Our Goldman Sachs Problem
The striking thing about Goldman Sachs’ profits isn’t so much that Goldman is making so much money as it is that, as Kevin Drum observes, the money is basically all coming from trading. It’s not that they’re bringing in big bucks doing investment banking or giving financial advice. They’re just gambling. And winning.
But what if they lose? For all we know, they’re actually making really unsound bets. Imagine putting $1 down on a lottery where there are 100,000 possible outcomes. In 99,999 of those outcomes, you win $3. But if that 100th ball comes out, you lose $1 billion. That’s a terrible bet. But you could still put a nice long winning streak together making that bet. You could earn a lot of money. Now you’d never do it with your own money on the line. But suppose you could do it with your company’s money, and then pay yourself an annual bonus based on the profits, and know all along that if you ever wind up with the bad outcome that Uncle Sam is going to bail you out.
52 Responses to “Our Goldman Sachs Problem”
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October 15th, 2009 at 3:19 pm
What if they are gambling, and winning because they have been able to stack the deck? We already know they have the computational resources to do high frequency trading. They probably have other ways to tilt the playing field in their favor. So instead of worrying what happens when they lose (since that won’t happen), we should worry about the money and resources they are sucking out of the real economy.
October 15th, 2009 at 3:28 pm
“Trading” is not gambling at all–it’s executing trades on behalf of clients for a small fee or the bid-ask spread.
“Prop trading” or “Principal investing” is a little closer to gambling except, you know, it’s not gambling. It’s investing. There is risk involved, but to say it’s “just gambling” is dramatically oversimplifying.
October 15th, 2009 at 3:29 pm
How can they lose? Half of Obama’s administration is on their payroll.
When the history of Obama’s 4 years in office is written, there will be a special chapter dedicated to the rampant corruption and inside-trading involved and how the media and the blogosphere essentially turned a blind eye to it.
October 15th, 2009 at 3:31 pm
Matt, it’s not gambling when you are the “house”.
GS has so many people in places of power and with access to inside information. They regularly trade against their own clients’ order flow, physically place your arbitade/HFT computers on teh floor of the exchanges to have speed of exectution advantages, and have the capital and power to force markets for periods of time.
There is a reason I own GS stock, and a reason they don’t lose trading. Can’t beat em, join em. When the treasury and fed are in your backpocket, and you have reams of early, inside information on everything from rate policy decisions to earnings of other companies, trading is easy.
Give me the contacts and power of GS along with a client base I manipulate through research reports and the “upgrade/downgrade” game, and it would be virtually impossible to lose trading. Keep in mind, these guys are accounting for large portions of the entire trade in some commodities.
October 15th, 2009 at 3:32 pm
soullite,
I think you are forgetting that Hank Paulson, Bushes secretary of treasury, was the former CEO of Goldman Sachs. He is the guy who created the plan to pay GS so much money for AIG.
October 15th, 2009 at 3:36 pm
Why do they care? Our current political class will just bail them out (again). There’s absolutely no risk for them; the Bush and Obama administrations have made that very clear.
October 15th, 2009 at 3:54 pm
Mike s, I think that you are forgetting that George W. Bush is no longer the President. Time for Obama to stand or fall on his own two feet. “But they were worse!” isn’t going to work in an era of falling wages and rising unemployment.
October 15th, 2009 at 4:01 pm
What’s good for Goldman Sachs is good for America.
(you know that claim is being made on CNBC right now)
October 15th, 2009 at 4:05 pm
soullite,
I think you’re airbrushing the past. Obama is bad, but he has had to cleanup a multi-trillion dollar mess left by his predecessor.
Also
“For all we know, they’re actually making really unsound bets”
This has already been proven to be true – note the AIG payments were “unsound bets”
October 15th, 2009 at 4:07 pm
Hey Matt. McMegan is going to jump on you for badmouthing those extremely talented people that perform a critically important work for the economy and deserve every penny they make regardless of the outcome for the company or the client. Now, walking away from your underwater mortgage or giving food stamps to poor children .. That’s immoral!!
October 15th, 2009 at 4:11 pm
I have a tiny bit of experience dealing with GS. They are not gambling…they are screwing all the weak market participants and squeezing every extra percent they can. Rapacious bastards but they are very good at their game. Of course they are exposed to systemic risk just like other financial firms but these guys know their shit.
October 15th, 2009 at 4:13 pm
Exactly!
But I thought you were approvingly reproducing some graphs from Cowen arguing that this kind of siphoning wasn’t going on: that there was no evidence that remuneration structures were contributing to the reckless behaviour.
