations of not putting customers’ interests first in the mortgage trades, is that Goldman, or at least its executives, did not think the firm did anything wrong.³⁶ Their argument, as articulated by Blankfein on numerous occasions, hinges on the firm’s claim that when Goldman sold the mortgage securities, it was not acting as an adviser to the clients, it was acting as a broker, and its role was simply to sell sophisticated institutional clients whatever they wanted to buy. As such, it completely fulfilled its legal duties when it acted as a market maker or broker with counterparties. Goldman maintains that it was essentially only making markets (making a bid and an offer for securities) and used responsible business practices in fulfilling all of its legal obligations.³⁷ The firm had a legal obligation to ensure that its clients are provided the proper disclosures, but that is as far as Goldman’s legal obligation goes: caveat emptor, or “buyer beware.”³⁸

Goldman argues that it was acting as a broker, not an advisor, in selling mortgage securities. Maybe that’s true legally, but there’s another question about their role. Can Goldman, or any bank, really so cleanly delineate when they are acting as a broker and when as an adviser? An executive at a competitor believed that Goldman’s characterization as simply acting as a broker was like Goldman suggesting a client called them to ask it to buy shares in IBM and the firm did so. He explained that this is not the case with complicated, fixed income securities that are not traded on an exchange. First, the bank typically maintains inventory to sell because the market is not as liquid. This does not mean the bank is not acting as a broker, but it certainly complicates the relationship. Second, banks are calling up with ideas and suggestions (unlike in stocks, which are more regulated and liquid) and the client does need some explanation of what the securities are and advice on how it meets what they are looking for. He felt that Goldman was disingenuous in saying it was merely acting as a broker when executing transactions in complicated securities.

A client elaborated that there are times when he calls Goldman and expects them only to simply execute and actually pays a higher commission than going to another bank that would do it cheaper in order to pay Goldman back for its ideas, research, and advice. But he also gets calls from Goldman making recommendations and suggestions, which he would characterize as advising him, to buy certain complicated securities that generally meet what he is looking for, some of which Goldman provides what could be called research and analysis on. He said that Goldman has an unbelievable ability to source and develop these investment opportunities. But many of them require a dialogue, an explanation, analysis, and expertise. He said it was unclear to him in many instances when Goldman was acting as a broker/agent or principal, even when giving “advice.” But he clarified Goldman was doing nothing that the other banks were not doing too; it is just that Goldman’s principal investing is much larger so it does raise more questions. And he felt the ultimate responsibility was his if he were to buy or not buy. But, it seemed to him that Goldman was being a little disingenuous in its characterization of its role. He pointed out that he thought Goldman’s objective was to be the adviser of choice, not the broker of choice.

“The investors that we’re dealing with on the long side, or on the short side, know what they want to acquire,” Blankfein said. “I don’t think our clients care, or that they should care,” what Goldman’s opinion is, he said. The rationalization was that Goldman’s clients were sophisticated investors, after all, and asked for the risk, which Goldman provided to them.³⁹

As mentioned earlier, according to my interviews with several Goldman partners, the general attitude at the firm was that the clients were “big boys.” Goldman was not selling products to “widows and orphans.” They insisted that the firm used legally responsible business practices. Some partners explained that, for all the Goldman partners knew, they could have been wrong and the clients could have been right—and no one would have wept for Goldman. Some clients I interviewed said they understood this argument, but in this case they believed the size of Goldman’s short (or hedge, as Goldman describes it) of the securities showed a great deal of confidence in its view and that the firm understood the catastrophe that could happen if it did nothing. They argued that, given the size of the short and direct communication amongst executives, and that Goldman clearly perceived clients could suffer, the firm did have an ethical obligation to warn them (especially considering its first business principle). Some partners I interviewed countered that they were just doing what they thought was right from an organizational perspective and right for their shareholders—and right for the survival of the firm. They told me they did not think they were breaking any legal rules or regulations or violating a business principle.

But the behavior was certainly in sharp contrast to John L. Weinberg’s insistence on making good on the BP loss even though Goldman had no legal obligation to the British government, as discussed in chapter 1. Nor was it in keeping with Paulson’s sitting on the other side of the table in the Sara Lee meeting.

