Why I Left Goldman Sachs: A Wall Street Story (21 page)

The piece was built on the thesis that even though everyone was still selling, eventually this cash supply was going to become so big that it would have to come back into the market in search of returns, with—no matter how good or bad the world happened to be at the moment—a significant impact. So I came up with a framework for showing how to track when the dry powder was actually getting deployed, and what that said about the direction of the markets.

The reaction at Goldman was electric. When I discussed the piece on our internal morning call that day in a conference room on one side of the trading floor—at which all the partners and managing directors were participating—one of the most respected salespeople on the whole trading floor immediately chimed in. “Guys, this piece is going to be essential reading today,” he said. “Everyone on Wall Street is going to be talking about it. I’ve already sent it to my three biggest clients, and they love it. I want everyone to send the piece out to all their clients.”

Everyone did: it got sent out to hundreds, maybe even thousands, of clients. Over the next few days, several partners came by the desk and patted me on the back. “This is great stuff,” they’d say. “Let’s do more of this.” They all seemed to be in agreement: commentary like this was a way to stay in front of our clients, to show them we were looking out for them.

I think another reason the piece caught on was that people were scared and looking for hope that the markets might recover, and in a calm, objective way, my dry powder thesis had provided some.

I e-mailed the salesperson who’d given me that surprising endorsement in front of everyone: “Thank you, man—that truly meant a lot to me.”

“It’s well deserved,” he wrote back. “In the new world we live in, content is the way we will differentiate ourselves. Keep it up.”

Passover, April 2009. Goldman Sachs had come through the wilderness of the financial crisis a changed firm. From a simple structural perspective, we were now a bank holding company instead of an investment bank, but the mind-set was changing, too, and the part of the business where this was becoming readily apparent was in how the firm dealt with its clients.

Every Jewish kid who was half awake during Hebrew school knows at least a few things about the Passover Seder, a Jewish Thanksgiving meal of sorts where we read from a book called the Haggadah about the liberation of the Israelites from slavery in Egypt. There is the matzah (unleavened bread), the bitter herbs to commemorate the hard times, the four cups of wine, and some delicious matzah ball soup. But every April, when I conduct the Seder at my cousins’ house in Chicago for the twenty-five jabbering adults and twenty screaming kids who come every year, I particularly like the part of the text that discusses the reaction of the Four Sons to Passover: one who is wise, one who is wicked, one who is simple, and one who doesn’t know how to ask questions.

And as it was told in ancient Egypt about the Four Sons, so, too, it was on Wall Street that there are Four Types of Clients: the Wise Client, the Wicked Client, the Simple Client, and the Client Who Doesn’t Know How to Ask Questions. I had seen all four types in action over the years, but coming out of the market meltdown, I was learning the new roles that each would be expected to play.

The Wise Clients are the large hedge funds and institutions that have access to all the resources their bankers and traders have to offer. This includes research; communication with the management teams of the companies they are looking to invest in (or short); first looks on deals that are coming to market, such as IPOs and capital raises; their own unbiased derivatives pricing models, to determine what opaque products are
actually
worth; but most important, human capital: really sharp people working for them. For a client to be wise, its managers must fully understand the conflicts of interest that are rife on Wall Street—in IPOs, in structured products, in proprietary trading. Therefore, many of the people at the helm of the Wise Client firms have previously worked at Wall Street banks and understand all the tricks of the trade.

As Goldman started looking more and more like a hedge fund, the Wise Clients were important allies. They’d get looped in early about the various trades Goldman Sachs liked, so they could invest alongside the firm and use their muscle to propel the firm’s investing ideas into self-fulfilling prophecies. Goldman would never try to push some high-margin financial product on our Wise Clients. The people who work at these firms are too smart. They also have the tools to spot when a trader is trying to play games. In the newly constituted Goldman Sachs, these multibillion-dollar hedge funds and institutions would be handled with kid gloves.

Which brings us to the Wicked Client. This is often a very smart client who pushes the envelope. Some funds engage in rumor mongering to drive down the prices of companies they are shorting. Some funds “spray their flow all over the street”—they try to game Wall Street banks against one another to get the best price for themselves. While this is not illegal, Wall Street firms don’t like to get played—they like to be the ones doing the playing. At worst, some clients—like Raj Rajaratnam, founder of the $7 billion Galleon fund and always highly charitable with his personal wealth—show bad judgment and trade on inside information. In October 2011, he was sentenced to eleven years in prison.

