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Iron Capital Insights

  • Iron Capital Insights
  • April 19, 2010
  • Chuck Osborne

Wall Street Revealed

On Friday Goldman Sachs Group Inc. was hit with charges of fraud by the SEC. That is a big headline, and it is worrisome; are major financial firms really committing fraud as a regular order of business? Goldman denies any wrong-doing and says it will fight the SEC allegations. Right now we are left with more questions than answers, including the seemingly political timing of the announcement, so for the moment I will withhold judgment on Goldman’s actions. However, I think this case is all too illustrative of how Wall Street works to allow it pass without comment.

Let’s quickly review the facts of the case as they have been reported thus far. The hedge fund firm of Paulson & Co. asked Goldman Sachs to create a Collateralized Debt Obligation (CDO) security, which included particular mortgage securities that Paulson was interested in shorting. To put this in layman’s terms, Paulson wanted Goldman Sachs’ help in betting on the value of mortgages going down. Goldman Sachs created the security and sold it to clients while Paulson bet on it losing value.

Pay close attention here. If you do not remember anything else about this scandal, remember this: these facts are not in dispute, and the SEC did not say there is anything wrong with what Goldman did. Their argument – the entire case – is simply that Goldman did not disclose material facts. Paulson has not been charged with any wrong-doing. There would be no charges at all if the SEC felt that Goldman had the appropriate disclosures in the contracts their clients purchased. The big picture facts in this case do not represent fraud; they represent the Wall Street business model.

Wall Street firms are brokers, not advisors, regardless of what they call themselves. Their job is to bring buyers and sellers together. As the legendary money manager Michael Price once said, “Wall Street is in the business of creating fees for Wall Street. Period. It is not in the business of getting good investment results. You have to be separate from Wall Street to do that.”

Goldman’s CEO summarized it best last month in a letter to shareholders when he said, “Our goal was, and is, to be in a position to make markets for our clients while managing our risk within prescribed limits.” Their goal is to “make markets” – to bring buyers and sellers together – not to provide advice and get a competitive rate of return for their clients.

I don’t know whether Goldman committed fraud. I am willing to allow our legal system to find that out. I do know that Goldman, and every other Wall Street firm, believes their role is to make markets, not to provide advice.

Regardless of the outcome, if one has a retail account at Goldman, JP Morgan, Merrill Lynch, Morgan Stanley, UBS, Wells Fargo Securities, or any other full-service broker dealer, that person should understand that they are on their own. Every time their broker, a.k.a. “adviser,” calls them with a suggested investment, they need to know that the opportunity has arisen because some other client of the firm is selling that very same investment, not because the investment is in the client’s best interest.

Fortunately, Iron Capital provides an alternative. Our goal is not to create markets but to provide counsel and to generate superior rates of return on our clients’ investments. If we buy an investment in your account, we are buying it for ourselves as well, and if we sell an investment out of your account, we are selling too. If you have ever wondered what the real difference is between Iron Capital and a firm like Goldman Sachs, you found out on Friday.

Iron Capital owns Goldman Sachs in several client accounts. We do business with Goldman and will most likely continue to do so. Regardless of what you may think of them, they do a very good job of their stated goal – creating markets – and as professional investors, we need markets. The problem in our system is that somewhere along the way people forgot what business the Wall Street firms are really in. Their role is to work with firms like Iron Capital and Paulson & Co. and to provide us with markets for the securities in which we wish to invest. It is our role to provide you, our clients, with independent investment counsel.

Chuck Osborne, CFA
Managing Director