Tuesday, July 14, 2009
Is Goldman Evil?
Goldman Sachs is one of the most respected private firms in the world. With their astronomical paychecks, and their selective recruitment, they clearly inspire a lot of envy.
Goldman is self-interested, which means they don't share all their ideas, and they don't hire everyone capable who wants a job there, but that's inevitable and you can't let that color your views. The latest hatchet job in Rolling Stone is by Matt Tiabbi, who has a profoundly adolescent and paranoid world-view that seems clever and witty only for the kind of people who read Rolling Stone to learn about finance. It's not worth a point by point rebuttal, because like Oliver Stone's JFK, you have so many issues of contention it becomes pointless rather quickly. The bottom line is Goldman is a large investment bank, so they have connections to everyone and everything. To hold them responsible for all the conspicuous bad things and people of the past is just a logical error, like blaming 7-11 for alcoholism (they sell a lot of alcohol!).
Those who think Goldman was the prime mover in our financial mess are simply wrong, as Goldman was as guilty as everyone who did not second-guess the assumption that aggregate housing prices do not fall in nominal terms (academics, legislators, regulators, investors, home buyers, investment bankers, rating agencies—did I forget anyone?).
Recently, Goldman filed a complaint against an ex-employee, and somehow got the Justice Department to effectively act as their attorneys in what should be a civil matter! That is, when I was sued by my ex-employer for 'violating my confidentiality agreement' in various nefarious ways (such as applying mean-variance optimization), it was a civil action. A criminal action is much more difficult to defend, and is very unusual for such a charge. Clearly Goldman has connections with the right people, but everyone knows that.
I think GS as an example of what happens when you have a bunch of smart, highly connected people working together to get rich. There is a lot of inside ownership, and so their large bonus structure clearly implies they understand the Lafffer curve, in that giving people stronger incentives helps everyone—capital and labor.
In the first half of 2009 suggested an average employee compensation of $700k per year. In general, GS pays about as much in bonuses they do in profits to shareholders. This suggests those on the ground, making the deals, are able to get about half of the profit.
This is often the case for alpha generators, as for example consider that hedge funds make 2 percent of assets and 20 percent of profits. Then over the glory years of convertible bonds from 1994 through 2003 when those funds returned 10 percent to investors with minuscule volatility, the owners of these funds pulled in about 4 percent of assets in profits for themselves, while investors received about 4.5 percent in annual returns above the LIBOR. As one might expect when you have two inputs, equally necessary, the split seems to be near 50–50. That is, in any investment with alpha, you have two things, equally necessary: he who identifies the alpha, and he with the capital. In any particular case the proceeds are split according to negotiating strength, but on average we should expect an approximate equal split, as there appears to be in high alpha strategies (I go over this in my book (of course) Finding Alpha).
The net result is that if you pay these lucky bastards a lot of money, as an equity owner you can make a lot of money too. There are surely a lot of overpaid Goldman employees as you would expect in any large organization (I know several!), and much of their value comes from Goldman's alpha: connections, brandname, and monopoly access. Yet on average these people are being rewarded appropriately and if you want a growing economy you have to accept this. I know this is hard for many people to accept because given the large number of smart, hard-working individuals of good integrity who don't make $700k a year, Goldman's workers are in that sense very fortunate and this is somehow unfair. You can't run an economy based on cosmic justice—that's for our creator—so you have to deal with the reality that life is somewhat arbitrary, and to accept that inequality in income is better than poverty. Considering they make this money out of their profits, not taxes, it doesn't bother me at all.