I don’t believe that the Goldman executives understood all the unintended consequences, the magnitude of the consequences, or the way their actions would be interpreted and processed externally and internally. If Goldman had understood the magnitude of the potential problems, it would have been even more aggressive in its actions, effecting even larger shorts, deleveraging faster, and raising more equity sooner. Based on my interviews and their actions, I don’t believe that the Goldman leaders realized they were so close to being swept away in a financial tsunami. In addition, I don’t believe that they truly understood how their actions would be interpreted by employees and how much that would most likely exacerbate the organizational drift.

Finding a balance between duty to clients and duty to shareholders is a long-standing issue. Most clients I interviewed argued that Goldman formerly believed that putting the clients first would benefit the owners over the long term, thereby serving shareholder interests. They generally did not interpret Goldman’s actions, such as selling the mortgage securities, as consistent with the business principles they expected from Goldman. They did not see it as illegal; they saw it as Goldman acting like the rest of Wall Street, but maybe a little worse, because Goldman waved its principles in front of clients and said it acted more ethically than others on Wall Street.

I asked some executives who were Goldman’s competitors about this dilemma—duty to clients versus duty to shareholders—and they, too, explained that Goldman was generally behaving as the industry does. The industry generally has moved to a legal standard in determining its duties. It was unclear to them when or how or why the legal standard became the industry standard. They believe no one really focused on it because, with a few exceptions, people were making so much money on Wall Street for such a long time as financial institutions generally grew—clients, employees, shareholders, even the public—that no one thought about it or cared. Many said the financial crisis should be a wakeup call to how cultures and incentives have changed, how the environment has changed, and how large and interconnected everything is. Many executives at competitors also said that in their opinion Goldman was living off the brand or reputation for trustworthiness that it had created in the 1980s (some questioned if it were even true at that time). They said that Goldman got away with it for so long because the firm was crafty in always playing up its “good guy” image, aura of public service, and powerful network.

Several current Goldman partners told me that since the Senate committee hearings, Goldman has been trying to take its business principles more seriously (and client anecdotes about this surfaced in my interviews). The partners also mentioned that the firm is educating its employees about the proper use of e-mails (including not using bad language) and about the firm’s various roles and legal obligations. The comments about e-mail training reminded me of an exchange between Viniar and Levin during the Senate hearings about both e-mails and behavior:

LEVIN: And when you heard that your employees, in these e-mails, when looking at these deals said, God, what a shitty deal, God what a piece of crap—when you hear your own employees or read about those in the e-mails, do you feel anything?

VINIAR: I think that’s very unfortunate to have on e-mail.

(The gallery bursts out laughing.)

LEVIN: On an e-mail?

VINIAR: Please don’t take that the wrong way. I think it’s very unfortunate for anyone to have said that in any form.

LEVIN: How about to believe that and sell them?

VINIAR: I think that’s unfortunate as well.

LEVIN: That’s what you should have started with.

The responses in the committee hearings are signals to the employees as to what is appropriate behavior. They also reflect a cultural change at Goldman.

Is Goldman Likely to Recognize the Change?

The perception of Goldman changed virtually overnight in 2008. I analyzed 345 selected articles in the New York Times from 1980 to 2012 and categorized them as positive or negative based on tone. From 1980 to 2007, no matter how I cut the data by time period, the number of positive articles was always higher than the number of negative articles (the total was 288 positive articles to 118 negative, for a ratio of 2.4 times as many positive). Using the same criteria, from 2008 to 2012 there were 103 negative articles to 57 positive articles, for a ratio of 0.6 times as many. I divided the articles into topic categories, and the two most common negative article topics were Goldman’s conflicts with clients and its connections to the government.⁴⁰

When Goldman announced it would review its business practices, Blankfein explained that there was “a disconnect between how we as a firm view ourselves and how the broader public perceives our role and activities in the market.”⁴¹ Goldman was concerned not only about public perception but also about client perception. The firm’s business standards committee commissioned an independent study conducted by a prestigious consulting company to interview two hundred clients to explore their concerns about whether the firm still lived up to its core values and business principles after the rapid growth and shift in Goldman’s business mix toward proprietary trading.

