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CHAPTER 1
Is Greed Good'
In 2008, on the eve of the global financial crisis, Drexel University used the pomp and circumstances of its annual commencement ceremony to confer an honorary degree on one of Wall Street's most famous investors.
Carl Icahn had amassed a fortune estimated at $17 billion by buying large positions in companies he considered badly managed, then using his ownership position to force managers and directors to take whatever steps he deemed necessary — shutting plants, selling off divisions and assets, slashing worker pay and pensions, reducing investments, buying back shares — to boost the companies' stock prices and allow him to sell out at a handsome profit. The strategy was so effective that just the news that Icahn had taken an interest in a company could boost the stock price by 10 percent. His targets have included Trans World Airlines, U.S. Steel, Phillips Petroleum, Texaco, Time Warner, eBay, Yahoo!, Apple and, most recently, Xerox.
When he started in the mid-1980s, people like Icahn were referred to pejoratively as "corporate raiders," "greenmailers" and "asset strippers," sneered at by the business press, criticized by business school professors and shunned by the business establishment. It should tell you how much our sensibilities have changed that Icahn is now commonly referred to as an "activist investor," lionized on the cover of Time magazine as a "Master of the Universe" and celebrated with an honorary degree.
"As a leading shareholder activist, Mr. Icahn believes his efforts have unlocked billions of dollars in shareholder value," Drexel's president declared in awarding him an honorary doctorate of business administration, awkwardly sidestepping the question of what Drexel believed. To nobody's surprise, there was no mention of the hardball tactics Icahn used to unlock all that shareholder value and amass his personal fortune. Rather, the citation went on to praise Icahn's generosity in giving away a portion of that fortune to benefit the sick and the homeless.
As the philosopher Charles Karelis has observed, academic ceremonies like the one that played out in Philadelphia — what was said as well as what was left out — perfectly illustrate the moral paradox of free market capitalism. The financier celebrated that morning had played an outsized role in an economic system that had conferred on every member of that day's graduating class a standard of living well beyond the reach of those still trapped in societies where free market capitalism does not exist. Yet despite those incalculable benefits, we are reluctant to praise the self-interested traits and aggressive tactics that have been vital to the success of that system. If such traits and tactics are not vices, we don't exactly view them as virtues, either.
Among the first to note this moral paradox between what he called "private vices and publick benefits" was Bernard Mandeville. Born in the Netherlands in 1680, Mandeville studied medicine and philosophy at Leiden before moving to England, where he found both popularity and controversy as a writer. Mandeville's most famous work was The Fable of the Bees, which told of a flourishing hive of bees that, though relentless and sometimes dishonest in their individual pursuit of self-interest, had achieved a level of collective comfort and pleasure in which "the very poor liv'd better than the rich before." The industrious bees, however, were not content merely to enjoy their luxurious new paradise — they begged the gods for a more selfless virtue. So Jove grants them their wish to rid themselves of all their selfish vices, and almost immediately the bees discover that they are no longer driven to compete with each other. Their prosperity disappears, apathy sets in and the hive is left vulnerable to a devastating attack. The few bees that survive take refuge in the hollow of a tree where their newfound virtue and thrift condemn them to a simple, impoverished existence.
Mandeville said his intent was to "shew the Impossibility of enjoying all the most elegant Comforts of Life that are to be met with in an industrious, wealthy and powerful Nation, and at the same time be bless'd with all the Virtue and Innocense that can be wish'd for in a Golden Age." Three hundred years later, this dilemma still confounds. We are still looking for a way to reconcile our moral distaste for the ruthless pursuit of self-interest with our admiration and appreciation of the benefits it generates.
Amorality on Wall Street
Nothing captures this ambivalence about capitalism better than Wall Street, which for many has come to represent all that is right and all that is wrong with the free market economy. And no firm has come to epitomize the Wall Street ethic more than Goldman Sachs. In the years leading up to the recent financial crisis in 2008, Goldman was the most respected and profitable of the Wall Street investment banks. Two of its chief executives had served as secretary of the Treasury. Its bankers and traders were thought to be the smartest and toughest on Wall Street. So coveted was a seat at Goldman's table that, at one point, more than half of the graduating seniors at some of the country's most prestigious colleges signed up to be interviewed by a Goldman recruiter.
By April 2010, however, seven of Goldman's top executives found themselves testifying before the Senate Permanent Subcommittee on Investigations, which had spent two years poring through the firm's internal documents to determine what role Goldman had played in the financial crisis.