Then there’s the Simple Client. You would be appalled at how backward and badly run certain large asset managers and pension funds can be. There’s a huge discrepancy between the sophisticated ones and the unsophisticated ones, even though they may be of equal size and look almost identical to the outside world. The bad ones are big and bureaucratic, have outdated systems, and still use fax machines for trade confirmations. They generally move very slowly—sometimes too slowly. These are perfect prey for Wall Street, and after they get fed one cup of wine, they are forced to eat bitter herbs. An example of a Simple Client would be a client whom a longtime salesperson on the floor dubbed the Queen of Wall Street. She was a piece of work: volatile, quirky, and given to peculiar utterances and outbursts. She liked to break in the new kids—once, when a scared first-year analyst named Jonah was doing some trades for her, she shrieked, “Jonah, if I could, I would reach through the phone line and bite your fucking head off!” Poor Jonah wasn’t the same for a while after that.

Though the Queen was responsible for trading billions of dollars in futures, options, and other derivatives, she was strangely unsophisticated about the business. She had a special paranoia about trading the incorrect amount of futures contracts. She would say crazy things like “I don’t care what the price is; I just don’t want to overtrade”—that is, accidentally trade too many contracts, an error on her part that could get her into trouble with her boss. For anyone on Wall Street, this was an insane thing to hear, since getting the right amount of contracts is the most basic of calculations; a rookie should get it right every time. The important thing is, what was your execution? Did you buy low and sell high? What was the price? The Queen’s wackiness was especially egregious in light of the fact that thousands of people’s pensions were tied to her decision-making processes.

We used to hold the Queen’s hand, and treat her like a queen. We assumed a fiduciary responsibility to tell her when she was doing something wrong or making poor decisions. But, sadly, the Queen of Wall Street is the type of client many people on Wall Street are looking to prey on.

The fourth? That would be the Client Who Doesn’t Know How to Ask Questions. This is the sorriest of the lot, because not only are these clients simple, but they are also trusting. They often are the investment managers who are meant to look after the pensions of cops, firemen, and teachers, or they might be running the portfolio of a charity, an endowment, or a foundation. In the brave new Wall Street that was coalescing during this time of market turbulence, these would be the target clients for elephant trades.

As an example, imagine a client who lived in the mountains of Oregon, running billions of dollars in state pension fund money. In his world, he was a big fish and thought of himself as a sophisticated investor, but he had never worked inside a Wall Street firm. He lacked the infrastructure to figure out exactly what he was buying, and after the crash of 2008, he was under pressure to make up for lost returns. He was the perfect target to sell a type of derivative known as an exotic—a very complex product that could be made to look much simpler for the client when dressed up with enough bells and whistles as a structured product. These were similar to the cans of tuna that Greece, the City of Oakland, and Jefferson County in Alabama had bought.

They are called exotics for good reason: these products are so complicated that often the clients don’t understand how much money they’ve paid to the bank. Exotics require very complicated financial models to value them accurately, and often the smartest quants within the bank are assigned to create and price them.

A certain Goldman cachet came into effect with the Client Who Doesn’t Know How to Ask Questions. He was dealing with the smartest guys on the Street, he figured, so why did he need to do the math for himself? And guys such as Lloyd Blankfein, Gary Cohn, and CFO David Viniar really were the smartest guys on the Street. They truly understood derivatives: they knew the risks inherent in them; they understood their theoretical underpinnings. On the other hand, Bear Stearns, Merrill Lynch, and Lehman Brothers all got into trouble by not understanding the risk they had on their books.

What the Client Who Doesn’t Know How to Ask Questions failed to grasp in 2009 was that Goldman’s sense of fiduciary responsibility was eroding. And every year, one or another of these clients probably shows up on the list of Goldman Sachs’s top twenty-five clients—these are clients ranked by
fees generated
, not assets under management or return on investment. There is something highly disconcerting about seeing a global charity or philanthropic organization or teacher’s pension fund in the top twenty-five of a firm’s clients.

When I returned to work after Passover, the gloom that had hung over the trading floor seemed to have lifted slightly. In March (before the holiday), the markets had hit new lows, and the banking stocks, ours included, were still getting hammered. Even with the government injecting hundreds of billions of dollars into the biggest banks, there were still significant worries about the scope of toxic assets still lingering on each balance sheet. But Goldman was navigating through the crisis, thanks to brilliant risk management. Derivatives desks make the most money when the markets are volatile, and in 2008 and early 2009, Goldman’s Derivatives desks across the firm made a killing. And this windfall didn’t come from taking bullets for clients; rather, a large part of it came from collecting large fees for unwinding panicked clients’ failed trades.