I am sure I am missing something but I would really like to be enlightened.
October 15th, 2009 at 4:14 pm
In “The Black Swan”, Taleb calls those trades
picking up nickels in front of a steamroller.
All fine until the day the steamroller jolts
ahead.
Mike S:
But when you are GS those unsound bets with AIG
pay off, too.
October 15th, 2009 at 4:15 pm
Nothing was more perfect for GOLDman than replacing BushCo/Paulson/Bernanke with Obama/Geithner/Bernanke.
October 15th, 2009 at 4:19 pm
I think the key is regulation of leverage. If you make it so it’s vanishingly unlikely — on the basis of simple mathematics — for any of these big institutions to go completely kaput — because there will also be some capital left in reserve, then there won’t be the need rescue them with taxpayer money. If they eff up, their share price will plunge is all.
I don’t see any other solution, because, rest assured, “simply letting them fail” sadly isn’t going to be an option, not if the institution in question is so large as to cause huge pain in the wake of its failure.
October 15th, 2009 at 4:24 pm
An entire year’s GDP disappeared in the months before Obama became president.
Some people keep forgetting that.
October 15th, 2009 at 4:29 pm
As an aside, the case for a few billion in arbitrage profits sloshing around is that it is a reasonable price to pay for making the markets more efficient.
Anyway, I agree with Jasper: stick them with relatively high capital requirements and relatively low limits on their leverage ratios. It is the only real way of dealing with these problems.
October 15th, 2009 at 4:33 pm
Mike S. No, I think you’re over thinking this. Obama is bad is as far as I need to go. I don’t care how challenging he finds his job. I only care that he is failing. I know that you want to make excuses for your team, but in the end, I don’t care.
Obama is corrupt. He has hired corrupt individuals, and he is ignoring it as they use their position to help their former employer that everyone knows they intend to go back to working for as soon as this adminstration is over. There is nothing you can say about GWB that makes that ok. Trying just makes you sound like Republicans screaming “9/11!!!!” over and over and over again.
October 15th, 2009 at 4:33 pm
Mike S. No, I think you’re over thinking this. Obama is bad is as far as I need to go. I don’t care how challenging he finds his job. I only care that he is failing. I know that you want to make excuses for your team, but in the end, I don’t care.
Obama is corrupt. He has hired corrupt individuals, and he is ignoring it as they use their position to help their former employer that everyone knows they intend to go back to working for as soon as this adminstration is over. There is nothing you can say about GWB that makes that ok. Trying just makes you sound like Republicans screaming “9/11!!!!” over and over and over again.
October 15th, 2009 at 4:34 pm
I think Jasper is right. Control leverage through capital requirements. Oh, and tax the bastards. We need a top rate for millionaires of 46%. It’s the only way for the taxpayers to get some of our money back. That, and a transaction tax.
October 15th, 2009 at 4:45 pm
I also endorse more progressivity at the top of the income tax, although I think that is a good idea regardless of the source of that income.
October 15th, 2009 at 4:52 pm
Guys, far be it for me to defend Goldman, but there’s no way Goldman’s making all this $$ from trading. I’d have to look at their quarterly, but what everybody’s referring to as “trading” (ie, prop trading) is probably a lot more like “trading activities” (ie, prop trading, trade execution for others, stock loan/repurchase agreements, customer acct interest income, etc.)
And: trading is only gambling when you don’t know what you’re doing.
October 15th, 2009 at 4:52 pm
Goldman tries to hire only the best people from the most elite schools. Back in the day, you could have landed a job a Bear or Lehmanwith an MBA from Babson. Goldman also pays more than almost any firm on Wall Street.
Lehman went bust and Bear was sold for pennies on the dollar – it doesn’t seem that paying their people less and therefore hiring a less elite staff really worked out for them.
Goldman, on the other hand, seems to have done very well hiring the best and paying them the most.
October 15th, 2009 at 5:02 pm
Lot’s Goldman’s ‘trading’ profits are really ‘market making’ profits and are better thought of as commissions. This includes ‘high frequency trading’.
Two of Goldman’s big competitors, Bear and Lehman, are no longer there, and Merrill is but a shadow of it’s former self, but that won’t last, but what ends it isn’t knowable at this point.
