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     Apr 17, 2012


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.

Note
1. See here.
2. See here.

Spengler is channeled by David P Goldman, president of Macrostrategy LLC. His book How 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.

(Copyright 2012 Asia Times Online (Holdings) Ltd. All rights reserved. Please contact us about sales, syndication and republishing.) 

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