GS… Fiduciary Duty,Materiality, Price vs Value vs Quality, Social Value, Markets

29 Apr

I’ve recently spent sometime reading and commenting on a number of financial blogs, discussing the current firestorm surrounding Goldman Sachs. Between the SEC suit and the senate hearings Tuesday the two major roles of GS are at the heart of these discussions.

The primary issue and the one that the SEC’s suit involves is the failure to disclose material information regarding the ABACUS synthetic CDO transaction/deal/offering. This is a legal matter on what defines something being material.

The second issue that has arisen and which gets mixed into the discussion is that Goldman as a market maker / seller of securities will often have an opposing and adversarial interest with the clients to/from which they buy and sell securities. This has thus far not been a legal matter but rather a question of ethics, as well as a topic in the regulatory/reform debate.

Lastly the entire question about the social value of financial firms and trading activity is brought up, asking what exactly does all this trading do for society?

Fiduciary Duty

Fiduciary duty deals with the question of ethics as applied to the second issue.

A large part of the Senate hearings dealt with the following: How can Goldman sell securities to clients that it thinks are poor and/or has positions against? (We will ignore offerings for now and concentrate on pure market making activities.) The confusion here lies in the belief that a market maker / broker has a fiduciary duty the same way a lawyer or investment advisor would. The fiduciary relationship rests upon the idea that one party, acting on behalf of the client will work to maximize the clients interests. As a market maker this cannot possibly be true. For one the incentives of both parties in a buyer / seller relationship are by nature adversarial, anyone selling a product invariable benefits from a higher price while the buyer benefits from a lower price. There is always going to be a conflict of interest and thus impossible to ever believe a principal trading market maker is your fiduciary.
What GS ‘sells’ as a market maker is the ability to transact, to find a price someone will buy at, and a price someone will sell at.

Consider even the instance of agency trading. Where a desk at Goldman has no positions of it’s own but merely matches orders. Many times in the day an agency trader will receive buy and sell orders on the same security from different parties. If we assume his role is fiduciary in nature, how can he accomplish this to the best interests of his clients? If the sell order is large the sales at the beginning of the order will likely come at the beginning of the day will come at a higher price than those at the end. Knowing this, if the agent performs to the best interests of the buyer, he should wait until the end of day to purchase securities at the lowest price. This however contradicts his duty to get the best prices for his seller as his holding of the buyers orders lowers demand and makes price drop quicker. One may argue that he could try to balance out their interests, but that also means that he’s sacrificing the interests of one party to maintain his relationship with the other. In fiduciary terms, this is an inherent conflict of duties, which makes being a fiduciary impossible.

In it’s very nature acting on behalf of multiple parties which may be diametrically opposed makes being a fiduciary impossible. It is impossible for a trader/agent/broker to run a successful business representing only 1 client. It is therefore impossible to ever assume that anyone executing a trade, principal or agent could ever have a fiduciary duty.

Materiality and Price vs Value vs Quality

We must make a distinction between the price of an item, the value of an item and it’s quality. Price is a number, it is what you need to pay to buy a service of product. The value of an item is not. Value is completely dependent upon the perspective of the buyer of any good, service of security. What an individual chooses to buy is ultimately determined by if the perceived value of the item intersects and exceeds the price required. Some people buy a $1000 Prada purse because they believe its value is greater than or equal that price. For many others of us, we would think this a ridiculous price to pay because we find little value in a purse. Now what is of concern when we make our decision about a purchase is it’s qualities. Quality as used here defined as: it’s inherent and distinguishing characteristics and properties. What an item IS. This too is absolute. Our concern when making this decision is that what the item as advertised in this case the designer bag, is actually a real Prada bag. The material information when it comes to buying a bag are the veracity of its qualities.

The same is true regarding securities. Too often people confuse the value of a security with its price, this is not true. We buy securities we believe have value exceeding it’s asking price, and sell securities that have prices exceeding its value. How we determine may depend upon a number of theoretical models / opinions (dividends, expected appreciation etc.). Because of uncertainty in the future, the value is something unknown and is completely dependent upon the perspective of the individual. (The value of a stock of DISNEY may simply be having a piece of a company someone loves) The qualities of a security are the assets and properties that define what it IS. This may be the company a stock represents, the cash flows / loss divisions in a CDO, the payoff and reference security on an option. The job of a banker/underwriter in an offering is to assure investors about these properties, verifying the numbers and the facts. While someone’s opinion (short of having material non-public information) may change our perceived value of these assets, it never changes what the assets represent.

In the case of ABACUS the argument is that Paulson’s view is material because it would change someones perceived value of a security. It moves the standard from the qualities of a security, to how information may effect its perceived value. While an opinion may change the price and even the associated value it changes none of the basic properties of a security, its long term performance nor what it represents. For every investor there are a different set of perfectly reasonable opinions and factors which would change the perceived value of a security. This is the problem with such a standard. After all an investor could want to know what the underwriter or manager thought the likelihood of default was, their view of the economy or any other pieces of information useful in our financial decision making. All these would clearly impact our value perception. A crazier investor may want to know if managers wore blue underwear, because he felt it was lucky. Where do you draw the line? No disclosure would ever be adequate. This is why material information has to be constrained to a securities qualities. (Management knowing that they lose a large contract effects what the security represents and therefore why it is material)

Social Value

The last question, how does trading securities add any social value. After all when you trade on the stock market, trade derivatives, you’re certainly no longer providing capital to companies that need it. So how does this activity create value for anyone.

The answer is liquidity.

When an investor puts capital into a company the expectation is that he will earn something from this investment eventually. This may come in the form of dividends or selling the shares off to someone for more than you invested. The markets provide the necessary function of helping someone sell off their existing investment. If it’s harder to find buyers for your shares and therefore exit your investment you will demand a higher return for committing your money. This means that businesses that the cost of capital for a business is significantly higher and makes growth harder. The markets create liquidity, helping to ensure that someone who puts capital into a business can find a flexible way to exit and be rewarded for their investment. Obviously this in turn relies on the principle that the new buyer of the shares can themselves exit their position. In essence the ability to transfer risk lowers the cost of investing and growing business. Derivatives, bonds, CDOS etc are all instruments used to spread and transfer risk between parties and increase liquidity.

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