What Congress Doesn't Know About Wall Street

Congress is appropriately grilling Goldman Sachs executives on the mortgage debacle which helped to create the financial crisis. The practice of Wall Street has been and is to create products in the mortgage market, the equity market, the bond market, the loan market and many other markets. We have had many years of experience with the workings of Wall Street. The interesting facts that are not being discussed in these hearings is how the business actually works. Institutional investors expected investment banks to perform due diligence on New Issue Product. In this capacity, the underwriter is expected to analyze the deals to make sure no fraud is involved.

In aggregate, institutional investors looking at a deal will come to a consensus as to whether they like a deal or not. On the other hand, there is a wide range of buyers along the risk spectrum. Some investors are very conservative in the way they manage money and will only buy high quality securities in an extremely diverse portfolio. Others take a high risk, high reward approach. Such investors might only buy the riskiest securities that might produce out sized returns.

The approach Wall Street takes is to find the group of investors that is most appropriate for the risk of each specific transaction. In this light, the role of the institutional salesperson has been to provide his/her client with product that fits its strategy. As Congress pointedly asks the Goldman employees if their job is to look out for the interests of their clients, the Goldman response has been blank stares while not answering the question. The true answer is their responsibility is to provide product that meets the risk posture of each client as long as they knowingly are not selling them financial instruments that were created with fraudulent intent.

Congress wants Goldman and all other Wall Street firms to have their institutional traders and salesmen to act in a similar manner as they do with retail mom and pop clients. Many times institutional investors have differing opinions from Wall Street firms. As such, they are happy to buy securities being shorted by Wall Street. In the heyday of the mortgage market as well as in the heyday of the LBO frenzy, many institutional investors were aggressively trying to invest hordes of cash in their portfolios. In these situations, investors may have increased their risk tolerance and bought many securities that ultimately decreased in value or became worthless. Does such behavior and desires of sophisticated investors mean that Wall Street misled their clients?

The Misguided Financial Reform Bill

We have written before about our concerns and dislikes for the Financial Reform Bill proposed by Senator Chris Dodd. We continue to believe that the focus should be on reducing leverage of Wall Street firms to limit Too Big To Fail dramas of the future. Derivatives are clearly a focus of the bill and the current Goldman Sachs Mortgage investigation has elevated this issue to not only Congress but Main Street's average Joe. We would argue that there may be some moral and ethical issues to address but a synthetic security by definition needs a buyer and a seller. The seller needs to be someone shorting the securities. As such, the government argument about ACA and the German Bank not being aware of Paulson's involvement is irrelevant. For 25 years on Wall Street, we strictly adhered to the unwritten rule that nobody disclose the name of the buyer or seller of a financial transaction. This was sacrosanct to keeping the trust of customers. As for Mr. Paulson, he was an unknown hedge fund manager in 2006 when he was loudly saying the mortgage market was going to crumble. Nobody cared what he was preaching and in fact, it wouldn't be surprising if many buyers of mortgages were happy to be on the other side of one of his trades. Congress needs to rewind the clock and realize Mr. Paulson is famous today as he was absolutely correct with his analysis of the mortgage market and made billions in the process. However, in 2006 and 2007, he was just a name and he preached the future that most investors, Wall Street experts, and congressman didn't want to believe.

We are quite troubled with the provisions in the Bill which relate to Angel investing. For 20 years we have been active Angel investors in start-up companies. Some of those enterprises failed but many have grown and flourished. Our small universe of investments have resulted in thousands of new jobs as well as some new technologies that have driven commerce in the United States. Each of the thirty or so companies we have financed started as business plans and ideas for a business of the future. These fledgling businesses have no sales and certainly no earnings. As such, banks do not give loans to such enterprises. The entrepreneurs only hope is to find wealthy individuals (using the Obama definition) to supply venture money to fund the initial stages of their businesses. Typically an entrepreneur writes a business plan and sets out to find some individuals to give him/her some money to get this business off the ground. It could take a year or two in some cases until capital is raised to buy computers, rent space, and hire a few emplyees to test the new business idea. The good news is that small businesses under five years of age generated all new job growth between 1980 and 2005.

Given these facts, how could the Dodd Bill create new restrictions on Angel Investing? The Wall Street Journal recently had an Opinion similar to ours on this topic. Amazon, Facebook, Twitter, and Google were products of Angel investors. Does anyone believe these companies have created problems during the Financial Crisis? Start-up businesses beg to find any capital and take the money when an investor offers it to them. The new restrictions in the Bill would require an SEC review of these angel investments and delay the start of the funding for 120 days. This is ludicrous and will likely cause many of those companies to fail before they get off the ground. The ignorant policy makers need to understand that the U.S. economy is driven by small business and employment depends on the success of entrepreneurs' dreams. The Bill also wants start-ups to be regulated by all 50 states and for the angel investors' financial means to be increased. Congress should stick to the real problems facing the stability of the financial system. Whoever gave Senator Dodd the idea to restrict Angel investing needs to understand the facts of entrepreneurialism. Hopefully, Mr Dodd and Congress will come to their senses and allow fresh ideas to become the technologies and business ideas of the future.