Is this ethical and how does it differ from what Goldman did?

So then is the 'Enron Loophole' which was created in 2000 through the CMA...would that be considered 'unethical'?
Goldman creates products for clients (indicies) which they can then sell to oblivion, and then must buy the underlying contracts, in deference to position limits, because they are 'hedging'?

 

There's nothing wrong with what you're suggesting. However, that's not what GS did. They convinced clients to buy pork bellies while they, GS, were financing the poisoning of all the pigs. There defense is now, damn, sure were a lot of deads pigs turned up. We don't own any pig farms. How did that happen?

 

I did not "blame Goldman for taking the opposite side." As I clearly stated in my post, I was specifically addressing the hypothetical scenario posed by the OP (with the pork bellies, etc.).

I don't know enough about the facts of the case to say whether there was some mitigating factor here. Either way, it smells like shit. As you say, "as a market maker you are not an investment advisor" - yet GS does everything from execution to advisory dealing, research, market-making and marketing exotic securities, to prop trading for their own account. Conflicts of interest are everywhere.

Just because fraud and swindles are 'business as usual' in the finance world doesn't mean it should be that way.

 

Can you show us where Goldman said the assets were basically riskless?

 

So countries went broke because Goldman arranged a trade between a bull and a bear on the US housing market? Ok buddy, enjoy your day release from the funny farm.

 

D+

 

I wasn't speaking to you specifically, just in general. I'm not bashing anyone, these products are not easy to understand for a lot of people in finance, let alone those outside. On that note, it was clear the Senate panel (minus maybe 2-3 members), even after hours of discussions, still did not understand that there HAD to be a short.

I understand as an outsider this all seems fishy, but man it is so tightly regulated and monitored. You are prohibited from talking to people in other divisions where any perception of a conflict might arise without a lawyer also on the line. They record every conversation and obviously every email. It's really serious. I get confusion, but it isn't the 70s & 80s, there really is a wall between divisions.

To be clear I do not work at GS and stand nothing to gain from showing the opposite point of view. Hell, my firm would benefit from their loss in market share.

 

Washington and populists versus Wall Street (Goldman) and the implications for Financial Regulation.

In my view, the SEC recently sued Goldman Sachs on the John Paulson “Great Housing Short” deal to help Democrats pass their Financial Regulation bill.

The 2010 (very important) mid-term elections hang in the balance. President Obama and Secretary Geithner continued the Great Bailout and passed Stimulus Bills, and the voting public hates both. It’s fueled the Tea Party, which may bring havoc to the elections.

Until the President can close the bailout barn door - after the animals are out - he can’t square this problem with the voting public. So the President’s Fin Reg campaign has taken on the same urgency and passion he used to strong-arm health care. Fin Reg is a must win for the Democrats before the midterm elections like health care was too.

After being strong-armed by the Democrats (3/2 vote in the SEC), Goldman’s CEO Blankfein played his dutiful role as hoped for by the Democrats. Blankfein predictably said Goldman did nothing wrong and yet also did not take the bait by Republicans on the panel to challenge the Fin Reg bill and he showed overall support for it. A total sycophant.

A market maker is different from an investment adviser.
Goldman’s business model as a market-maker, proprietary trader, investment banker is not grossly wrong as alleged by Democrats on the Congressional panel. Drastic financial regulatory reform and change is poorly conceived, it will have great unintended consequences and concentrate weigh too much power in the hands of government, who itself is the biggest issuer of debt and should not have it’s hands on the market maker switches.

The Congressman on the panel during the Goldman testimony showed that they don’t understand how markets work, and what a market maker does and should not do. They compared derivatives and Wall Street and trading to a casino, sports betting and socially-useless behavior. Is hedging the dollar, commodities and other risks for Caterpillar and American farmers’ socially-useless? Without these derivatives and hedges American exports would cater off a cliff. Warren Buffet the most respected billionaire in America is the biggest buyer of derivatives in the world. He is a happy customer of Goldman and even was an important bailout equity stake buyer in Goldman too.

A market-maker is a company offering services either off-exchange or through exchanges that matches buyers and sellers. See Wikipedia at http://en.wikipedia.org/wiki/Market_maker. “A market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn.[1]” “In stock exchange. Most stock exchanges operate on a "matched bargain" or "order driven" basis. In such a system there are no designated or official market makers, but market makers nevertheless exist. When a buyer's bid meets a seller's offer or vice versa, the stock exchange's matching system will decide that a deal has been executed.”

Fin Reg is flawed.
If Fin Reg is passed as its conceived now, picture off-exchange derivative transactions move to exchanges and central clearing. Just like buying or selling a stock on an exchange now, do you think a commodities exchange (in Obama’s home town) has the time, role or capability to (investment) advise a buyer or seller on their transaction - to ask the party why they are buying or selling, or asking them to disclose those facts to party on the other side of the transaction? That is a ridiculous idea borne from complete ignorance from Congressman who confuse market-making with the role of investment adviser.

