Wallace Turbeville

 

Recent Posts by Wallace Turbeville

  • Which is the Bigger Threat: Terrorism or Wall Street Bonuses?

    Jul 26, 2010Wallace Turbeville

    stockmarket-1500001The current system of trader compensation will continue to decay the heart of Wall Street.

    stockmarket-1500001The current system of trader compensation will continue to decay the heart of Wall Street.

    Which is a greater threat to the nation -- terrorism or the relentless decline of middle income families? Unless we abandon our core values out of unwarranted fear, terror cannot fundamentally change our way of life. The number of people affected by growing income disparity is vast. When I was a student, income disparity was indicative of an underdeveloped and unstable society.

    The government appropriately devotes enormous resources to protect our lives and property from terrorism.  It is unthinkable that a leader would display any weakness opposing this threat.  Politicians have stiff backbones when it comes to terrorism.

    In contrast, the government is timid and half-hearted in its approach to the system which perversely rewards a few Wall Street traders with billions of dollars of bonuses, yet allows the foundation to decay.

    Kenneth Feinberg issued his report identifying outrageous Wall Street compensation of executives despite their role in the financial disaster and bail out. He proposed that the banks voluntarily adopt "brake provisions" that permit boards of directors to nullify bonuses in the event of a new financial crisis.

    He might have more success asking the lions of the Serengeti to give the wildebeests a sporting chance of making an escape.

    Over the last fifteen years, the financial sector's percentage of GDP has increased dramatically.  At the same time, the median family income stagnated and then declined.  I do not believe that this is a coincidence.

    The large banks have changed. They slice and dice the constituent elements of a stagnant economy, squeezing value out in ever more sophisticated ways.  Wall Street has turned away from its roll as the financial backer of industry and commerce. In the short term, it is more profitable for them to use their capital for trading. Newfangled software and MIT "quants" allow the traders to "rip the faces off" of corporate counterparties and investors which were once trusted clients.

    These young traders are simply doing what America has told them to do.  They are allowed to earn obscene amounts of money using the advantageous information, technology and capital of their employers. Making money from less powerful counterparties is like shooting fish in a barrel.  The banks make so much money that they have no problem shoveling it out to the traders.

    The alternative careers for these talented young people offer upside which is modest by comparison.  Besides, the trading world, in which the law of the jungle prevails, appeals to youthful aggressiveness.  Michael Lewis expected that college students would be appalled by the amoral environment he described in "Liar's Poker." Instead, the overwhelming response he received from students was a desire to get in on the action. The draining of talented and energetic young professionals away from corporate America where they could help create jobs by the millions may be as damaging as the new allocation of wealth.

    The government's flaccid approach to Wall Street compensation, embodied in the Feinberg report, is appalling.  Geithner and Bernake appear intimidated by Wall Street, yet intent on its approval.  Why do they guilelessly buy into the notion that giant, multi-purpose banks dominated by trading are essential to America's competitiveness in the world? Smaller, less risky institutions aligned with economic growth would seem to be a better idea for the vast majority of Americans.

    Greenspan and his progeny, including Geithner and Bernake, are enthralled by financial innovation. Innovation, by itself, can be good or bad. Innovation does not fall into the "good" category if it corrupts the home mortgage market, siphons off business productivity and the jobs and wages of employees and unfairly enriches the few at the expense of the many. It is good if it creates jobs and enriches the public as a whole.

    Trader compensation is at the heart of the problem. It encourages behavior that is inconsistent with Wall Street's most important function: raising capital for industry and commerce. The banks and the government are afraid that the traders will desert the banks and move to hedge funds if their compensation is reduced. If they do jump ship, it is all the better for America. At least hedge funds can blow themselves up without crippling the US economy in the process.

    Former traders now run most of the financial sector.  They believe that the traders somehow deserve compensation at the prevailing levels. The system will not change unless it is forced to do so. The restrictions in the financial reform legislation only inhibit specific abuses.  The banks will concoct new ways to trade risk. It is the only way to maintain their unconscionable profits (that is, until the next bubble bursts and we are in an even worse predicament).  The only way to really change the system is to reduce short term incentives, that is to say limit bonuses.  The government needs the kind of resolve it uses when fighting terrorism.  After all, the stakes are actually higher.

    Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.

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  • Energy Deregulation - Troubled Past Portends Scary Future

    Jul 22, 2010Wallace Turbeville

    oil-rig-150A deregulated energy sector encourages manipulation, greed, and catastrophes.

    oil-rig-150A deregulated energy sector encourages manipulation, greed, and catastrophes.

    My earlier ND20 article outlined the deregulation of energy commencing in the 1990s.  Unleashed from government constraints, the industry was to serve the public's energy needs efficiently and economically. Free market forces were to supplant the waste and unwarranted burden of governmental oversight, forcing down prices and improving operations.

    I must report that things did not work out very well.  Everyone is aware of the Deep Water Horizon oil spill and the Upper Big Branch Mine explosion.  The costs in human life, environmental damage, jobs and financial loss have been enormous.  It was all the direct result of the subversion of regulation by the oil and coal industries, a form of deregulation known as "regulatory capture."

    Far less understood are the consequences of deregulating the other two energy sectors, natural gas and power.  After 60 years, price regulation of wholesale markets was ended by Congress and the regulators.  Vertically integrated power utilities divested many of their generating assets to unregulated Independent Power Producers to take advantage of the new free market.  Derivatives trading in these markets was then deregulated, allowing the banks and big oil firms to dominate price hedging.

    Consumer prices were supposed to fall as fierce competition and unfettered trading improved efficiency.  That did not happen.  For the decade commencing in 2000, when the last phase of deregulation was completed, power prices increased 40% more than the rate of inflation. Natural gas price performance was worse. In 2009, gas prices plummeted as demand evaporated with recession. Before that year, gas prices increased 110% more than inflation for the period.

    No doubt, competition drives down prices.  But if the costs of creating competition increase prices more, the net result is just a bad business deal.

    Energy is a capital intensive industry.  Before deregulation, most capital investment was made by price-regulated businesses, such as gas pipeline companies and vertically integrated utilities operating within protected franchise territories. Regulated utilities and pipelines had extraordinarily low capital costs because of low risk. The new unregulated businesses were much riskier because they were exposed to market price changes.  For the consumer to benefit from deregulation, savings from competition had to overcome higher capital costs of the riskier companies.

    This problem has gotten progressively worse since full deregulation.  Price risk was seen to be an unacceptable credit exposure for the unregulated companies.  Prices had to be hedged through derivatives transactions for the companies' credit standing to be acceptable.  Today, when energy companies present themselves to investors and ratings agencies, they feature their hedging strategies prominently to justify higher share value.

    Most energy firms are not well-equipped to secure hedges in the conventional trading markets.  Derivatives positions require ready access to cash, and a lot of it.  Values change abruptly and the swings can be very large.  Adverse moves must be covered immediately with cash collateral posted to clearinghouses and counterparties.

    Whipsawed by the need to hedge and the intolerable cash requirements of hedging, energy companies have turned to devices created by banks which can be used to avoid liquidity demands.  These devices involve risks and costs that the energy companies often do not understand (or, perhaps, care to understand). As long as they have access to hedges and the costs and risks are obscure, their businesses can survive.

    Incidentally, the energy companies fought hard to secure the "end user" exemption in the financial reform legislation largely to preserve these devices.  If the cost of hedging were to become transparent under the reforms, share values would be lower.

    The weakness and high capital cost of unregulated energy are illustrated by the bankruptcy of three of the largest unregulated power companies since 2003 - Calpine, Mirant and NRG. In 2008, Constellation went to the brink of bankruptcy, only to be bailed out by a cash infusion of $1 billion by Warren Buffet and the sale of a 49.9% interest in its nuclear facilities to Electricite de France for $4.5 billion.  Constellation was considered the most sophisticated unregulated producer since it was staffed largely by former Goldman Sachs personnel. Ironically, it almost failed because of a recordkeeping error related to trading.

    The bankrupted companies and Constellation represent power generating capacity sufficient to serve all of the needs of New York, New Jersey, Pennsylvania and New England.