Once it seemed as though the last of the panicked trades had been unwound, Wall Street did what it does best: it saw a huge dislocation in the market and started figuring out how to act on it. Baron de Rothschild, the famous eighteenth-century British financier, captured what Goldman Sachs and other banks on Wall Street would soon start doing: “The time to buy is when there is blood in the streets.”

To put it in layman’s language, Goldman Sachs was ready to wager a lot of its own money that the markets were going to calm down very quickly. In mid-2009 before it was obvious that the markets were going to start recovering, a number of the smartest traders at Goldman Sachs started noticing an anomaly in the derivatives markets: derivatives prices were implying that for the next ten years straight, we were going to continue to see the levels of unprecedented volatility that we had been seeing in the nine months since Lehman Brothers went bankrupt. Could this kind of turmoil and unpredictability continue for ten years, unabated? Surely things would calm down—maybe not immediately, but sometime soon. A ten-year period of constant turmoil had not occurred since the Great Depression. And by now the government had shown the will to step in and support the system through capital injections to banks and an $800 billion stimulus package to help the economy. No one thought the mistakes of a passive Herbert Hoover would be made all over again.

So Goldman Sachs and other banks on Wall Street, plus a number of the Wise Clients, started implementing a bullish bet: that the markets would start rising, and that volatility would start falling. The way many investors put this trade on was through shorting a derivative called a ten year S&P 500 variance swap—an over the counter, opaque product with very little liquidity.

Famously, another smart investor had thought of a similar idea. Warren Buffett, the Oracle, who had previously called derivatives “financial weapons of mass destruction,” also noticed this dislocation and made a similar bet (albeit using a different tactic).

This trade made banks and clients all over Wall Street hundreds of millions of dollars from mid-2009 until mid-2010 as the markets rallied and volatility compressed. In many ways, betting that the markets would calm down was a brilliant move. It was certainly a daring one. After Bear Stearns went bankrupt in early 2008, a lot of people had thought that the firm’s fall was just an anomaly and that the worst was over. A number of hedge funds went bust at the time by getting the timing of this return to calm extremely wrong. Having the right investing thesis is only half the battle; knowing when to put the idea into practice is arguably more important. And the beauty part was, the more Wise Clients Goldman could line up behind the short, the more long-dated volatility would go down.

But the strategy backfired significantly in the summer of 2010, when there was a huge short squeeze—a lot of people got wind of these positions and all started buying at the same time. On Goldman’s second quarter earnings call on July 20, 2010, CFO David Viniar would offer a mea culpa: “As a result of meeting franchise client and broader market needs, we had a short equity volatility position going into the quarter. Given the spikes in volatility that occurred during the quarter, equity derivatives posted poor quarterly results.”

The real question though, is this: Was this trade formulated primarily in the service of clients, as Viniar says? Or was it being driven by Goldman Sachs’s and other Wall Street banks’ desire to implement a proprietary bet? I would argue the latter.

It was in the context of pondering this type of question—of whether the firm saw its customers as “clients” or “counterparties”—that I attended the exclusive Goldman Sachs leadership program called Pine Street. Based on Jack Welch’s pioneering Crotonville Management Development Center at General Electric, Pine Street started during the Hank Paulson era as a way to ensure that the leadership and cultural tenets of the firm weren’t diluted after Goldman Sachs went public. In the beginning, the series of seminars was reserved for managing directors, but later VPs and even select clients were allowed to attend. I took the president of my largest client.

At Pine Street, thought leaders such as Bill George, the former CEO of Medtronic turned Harvard Business School professor, the author of
Authentic Leadership
, and a Goldman Sachs Board member, talked about how leaders are meant to behave. A scientist talked to us about the Stanford marshmallow experiment—the one where children were left alone in a room with a marshmallow. Some gobbled up the marshmallow; others waited and then ate it; still others waited until the tester returned to the room. The subjects were tracked over the next forty years, and the researchers found that the ones who had delayed gratification the longest ended up growing into leaders; the little piggies, not so much. It occurred to me that back on the trading floor I was seeing more little piggies and instant gratification than I was seeing under the old Goldman model of “long-term greedy.”