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?