    There is much, much more.  The effect of predatory bank energy trading of energy is the subject of a forthcoming article. In addition, several notorious events in the recent past were rooted in energy deregulation. Four are described below. Remedial action was taken in each case, but the stories should not end there.  Sharp minds are still hard at work seeking unfair advantages which endanger the system. We must expect similar disasters and scandals if regulatory controls are not somehow re-imposed.

    California Energy Crisis. Anticipating deregulation, the state established a set of rules for the economic allocation of wholesale demand among competing power suppliers. A continuous auction process set prices during each day at levels necessary to secure supplies. In the summer of 2001, as demand peaked, suppliers implemented strategies to game the system. There were many complex strategies with ominously named, as if the traders were playing video games. (Enron's "Death Star" was most notorious.) Generally, they were designed to withhold supply, drive up prices and then sell at enormous premiums, all within short timeframes. The utilities commission refused to allow the power distributers to pass along the costs to customers. After suffering brownouts, $45 billion in losses and the bankruptcy of Pacific Gas and Electric (which serves most of northern California), the Federal Energy Regulatory Commission and the state combined to force an end to the crisis using price caps.

    Round Trip Trading. Unregulated electronic trading on the Intercontinental Exchange offered a major opportunity for manipulation. Traders at two firms could collude to transact at a price and then execute a reversing transaction later so no one lost money. Energy markets are really collections of small markets based on specific delivery points.  Round trip trades artificially moved the price of gas and power at specific delivery points for the advantage of the participants. As an added incentive, ICE had a program of granting stock warrants (tremendously valuable in an IPO) based on customer volume which was inflated by the rigged trades.  When round trip trades were discovered in 2003, it became apparent that the practice was widespread.

    Amaranth. This hedge fund put on a massive, highly leveraged position betting on the spread between natural gas prices for deliveries in March and April in each of the years 2007 and 2008. It was the idea of Brian Hunter, a 30 year old trader who was later dubbed by the DealBreaker blog as "the destroyer of all worlds."  In 2006, the trades lost $6.8 billion and Amaranth (a symbol of immortality in Greek mythology) collapsed. Energy markets were massively disrupted. To put this in perspective, Long Term Capital Management lost "only" $4.6 billion in 1998.  However, LTCM was integrated into Wall Street and the Fed stepped in to force a takeover by several banks to bail out investors. Does this sound familiar?

    Financial Transmission Rights. The theorists behind deregulation of the power markets had a problem.  Power delivered to the grid nearer the site of demand and transmitted along uncongested paths is more valuable than the alternative. Power could not be priced efficiently in daily auctions without accounting for this value. Predictably, the experts came up with a market-based solution.  Rights to transmit from point to point would be periodically sold at auctioned by system operators to provide price signals.  But too few parties were interested in such rights to assure a valid auction.  The theorists proposed mechanisms to attract outside, financially interested bidders.  To a cynical, market-savvy observer, this was a recipe for speculation by traders in a highly volatile derivative instrument without having to post margin to cover risks.  In 2007, unsurprisingly, a few thinly capitalized shell companies which faced transmission rights losses to PJM (the system operator for the Mid-Atlantic region) simply walked away. PJM members had to kick in $100 million or so to cover the loss.  While this loss pales in comparison with Amaranth's, the episode illustrates how deregulation of complex markets can have perverse and unpredicted consequences.  If the members had refused to pick up the tab, claiming that PJM was inept and the risks were undisclosed, the largest power system in the United States might have financially failed.  In truth, this alternative appealed to many members.  We are lucky that the loss was small enough so that they paid up after a short struggle.

    Some may say that the chicanery and ineptitude outlined above should not trouble us.  After all, remedies and firewalls have been put into place.  Do not believe it.  The deregulated energy sector is complicated, fast moving and large. It bristles with tempting opportunities to make a quick buck by manipulating the system. For deregulated energy, the past portends the future.

    Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.

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  • The Stealthy Deregulation of Energy

    Jul 19, 2010Wallace Turbeville

    electric-tower-150How the energy sector is running rampant -- and what to do about it.

    electric-tower-150How the energy sector is running rampant -- and what to do about it.