Goldman was not just a market-making exchange-mechanism. It was also a match-maker, cooking up deal ideas like investment bankers do for buyers and sellers of entire companies. Goldman also took on the role of principal, taking the buy or sale side of a market-making transaction, when another party dropped out of the transaction of did not take the full size of the transaction. Can a market-making exchange play that role?

Simple public securities, futures and commodities are easily traded on exchanges. For some large players (manufacturers, farmers, energy companies, shippers, insurance companies and others), very large blocks or risk-adjustment derivative instruments may be better suited for an off-exchange derivatives market. These players would influence on-exchange prices and they don’t want that either. Investment-banking can never be conducted on exchanges, it benefits from special deal making counsel and ideas from investment banking. Derivatives are somewhere between commodity transactions and private company mergers and acquisitions. It belongs in Wall Street banks. Fin Reg is wrong about this.

The same goes for prop trading, the Volcker Rule is wrong. Goldman is in the risk-adjustment business and prop trading is a way to reduce risks and of course make new risks too. But one goes with the other. Strip prop trading out of commercial banks and you leave them in the bad loan business only. Banks prop trading gains offset bad loan losses. But that story is beyond the scope of this article.

Disclosure can be inappropriate.
During the Congressional inquiry into Goldman on April 28, 2010, Congressman argued that Goldman should have disclosed their bias change to negative thoughts about the US housing market. To the equity buyers in the Abacus (Paulson) deal and investors in other (crappy) mortgage securities in their pipeline.

Goldman correctly pointed out that it would be inappropriate for a market-maker (or a mechanism) to make those disclosures. Here’s why Goldman is right.

Congressman on the panel - even the Republican ones too - loved using denigrating analogies about how derivatives resembled sports betting and a casino for disinterested parties (who are not farmers hedging their crops) carrying on “socially-useless” behavior for their own greedy profit. Congressman thought they were dumbing-down these complex concepts for American viewers, but in my view they showed they are just dumb on these subjects in general and don’t understand or respect the role of market-markers, traders and others who play a vital role in financial markets. Goldman tried to explain, but they wouldn’t listen.

Traders understand that they provide liquidity, narrower buy and ask spreads, usually help confidence and lead to the overall health of financial markets. When markets deserve a good beating down, short-sellers help uncover and bring the truth. It may hurt, but it’s better than suppressing the truth, which leads to far worse bubbles and busts.

Exchanges can not handle all the tremendous risk-adjustment needs of global businesses and if derivatives are forced on exchanges, it could mess up pricing for farmers, and lead to a vicious cycle of risk-adjustment transactions on exchanges. The private derivatives marketplace safeguards exchanges and users of exchanges.

A better analogy.
Here’s a better more honest analogy for Americans to consider when viewing Wall Street over the past meltdown years.

Market pundits and the media are warning Americans to fix their deficit crisis. They argue that is not fixed, American may receive junk bond status from ratings companies and interest rates could skyrocket, putting back-breaking stress on the system and leading to failure.

If and when Goldman comes to the judgment that US, state and local government debt is very overrated by the rating companies, and that Goldman needs to rein in risk on their long-positions in government debt or divisions dedicated to pedaling government debt around the world – in other words a new Great Short (counterbalancing) trade – what should Goldman do at that point? Should Goldman listen to what the Congressmen called for yesterday?

Should Goldman stop issuing government debt and broadcast to investors around the world that the Great Goldman Wizard of Oz thinks US, state and city debt is poised for a huge sell-off? Wouldn’t that cause a ‘run on the (US taxpayer) bank’?

Or, should Goldman just keep its own market predictions to itself and not allow those predictions to influence its role as a public-servant to be a private and trusted market-maker for government debt? Wouldn’t Goldman disclosing its negative feelings about the government debt market influence buyers and sellers and shouldn’t a market-maker function be neutral? Isn’t an on-exchange market-marker function neutral by design too? Exchanges don’t have artificial intelligence programs that snap into use to tell buyers to think twice about their orders and give their market advice.

Part II next

 

Part II

A run on the Repo Bank.
In case anyone has forgotten already, most debt-financed business models (non-depositor bank balance sheets, some hedge funds, Enron and arguably governments themselves) are one day or week away from failure. Highly-leveraged business models using overnight repo financing – think Bear Stearns, Lehman Brothers, Long-Term Capital) survive on the good graces and confidence of repo financers, reappearing each day to rollover their repos. If the market loses confidence in a highly-leveraged company and decides to pull their financing, the business can be toast. It’s that simple and severe.

“Too big to fail” is a political red herring and not a serious discussion. If and when the Federal Reserves perceives a run developing on a bank, serious of banks and contagion, they will plug that dike faster than the FDIC can come in with resolution authority.

I am reading Bill Cohan’s “House of Cards” on my vacation this week, the story of Bear Stearns demise kicking off the 2008 market meltdown. Bear Stearns and Lehman were shut down effectively and not bailed out like others because they both said no to the Fed in chipping in on the Long-Term Credit bailout (Bear said no to the entire 250 million and Lehman short-changed them with 100 million). When Bear and Lehman’s turn came up for bailout, the elephant remembered.

