Method in Goldman's Madness?

By David Skeel, author of "The New Financial Deal: Understanding the Dodd-Frank Act and its (Unintended) Consequences" (Wiley, 2011).

NEW YORK ( TheStreet) -- Bobby Fischer, the chess genius who died recently, was famous for audacious moves such as a decision to sacrifice not just a pawn, but a bishop, as part of his strategy for a key early victory. I suspect there may be more than a little Fischer in Goldman Sachs' ( GS) puzzling decision to dismantle its proprietary trading operations even as experts question whether the new ban on proprietary trading can effectively be enforced.

The puzzle was nicely laid out in TheStreet's piece on the reinvention of Goldman Sachs. Much of the article detailed the remarkable exodus from Goldman of high profile proprietary traders like Morgan Sze, who in 2009 was "the most valuable man at the most profitable firm on Wall Street," due to the Volcker Rule enacted as part of the Dodd-Frank Act. (The Volcker Rule forbids proprietary trading anywhere in commercial banks, their affiliates, or their holding company, and limits banks' investments in hedge funds or equity funds.) While the Volcker Rule seems to mandate this divestment, many commentators (including former regulators, as TheStreet noted in "Reinventing Goldman Sachs" ) suspect the big banks will have little trouble evading it.

While Goldman isn't the only bank that has shed proprietary traders, its move is the most mysterious. This fall, Morgan Stanley announced plans to reduce its stake in the hedge fund Front-Point Partners. It was a dramatic gesture, but Front-Point wasn't particularly profitable for bank. So it wasn't clear whether Morgan Stanley was really giving something up. With Goldman, by contrast, no one doubts the profitability of the traders who are leaving or have left. These traders have made enormous profits, in some cases even during the crisis.

Why let them go? Why give away the golden goose if the goose police aren't likely to ever find you?

I suspect that the answer lies in the very visibility of the traders. By giving up these lucrative proprietary trading operations, Goldman is -- as with Fischer's knight -- giving up something that really matters. But as with Fischer's knight, it is highly unlikely that Goldman would sacrifice such valuable operations except as part of a larger strategy. One plausible explanation is that Goldman has shed its existing proprietary traders with the thought that it can gradually reintroduce proprietary trading in the future.

This would suggest that Goldman sees the same malleability in the Volcker Rule as the rest of us, but doesn't think it can take advantage of the malleability just yet. In the future, Goldman may gradually blur the lines between its market making operations, which are permitted under the Volcker Rule, and proprietary trading, which is not. It may also conduct trades for clients (permitted) that look increasingly like proprietary trading.

Like the other big banks, Goldman also may warn regulators that strict enforcement of the Volcker Rule could undermine American banks' competitiveness, given that European and Asian Banks are given much more leeway to mix operations. From this perspective, Goldman has given up something truly valuable -- like Fischer's knight -- but in service to a long-term strategy that will keep it on top.

A slightly different line of reasoning leads to the same conclusion. Suppose Goldman had kept star proprietary traders like Morgan Sze, and simply shifted them to market making or client services. Because these traders are well known as proprietary traders, such a move would invite a crackdown by regulators. They're simply too closely associated with proprietary trading. We're still not far enough away from the crisis and the enactment of Dodd-Frank to so blatantly defy the intent of the new law.

The newly released Financial Crisis Inquiry Commission report has further underscored the need for Goldman to keep a low profile, and to bide its time. Although the report has been widely criticized for its dime-store prose and lack of compelling narrative, it won't help Goldman's damaged reputation. The report provides further evidence that Goldman was busy doing well for itself, not good for others, before and during the crisis.

I think Goldman's actions have often been unfairly portrayed during the soul-searching that has followed the recent crisis. Goldman doesn't seem to me to have been uniquely evil. The SEC's case against Goldman in connection with the Abacus transaction, for instance, which led to a $550 million settlement, always seemed tenuous as a legal matter. But it also seems clear that Goldman is no modern day J.P. Morgan, acting out of sense of noblesse oblige during a crisis.

If my reasoning is accurate, it suggests that the Volcker Rule will have a very limited practical shelf life. In my view, that wouldn't necessarily be a bad outcome, given that banks' proprietary trading doesn't seem to have been a major component of the recent crisis. But it's also possible that the Volcker Rule will serve primarily as a club that the government will use when the government wants something out of the big banks. The Volcker Rule is one of many provisions in Dodd-Frank that could further politicize the regulation of the largest banks.

I hope none of these predictions comes to pass. It is possible that regulators will aggressively enforce the Volcker Rule; or, better yet, that they will take advantage of other provisions in Dodd-Frank that at least theoretically could force the largest banks to downsize over time. But when I see Goldman Sachs bidding adieu to some of its most profitable traders, I can't help thinking that there's more to the story than Goldman hastening to do the right thing by complying with the new financial regulation.

David Skeel is a law professor at the University of Pennsylvania and author of the new book "The New Financial Deal: Understanding the Dodd-Frank Act and its (Unintended) Consequences" (Wiley, 2011).

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This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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