    A colleague with an encyclopedic knowledge of the economy told me recently that he did not have a good feel for energy deregulation.  My friend thought its obscurity may have been planned by the industry. From my perspective, deregulation happens because the energy sector is treated as multiple sub-units by state and federal law: oil, coal, gas and electricity; fuel extraction and transportation; power generation, transmission and distribution; energy derivatives trading. For example, it's impossible to find government data on the size of the energy sector in relation to GDP.  The regulatory framework, dismantled in the last two decades, viewed energy as a many separate businesses. Deregulation was not a single act, but several, taken a different times and affecting different agencies.

    The industry, however, sees itself as integrated.  At the strategically important hub of the industry are the large banks and oil companies. They exploit the relationships between the types of fuels and energy as well as the phases of the process, from fuel extraction to retail consumption. It is time that policymakers thought the same way.  The various legislative and regulatory steps in deregulation need to be catalogued and tied together to understand the industry's perspective.  In a follow-up post, I will examine a chain of disastrous consequences that grew out of deregulation, a window on our future if deregulation is not reined in.

    The stakes are large.  Viewed as a whole, energy is enormous and affects almost every component of the economy.  An industry so large and fundamental can do much damage if allowed to run rampant. The opponents to regulation are the most powerful and politically influential corporations in the world.  Remedies for deregulation must be muscular, and the politics must be aggressive and direct. It is simply not possible to meaningfully reform energy by seeking compromise and consensus.

    Oil and Coal Deregulation

     

    These fuels, developed more than a century ago, have been regulated primarily through safety and environmental rules at the point of extraction. Commercial activity is relatively unconstrained.  In fact, the government encourages exploitation of the resources through tax incentives, a form of "anti-regulation."

    Deregulation has been accomplished through subversion of the bureaucracies.  Because of the British Petroleum oil spill in the Gulf and the Upper Big Branch Mine explosion, we are painfully aware of industry control of the Minerals Management Service and the flaunting of violations by Massey Energy and others.  Given current events, further discussion is not required.

    Natural Gas Deregulation

     

    Commencing in 1938, all pricing in the natural gas business chain was regulated by the state and federal governments.  The Federal Energy Regulatory Commission (the FERC) was given jurisdiction over pipeline companies. Federal law required that the producers sell to the pipeline companies who, in turn, sold to distributers. Prices at the wellhead and on the pipelines were regulated by the federal government.  Prices paid by customers to distribution companies were controlled by state utilities commissions. The goal was to avoid exploitation of market power in the concentrated industry.

    In 1985, Congress amended the law to allow pipelines to transport and store gas on behalf of producers.  This allowed producers to sell directly to distributors, transactions outside FERC jurisdiction. Direct sales in the wholesale market were deregulated. FERC Order 636 issued in 1994 mandated open access to pipelines for producers, ending price regulation of the wholesale market completely.

    Electricity Deregulation

    The power industry originated as a collection of local enterprises.  Power was generated, transported and sold within state-franchised regions. This made sense because power plants could be built near the customers to minimize transmission. In contrast, fuels were extracted at places where they could be found and transported over long distances. Consumer prices (except for prices charged by non-profit state entities and rural co-ops) were regulated by state utilities commissions.  Private utilities were allowed to price power sufficiently high to recover fuel costs, operating expenses and a fair return on invested capital, all subject to review and approval by the commissions.

    As demand grew, utilities established interconnections between the franchised territories to serve customers more flexibly. The interconnected transmission evolved into the grid, owned separately by the utilities but operated under agreements governing cooperation. The FERC was given regulatory authority over the system to assure reliability.

    The Energy Policy Act of 1992 mandated that the grid be opened up to allow access to all qualified marketers of power.  The utilities resisted the mandate by imposing restrictions that stifled access.  The FERC issued a series of Open Access Orders in 1996 which brought an end to resistance.