Management had been enthusiastic about the proprietary trading business since the early 1990s but approached it carefully, with top talent and “attentive management,” and, financially, it was an “unqualified success.”⁴² Still, the study revealed that clients believed Goldman was placing too much emphasis on its own interests and not enough on those of its clients. The report stated, “Clients raised concerns about whether the firm has remained true to its traditional values and business principles given changes to the firm’s size, business mix and perception about the role of proprietary trading. Clients said that, in some circumstances, the firm weighs its interests and short-term incentives too heavily.”⁴³

Clearly, Goldman knows that it has a serious public relations problem. The business standards report expresses Goldman’s recommitment to the core values that once made the firm the most respected of Wall Street institutions. However, some clients I interviewed said that Goldman’s response has been more to increase its investment in public relations and public service, and to reassure clients and the public that Goldman has not lost its customer focus, and less to make substantive changes such as spinning-off or closing businesses, as the firm had done with the Water Street Fund when clients complained. The clients are not surprised because Goldman is in a much more powerful position than it was then.

The lead in the Wall Street Journal’s sneak peek at highlights of the business standards committee’s report attributes a defensive motive to Goldman’s imminent release of the report: “Goldman Sachs seeking to beat back criticism that it abused its muscle and trading savvy to put its own interests ahead of clients, agreed to release details on how and where the Wall Street giant makes its money.”⁴⁴ The report was released “to great fanfare” but was not received by the outside world with much enthusiasm.⁴⁵ Its primary purpose seemed to be “a more aggressive defense of Goldman’s image, not a deep restructuring of its business model.”⁴⁶ Or it sought “to reassure Goldman’s clients, to placate regulators, and to direct employee activity.”⁴⁷ More bluntly, the report was described as “an exercise in misdirection.”⁴⁸

The starting point for evaluating the report must be the assumption that Goldman is not very likely to shift away from trading, because “at least as Goldman has pursued it … [trading] can make money in good markets and bad” and because it cannot return to its earlier self: “smaller and a partnership that defined itself as an adviser or intermediary.”⁴⁹

The media’s treatment of the report implied that it avoided the real issues, including Goldman’s “size, complexity and the role of shareholders and employees.”⁵⁰ What some found most notable was that the report did not include “mention of any issues that are of first order importance regarding how Goldman (and other banks of its size and with its leverage) can have big negative effects on the overall economy, [even though] one of Goldman’s business principles is ‘we consider our size an asset that we try hard to preserve.’”⁵¹ Consequently, another critic claimed that the report read “more like a consultant’s brief—banal, crowd-pleasing, and recommending organizational changes. It will, for this reason, be little read and less heeded.”⁵²

In May 2013, Goldman released a thirty-page report on its business standards that followed up on its January 2011 report. Goldman stated that by February 2013, all thirty-nine recommendations had been fully implemented. The report’s opening line is “Our clients’ interests always come first.” The report’s standards address relationships with clients and conflicts of interests, with an emphasis on client understanding, transparency, and disclosure. The media reaction was that “ambitions like these are frequently aspired to in public policy statements, but are difficult to effectively implement … in the profit-led and bonus-driven culture of Wall Street that led up to the financial crisis. Such a culture is most prevalent among traders and front-office staff, but it can also influence compliance and control functions.”⁵³

Hiring Lawyers

On August 22, 2011, shares of Goldman tumbled nearly 5 percent, knocking $2.7 billion off the firm’s market value, after a report that Blankfein had hired a prominent criminal defense lawyer. Goldman portrayed it as routine, given the several government investigations faced by the firm. But the sharp reaction in the stock price showed the fragile nerves of investors, who were worried that potential legal liability could damage the firm and its earning power.⁵⁴

Goldman executives were expected to be interviewed by the Justice Department. The agency was conducting an inquiry that resulted from a 650-page report produced earlier in 2011 by the Senate Permanent Subcommittee on Investigations. That report said that Goldman generally had misled clients about its practices related to mortgage-linked securities.

Some partners told me that Blankfein’s action was interpreted and processed by Goldman employees. However, some of the partners also saw it as a reflection of a change in culture and the environment. They said that now if an employee is unhappy with a bonus or feels he or she was unfairly passed over for a promotion, he or she will consider consulting a lawyer or speak to human resources (or both). They said partners privately complain about such behavior as a change in culture and rationalize it as a “sign of the times.” They said employees were following the lead of the executives, who had resorted to legalese defensive language in the hearings by executives. In any case, some conceded Blankfein’s actions had the unintended consequence of supporting behavior that would not have occurred otherwise.

