Goldman Sachs' Hidden Letter Bomb

NEW YORK ( TheStreet) -- Goldman Sachs' ( GS) biggest clients -- including U.S. pension funds, insurance companies and other banks --- should be very worried about disgruntled former exec Greg Smith.

But they shouldn't fret about Wall Street culture or how much bankers really love clients. Instead, they should worry if Smith and Goldman Sachs pushed them into an expensive but money-losing equity derivatives trade that has yet to blow up.

Smith argues in his public resignation letter published yesterday in The New York Times that instruments that he and the firm were selling to U.S., European and Middle East institutional investors were "opaque products with a three-letter acronym," implying that clients had little use and even less understanding of the products.

In the letter, Smith argues that even thought he has "always taken a lot of pride in advising my clients to do what I believe is right for them, even if it means less money for the firm," arguing Goldman higher-ups pushed him to sell against the best interest of his clients.

"This view is becoming increasingly unpopular at Goldman Sachs. Another sign that it was time to leave," Smith adds.

So where did Smith work? Equity derivatives.

Equity derivatives are complex financial instruments that are traded on and off exchanges and have become a popular way of "hedging" stock volatility with big investors. Some of the more interesting names for the products include flow derivatives, index arbitrage and convexity trades.

But rather than control a volatile market -- as the investment banking sales pitch would go as Wall Street blanketed Europe with the instruments throughout the financial crisis-- history proves that equity derivatives have nearly killed two banks.

Last year, UBS disclosed that trader Kweku Adoboli had racked up $2.3 billion in bad equity derivatives trades, and in 2008, Societe Générale accused equity derivatives trader Jerome Kerviel of losing 4.9 billion euros through a another series of "unauthorized trades."

All the while, the sellers of the products seem to be doing just fine.

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