OK, so who do we believe? In a cover story in New York magazine last month melodramatically headlined "The Emasculation of Wall Street," journalist Gabriel Sherman made the case that the big financial firms were engaged in "something that might be called soul-searching" about their many sins and their wildly overcompensated contribution to the U.S. economy. Wall Street, under the whip of the giant Dodd-Frank law, was learning to behave. Reduced compensation packages and increased capital requirements were going to tame or snuff out some of the riskier and most reckless practices that brought the nation to the edge of a second Great Depression, Sherman wrote. Best of all, the domestication of Wall Street would redirect the best minds in the nation back into useful things like real engineering rather than financial engineering. Cool!
Now comes Greg Smith, an apparently conscience-stricken renegade from Goldman Sachs, who tells us that not only has nothing changed in the firm's culture, but he "can honestly say that the environment now is as toxic and destructive as I have ever seen it."
Can these two things both be true?
Actually, maybe yes. But the larger point is: We need to pay a lot more attention to Greg Smith than to Gabriel Sherman. There is, first of all, every reason to think Smith was telling the truth.
Some smart observers of the Street, like the Pulitzer-Prize-winning author ("Lords of Finance") Liaquat Ahamed, say that while Sherman is correct to say Wall Street is much more restrained at the moment, much else has not changed. "Greg Smith is dead right," Ahamed wrote me in an email today. "Goldman and all the other investment banks are plagued by conflicts of interest. The problem is that over time all of them, but especially Goldman, have shifted from the business of advising clients or raising capital for clients to trading on their own account. I have the impression (from books about the Pecora hearings) that in the 1930s Glass Steagall was motivated as much by outrage at conflicts of interest (e.g. Citibank famously stuffing the accounts of its deposit holders with foreign bonds that then went bankrupt) as the desire to make the banking system more stable."
But we didn't get a new Glass-Steagall. Instead, courtesy of Tim Geithner and Co., we got the milquetoasty Volcker Rule (which the Treasury only backed, after a year of ignoring Paul Volcker, when Barack Obama insisted on it, as I have previously written), dubious rules about unwinding Wall Street's still-giant firms in a crisis, and a Consumer Financial Protection Bureau that is under constant assault on Capitol Hill. So it beggars common sense to think that we're really getting a new Wall Street.
And none other than Goldman CEO Lloyd Blankfein--whom Smith attacked yesterday for losing "hold on the firm's culture"--has already conceded this point. As I wrote in my 2010 book "Capital Offense,'' Goldman Sachs became the biggest earner and most prestigious firm on Wall Street in part because it had no scruples about simultaneously betting against products it was selling. Goldman justified this by saying that it had more sophisticated customers, like big institutional and professional investors, who didn’t mind if Goldman placed hedges against the very investments it was touting to other clients.
Back in 2010, Blankfein admitted, in effect, precisely what Greg Smith is alleging now. In the now-famous hearings held by Sen. Carl Levin's Permanent Subcommittee on Investigations, Levin tried to get Blankfein to concede that Goldman was morally wrong to bet on the sly against securities that it had touted as solid investments to its clients. No, no, the Goldman CEO demurred, that’s not how the financial system works any more. “There’s been a change in the sociology of the business in the last 10 to 15 years,” Blankfein explained patiently. “Somewhere along the line,” he said, big clients stopped asking investment banks for good advice and started to seek them out only to set up deals for them -- merely to underwrite the transactions and be on the other side of them. That forced Goldman to transform itself from a private partnership in the late ‘90s into a publicly traded company in order to obtain the big-time capital it needed to create such deals. It also apparently gave Goldman carte blanche to shaft any helpless investor on the other side of those transactions. Liquidity was all. Nothing else mattered.
We have heard again and again in the past two years how Dodd-Frank is delivering up to us a new Wall Street, how banking is becoming blessedly "boring" again. But Greg Smith now joins a very small group -- an absurdly small group -- of truth-tellers who seem to be telling us that, for the most part, things still work the way they used to. One of Smith's predecessors in this select company, Frank Partnoy, exposed the practices of Morgan Stanley back in the 1990s--a firm that he wrote had evolved from a stodgy white-shoe bank into a furious profit machine that was mainly involved in speculation and scamming, using arcane derivatives and complex new packages of debt obligations and interest-rate payments that Morgan foisted on customers who barely understood them. Another whistle-blower, Eric Kolchinsky, a former Moody’s managing director, revealed in congressional hearings in late 2009 that even into the year after the financial crisis, the firm continued to deceive investors by inflating ratings on dubious securities.
How much can we really expect this to change? Not much. Yes, as Gabriel Sherman wrote, Wall Street is going through something of an existential crisis. The Volcker Rule, as shot full of holes as it is, may help to prevent FDIC money intended for traditional banks from being used to bail out firms that continue to deploy hedge-fund practices. But if Sherman had it right, and the habits and culture that pervaded Goldman and Morgan Stanley have been fundamentally altered and have "boxed in" the firms since they were forced to convert to bank holding companies during the crisis (in order to tap the Fed's discount window), then why is Greg Smith writing that even in the aftermath of Dodd-Frank, the Levin hearings and a giant civil suit that Goldman settled (without admitting wrongdoing), the firm is as vicious as it's ever been? "Even after the S.E.C., Fabulous Fab, Abacus, God’s work, Carl Levin, Vampire Squids? No humility? I mean, come on. Integrity? It is eroding," Smith writes.
So there's even less integrity than there used to be? That's especially scary considering that giant banks are still giants and are going to remain so and that they are still having trouble passing stress tests, as we saw this week. There is nothing to fix the too-big-to-fail problem beyond a host of as-yet-unwritten "living wills" that are supposed to tell regulators how to liquidate the banks in a crisis. The largest surviving banks—mainly Goldman, Citi, JPMorgan Chase, Bank of America, Morgan Stanley, and Wells Fargo—are growing bigger and more global relative to the rest of the industry. They are pushing out smaller banks in key areas, having increased their overall market shares in deposits, mortgages, credit cards, home-equity loans, and small-business loans. Beyond that, at more than $700 trillion, the derivatives trade is already much larger than it was during the 2008 crisis. And meager as it is, Dodd-Frank is in the process of being gutted by the GOP-led House (never mind what might happen if Mitt Romney gets elected president, because he has vowed to repeal it). Regulators are starved for staff.
Eric Kolchinsky, the former Moody's derivatives expert, in a conversation with me today, said "things obviously have not changed. Dodd-Frank in my estimation doesn’t really do much at all," especially to change the ethics on Wall Street or to help protect Wall Street's clients from getting snowed over the super-complex derivatives they are still being sold. Instead, Dodd-Frank "really just focuses on paperwork without any changes in practices," Kolchinsky said. "What happened is that some of the products that made that kind of money were directly outlawed. You can’t do what you did last time. But the attitude [on Wall Street] is, 'Let's find something else.' That hasn’t changed. What Greg Smith was doing, as head of equity derivatives, that’s another complex product, and it’s in that complexity where the banks can make a lot of money.”
Indeed, it's no surprise that the bank lobby threw most of its energy during the Dodd-Frank legislative process into watering down rules requiring over-the-counter derivatives to trade on an open and supervised exchange. The reason is that derivatives and structured finance products traded off exchange were still a major source of Wall Street’s profitability because they were not exposed to market and risk valuation. And the more complex they are, the easier it is for the banks to charge their customers huge spreads. In other words, the market is still rigged and full of scams, just as Frank Partnoy warned back in the 1990s.
Who to believe? I think I'll go with Greg Smith over Gabriel Sherman. You can take that to the bank.