    A more subtle form of deregulation which arose from open access was "disaggregation."  Utilities could sell generating assets to unrelated parties or unregulated subsidiaries of utility holding companies. The new owners now had access to the grid.  Returns on the invested capital would no longer be regulated by the state.  Investment banks relentlessly marketed the idea to utilities and made enormous fees restructuring and recapitalizing the utilities and the independent generation companies, now known as "independent power producers" or "IPP's."  On a worldwide basis, the most successful and aggressive IPP was a rather boring gas pipeline company which jumped into the business under a suitably modern name - Enron.

    Trading Deregulation

     

    Enron, the banks and big oil perceived an enormous new opportunity.  Deregulation meant that there were new buyers and sellers of fuel and wholesale electric power.  The new buyers and sellers no longer relied on the certainty of regulated prices.  They now were exposed to layers of price risk and became customers for financial hedges. A new derivatives marketplace was born.

    After a period of moderate success, it became clear that more deregulation was needed for a completely unfettered market.  The Commodities Futures Modernization Act of 2000 (CMFA) contained provisions known as the "Enron Loophole" in honor of that company's immense effort to secure its passage by a skeptical congress.  Over-the-counter energy derivatives trading and electronic trading platforms for energy were both exempted from the Commodities Exchange Act regulations.

    Initiatives to exploit the new unregulated market sprouted like weeds during the debate on the CFMA.  Enron Online was established in late 1999.  Using internet-based screens, traders could transact with Enron without using (and paying) brokers.  Enron made markets in all energy products (meaning it would respond to a bid at some price, even if no other trader would transact). If a trader used Enron Online, he or she was certain of getting a transaction done, even at obscure delivery points with uncertain prices.  Enron Online quickly captured a huge market share and one year later its unregulated status was clarified by the CFMA. Enron profited from the fees for use of Enron Online; but the market power resulting from dominance of multiple energy price points was far more valuable.

    The major banks and oil companies founded the Intercontinental Exchange, an electronic energy trading environment, in mid-2000.  Using ICE, the sponsors and other traders could meet and transact physical contracts and derivatives. The brokers were cut out of more business.  Like Enron Online, ICE was exempted from regulation under the CFMA.  The sponsors could replicate the Enron strategy of exercising market power by becoming market makers for energy price points. The sponsors pumped business through ICE and eventually sold off their shares for a profit considered at the time to be outrageous.

    The two banks in the forefront of energy trading were Goldman Sachs and Morgan Stanley. In those days, before energy was completely "derivatized," it was thought that traders needed access to the physical energy product to mitigate risks in these volatile and relatively thinly traded markets.  In late 2001, Goldman partnered with Baltimore Gas and Electric to own an unregulated IPP. Goldman supplied the traders and BG&E supplied the physical product.  The new energy trading firm called Constellation became wildly successful.  Goldman dissolved the relationship in 2003, after becoming comfortable with naked energy derivatives.

    So by the end of 2001, the second phase of deregulation of energy was completed with the emergence of a huge new and unregulated trading market for energy derivatives controlled by Enron, the banks and big oil. Alas, Enron did not enjoy the spoils of its victories for long.  It soon exploded like a supernova and filed for bankruptcy. Enron was a victim of its own aggressive free market philosophy carried to the extreme of self-dealing and fraud by its officers and employees.

    Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.

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  • Overhauling the Energy Grid, or, Why Cap-and-Trade Won't Cut It

    Jul 13, 2010Wallace Turbeville

    electric-tower-150Energy legislation has to radically transform the electric grid.

    electric-tower-150Energy legislation has to radically transform the electric grid.

    While the centerpiece of the proposed energy legislation is "Cap-and-Trade," a power pricing system and infrastructure that accommodate clean energy are prerequisites for an energy overhaul. Green energy will not reach its potential until facilities can be routinely financed with private capital. The key is the energy grid. Its physical configuration must be changed to support green energy. And, as the hub of the wholesale power market, the grid can be a vehicle to reconcile prices continuously so that the social value of clean energy is measured and recognized as it changes over time.

    Cap-and-Trade is no silver bullet. From a purely political perspective, carbon pricing is vulnerable to being characterized as a "tax." Making the case that it is really recovery of a social cost is a challenge, to say the least. Subsidies and disincentives are imprecisely calibrated to overcome the significant obstacles inherent to clean energy projects over their lifecycles. Because of inevitable political compromise, they are also likely to be inadequate.