Identity and Identification

The most recent glaring criticism of Goldman’s reputation came from Greg Smith, an employee who had worked at Goldman for twelve years. Smith delivered his resignation in an op-ed piece published in March 2012 in the New York Times: “Why I Am Leaving Goldman Sachs.”

In the op-ed, Smith attributed his resignation to the drastic changes in Goldman’s culture in the past decade or so: “The firm has veered so far from the place I joined right out of college that I can no longer in good conscience say that I identify with what it stands for.”⁵⁵ He pointed out specific symptoms of the current “toxic and destructive” environment, such as referring to clients as “Muppets.”

More significantly, Smith pointed out the lack of focus on clients, which had been crowded out by a “how much did we make off the client?” attitude. Smith saw Goldman’s cultural ills as the result of leadership style—specifically charging that Blankfein and Cohn had “lost hold of the firm’s culture on their watch” because of a sea change in the way the firm thought about leadership. Smith claimed that there were now three quick ways to become a leader at Goldman: persuading clients to invest in the things Goldman wanted to get rid of because they were not sufficiently profitable; hunting elephants—that is, getting clients to buy things that may be wrong for them but have the highest profit potential for Goldman; and finding yourself “sitting in a seat where your job is to trade any illiquid, opaque product with a three-letter acronym.”

Goldman’s formal internal response to Smith’s op-ed piece, issued over the signatures of Blankfein and Cohn, characterized Smith as “disgruntled” and expressed disappointment that an individual opinion spoke louder than the “regular, detailed and intensive feedback” from the 89 percent of employees who believed Goldman served its clients well.⁵⁶ Citing both internal and external surveys, Blankfein and Cohn maintained that Smith’s assertions did not “reflect [Goldman’s] values … culture and how the vast majority of people at Goldman Sachs think about the firm and the work it does on behalf of our clients.”⁵⁷

Though Goldman aggressively dismissed both Smith and his accusations, some current and former employees say that there is “a sizable, yet silent contingent within the investment bank, a group of people who are increasingly frustrated with what they see as a shift in recent years to a profit-above-all mentality.”⁵⁸ Therefore the normalization process doesn’t impact everyone in the same way and at the same time. While many partners I interviewed thought that the culture had not changed, there were a few that would admit it and could see it. Two partners I interviewed admitted that they may be in the minority in seeing or admitting the culture has changed. I asked why they did not leave. They explained that they heard the culture is much worse at other firms. Also, they know of others leaving and being bored, unimpressed, and disappointed with their new employers. They said there are many things they like about Goldman, such as individual friends/relationships, the intelligence and drive of the people, the social status (which they said had taken a hit, but they believed most people still think it is the best and most prestigious firm with the best people), the network internally and externally one builds at the firm, and the good work that the firm and its people do. They talked about how much good the firm and its employees do that gets no real press. They said the firm is better run operationally today than it ever has been, but admitted that its operational efficiency does not mean the culture has not changed.

Goldman performed an exhaustive investigation of Smith’s allegations, including combing through e-mails looking for the word “Muppet,” and claimed it found nothing material. However, it was unclear to a partner I interviewed if the goal was to prove Smith wrong, to identify badly behaving people and punish them, to show that Goldman is taking the charges seriously, to frighten staff into being more discreet in what they write in corporate e-mails—or all of the above.

Goldman aggressively went after Smith personally. But one partner I interviewed explained with reflection that in the end it didn’t matter whether Smith was disgruntled or not, too junior or not, in enough strategically important areas of the firm or not, motivated by money or not, and it didn’t even matter whether he got the reasons right; at a high level, his letter was making a basic claim: that the culture of Goldman had changed from when he started, and for the worse. That statement could not easily be dismissed, because after the hearings, the fines, the negative articles, and the investigations, and the executives’ responses to them, many people were taking a minute out of their busy lives and daily routines and looking around and starting to wonder whether the culture itself had indeed changed. But for whatever reason, most people went back to their jobs, and maybe the silent group would slowly leave not just Goldman, but the industry.

