Investors need honest information

By DAVID MOON, Moon Capital Management, LLC
May 2, 2010

The most recent brouhaha from the 2008 financial collapse relates to subprime-related investments Goldman Sachs organized and sold to its clients. Recently disclosed internal documents disclose that certain Goldman’s executives were convinced that the mortgage market was overextended and bound to eventually collapse.

In one email, Thomas Montag, then Goldman’s head of sales and trading for the Americas, called one of the firm’s mortgage investments “a shitty deal.”

He was right. Investors in Timberwolf, a Goldman Sachs mortgage product, lost more than $1 billion.

In a recent lawsuit, the Securities and Exchange Commission alleges that Goldman defrauded investors by misstating and omitting certain key facts. If that is true, the firm should be punished. Our financial system requires investors to make their own informed decisions – and that requires a free and honest flow of information.

But many people are outraged that Goldman Sachs would bet against the US mortgage market, especially at a time when it was encouraging its clients to do the exact opposite.

This is how the system works. Every day. Millions of times a day.

If you do business with a brokerage firm that acts as a dealer for any transactions, that firm is on the other side of the transaction from you. When you buy a bond or stock from a dealer, it is the seller. That seller has an incentive to get as high of a price as possible.

Sometimes the firm acts as a broker, and is merely facilitating a trade between you and some unknown seller. Most times you have no idea in which capacity your brokerage firm is acting.

When a firm trades for its own accounts, it has the advantage of seeing the orders being placed by its customers; hence it has some idea of whether there is more selling or buying pressure. It can “front run” customers’ trades, profiting from knowledge that the rest of us don’t have.

It can be even worse when a firm acts as an investment banker. Investment banks help corporate clients raise capital in the stock and bond markets. The compensation of the investment bank is typically based on the amount of money the firm is able to raise for its client. The more stock or bonds of the corporate client the brokerage firm can sell to his retail client, the more money the entire firm will make. This creates multiple conflicts of interest. Brokerage firms may be tempted to favor these new stock and bond issues over existing shares in order to create an illusion of strength or popularity.

If a firm can both sell investments to its clients and buy investments on behalf of its clients and itself, a conflict exists.

In Senate hearings this past week, four current or previous Goldman Sachs executives were asked by Senate investigators if stockbrokers have a duty to act in the best interest of their clients.

Only one answered yes.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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