    Meanwhile, green energy production has long been a promise and not a reality. It represents only about 3% of all power production. Replacing our current vehicular fleet with vehicles powered in whole or in part by rechargeable batteries will require more power production. Promising green energy is good politics. Boosting the green percentage at the same time as overall production is increasing requires a new approach.

    As mandated in 1992 legislation, fair access to the transmission grid for all sources of generation now drives the organizational structure of the industry. Under the structure, all generation sources are theoretically available to meet demand wherever it exists. Power is allocated to retail distributors as needed. Priority for granting generators access to the grid is determined by engineering limitations. But the principle prioritization logic is based on cost. Regional system operators regulate the mix of generation sources using an internet-based system known as the Open Access Same-Time Information System (or, OASIS). Generation and load (supply and demand) must continuously be in balance or the system shuts down, ultimately resulting in a blackout. This means that OASIS must work virtually in real time.

    OASIS works well to achieve an optimal mix based on engineering constraints and costs. The actual transmission grid is another story. Ownership is anachronistically based on the business organization structures prior to open access. Over 500 entities own pieces of the grid, primarily private utilities, municipalities, rural cooperatives and federal agencies which distribute power to customers. Investment decisions and policies relating to fees for use are understandably influenced by the parochial views of the owners. Transmission assets do not generate profits on their own; they are a means to the end of buying or generating power and selling it to customers. Local ownership of transmission infrastructure is not strategically important to distribution utilities so long as access to supply is assured and clear, fair and predictable rules governing cost allocation are put in place.

    The Federal Energy Regulatory Commission has identified the outdated ownership structure as an impediment to maintaining a grid that is responsive to the evolving patterns of generation and consumption. Improving and expanding the grid is inherently difficult because of its large capital cost and thorny land use issues. Matters are made worse by bickering over cost allocation. Balkanized ownership is also troubling because of the security issues related to the grid. Cyber attacks on the management systems are important concerns, but strategic transmission paths are also subject to lower-tech physical threats.

    The FERC appropriately views the transmission grid as similar to the interstate highway system. Interstates benefit the entire nation, not just localities. So it is with the power grid.

    Green generation faces many obstacles. Although these facilities do not require fuel, capital costs per kilowatt hour produced are typically so high that total cost compares unfavorably with carbon-fueled alternatives. The cost difference depends on the price of coal, gas and oil. Therefore, the cost deficit changes over time.

    But there are other obstacles which may be more daunting. Generally, green generation must be located where the source of energy (wind, solar etc.) is found. Convenience of the site to the grid is highly unlikely. In fact, green generation sites are typically in very remote locations. This means transmission construction, often over long distances, will be required. Under current practices, the cost must be borne by the customers served by that generation, directly burdening green power.

    Other obstacles relate to the requirement that generation must be constantly balanced with demand as demand changes minute by minute. Take wind generation as an example.

    • Windmills are susceptible to lightning strikes.

    • As a weather front passes, wind increases and then dramatically falls off, and output fluctuates accordingly.

    • Wind speed is highest in early morning hours, a low point in intra-day demand cycles. Power generated at these times fetches a lower price.

    Because of these uncertainties, wind generators cannot guarantee output on a day-ahead basis. The risk of penalties is too great. Consequently, grid managers must pay other generators to standby to meet demand the next day, if needed. The costs are highest for hours of peak usage. These standby costs are charged to the wind generator whose unreliable capacity caused the problem.

    The transmission grid touches all of these obstacles.

    We are in the process of deciding that energy generated without greenhouse emissions has benefits for society which outweigh the disadvantages of carbon-based fuels. A system which implements this decision should have several characteristics:

    • Reconciliation of costs between green and carbon-fueled generation must be flexible, since fuel costs vary and innovation could improve the competitiveness of green generation.

    • Transmission construction costs should be allocated broadly rather than burdening the green generator specifically. Green energy is a society-wide concern and costs should not be localized.

    • Transmission expansion should be efficient and based on a national policy that promotes green generation.