Another partner compared what Smith had done to an employee who had been elected partner in 1994 and whose name had been listed publicly as being elected. But then he turned down partnership and left the firm to join a private equity firm with a reputation of values in its industry. The partner explained it was hard for the firm to dismiss him, considering he was elected a partner just weeks prior, but as if it were standard operating organizational response, rationalization rumors of why he didn’t accept were whispered. But when the event happened, whether or not intentional, it sent a signal questioning what was going on at the firm in 1994 that someone would turn down what so many were looking to become, and maybe people thought about what it meant and then went back to their daily routine. I remember it was only discussed very privately because it was a very sensitive topic. Maybe it was a data point for those already wondering about the firm, and then they just quietly left. Maybe, the people who stayed processed it and it impacted their future behavior. Based on my interviews and my own personal experience, upon reflection it had some impact, but what or how much is unclear.

Why Do Clients Stay?

Despite public outcry and even disappointment among clients, Goldman doesn’t lack for business. Its brand is still highly rated, and Goldman offers a unique value proposition to clients for several reasons, primarily related to access, information, risk management, and people.⁵⁹ Goldman has the best network of connections globally and attracts the best and brightest people. For the Vault Banking Survey in 2012, some thirty-five hundred investment banking professionals were interviewed. For the thirteenth straight year, banking professionals named Goldman the most prestigious bank to work for in North America. Professionals also ranked Goldman first in Europe.

Goldman is in the center of a large information flow that it gathers from clients. Goldman uses its risk management capabilities and its culture of teamwork to gain insights and then packages the insights and information, makes timely introductions, and executes smart trades. According to client interviews, the firm will continue to excel and dominate, because, relative to its competitors, it generally provides better advice, information, access, and liquidity. However, there are signs that Goldman’s culture continues to drift, and therefore Goldman runs the risk of becoming less ethically distinguishable than its competitors in the long term (if it isn’t already). Many competitors and clients believe that ethically Goldman is already where the rest of Wall Street is—but smarter about it. However, they generally agreed that its ability to execute and take advantage of the information and network and use it for itself and its clients is unparalleled. And so until there is a system failure of such massive proportions from unintended consequences or significant regulatory changes, it is difficult to imagine that Goldman will not continue its leadership position.

Why do people continue to do business with Goldman? The simplest answer is that they need to, although that does not necessarily mean they are always happy about it. Some profess to a love-hate relationship.⁶⁰ For example, a senior executive at a large European industrial company claims not to be very concerned about Goldman’s image problems: “We hated Goldman as a matter of policy. You kept your hands in your pockets when you dealt with them … They are indeed very aggressive and you better not turn your back on them … They are also highly competent. It is like everywhere else: high risk equals high return. If you deal with Goldman you always have to keep that in mind and then you can’t complain if the more intelligent guys are sitting on the other side of the table.”⁶¹ Referencing Taibbi’s Rolling Stone article, a client I interviewed said Goldman is everywhere; it is the most powerful investment bank. When I rhetorically asked if it is “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money,” he said not exactly, but then he explained that Goldman is everywhere, knows everyone, and is wherever there is a market in which to make money.⁶² And to make money as an investor, he needs to deal with them and get along with them.

Moving into the credit crisis, with trading and principal investing contributing 68 percent of the company’s 2007 revenue, compared with 9 percent from advisory fees, some clients questioned whether they could count on Goldman to provide unbiased advice:

“We always need to worry a little about Goldman because we need them more than they need us, and the firm is run by traders,” Todd Baker, then-executive vice president for corporate strategy and development at Washington Mutual Inc., wrote in an October 2007 e-mail to Kerry Killinger, CEO at the time. Killinger, in considering whether to hire Goldman Sachs for advice on transferring credit risk off of WaMu’s balance sheet, wrote back, “I don’t trust Goldy on this …”

“There was an underlying suspicion that Goldman did play in the gray areas [of the law], and I’ve spoken to a number of clients who finally did leave Goldman or refuse to do business with Goldman because of that concern,” [Charles Peabody, an analyst at Portales Partners LLC in New York] said, declining to name any.⁶³

It may be that Guardian financial editor Nils Pratley is right when he says that “the clients (or most of them) know they are at risk of being treated as Muppets” and even profess to hate Goldman, but choose to continue doing business with the firm because as an investment bank it enjoys “an extraordinarily privileged position in being trading houses, market-makers and advisers to companies[, making] them both impossible to avoid and riddled with conflicts of interest.”⁶⁴ Dealing with Goldman simply makes good business sense, but it carries a sense of caveat emptor these days.

