Authors: Steven G. Mandis
What Happened to Goldman Sachs: An Insider's Story of Organizational Drift and Its Unintended Consequences (10 page)
Financial Interdependence and Risk Management
As a private partnership, if Goldman suffered large trading losses, lost a lawsuit, or received fines for criminal or illegal practices, then the partners were personally liable. Their equity was at risk every day. Even with the protection afforded personal assets by the LLC structure, which Goldman changed to in 1996, partners still faced the risk of losing their invested capital, which for many represented the bulk of their wealth.
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When one’s own money is at stake, management of risk, both financial and reputational, is a key concern.
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According to the partners I interviewed, managing risk for one’s entire net worth, and that of all the partners, brings a higher level of intensity than managing risk for shareholders and a longer-term orientation than today’s typical three-to-five-year equity vesting period. That is probably why, in Goldman’s own accounts of its culture, risk management often is not included: it was so obviously a no-brainer that it was assumed.
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As mentioned earlier, Peter Weinberg stressed this issue in his
Wall Street Journal
op-ed, “right down to their homes and cars,” noting that “[t]he focus on risk was intense.”
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The firm’s culture and principles, combined with the partners’ financial interdependence and the risk to their own capital, ensured that collective risk management and reputational risk management would be a priority. The structure of Goldman’s pre-IPO partnership resulted in financial interdependence and a social network of trust, virtually ensuring teamwork and dissonance; in turn, the business practices, policies, and values supported it.
Part Two
DRIFT
Chapter 4
Under Pressure, Goldman Grows Quickly and Goes Public
A
T A GOLDMAN PARTNER MEETING, THE STORY GOES, A SENIOR
partner asked the new partners to identify the two men who were most important to the firm’s business. The new partners responded with last names: Goldman, Sachs, and Weinberg. The senior partner then revealed the answer: Senator Carter Glass and Representative Henry Steagall.
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Congress passed the Glass–Steagall Act (formally known as the Banking Act of 1933) to provide Depression-era deposit bank customers protection against the additional risks involved in trading and investing.
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Its intent was to separate the consumer deposit–based commercial banking industry from investment-banking activities by prohibiting well-capitalized commercial banks from getting involved in the securities business. It also had the unintended effect of protecting the profitable underwriting business of the investment banks.
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The act explains why both a J.P. Morgan and a Morgan Stanley now exist.
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J.P. Morgan had to spin off its investment banking business, creating two entities: J.P. Morgan became the commercial bank, whose business was deposits and lending, and Morgan Stanley was spun off as the investment bank, handling the securities and underwriting businesses.
However, in 1999 the act was repealed. Such deregulation and other external pressures—such as competition and technology—as well as pressures from within the organization, had a transformative effect on how Goldman did business and on the organizational culture. From then on, Goldman had to compete more vigorously for scarce resources—capital, talent, clients, reputation, and more—against larger, publicly traded competitors (discussed later). In addition to having limited personal liability or capital constraints, these publicly traded competitors had more, and permanent, capital and didn’t espouse the same business principles or have the same financial interdependence.
These combined pressures had one major effect: the leaders of Goldman felt that the firm needed to grow—and grow fast.
I have had lengthy, spirited philosophical discussions with Goldman and McKinsey partners about growth. Growth in itself is not a bad thing. But as Goldman navigated its environment, the rapid pace of its growth had dramatic (and often unintended or unanticipated) consequences—many of which were not fully understood inside the firm or out—and they compounded over time. In essence, Goldman’s response to the various pressures in a dynamic environment—in particular, rapid growth—made it even more difficult to notice that the firm was drifting away from its traditional interpretation of its principles. The rapid growth, combined with multiple, conflicting organizational goals, resulted in a series of many small everyday decisions happening so quickly that most people didn’t notice (or were too busy to notice, or didn’t care).