Not all of their trading profits are commissions though, and that is a problem, in that the govt has no business cosigning their margin loans. Fixing this is Washington’s job, not Goldman’s, and maybe something might move on that except Barney Frank, a true Solon if there ever was one, is busy fixing the problem of making Goldman’s compensation practices legally necessary. If he had a clue he’d be working on that rather than ‘compensation practice reform’, but I don’t see that happening, as Frank has no clue. Or maybe Goldman has bought him, but I don’t think so.
October 15th, 2009 at 5:10 pm
jmo,
Nice theory but with its political connections, Goldman Sachs would make just as much money if they recruited out of barber schools.
October 15th, 2009 at 5:15 pm
Nice theory but with its political connections, Goldman Sachs would make just as much money if they recruited out of barber schools.
Where do you think the Goldman first met many of these “policial connections” could it be Llyod Blankfein and Ben Bernake both lived in Withrop House while undergrads at Harvard? Why yes, as it turns out they did.*
*. Now keep in min Blankfein grew up in public housing, the son a postal worker and Bernanke was the son of a Pharmacist and school teacher. So, its not like they came from wealthy families. They got into Harvard, presumably, because they were the best of the best.
October 15th, 2009 at 5:16 pm
That should read:
“Where do you think the Goldman boys first met many of these “policial connections”? Could it be Llyod Blankfein and Ben Bernake both lived in Withrop House while undergrads at Harvard? Why yes, as it turns out they did.*”
October 15th, 2009 at 5:23 pm
Matthew–
You are absolutely right that this should be a concern. This is the business model of the (hypothetical) firm Capital Decimation Partners–originally described by Andrew Lo at MIT. See http://www.econbrowser.com/archives/2005/11/hedge_fund_risk.html
Capital Decimation Partners–I love that name!
October 15th, 2009 at 6:07 pm
Look, the big problem is that a lot of people have hated this system for a long time. They hate the corruption. They hate the fact that America is becoming a third-world nation. They hate the fact that their children will be much worse off than they are. Obama ran on a platform of reform and change. He has thus far refused to change anything, and his reforms have been a sick joke.
So yeah, GWB was a bastard. But thats what people expected from him. We expected a lot more from Obama, because he promised to end this shit.
October 15th, 2009 at 6:17 pm
DTM @17: “As an aside, the case for a few billion in arbitrage profits sloshing around is that it is a reasonable price to pay for making the markets more efficient.”
Define “efficient.” Do you mean it in the colloquial sense of “working better,” or in the sense used in “efficient markets hypothesis” (EMH)? They are not at all the same, and while a technical argument can be made that the trading done by GS contributes to the second form, it’s harder to argue it helps with the first.
By the way, the second version is roughly equivalent (in its stronger forms) to “the market is functioning in a state where no one can beat it, no matter how much knowledge they have” – or, shorter version, “behaves randomly.” This correlates well with Matt’s hypothetical about gambling.
October 15th, 2009 at 6:53 pm
Goldman says the key to their winning trades is speed, high velocity trading. Max Keiser thinks its front running.
October 15th, 2009 at 6:58 pm
Since the “collapse” Goldman Sachs’ VaR has increased by 25% to its all time high. You can take more risk when Timmy has your back.
October 15th, 2009 at 7:08 pm
The Stock Market is not a lottery. Goldman Sachs is not gambling. They did not lose money even on the sub-prime mortgage business because they bet against it (they lost some because of the fallout, but not much). They’re fucking smart.
October 15th, 2009 at 7:36 pm
And this second, higher intelligence was allowed to make a mockery of the labors of the first. I can’t think of another example of a big Wall Street firm saying so clearly through its trading positions as Goldman Sachs did over the past year that it thinks the rest of its industry, including its own people, is a bunch of idiots. They have obviously designed their firm to take into account their idiocy — without ever having to put too fine a point on it.
and remember GS had other people’s money in subprime and CDOs and their own money in the shorts
October 15th, 2009 at 9:45 pm
Define “efficient.” Do you mean it in the colloquial sense of “working better,” or in the sense used in “efficient markets hypothesis” (EMH)?
The latter.
By the way, the second version is roughly equivalent (in its stronger forms) to “the market is functioning in a state where no one can beat it, no matter how much knowledge they have” – or, shorter version, “behaves randomly.”
That is basically correct, and it is a desirable state of affairs. Among other things, that means that spot prices for assets traded in efficient markets very, very quickly reflect all available and relevant information. Therefore, most people can buy and sell assets in efficient market exchanges without spending a lot of time and effort doing their own independent spot pricing, which would be a duplicative and zero-sum waste of resources.