Joe Nocera, a New York Times columnist, agrees: “The [client] calculus at Goldman has always been, ‘There’s no one smarter out there. I actually can get the best advice from Goldman Sachs and they will often bring me the best deals, but I also know that I can’t trust them, that ultimately, their motives aren’t necessarily aligned with my motives.’”⁶⁵ Perhaps this lack of trust is less important in trading, where competition is based more on price and liquidity, but it should be of concern in investment banking, where clients must be able to trust that Goldman will not use the client’s information against the client’s best interests.

But the Goldman response to Smith’s letter hangs over its client relationships. One client, the very large Dutch investment adviser APG, said it took Goldman more than a day to contact APG with reassurances about Smith’s allegations: “We would have expected that a company that faces such a big media backlash over something so core to their business such as client trust would have instantly reached out to those clients to say something.”⁶⁶ The client’s real objection was having to explain to its own clients why it was doing business with Goldman, and having to explain about Goldman’s culture.⁶⁷ Ultimately, however, another client said, “For us it’s about what these banks bring to the table. I think Goldman has the intellectual capital; they’ve got the know-how to do these transactions. There are other banks out there, but Goldman is still the preeminent investment bank and they give solid advice.”⁶⁸

As a client, I had a chance to see how different Goldman’s value-added proposition was. I had a potential investment idea, but it required the coordination and collaboration of several parts of a bank to execute the transaction. I took the idea to several banks, but I never got past the first meeting with any of them. The groups within the same bank couldn’t agree on who would get what credit or revenues, something that would impact their bonuses (they never said this out loud, and I am reading between the lines of politically correct bankerspeak). So instead of executing a trade for a client, the banks did nothing.

I had a meeting with Goldman, and the partners understood that overall the firm would make money, even though each area might not be happy with its individual credit or revenues. The partners saw an overall opportunity, spoke among themselves, came to an agreement, and agreed to do the transaction (my personal relationship with them probably also helped). This teamwork in execution is a tremendous advantage for Goldman and shows that a residual social network and partnership culture still exists.

As the deal progressed, Goldman better understood what I was doing and thought it was a great investment idea. Later, Goldman said it wanted to coinvest in the deal. This is an example of the powerful strategy Goldman claims of combining advisory work with coinvesting. Goldman, to its credit, was the only bank smart enough to figure out how to get the deal done and recognize it was a good deal. Goldman’s coinvestment helped execute the deal for us at attractive terms.

I was very happy with Goldman’s advice and execution. However, a few months later I heard a rumor from a competitor that Goldman had done a similar deal with another client—much larger than we were—implying that Goldman took information about the deal and showed it to another client. I do not know whether this is true. So even though I had good feelings about Goldman getting the deal done for me, recognizing I never would have gotten it done without Goldman’s approach and ability to execute, I was slightly annoyed that, allegedly, Goldman used information to benefit itself with a larger client.

When I heard the rumor (again, only a rumor), it kept me on my guard. I didn’t say anything. I didn’t want to upset Goldman, because it is a very important player in the marketplace. I kept doing business with Goldman (and later I was involved in hiring Goldman to sell my firm). In my opinion, its people were responsive, well prepared, thoughtful, and connected. However, I did not feel as if all the people at Goldman could be trusted completely all the time. This should not be a shocking revelation in hindsight, but it was for someone who started at Goldman in the early 1990s. And the point I am making is the change.

What makes Goldman a tough competitor is its depth of talent and its systematic approach to providing high-quality client service (including getting senior partners to connect with clients). As an outsider, one can appreciate that, relatively speaking, Goldman is stacked with talent. The bench is deep, and the quality of the talent is relatively consistent. The firm’s expertise is phenomenal, again benefiting by pulling information from various people, geographies, and areas.

