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Goldman Sachs’s long history of duping its clients

By William D. Cohan,

Greg Smith doesn’t know the half of it.

Smith, now the most famous former Goldman Sachs derivatives salesman on the planet, went off on his former employer in the opinion pages of the New York Times this past week — much to the amazement of nearly everyone — because he claimed that during his 12years at the firm, the ethics and morals of his co-workers deteriorated so dramatically that he just couldn’t take it anymore.

“I can honestly say that the environment now is as toxic and destructive as I have ever seen it,” he wrote. “To put the problem in the simplest terms, the interests of the client continue to be sidelined in the way the firm operates and thinks about making money.”

Guess what, Greg? You didn’t do your homework about the firm where you worked for more than a decade and happily took home one bonus check after another. Goldman Sachs has been in and out of trouble throughout its 143 years — chiefly because it chose to put its own interests before those of its clients. What appeared to be a revelation to Smith was actually available to anyone who looked for it, buried deep within Securities and Exchange Commission and court records. Smith could have saved himself grief if he had only used his Stanford education to examine Goldman’s DNA before crossing its threshold.

There are numerous examples of Goldman putting its own interests first. But one will suffice: the June 1970 bankruptcy of Penn Central Transportation Company, the nation’s largest railroad.

At the time, Penn Central operated 20,530 miles of track in 16 states and two Canadian provinces and provided 35 percent of all railroad passenger service in the United States. The company also had substantial real estate holdings, including Grand Central Terminal in New York, along with much of the land on Park Avenue between Grand Central and the Waldorf-Astoria hotel. Nevertheless, Penn Central ended up defaulting on $87 million of its short-term unsecured debt — known in the industry as “commercial paper” — and Goldman was at the epicenter of its financial difficulties.

In 1968, after years of being shut out of doing business with many of the nation’s railroads — in large part because it was a Jewish-owned firm — Goldman won the opportunity to underwrite Penn Central’s commercial paper, widely seen as among the safest short-term investments. For large fees, Goldman sold the paper to its clients, including big companies such as American Express and Disney, and smaller ones such as Welch’s Foods, the grape-juice maker, and Younkers, a Des Moines-based retailer. Welch’s and Younkers, particularly, counted on the fact that Goldman told them that the Penn Central paper was safe and could be easily redeemed. Welch’s invested $1 million — some of it payroll cash — and Younkers invested $500,000, both at Goldman’s recommendation.

After Penn Central filed for bankruptcy, an SEC investigation discovered that Goldman had continued to sell the railroad’s debt to its clients at 100 cents on the dollar — even though, by the end of 1969, the firm knew that Penn Central’s finances were deteriorating rapidly. Not only was Goldman privy to Penn Central’s internal numbers, it also heard repeatedly from the railroad’s executives that it was rapidly running out of cash.

According to the SEC, Goldman “gained possession of material adverse information, some from public sources and some from nonpublic sources indicating a continuing deterioration of the financial condition of the [railroad]. Goldman, Sachs did not communicate this information to its commercial paper customers, nor did it undertake a thorough investigation of the company. If Goldman, Sachs had heeded these warnings and undertaken a reevaluation of the company, it would have learned that its condition was substantially worse than had been publicly reported.”

But, according to the SEC, while Goldman did not share the bad news with its customers and continued to sell them the increasingly squirrelly Penn Central commercial paper, it did use the public and nonpublic information to protect itself and its partners from having any of the paper on their books when the music stopped. After all, back then, Goldman was a private partnership with only its partners’ capital at risk, not that of outside investors, like today.

By the beginning of February 1970, Goldman had $10 million worth of Penn Central’s commercial paper on its balance sheet, some 20 percent of Goldman’s $50 million in capital. Losing 20 percent of its capital would be devastating and would jeopardize Goldman’s ability to stay in business — because, as we learned so clearly in 2008, once customers question a securities firm’s ability to make good on its obligations, a bank run can materialize overnight.

Goldman’s partners decided that they could not take that risk. On Feb. 5, 1970, the very day the firm received Penn Central’s latest dismal numbers, it demanded that the railroad buy back Goldman’s $10 million inventory of its commercial paper at 100 cents on the dollar, even though it was worth far less at that point. None of Goldman’s customers were made a similar offer, nor did the firm tell them that it had taken care of itself while leaving them to suffer the vicissitudes of Penn Central’s rapidly deteriorating fortunes — making companies such as American Express, Disney, Welch’s and Younkers some of Goldman’s original “muppets,” as Smith might say.