Regulatory Pressures
A great many rules and regulations govern banking in the United States: the Glass–Steagall Act, the Sarbanes–Oxley Act, exchange rules, and so on.
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I focus here on the key regulatory changes that had a particularly strong influence on Goldman.
Public Trading of Investment Banks in 1970
Even before the repeal of Glass–Steagall, Goldman was facing increasing competitive and other pressures, and those combined pressures led ultimately to the decision to go public, which the partners voted to do in 1998, before the act’s repeal (the IPO didn’t actually happen, though, until 1999). Much emphasis has been placed on how the IPO affected Goldman’s culture, and that’s true, but the organizational drift had started well before that. Goldman had been feeling the increasing heat of competition and other external forces for years.
The public listing of investment banks is a relatively new development. Investment banking, for most of its history, was conducted by firms organized in partnerships. But before the 1970s, some partnerships decided they wanted to go public to raise capital, reduce the risk of loss of partner capital, and improve liquidity, sparking a significant change in the organizational structure of the banks.
In 1970, the NYSE repealed provisions that had prevented publicly listed companies from being members of the exchange, and the floodgates opened. That year, Donaldson, Lufkin & Jenrette was the first to list on the exchange, with Merrill Lynch, Reynolds Securities, and Bache & Co. following in 1971. Salomon Brothers listed a decade later, and Morgan Stanley went public in 1986. Goldman, in 1999, was the last major full-service investment bank to be publicly listed.
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Goldman followed much later for two key reasons: first, unlike most of the others, it had no retail banking business, wherein banks deal directly with consumers on smaller transactions like mortgages and personal loans rather than big institutional clients or corporations executing large transactions. Second, Goldman didn’t distribute the firm’s profits to partners annually, as the others did. The differences between Goldman and the others were illuminated by a 2004 study by Alan Morrison and William Wilhelm Jr.
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In the decade before the banks started to go public, because of increasing technological and regulatory pressure to scale up (an example of the interrelationship between these pressures), those with retail business units increased the number of partners, the capital employed per partner, and the number of employees per partner, according to the study. They also needed to raise considerable sums to invest in computers and data management technology to facilitate faster handling of administrative activities to support the smaller size, but higher volume, of transactions.
Going to the market (to the outside equity capital markets or private investors) to raise this cash was considered the best, if not the only, option. Without outside capital, the only ways to infuse new capital into a partnership were to admit more partners or to increase the amount of capital contributed by each new partner (while balancing the retiring partners’ capital withdrawals). Each approach has limits. Also, because these banks typically distributed their profits to the partners annually, they had less capital to work with. Going public offered the cheapest cost of capital, because equity investors in the public markets were willing to receive a lower return on their capital, in part because their investments are so liquid, than private equity investors. But it was appealing for one other crucial reason. Under a partnership model, all partners are personally responsible for all the firm’s liabilities. As a public corporation, it is all of the shareholders who are liable (and liability is not personal liability).
According to interviews I conducted, Morgan Stanley had no retail banking at the time, but it generally distributed a meaningful portion of its profits to partners annually, and this meant that it faced pressure to go public earlier than Goldman. As a Goldman partner explained to me, because Goldman required partners to keep their capital in the firm until they retired, the firm had more capital to invest to stay competitive.
In 1986, when Morgan Stanley went public, Goldman had about $1 billion of equity capital, twice that of Morgan Stanley. Even so, the competitive and other pressures were such that the Goldman partners gave consideration to an IPO at that time. The first serious proposal to go public was presented by the management committee at Goldman’s partnership meeting that year. It was championed by Bob Rubin and Steve Friedman, who at the time were on the management committee, and it was met with serious opposition from the partners. John L. Weinberg distanced himself from the proposal, remaining silent during the meeting. After Jimmy Weinberg spoke against it in the meeting, it was not brought to a vote.
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Although the proposal was set aside, it was clear from the meeting that Goldman’s decision to expand to pursue a global business strategy “placed additional capital pressures on the firm, making its remaining a partnership less and less feasible.”
