Summer Rerun: A Conflict of Interest is Not a Conflict of Interest If It Involves Goldman

This post first appeared on May 4, 2009

The “all animals are created equal, but some are more equal than others” logic appears to operate in full force as far as Goldman is concerned. Violations of normal rules of conduct are not merely tolerated, but are asserted to be acceptable.

Now admittedly, the latest news tidbit, of former Goldman co-chairman Steven Friedman staying on as chairman of the New York Fed after Goldman became a bank holding company, isn’t as troubling as when current Goldman chief Lloyd Blankfein was the only Wall Street denizen to meet with Hank Paulson when the Treasury was deciding what to do about AIG. Readers may recall that Goldman had the biggest exposure to AIG and thus had the most to benefit from a course of action that would be generous to counterparties (who had chosen of their own cognizance to enter into contracts with the big insurer).

What is disturbing about the Wall Street Journal is the moral blindness of too many of the key actors, namely Friedman himself and some Fed officials. Let’s parse some of the key bits of the Wall Street Journal story:

The Federal Reserve Bank of New York shaped Washington’s response to the financial crisis late last year, which buoyed Goldman Sachs Group Inc. and other Wall Street firms. Goldman received speedy approval to become a bank holding company in September and a $10 billion capital injection soon after.

During that time, the New York Fed’s chairman, Stephen Friedman, sat on Goldman’s board and had a large holding in Goldman stock, which because of Goldman’s new status as a bank holding company was a violation of Federal Reserve policy.

The New York Fed asked for a waiver, which, after about 2½ months, the Fed granted. While it was weighing the request, Mr. Friedman bought 37,300 more Goldman shares in December. They’ve since risen $1.7 million in value.

Yves here. It’s bad enough that Friedman owned Goldman shares while involved in policy discussions that would affect the bank. The fact that he went and bought more shares is breathtaking. Of course, this shows a huge deficiency in Fed procedures. Directors should be barred from trading stocks in any institution regulated by the Fed. While it is technically not inside information (you need to be an insider of the company in question, that is, have a fiduciary duty to its shareholders), it certainly raises the specter of trading on privileged information.

It would be a scandal if someone on the FOMC were to be found to be trading interest rate futures. Being party to discussions about regulatory policy (as in having advance knowledge of how things are likely to play out) means one similarly has advance knowledge of facts that investors would find important.

Yet we get this comment from Friedman:

Last week, following questions from The Wall Street Journal, Mr. Friedman, 71 years old, disclosed he would step down from the New York Fed at year end. In an interview, he said he made the decision because the waiver letting him own Goldman stock and be a Goldman director expires at the end of the year. He added: “I see no conflict whatsoever in owning shares.”

Yves here. So we get the Big Lie. A conflict is not a conflict. The Journal does find someone to take issue with this view:

Jerry Jordan, a former president of the Fed bank in Cleveland, says Mr. Friedman should have stepped down once Goldman became a bank holding company in September and thus fell under the Fed policy barring stock ownership by certain directors of Fed banks. “Any kind of financial transaction at all by any of the directors is always a problem,” Mr. Jordan said. “He should have resigned.”

Yves again. But we then get the Fed’s defense:

New York Fed officials say that to have forced Mr. Friedman off the board while it sought a Geithner successor would have deprived it of two leaders at a crucial time.

“Steve Friedman is a very capable chairman,” said Tom Baxter, the New York Fed’s general counsel, “and was the kind of person who we needed to head the search” for someone to succeed Mr. Geithner.

In Washington, the Fed’s general counsel, Scott Alvarez, also says Mr. Friedman was needed during the New York Fed’s transition.

Yves here. While I have trouble with that notion, there appears to have been no consideration of a compromise, say having Friedman head the search committee and recuse himself from discussions and decisions that could benefit Goldman.

The article provides more detail on normal Fed procedures:

The Federal Reserve Act bars directors representing the public interest from owning bank stocks or being bank directors or officers. Because Goldman had always been an investment bank, Mr. Friedman’s board membership there and his ownership of about 46,000 Goldman shares, at that time, hadn’t run afoul of this rule. Now it did.

The regional Fed banks have three classes of directors: Class A, elected by member banks and representing them; Class B, elected by banks but representing the public; and Class C, representing the public but picked by the Fed. Under law, directors in Class C, including Mr. Friedman, and Class B can’t be officers or directors of banks, and Class C directors like Mr. Friedman also can’t own shares of banks. This means not of bank holding companies, either, by the Fed’s interpretation of the 1913 law.

Mr. Baxter, the New York Fed general counsel, realized that the bank’s chairman was now in violation of the Fed rules. But the institution had just lost another director, Richard Fuld Jr., a few days before the September collapse of the firm he led, Lehman Brothers Holdings Inc. So on Oct. 6, at the urging of New York Fed lawyers, Mr. Geithner asked the Federal Reserve Board for a waiver enabling Mr. Friedman to continue owning Goldman stock and serving on Goldman’s board.

While Fed officials in Washington weighed the request, Mr. Baxter stayed in touch with a senior lawyer there, pushing for a decision, says a New York Fed official. This official says that in conversations with Mr. Friedman, who began voicing concern about the delays in December, Mr. Baxter suggested that the Fed policy should be considered to be in abeyance until the waiver came through.

Mr. Friedman’s role grew more prominent in November after Mr. Geithner became the pick for Treasury secretary…

Mr. Friedman saw that Goldman’s battered stock was trading below book value, or assets minus liabilities. On Dec. 17, he bought 37,300 Goldman shares at an average price of $80.78, a $3 million purchase, according to regulatory filings

Yves here. Recall that in the waning days of the Bush Administration, it wasn’t clear how bank friendly the new Administration would be. Even thought Geithner was Treasury secretary designate, there was some discussion in the press as to the divergent views within the Obama economic policy team, and whether that would create creative friction or conflict. Conflict (or having Volcker, who is not a fan of innovative finance, have a strong voice) could have kept bank valuations at bay.

Thus while Goldman’s stock was arguably cheap, cheap stocks can get cheaper. One of the important inputs to the wisdom of going long would be knowing how bank friendly the new Administration’s policies would be. To think that Friedman didn’t have some insight into that question by virtue of his advantaged position is naive.