By the way, the expected return on assets priced in this way isn’t entirely random: it is supposed to be a risk-adjusted market return. What is effectively random is whether or not a given asset’s actual return will be above or below this expected return (the former defined as “beating the market”). In other words, you can still actually invest for profits in assets priced through efficient market exchanges. There just isn’t supposed to be any known method for getting profits other than those investment profits, which again is a desirable state of affairs.
This correlates well with Matt’s hypothetical about gambling.
Not really. The real world version of the EMH is dependent on the idea that there are a set of extremely well-funded arbitragers competing with each other in the markets to identify and exploit any pricing inefficiencies that may temporarily arise. The competition to exploit inefficiencies between these entities explains how exploitable inefficiencies disappear so quickly. But for this to be possible, there do in fact have to be temporary inefficiencies available to exploit, or otherwise these well-funded arbitragers would lose their funding.
So what these arbitragers are doing isn’t supposed to be gambling–as the label implies, it is arbitrage. The gamblers are the people who still think they can “beat the market” after the arbitragers have done their work.
To sum up, my point above was that highly efficient markets are good, and it is probably worth spending a few billions annually to have them. And in the real world some such cost is unavoidable, because you won’t have highly efficient markets unless such profits are available to a few arbitragers. So if Goldman is one of those arbitragers–and they undoubtedly are if anyone is–then that is a reason not to be concerned if they are making a few billions annually through arbitrage.
October 15th, 2009 at 9:49 pm
2 ways of killing it at GS:
1) HFT aka high frequency trading. The exchanges PAY YOU because you are a big “liquidity provider.” You are in and out so quick that the price change makes little difference as long as the exchange payment for the “liquidity” service is greater than any potential loss on the trade which it almost always is.
2)You talk to a GS analyst about a stock she’s about to release a report on. You find out she’s about to change the GS rating from neutral to a buy. You immediately take a huge position. 3 days later, she recommends purchase of the stock. You sell your position to the suckers.
No gambling involved.
October 15th, 2009 at 11:44 pm
Recruitment based on University prestige is a sign something is wrong. If they would hire from the 1% with the best grades at staate Universities, that would look more like serious selection of the best.
October 16th, 2009 at 12:40 am
…if GS really does turn out to be wantonly sucking the country dry… and our government isn’t going to ever move to stop it… and violence simply isn’t an option because GS has the government watching its back, and “our” money in its coffers…
…what could we, “the little people”, ever possibly hope to do to survive as free individuals?
Is this Eliot’s Whimper?
October 16th, 2009 at 2:34 am
“Since the “collapse” Goldman Sachs’ VaR has increased by 25% to its all time high. You can take more risk when Timmy has your back.”
If they do everything right, VAR should increase when the stock market goes lower. VAR is just some math vodoo that does not reflect valuation levels. So some unmathematical common sense adjustments are necessary (lower your var during a huge boom, increase during a crisis like that with low valuations).
Finance deserves lots of bashing, but the attacks on Goldman Sachs right now are kind off over the top. Why singling out Goldman right now? They rather did less, not more crap.
October 16th, 2009 at 5:31 am
If we had our own Peoples Bank of the United States, an old fashioned, conservative, savings and loan, nationwide, just to meet the normal and basic banking needs of Americans, we wouldn’t ever have to worry about Wall Street bankers and brokers again.
Hell, we could actually encourage them -we could deregulate the system all the way. We could grant them the power to create what they claim they desire most, the freest Free Market ever. Whether banks and other financial institutions survive or die in this Wild Casino wouldn’t matter on iota to the government or to any American who wasn’t gambling with them.
And you know what else? The Wild Casino would have a hard time buying a government that already gave them everything they wanted.
Two separate BANKING SYSTEMS, one for us and one for them. And only one rule. Our system never again bails out their system.
October 16th, 2009 at 5:41 am
The mathematical expected value of the bet proposed by Matt is negative $99997. Goldman Sachs would have to be really crazy or stupid to take that bet, which they’re not. You’ll need a better example to explain excessive risk-taking in financial markets.
October 16th, 2009 at 6:19 am
[...] to hear demands for a return to ‘responsibility’ once the very same people have resumed their siphoning operation. As Yglesias points out, those arguing for tight money are looking after the interests of the [...]
October 16th, 2009 at 6:54 am
“The mathematical expected value of the bet proposed by Matt is negative $99997. Goldman Sachs would have to be really crazy or stupid to take that bet,.”
Wrong, since the losses are largely other peoples money, while the gains are 100% Goldmans.