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In my interviews, however, some partners said the firm had enough capital at the time to fund international expansion, albeit at a slower pace, or that it could continue to take outside private capital. Although outside private capital was more expensive than capital from the public markets, it would allow the firm to stay a private partnership.
Ultimately in 1986 the partners decided to accept a $500 million private outside equity investment from Sumitomo Bank in exchange for 12.5 percent of the firm’s annual profits and appreciation of equity value. The deal with Sumitomo was appealing because, according to the terms of the deal and the Bank Holding Act of 1956’s preclusion, Sumitomo could not have any voting rights or any influence over the firm’s operations.
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Goldman was growing rapidly in both size and complexity at this time. The firm ballooned from a few thousand people in a few offices in 1980, to thirteen thousand at the time of the IPO, with much of that growth overseas. At the time Whitehead codified the firm’s values, Goldman’s business was entirely within the United States. It was strictly a New York firm. By 1996, international employees constituted 35 percent of Goldman’s workforce. Further, the total number of international employees was now larger than the total number of employees in the previous decade.
In 1987 a member of the management committee voiced a common opinion: “Everyone is uncomfortable with the rate of growth. We all feel that if we don’t keep expanding, we’ll lose our position. But if we keep growing at a certain rate, we’ll lose control.”
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As early as the late 1980s and early 1990s, Goldman was having meetings, even hiring a consulting firm, to discuss the consequences of hypergrowth.
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However, Goldman’s growth was phenomenally successful. Earnings nearly doubled between 1990 and 1992, funding the opening of new offices in Frankfurt, Milan, and Seoul. In 1992, the Kamehameha Schools/Bishop Estate, a Hawaiian educational trust, invested $250 million for around a 5 percent stake.
In 1994 Goldman suffered big trading losses and the unprecedented wave of resignations among the partners that followed, starting with the sudden resignation of then senior partner Steve Friedman, who cited health reasons. Making Friedman’s departure all the more disruptive and unsettling was that it followed Bob Rubin’s abrupt resignation after a short tenure (1990–1992) as co-senior partner with Friedman to become assistant to President Clinton on economic policy. Friedman had refused to accept a co-leader in running the firm and left the choice of successors in the hands of the management committee.
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Almost every partner I interviewed who worked at the firm in 1994 said that, in hindsight, the sudden departures of Friedman and Rubin, who had been handpicked by Weinberg and Whitehead to lead the firm, had significant unintended consequences for Goldman. Some even believe that the timing, circumstances, and handling of the departures caused a greater impact on culture than the IPO and were one of the main reasons behind the IPO itself.
The 1994 departures also raised serious issues of trust among the partners. In addition to the senior partner, almost one-third of the other partners retired, giving their capital preferential treatment and more protection than that of the general partners who stayed and allowing the retirees to begin cashing out their capital. The resignations would remove hundreds of millions of dollars of partners’ capital from the firm, requiring a larger influx of new partners than in the past. This situation upset what had been a stable, cohesive group that traditionally had seen just enough partner turnover to balance junior and senior partners. The fifty-eight new partners, the largest partner class Goldman had ever announced, now also formed a large voting bloc on key firm decisions, and they had just seen the firm at its worst with the old partners jumping ship.
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Discussing the resignation of a senior partner who had been running the financial institutions group and was generally considered one of the most knowledgeable about the financial sector and the firm’s prospects, one partner expressed the sentiment of many of them: “Aren’t these the guys that I’ve been slaving with—not for? I mean really working hard with for a long time, and they are quitting? I don’t get that. How can you leave? I mean, just how does that square? When it gets tough, you are supposed to get tougher.”
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Based on the accounts of partners at the time, when the old guard—many of them viewed as culture carriers—started bailing and looking out for themselves, it shook the belief in the core values and principles of the firm. The resignations caused people to think more about themselves, their own interests, and their own personal ambitions—and materialism began to grow.
