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.

Equity derivatives is a multibillion-dollar revenue generator for Wall Street, as other business dealmaking and credit markets have faded. The biggest trading firms such as Goldman, Morgan Stanley ( MS) and Deutsche Bank ( DB) have been pushing the complex products.

In fact, equity derivatives trading and underwriting has grown to make up at least 10% of all investment banking fees generated in 2011 in the Middle East, Europe and Africa (MENA), according to an article in Bloomberg.

The MENA region also happens to be Smith's old sales stomping ground.

These complex instruments don't come cheap for the investor. A typical European equity derivatives buyer paid approximately $2.6 million in trading fees and approximately $1.9 million in clearing and execution commissions in 2011, according to the research firm Greenwich Associates.

That is in spite of what Greenwich describes as a "a year of disappointing trading volumes."

So while Wall Street and the bloggers worry about what has happened to Goldman Sachs' culture and the future of the firm, Smith's clients should be reviewing their last statement.

Smith's diatribe shouldn't be taken just as a contemplation of Wall Street ethics. There may be a more immediate -- and more expensive -- warning for Goldman clients.

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