October 16th, 2009 at 7:17 am
Another aspect of the GS problem is that it attracts many of the brightest college graduates to indulge in zero sum games.
These banks are a tragic waste of national resources.
October 16th, 2009 at 10:31 am
If we had our own Peoples Bank of the United States, an old fashioned, conservative, savings and loan, nationwide, just to meet the normal and basic banking needs of Americans, we wouldn’t ever have to worry about Wall Street bankers and brokers again.
Maybe. But I don’t see the PTB ever allowing this to happen. Credit Unions have been under attack from the big boys for years, for instance.
Is there any currently legal framework, short of cash-in-the-mattress, that would allow folks to ‘check out’ of a corrupt financial system without having to move to a shack in Idaho?
October 16th, 2009 at 10:50 am
They do both, actually. Quite a few friends of mine interviewed with GS – they spend a lot of time interviewing at elite engineering/math/CS programs (many of which are state schools). Goldman essentially makes money from HFT because they have systemic advantages other people don’t (i.e. having very, very fast computers plugged directly into the market) – this also means lots and lots of money for the likes of Intel, AMD, nVidia, IBM, HP, and Sun, as GS pays top dollar for the top of the line chips that these companies make as they come out.
The main argument I’d make against Goldman is this:
What, exactly, is the value of having credit default swaps? Or , for that matter, securitization in general? The solution, IMO, is to work to reduce college costs so that college graduates don’t have 100k in student loan debt, and to incentivize graduate work in engineering/pure science/mathematics by means of awarding more fellowships and scholarships, and loan repayment assistance for students who go on to get doctorates in these areas and end up doing research work (sort of like what law schools do for students who end up in public interest work).
October 16th, 2009 at 11:28 am
What, exactly, is the value of having credit default swaps? Or, for that matter, securitization in general?
So you have a lending business. This lending business may be somewhat concentrated in various ways–by geography, type of borrower, terms, and so on. That leads to diversifiable risk in your loan portfolio, and you have to charge your borrowers to cover this diversifiable risk, resulting in higher interest rates and lower loan volumes for your borrowers because of this concentration in your loan portfolio.
OK, now imagine you can easily transfer those risks to a third party, who can also take on such risks from other lending businesses, thus diversifying them away (or you can eliminate the third party and imagine the lenders trading risks with each other to diversify away these risks–it has the same implications). Easily eliminating those diversifiable risks means you can charge your borrowers less in interest rates and increase your loan volumes.
That is the essential purpose of loan securitizations and credit default swaps: to allow this diversification of risks that would otherwise accumulate at concentrated points of origin, all to the ultimate benefit of borrowers and potential borrowers. The problem is that these instruments can also be abused for other purposes if not properly regulated, which is what we let happen.
October 16th, 2009 at 12:46 pm
Our Goldman Sachs problem… is that this corporation would be bankrupt if not for various government backstops, guarantees, handouts and regulatory changes.
When certain businesses are given vastly preferential treatment in the market there are myriad severe unfortunate consequences to the whole economy.
Perhaps it is of societal value to further the existence of GS, in which case we should set in place a way to measure this outcome. How about if in five years the average standard of living in America has not improved, we are allowed a few firing squads?
October 16th, 2009 at 1:03 pm
Their results in the second quarter where they made money on 90% of days means that they are not ‘trading’. They are controlling their ‘trades’. Often with the use in inside information or by creating the ‘information’ that moves the markets.
At any rate this is the result of the anti Hooverite policies MY has applauded. This was the only way to save the world. If it continues to work then soon GS’s debt will trade below the Treasuries and then, finally, government can take its proper place behind private capital. Who knows, the notes your children carry in their wallets might have pictures of Hank Paulson or Walter Wriston.
The main political story going forward is how Ceasar and the corporations will accomodate each other or if they can.
October 16th, 2009 at 2:34 pm
Guess who might conduct an investigation into suspicious, highly profitable Goldman Sachs trading?
One of the Goldman boys was hired as COO in the SEC’s enforcement division:
http://www.latimes.com/business/la-fi-sec-coo16-2009oct16,0,6370675.story
October 16th, 2009 at 4:27 pm
Goldman Sachs scum (um, employees) would be laughing at all of you if they ever took the time out from counting your (oops, I mean their) money to read this.
Look, GS owns the country. Why shouldn’t they collect the dividends?
October 17th, 2009 at 5:53 pm
[...] are using the treasury as a backstop for their siphoning activities. After Kevin Drum, Yglesias notes that the recent profitable splurge is all coming from trading. But what if they lose? For all we [...]