The Wall Street Crisis and the Fiduciary Standard

During FCIC testimony, Goldman Sachs CEO Lloyd Blankfein, responding to questions of whether betting against securities it was selling to investors was a conflict of interest, said that Goldman had no legal obligation to disclose its bets. "We are not a fiduciary," he said.

From the first hearings of the Financial Crisis Inquiry Commission (FCIC) in January to the release of Michael Lewis’ best-selling book, The Big Short, in March, there has been a lot of discussion and examination about what caused the subprime crisis of 2008-2009.

The hearings provided an insider perspective on how Wall Street firms continue to view themselves as victims of circumstance, rather than as institutions that somehow expected that their models could protect them from the dangers of high leverage in a wide array of investments. In some cases, Wall Street firms were leveraged 35 to 1. With that ratio, it is easy to see how a small drop in asset value could spell disaster. Can you imagine doing that with your assets? So, why would Wall Street behave so recklessly?

Wall Street

Michael Lewis explained it in simple terms by stating that all of the incentives in Wall Street’s bond market were bent on making money in the subprime market, which had been feverishly pumping out profits since 2005.

He states: “One of the lessons of this story is that people will see what they are incentivized to see. If you pay someone not to see the truth, they will not see the truth. And that’s one of the central messages of this story. You have to be very careful how you incentivize people because they will respond to the incentives. [It was a case where] the incentives for people on Wall Street got so screwed up, that the people who worked there became blinded to their own long-term interests. And, because the short-term interests were so overpowering, they behaved in ways that were antithetical to their own long-term interests.”

We know where this type of behavior landed the country: A loss of $1.75 trillion of wealth in the subprime mortgage market; $700 billion in Troubled Asset Relief Program (TARP) bailout money; and more than $6 trillion committed by the Federal Reserve to restore liquidity to the financial markets. It also cost a lot of people their homes and their jobs. And, while the big firms got bailed out by the government, it was the average investor who was left without a seat when the game of mortgage musical chairs ended.

Banks on the right, taxpayer on the left.

This was made remarkably clear on the first day of FCIC testimony when Goldman Sachs CEO Lloyd Blankfein was asked whether a practice of betting against some of the subprime mortgage securities Goldman was selling to investors was a conflict of interest.

His reply was a frank admission of what everyone in the financial industry already knows but is rarely publicly acknowledged by Wall Street. He said Goldman didn’t have a legal obligation to disclose when it was betting against securities it was selling to investors. “We are not a fiduciary,” he said.

Fiduciary - that little-understood word requires that Registered Investment Advisory (RIA) firms place clients’ interests first. When conflicts of interests exist, it requires full disclosure and management of those conflicts. It’s the highest standard of care under the law and requires that clients’ interests supersede the interests of RIAs in the financial advice they provide.

By contrast, Wall Street firms (broker-dealers) and the brokers who work for them as sales agents operate under a suitability standard of care. They are permitted by law to make recommendations that are “suitable,” as opposed to what is best, for the client.

Suitable, yes. Ideal? No.

For example, there may be multiple, similar investment products that are “suitable” for a particular client. One may be better than the rest, but the broker may select one that provides his or her firm with the highest commission. Essentially, a broker’s primary duty is to his or her firm, not to the client.

The subprime mortgage disaster illustrates the clear difference between the two standards and shed some light about how Wall Street firms operate. Sure, when times are good, investors and shareholders both can do well. But when things get dicey, Wall Street’s first responsibility is to their shareholders, not to investors. So, if you are a client of a big bank and you’re comfortable with your relationship, that’s fine. Just know where you stand, especially when the next crisis hits.