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With Friedman’s sudden resignation and no succession plan, a fierce power struggle ensued, increasing the instability and prompting personal reflection.
Corzine, a trader in the FICC department who also had a CFO-type role (which at the time was typically the head of fixed income and chief risk allocator), aggressively announced to the management committee that he wanted to be senior partner (and be given the title of CEO) and for Paulson to be the number two, with the title of COO. In recent memory there had always been co-head senior partners, reflecting a culture of teamwork. There were “the two Johns” and then “Steve and Bob.” Many divisions and departments had co-heads. The firm had never had CEOs or COOs (it had senior partners or co-senior partners); the CEO title didn’t make sense in the context of a partnership (it typically was used in public corporations with a hierarchy and organization charts). Although the people with the senior partner titles were everyone’s bosses, everyone on the management committee had a vote, so no one person could dictate.
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In the end, Corzine got what he pushed for. Paulson did not have enough support on the management committee to push for a co-senior partner role. Some people said it was in part because Paulson was not based in the New York office 100 percent of the time and lacked experience in trading, where the greatest profits and risk were. But the partners I interviewed said that they recognized the need for a balance or compromise between banking and trading (and a few said they needed someone to “watch” Corzine, who they worried could be too aggressive). In hindsight, partners said, the precedent of having no co-senior partner, along with the power struggle, sent a poor message to the troops, especially in view of the defections.
Interviewees explained that once he became CEO, Corzine convinced some partners to stay, rather than retire, by leading them to believe they would get rich when the firm went public in the near future.
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For a variety of reasons—including alleged promotion promises, guilt, and John L. Weinberg’s pleading—more partners stayed than initially had been predicted. But they told me the trading losses, combined with the defections, dramatically affected the culture.
In addition to significant trading losses in 1994, throughout that year the firm worked to settle suits with a number of pension funds related to Goldman’s involvement with publisher Robert Maxwell.
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Eventually it was settled for $253 million.
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This cost was borne by those who had been general partners between 1989 and 1991, and the size of this settlement surprised many of them.
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A November 1994 AP article made this prediction: “The general partners may find themselves sitting with a smaller capital account at year’s end than they had starting off. That rude and unfamiliar prospect explains why persistent rumors have been circulating on Wall Street that Goldman’s management has recently put pressure on the firm’s general partners to ante up additional capital. (One partner’s capital account was reportedly wiped out completely.)”
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Layoffs were announced for traders, analysts, and support staff.
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An unintended consequence was the emergence of “a culture of contingency … a sense not only that each day might be your last, but that your value was linked exclusively to how much revenue was generated for that firm on that day—regardless of its source.”
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Between 1987 and 1994, the firm had downsized six different times in different divisions in response to different earnings.
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Despite the instability, the partners opposed going public at the time. It was commonly thought, however, that there was an IPO in Goldman’s future: “Down the road Goldman will surely revisit the idea of going public, thereby gaining permanent capital. But Corzine has said that a stock offering isn’t ‘practical’ right now. You need profit updrafts, not downdrafts, to go public.”
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Goldman had been stressed by the events of 1994; it would recover, but the partnership showed signs of vulnerability.
Goldman’s problems at that time were not related only to costs and “bad bets”; one partner noted, “[A] culture of undisciplined risk taking had built up over many years.”
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That same partner named other “stuff [that] built up,” such as “the lack of a risk committee, trusting individual partners, model-based analytics, [thinking] that by God, you can be smart and figure it all out, and letting traders become too important and being afraid to confront them if they’ve been money makers.”
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When I asked partners about this, they said the statement was probably relative. They admitted that changes in business practices needed to be addressed, but they believed Goldman was still much better than its competitors. And, more importantly, the adjustments to the losses helped Goldman “strengthen” its risk management culture, and that is one reason Goldman did better than its competitors in the credit crisis, discussed later.
