12/10/12 Want to Improve Goldman Sachs? Convert it Back into a Partnership - Forbes

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Former Goldman CEO Jon Corzine. Image by

AFP/Getty Images via @daylife

Greg Smith, a former executive

director at Goldman Sachs, is

making waves today with a blunt

op-ed in the New York Times, in

which he says that he is resigning

from Goldman Sachs because the

bank’s culture has mutated into

one of “ripping…clients off” from

one of putting its clients first. Those

who think that banking and finance

are inherently corrupt are already

describing Smith’s op-ed as a kind

of Thomas Paine-like call to arms against the institutions of high finance. But

banking’s populist critics are glossing over a question that Smith doesn’t even

address: if Goldman Sachs has indeed changed, why has it changed?

I’ve worked at J.P. Morgan, but not Goldman Sachs, so I have no personal

insight into whether or not Smith’s critiques of Goldman are accurate.

Usually, when you leave an investment bank, you sign a severance agreement

in which the bank agrees to pay you some nominal amount, in exchange for

your promise not to say anything bad about the bank in public. So, in Smith’s

case, either the money was not enough, or he didn’t care. Cynics on Twitter

are already suggesting that Smith is attacking his former employer because he

didn’t get promoted to managing director.

The old Goldman, says Smith, “revolved around teamwork, integrity, a spirit

of humility, and always doing right by our clients.” The new Goldman, he says,

is about doing “whatever will bring the biggest profit to Goldman,” even if that

goes against the interests of its clients. I’m not in a position to say if this is

really true. But let’s assume for the sake of argument that Smith’s criticisms

are sincere and accurate.

Smith blames the current Goldman CEO, Lloyd Blankfein, and its president,

Gary Cohn, for losing “hold of the firm’s culture on their watch.” But the real

culprits are Goldman’s 1990s partners, led by Hank Paulson and Jon Corzine,

who in 1999 converted the venerable bank from a 221-member partnership

P HAR MA & HEALT HC AR E | 3/14/2012 @ 11:51AM | 1,862 views

Want to Improve GoldmanSachs? Convert it Back into aPartnership

Avik Roy, Contributor

The Apothecary is a blog about health-care and entitlement reform.

into a publicly traded company.

There is a huge difference between Goldman Sachs, the partnership, and

Goldman Sachs, the publicly-traded entity. If you’re a partner at an

investment bank, your incentives are long-term-oriented. You’re going to be a

partner for decades, and you know that you stand to be best rewarded by

maintaining the loyalty of your best clients. This incentive, in turn, leads you

to want to take pride in your work, as something that is about your clients,

rather than about short-term moneymaking.

On the other hand, Goldman the publicly-traded entity is owned by its

shareholders, who demand quarterly profits. A bank that is oriented towards

quarterly profits is going to put short-term financial incentives above the

long-term interests of its clients. When it comes to investment banks, not all

profit motives are created equal.

Goldman’s 1990s partners did just fine. At the time of the Goldman IPO, the

largest partnership interest belonged to Jon Corzine. Corzine converted his

0.9 percent partnership interest into $305 million. But Goldman’s clients

were not as well-served by the change.

Goldman wasn’t the first major investment bank to convert from a

partnership into a public company. Indeed, it was one of the last. It was John

Gutfreund, the former kingpin of Salomon Brothers, who pioneered the

conversion of investment bank partnerships into public corporations. Indeed,

one can make the case that one of the primary causes of the financial crisis

was Gutfreund’s innovation. “No investment bank owned by its employees

would have levered itself 35 to 1 or bought and held $50 billion in mezzanine

C.D.O.’s,” observed Michael Lewis in 2008. “I doubt any partnership would

have sought to game the rating agencies or leap into bed with loan sharks or

even allow mezzanine C.D.O.’s to be sold to its customers. The hoped-for

short-term gain would not have justified the long-term hit.”

So what can be done about this problem? The stock left-wing answer is: tax

the rich. If you reduce bankers’ profits, the thinking goes, you reduce their

ability to be rewarded by their greed. But eliminating greed is impossible,

whether in bankers or painters. The more thoughtful question to answer is:

how can bankers’ self-interest be realigned with that of their clients and the

public? And that answer, necessarily, involves moving back to the partnership

model.

Congress should figure out a way, by statute or regulation, to require

investment banks to move back to the partnership model. Such a move would,

necessarily, involve deleveraging of the banks, and a contraction of credit:

something that would require careful thought. Last week in The Atlantic,

Pascal-Emmanuel Gobry published a perceptive piece on this problem.

Greg Smith will gain many fans with his anti-Goldman broadside. But he

lashed out at Goldman’s flaws, without observing their underlying cause. In a

sense, it’s not surprising, because Smith wasn’t at Goldman when the IPO

took place, and he therefore lacks perspective on the change. But the profit

motive is human. Real banking reform isn’t about lashing out, but about

restoring the connection between bankers’ profits and the economy they

serve.

Follow Avik on Twitter at @aviksaroy.

12/10/12 Want to Improve Goldman Sachs? Convert it Back into a Partnership - Forbes

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