The story line of this book is still is the most important element in many financial markets today. Financial assets are often backed by very high leverage (debt) and unless that debt is rolled over with repos on a daily basis, the issuer may fail quickly and it can lead to meltdown contagion. If the repo investors lose confidence in the issuer’s business or model they can say no. A few no’s lead to panic, counter-party risk, contagion and a run on the issuer’s bank.

Keep quiet.
The second worst thing anyone can do is to help cause a run on a bank. Did the SEC and Congress think Goldman should have put the run on the bank call out in early 2007?

Even worse than a run on the bank call to action is perpetuating bad business and excessive risk with government strong-arm tactics. To freeze short sellers, and attack traders (speculators and market-makers) and Wall Street overall. Like that very bad idea for a financial-transaction tax, which thankfully now is off the legislative radar?

Go a step further like in China, where they don’t allow negative media stories and the state exerts control over markets with a state capitalism model versus free-markets. Is the US feeling the heat from BRIC countries and trashing our free-market model to replace it with state capitalism a la BRIC countries? That is a Thomas Jefferson nightmare of an idea.

So let’s apply this above analogy to Goldman in 2007 and 2008. Should Goldman have said no to continue as a market-maker on mortgage-backed securities? Should it say no to California bond issuance and derivative deals now?

Wouldn’t those disclosures cause a run on the bank? Shouldn’t Goldman continue to provide a very socially-useful role as a private market marker to governments no matter what its bias is? It’s trusted with that role and shutting down is not fair to the public. Risk-adjustment can be done within the market itself. A market-maker has a responsibility to be open during the good, bad and ugly.

Is Goldman guilty as charged?
Is Goldman guilty on the Abacus deal as alleged by the SEC? Goldman’s person on the Abacus market-making deal Fabrice Tourre may be a little guilty. Not for not making disclosure in general, but for allowing an incorrect perception from ACA, based on incomplete disclosure from Tourre to serve Goldman’s and Paulson’s interests perhaps at the expense of ACA. Being neutral and quiet is one thing, but giving a half-truth is another.

During the Congressional testimony, a few discussed emails indicated that the buyer and official “deal selector” ACA thought Paulson was an equity investor. Tourre only said that he disclosed that Paulson was buying protection. Congress jumped to the wrong assumption that it meant Paulson was short. They should have asked the following question. If Paulson was buying protection that statement implies he was protecting a long-side position either directly in that deal (indicating a long position in the deal) or he was entirely short in this deal but protecting long positions in his overall portfolio. Tourre probably knew that Paulson was pitching the Great Short on housing, scurrying to buy protection wherever he could all over Wall Street, and paying Goldman dearly to match-make his Great Short interests. Again, I am not sure that Goldman as a market-maker should even be allowed to tell the other side of a transaction what a buyer or seller seeks to accomplish in the transaction.

Sausage making comes to Fin Reg.
The Washington sausage-making legislative process stinks and it will hurt financial markets and the government’s own interests to pedal their debt instruments to the world.

Consider the dirty dealing and arm twisting behind the Democrat’s efforts to pass their poorly-conceived version of Fin Reg. The (supposedly-independent) SEC sued Goldman and held their woodshed hearing to (in my view) blackmail Blankfein into saying he supports their Fin Reg bill. He probably does not, since he knows that taking prop trading away from banks and putting derivatives on exchanges increases risks and does not decrease them for Goldman’s customers and banks in general. Goldman is in the business of risk management and offers risk-adjustment transactions to their clients.

Is it prudent and better for financial markets to allow the biggest debt issuer in the world – the US government – to take over regulation, influence and control of markets and market-makers? Some argue that Goldman manages conflicts of interest as market-maker, investment adviser, investment banker, and proprietary trader for its own account. But the government has an even bigger conflict of interest as the biggest debt issuer in the world with some could argue insolvent balance sheet and deserved junk status – a la Greece. Who is going to check the government? Do we need to bring back the gumption of founding father Thomas Jefferson himself?

Didn’t the government push the housing crisis to the max with GSEs Fannie, Freddie and more? With HUD, the Community Investment Act, forced lending to minorities, forced sub-prime mortgages, the whole creation of the mortgage-backed securities market and more? Not to mention mortgage interest tax deductions, income-exclusions on gains, prior rollovers and more.

Look at what the government officials have recently done and do you want to trust them at control of the switch? They used the media, populist forces and subpoena power to blackmail the most powerful investment bank’s CEO to support their Fin Reg bill, so it can pass and they can maintain power in Congress during the midterm elections. Republicans are boxed in and can’t come to support Wall Street either.

This is what founding father Thomas Jefferson feared the most, that a federal government would get way too big and overburden states, private industry and citizens and jeopardize American liberty.

Is our federal government too big to fail? The Tea Party needs to speak up for Wall Street as they are the (unfortunately billionaire) canary in the coal mine.

 

Mr Green, great post. Thanks.

ditto for Chelsea.