    • Costs arising from transitory reliability issues (such as weather) should be borne broadly, since the benefits of green energy are societal.

    • Innovations that store power generated during hours of low demand for use during peaks allows for a more efficient generation mix. It also helps green facilities that do not always generate power during demand times. The grid must accommodate flows into and out of storage.

    • Access to the grid cannot be based solely on engineering constraints and cost. Environmental policy must be a consideration. The rules employed by "OASIS 2.0" should be transparent and predictable.

    All of this suggests that the transmission grid should be owned centrally and that allocation of costs for use should be determined based on national policy. Charges to green generators should be potentially negative (in other words, payments) if the policy demands it.

    There is a role for Cap-and-Trade and financial incentives. Carbon pricing dis-incentivizes industrial emissions as well as carbon-based generation. Financial incentives are useful to foster research and development and start-ups. But a new structure for transmission is more efficient and powerful. It enables a strategic plan for transmission expansion to integrate green generation facilities and allocation of costs broadly, reflecting the benefits to the whole society. It also can be the vehicle for dynamic reconciliation of power prices to reflect the social value of greenhouse gas reduction. On this basis, green power generation is subject to the same general costs and risks as carbon based generation. Importantly, it can be financed with private capital. The scale and pace of green generation will be increased so that there is a reasonable chance that it can replace carbon-based generation and goals can be achieved.

    Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.

    ND20 ALERT: Join us in NY for fresh ideas, July 16-18! Guild Hall, in collaboration with the Roosevelt Institute, will gather thought leaders in the arts, the economy, and the media in East Hampton for a can’t-miss symposium featuring George Soros, Van Jones, plus ND20 contributors Elizabeth Warren, Rob Johnson, Jeff Madrick, Editor Lynn Parramore, and more. RSVP today - seats are limited.

     

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  • DON'T Let Goldman Be Goldman

    Jul 12, 2010Wallace Turbeville

    wall-street-150Is it fair to single out Goldman in a sea of financial wrongdoing? Absolutely, says Wallace Turbeville, a former Goldman VP.

    wall-street-150Is it fair to single out Goldman in a sea of financial wrongdoing? Absolutely, says Wallace Turbeville, a former Goldman VP.

    William D. Cohan's op-ed piece in the July 7th New York Times had the same title as this article, but for the word "Don't."

    At first glance, I thought the Times piece might be a report on New Age self actualization for investment banks. But the title suggests something more troubling. The whole point of financial reform is that Goldman (and the others) should no longer be permitted to be Goldman. A return to business as usual is the last thing we need.

    Mr. Cohan is a student of Goldman, but he profoundly misreads the firm's role in the Wagnerian drama we know as "The Great Recession." He begins by imploring us all to "fess up" to the fact that financial reform would have been impossible had the Administration and Congress not "demonized" Goldman.

    "Demonization" is a popular word in today's political discourse. It suggests unfairness. Mr. Cohan does not dispute the facts asserted by the Administration and Congress. Instead, he points out that underlying ethical flaws were shared throughout Wall Street. They arose from the shift toward a business model that rewards taking imprudent risks with other people's money. Mr. Cohan says that "Goldman Sachs did nothing differently in the years leading up to the crisis than did other firms of its stature."

    Anyone who has raised a child is familiar with a common excuse for bad behavior. The proper response to "Everyone else is doing it" is a stern demeanor and the answer: "Maybe, but so what?"

    But let's give the article a generous interpretation. While the casual reader might interpret the shared lapse in ethics as an excuse, perhaps it is not intended to be read this way. We will assume that Mr. Cohan intended not to excuse Goldman but to find fault with political leaders who unfairly singled out the firm.

    It seems obvious that the example of a single firm is a more effective rhetorical device than calling out generalized bad behavior. Politicians used this device and public opinion was successfully mobilized. The job got done. I believe that the public understood that the bad behavior was widespread, and that Goldman was merely one example.

    Was it unfair to make Goldman the example? The article argues that Goldman was just like all the other firms. It was not.