In the years leading up to the crisis, Goldman had made billions of dollars packaging residential and commercial mortgages into bond-like financial instruments and selling them to hedge funds, pension funds, insurance companies and other sophisticated investors — a process known as "securitization." When investor demand for these securities began to outstrip the available pool of mortgages that could be packaged, Goldman led the way in creating "synthetic" securities whose value tracked that of the real thing — in effect, allowing more people to invest in the mortgage market than there were actual mortgages for them to buy. And when investors wanted to protect themselves against the risk that these securities might someday fail to deliver on their promised cash flow, Goldman made it possible for them to hedge their bets with an instrument that amounted to an insurance contract known as a "credit default swap."
All of these activities put Goldman at the center of what came to be known as the "shadow banking system" that, by the first decade of the twenty-first century, had become larger than the traditional banking system. The shadow banking system flooded the economy with cheap credit, inflated real estate prices and sent Wall Street profits and bonuses to levels never before imagined. By 2007, however, there were some who were beginning to realize that many of the original loans should never have been made, that the prices of the securities and the real estate that backed them were unsustainable and that the credit bubble was about to burst.
One such skeptic was a hedge fund manager named John Paulson, who began looking for a way to profit from the market's inevitable collapse. Paulson called Goldman and asked if the bank would be willing to create a security backed by a basket of particularly risky subprime loans so that he could buy credit default swaps tied to that security — swaps that would generate handsome profits if, as expected, those securities failed to pay off. Paulson was a big Goldman client, so the bank was not only willing to accommodate his request but even allowed his associates to recommend specific mortgages for the package.
Until the 1980s, investment banks would compete to demonstrate to clients how trustworthy they were, and in that earlier era, the Goldman name was the gold standard. As the firm's legendary senior partner Gus Levy famously put it, Goldman meant to be "long-term greedy," never cutting corners to earn a quick buck and always putting clients' interests before the interests of the firm. When a blue-chip firm like Goldman put its name on a securities offering, it was a signal to investors that the partners at Goldman were giving it their own seal of approval. It wasn't necessarily a sure bet — nothing in finance is — but you could rest assured that it was an honest bet.
By 2007, however, the time horizon for Goldman's greediness had significantly shortened. Goldman was now willing to create for one client a security that was designed to fail, and then peddle it to other clients who were unaware of its provenance. The old presumption that an investment bank staked its reputation on the securities it underwrote had become a quaint anachronism.
Goldman's duplicity, however, went far beyond that one security. For by that time Goldman, too, had concluded that the real estate market was about to crash and began quietly scrambling to reduce its own housing risk. Even as it was moving to protect its own portfolio, however, Goldman's bankers were continuing to underwrite and sell new securities that its executives knew were backed by some of the dodgiest mortgages from some of the dodgiest lenders.
In January 2007, Fabrice Tourre, a Goldman vice president, wrote an email to a friend that would later be unearthed by Senate investigators: "The whole [edifice] is about to collapse any time now. ... The only potential survivor, the Fabulous Fab, ... standing in the middle of all these complex, highly leveraged exotic trades he created without necessarily understanding all the implications of these monstrosities!!!"
At the Senate hearing, incredulous senators, Republican and Democrat, demanded to know why Goldman executives had sold securities to valued clients that even their own employees had characterized as "crap." The men from Goldman, however, were equally incredulous, failing to see why anyone would think there was anything wrong with what they did. Their answers were defensive, nitpicky and legalistic, and no purpose would be served by quoting them here. But if you will allow me a little license, here is a concise rendition of what they meant to say:
Senators, we operate in complex markets with other knowledgeable and sophisticated traders who spend all day trying to do to us what we do to them. What you find so strange or distasteful is, in fact, how the game is played.
In our world, in order for there to be a transaction, people must disagree about the value of the thing they are trading. The buyer thinks the price will go up, the seller thinks it will go down. Only one of them can turn out to be right. Finance is largely a zero-sum game — for every winner there is a loser.
As the middleman in these transactions, what Goldman or any of its 35,000 employees happens to think about a security is irrelevant. It's not for us to judge whether they are "good" or "bad" — it's for the market to do that. And the way the market does it is by determining the price. At $100, a bond might be a bad investment, but if you pay $10 for it, it could be quite good. If our sophisticated clients want to take housing risk, or oil price risk, or interest rate risk — or if they want to hedge those risks — our job is to help them do that by finding somebody to take the other side of the bet, or by taking it ourselves.