In my interviews with clients, many said the quality of talent on Wall Street had declined overall, Goldman included, perhaps because many clients themselves have become specialized in their knowledge and technology has commoditized information and the business in many ways. There is also strong competition for the best talent. Many talented individuals interested in finance go to private equity firms and hedge funds, which offer attractive opportunities.⁶⁹ Many smart people are going into technology or other fields. But clients felt that Goldman would probably be considered the best alternative generally, not necessarily in every area of specialization, if one is interested in banking or wants training and credentials.

Clients I interviewed said that other firms have equal (if not better) talent in selected people or specialties, but it is not nearly as broad, consistent, and deep, nor as coordinated, as it is at Goldman. A Goldman banker or employee will speak to multiple people to get their views and then present a firm view. At many other banks, clients explained they typically get the talent of only one person of high quality that they trust. They elaborated that one individual has a tough task competing against Goldman even if the one person is more trustworthy. The organizational elements that support coordination set Goldman apart, and this is one reason clients still use the firm. This differentiator has been and will be challenging to maintain. Some partners I interviewed said that the volume of deals, geographic dispersion, information overload, technology changes, new regulations, and client expectations have changed the dynamics of collaboration and that they are more rushed and have less time to help others than they had in the early 1990s, for example. However, they pointed out that their peers have the same challenges and were confident that Goldman has the ability to adapt.

Many clients pointed out that not just at Goldman but at its peers, even if they trust their one key adviser, they are always skeptical of the organizational pressures. Their adviser may have the client’s best interests at heart, but at the same time the adviser has internal pressures to sell products or do things in order to get paid or keep his job or get promoted. Therefore, the quality of execution, the ability to provide liquidity or find a buyer that no one else thought of or find a creative solution often trumps trust on deciding which firm to hire because clients are skeptical anyway.

Goldman still attracts a staggering amount of business. If clients were sick of alleged abuses, they would go to another competitor. Every time clients choose to do business with Goldman, essentially they are subconsciously performing a cost–benefit analysis, and they are making the unpopular (even if financially prudent) decision of giving their business to Goldman. Even though Goldman’s market shares seem to be fine after the crisis, I did find one interesting fact, that the premium fees that it charged clients above its competitors dissipated in at least one key area.⁷⁰ Perhaps this is a coincidence or there are not enough data points, but it is interesting to see if changes in Goldman’s fees in the future will be a barometer of what clients think beyond just market share.

Justice Department Declines to Prosecute Goldman

The Justice Department began an investigation of Goldman in 2011 after the Senate’s Permanent Subcommittee on Investigations issued a report highlighting questionable conduct by Goldman and other banks. The Justice Department focused on Goldman’s practices in selling pools of subprime mortgage securities to clients while simultaneously betting on a decline in the housing market. The report essentially alleged that Goldman had profited by betting against the very mortgage investments that it sold to clients. In addition, the report insinuated that Blankfein might have misled lawmakers when testifying about the mortgage deals. Blankfein testified that the bank never bet against its clients for its own profit. In April 2011, Senator Carl Levin, chairman of the subcommittee, referred Goldman’s case to the Justice Department for a criminal investigation.

In August 2012, the Justice Department took the unusual action of publicly announcing that its investigation into Goldman was closed and it would not bring a case: “[B]ased on the law and evidence as they exist at this time, there is not a viable basis to bring criminal prosecution.”⁷¹ The statement continued, “The department and its investigative partners conducted an exhaustive review of the report and its exhibits, independently gathered and scrutinized a large volume of other documents, and tenaciously pursued potential evidentiary leads, including conducting numerous witness interviews.”

According to news reports, this action came as a result of pushing by Goldman’s lawyers.⁷² Senator Levin responded, “Whether the decision by the Department of Justice is the product of weak laws or weak enforcement, Goldman Sachs’ actions were deceptive and immoral.”⁷³ In addition, separately, Goldman soon afterward disclosed that the SEC would not pursue any further claims against the bank related to a $1.3 billion mortgage bond deal.

Goldman seemingly focuses on its legal exoneration, although it does not claim to be free of all wrongdoing. At an investor conference in 2009, Blankfein said, “We participated in things that were clearly wrong and we have reasons to regret and apologize for.”⁷⁴ But as a current partner pointed out to me, upon further reflection, legal exoneration does not mean that the original principles have been upheld or that the ethical standards are the same as they were ten or twenty or thirty years ago. He said he doubted Goldman would ever publicly admit to that.