“Most customers believed that Goldman, Sachs maintained an inventory in all commercial paper which [it] offered for sale,” according to the SEC report. “Many who purchased the company’s paper after February 5, 1970, looked to the fact that Goldman, Sachs had an inventory of the company’s paper as assurance that Goldman, Sachs felt the paper to be credit worthy.”

The SEC sued Goldman civilly as a result of its behavior in selling Penn Central’s commercial paper, and the lawsuit was quickly settled, with the firm neither denying nor admitting guilt.

After Penn Central filed for bankruptcy, Goldman faced an existential threat as client after client sued the firm for selling them the questionable commercial paper. “Everyone hunkered down,” George Doty, a former Goldman partner, told me. “We had a couple of difficult years.”

The firm was able to settle many of these lawsuits for pennies on the dollar. But several suits went to trial, including one brought collectively by Welch’s, Younkers and C.R. Anthony, another Midwestern retailer. In their complaint, they charged Goldman with “fraud, deception, concealment, suppression and false pretense” in the sale of the commercial paper to them. They claimed that the firm had “made promises and representations as to the future which were beyond reasonable expectations and unwarranted by existing circumstances,” and had made “representations and statements which were false.”

Incredibly, Goldman thought it could win the lawsuits and allowed them to go to trial, where much of the firm’s dirty laundry was aired. In the end, it lost the suit brought by the three companies and paid the plaintiffs 100 cents on the dollar, plus interest.

More important, the firm’s partners were petrified that with more than $80 million in potential claims against it and only $50 million in partners’ capital, continued lawsuits could put Goldman out of business, taking everything the partners had earned over the years with it.

“There was real fear that the liability for the Penn Central lawsuits could put the firm under,” Robert Rubin, a former co-senior partner at Goldman and a former Treasury secretary, told me. (Rubin became a partner at the firm in December 1970.) “People were really deeply worried that the firm and their net worths were going to be gone. They were surprised by the dangers lurking in the firm’s commercial paper business. They weren’t traumatized, but they were deeply worried. Deeply worried.”

In the end, the firm squeaked through the crisis, thanks to a combination of good luck and an assortment of insurance payments and settlements. It also held on to the Penn Central commercial paper it took back from its clients through the company’s bankruptcy until it regained its value.

Anyone who watched the 11-hour evisceration of Goldman’s top executives by Sen. Carl Levin’s Permanent Subcommittee on Investigationsin April 2010 will immediately recognize similar greed and self-dealing in the Penn Central incident as in the months leading to the 2008 financial crisis, when Goldman made a huge bet against the mortgage market in December 2006 — netting the firm $4 billion in profit — while it continued to sell mortgage-backed securities to its customers at 100 cents on the dollar. Only the amounts were different: millions at stake in 1970 vs. billions in 2007.

So, by the time Greg Smith started picking up on Goldman’s duplicitous behavior, the firm’s culture had been long established. What took him so long to figure it out? Goldman’s culture is no different now than in 1970 — or even in 1928, when it created the Goldman Sachs Trading Corporation, a notorious Ponzi scheme(that’s a whole different story).

Perhaps Smith’s youthful enthusiasm to join Goldman Sachs and become part of Wall Street’s elite blinded him to the firm’s history. For all the venom he has now focused on Goldman, he probably drank the Kool-Aid for most of his time there and still seems convinced that it had been a unique and special place — a place to which he could recruit young talent — until the firm’s values only recently eroded.

In that misconception, he has not been alone. Presidents of both parties have been similarly blinded by the Goldman mystique, appointing Treasury secretaries with Goldman pedigrees, to say nothing of various White House chiefs of staff and officials throughout the federal government.

The shocking thing about many Goldman Sachs employees — including Smith, apparently — is that they actually think the firm intends to live by the 14 principles that former partner John Whitehead, now 90 years old, sketched out on a yellow pad of paper one Sunday afternoon a generation ago. Whitehead said he wanted to emphasize what made Goldman a “distinctive” and “unique place to work” without “sounding too schmaltzy.”

Principle No. 1: “Our clients’ interests always come first. Our experience shows that if we serve our clients well, our own success will follow.”

But some Goldman executives, perhaps more cynical, have seemed to understand well that the truth about the firm does not resemble its public relations material. As for putting clients first, former Goldman partner Pete Briger used to say around the trading desk, “Yeah, and when we do, make no mistake about it, it’s a business decision.”

wdcohan@yahoo.com

William D. Cohan, a columnist for Bloomberg View, is the author of “Money and Power: How Goldman Sachs Came to Rule the World.”

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