As underwriters, market makers and buyers and sellers of credit insurance, we are constantly on the other side of transactions from our customers. In doing that, we are merely cogs in a marvelous system that efficiently allocates the world's investment capital at the lowest price to those who can put it to the highest and best use, making us all better off. Within that context — a context well understood by our customers, our competitors and our regulators — we did nothing wrong and we have nothing to be ashamed of.
To those watching the exchange, it was as if the politicians and the financiers were from different planets. The senators imagined they were living in a world of right and wrong, good and bad, in which bankers owed a duty of honesty and loyalty to their customers and to the public that obligated them not to peddle securities they knew to be suspect. The men from Goldman, by contrast, came from an amoral world of hypercompetitive trading desks in which customers were "counterparties" and there was no right or wrong, only winners and losers.
"We live in different contexts," Goldman chief executive Lloyd Blankfein told committee chairman Carl Levin, who at the outset of the hearing had chastised the bankers for their "unbridled greed." For hours, as almost everyone on Wall Street sat glued to their screens watching the drama play out, the two sides continued to talk past each other until an exasperated Levin finally gave up and gaveled the hearing to a close.
Over the next five years, the Justice Department and the Securities and Exchange Commission would extract record fines of $5.6 billion from Goldman, along with a grudging acknowledgment that it had knowingly misled its customers. Similar settlements, amounting to almost $200 billion, were reached with all the major banks. Yet through it all, Wall Street has continued to reject accusations that it did anything wrong, or that its practices and culture are fundamentally unethical or immoral.
"Not feeling too guilty about this," Tourre emailed his girlfriend in January 2007. "The real purpose of my job is to make capital markets more efficient ... so there is a humble, noble, and ethical reason for my job." But then, after inserting a smiling emoji, he added, "Amazing how good I am [at] convincing myself!!!"
Tourre, who reportedly earned annual bonuses as high as $2 million during his decade at Goldman, would later be convicted of six counts of civil fraud and fined $825,000. As the only Wall Street executive brought to justice in the wake of the 2008 crash, the young Frenchman became a symbol — some would say a scapegoat — of the financial crisis. After leaving Goldman, Tourre took up graduate studies in economics at the University of Chicago, where he was scheduled to teach an undergraduate honors seminar. Once word of his appointment leaked out, however, embarrassed university officials dropped him as the instructor.
The Hijacking of Adam Smith
That Fabrice Tourre chose to retreat to the University of Chicago was only fitting. Since the days of Nobel laureates Milton Friedman, George Stigler and Gary Becker, Chicago has become the Vatican for an economic ideology based on a holy trinity of self-interest, rational expectations and efficient markets. In time, this ideology came to be widely embraced on Wall Street and in the business community, providing an intellectual justification not just for lower taxes, less regulation and free trade, but also hostile corporate takeovers, outsized executive compensation and a dramatic rewriting of the social contract between business and society.
The man held out as the patron saint of this ideology was the eighteenth-century Scottish philosopher Adam Smith. In his most famous work, An Inquiry into the Nature and Causes of the Wealth of Nations, Smith demonstrated that our "disposition to truck, barter and exchange," driven by self-interest, had allowed millions of farmers, artisans and laborers to escape grinding poverty.
"It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest," he wrote in one of the most famous passages in all of economics. "We address ourselves not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages."
Smith's great insight was that as each of us goes about selfishly enhancing our own wealth, we unintentionally but magically — in his words, "as if led by an invisible hand" — wind up enhancing the wealth of everyone else.
In pointing out the social utility of selfishness and self-regard, Smith was well aware of Bernard Mandeville's fable of the bees. He was also drawing on more than a century of thinking by Enlightenment thinkers who rejected the traditional Catholic notion that wealth could only be acquired through evil and exploitation.
"It is as impossible for society to be formed and lasting without self-interest as it would be to produce children without carnal desire or to think of eating without appetite," Voltaire wrote. "It is quite true that God might have created beings solely concerned with the good of others. In that case merchants would have gone to the Indies out of charity and the mason would have cut stone to give pleasure to his neighbor. But God has ordained things differently. Let us not condemn the instinct."
Looking back on centuries of war driven by religious zealotry, Voltaire saw in our commercial tendencies a better foundation for peace and social order. And it was Smith's great friend and mentor David Hume who wrote of the civilizing effect of wealth in an essay celebrating luxury.
(Continues…)
Excerpted from "Can American Capitalism Survive?"
by .
Copyright © 2018 Steven Pearlstein.
Excerpted by permission of St. Martin's Press.
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