    Goldman was actually better at executing a certain investment banking business model than anyone else. It became a leader in the industry, admired by competitors, the media and politicians. The problem was that the business model, so effectively executed by Goldman, turned out to be bad for America. The model inherently risks the survival of critically important institutions. It is also nearly impossible to use the model and, at the same time, maintain business ethics conforming to the shared values of the society.

    Goldman historically promoted its commitment to ethics when soliciting clients. I am convinced that Goldman people genuinely believed this commitment to be true. It may even be the case that ethics were taken more seriously at Goldman than at its competitors. But seeking business based on ethics carries with it a responsibility. Pursuit of a business model with inherent ethical challenges has consequences that are unavoidable, especially to a firm which has held itself out to clients as particularly ethical.

    Goldman's success was envied up and down Wall Street. The pressure to keep pace with Goldman's earnings drove other firms to emulate its model. At a minimum, managers at other banks were driven to take greater risks hoping for greater rewards as proof to shareholders that they measured up to the Goldman team.

    It is ironic that Goldman was first to foresee risks of a deteriorating market and acted to defend itself. Goldman's aggressive preparations, including the extraordinary demands to AIG for collateral, may have actually contributed to the intensity of the panic. Goldman was so prepared that, when the tsunami finally hit, the only real threat to it was a total systemic collapse. Congress and the Fed stepped in with cash to avoid catastrophe and Goldman, now even more powerful compared with competitors, immediately prospered. The real irony is that Goldman was greatly responsible for the problematic business model; yet, because management pulled the plug so effectively, the value of the bailout to Goldman shareholders was disproportionately large.

    Mr. Cohan suggests that it was unfair to use Goldman as an example because of its relative ethics and its effective response to the danger. Those points may be relevant if the real issues were incompetence and larcenous intent. Instead, the core concern was and is the dysfunctional business model that generated massive profits for the firms but devastated the society.

    Goldman was not just like all of the others. It was the leader. Becoming the leader involves a trade that should be well understood at the highest levels of Wall Street. Investment bankers often engage in businesses with underdeveloped rules of conduct. Pushing the envelope may be risky, but the rewards are more than worth it. If a firm is a leader, its profits and the wealth and power of its managers are virtually limitless. If it turns out that the business has consequences to society that are intolerable, even if the consequences were unforeseen, the leader will be the example held out to the public. Management is held to a high standard, but the pay scale more than reflects the level of difficulty.

    Is this an unfair trade? I don't think so.

    Finally, Mr. Cohan concludes that we should "lay off the firm and allow Goldman and the rest of Wall Street to return to some semblance of normalcy." Besides unfairly demeaning the entire financial reform effort, this statement suggests that our problems have been solved.

    In fact, it would be a monumental error if financial reform ends with the passage of the legislation this month. James K. Galbraith points out in testimony to the Commission on Deficit Reduction that focusing on Medicare and Social Security as a means to reducing deficits is misguided. Economic growth is the only sensible solution. He cites the need to restore the financial sector's role of capital formation for productive purposes, i.e., commercial lending and equity investment. The current legislation focuses on curbing dangerous behaviors and on procedures to deal with financial panics. It does not reconnect Wall Street capital to the engine of economic growth: productive and innovative businesses which employ American workers.

    No one wants to drive Wall Street out of business, certainly not politicians whose campaigns rely on it as a source of funds. But the economy will not prosper unless Wall Street reengages with the broader economy. Current bankers will keep their Hamptons estates under the new regulations. But their successors may not be able to afford mansions if 10-20% unemployment is the new American reality. Wall Street's attention must turn away from churning derivatives on existing products and instruments and toward growth of the economy and jobs. If more government intervention is needed to force this turn, so be it. Neither the public nor its political representatives should feel regret if this means Goldman and the other banks must fundamentally change.

    Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.

    ND20 ALERT: Join us in NY for fresh ideas, July 16-18! Guild Hall, in collaboration with the Roosevelt Institute, will gather thought leaders in the arts, the economy, and the media in East Hampton for a can’t-miss symposium featuring George Soros, Van Jones, plus ND20 contributors Elizabeth Warren, Rob Johnson, Jeff Madrick, Editor Lynn Parramore, and more. RSVP today - seats are limited.
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