Alasdair Macleod – 23 July 2010
Goldman Sachs has agreed to pay a fine of $500m in return for which the SEC is dropping its charges against the firm in connection with a mortgage securitisation which went badly wrong for its investing clients. It is worth briefly recapping the events that led to these charges, to understand the seriousness of them.
Goldman marketed to investors a synthetic collateralised debt obligation in early 2007, named ABACUS 2007-AC1, which was tied to the performance of sub-prime residential mortgage-backed securities when the US housing market was beginning to “show signs of distress”. What the investors did not know, and was not disclosed to them, was that this CDO was specifically constructed to enable another Goldman client, Paulson & Co. Inc to take a very large short position against the US housing market. Furthermore, an independent company called ACA Management LLC which specialised in analysing credit risk in securitisations was employed to front the deal and the involvement of Paulson was concealed. That is a brief summary of the charges laid by the SEC against Goldman on 16 April 2010.
These charges paint a picture of the worst sort of market abuse: they are completely against the spirit of regulation and are an indictment of dual capacity, by which we mean a securities business acting as both broker and market-maker. A securities house acting in dual capacity is inherently conflicted, and strict regulations are meant to ensure that these conflicts of interest are avoided where possible, and to ensure adequate disclosure where they are unavoidable.
The charges were alleged at about the same time that Goldman proudly boasted that they had managed to make net profits on trading activities every day in the first quarter of 2010. Bully for them. It is actually impossible for this to happen by skill alone: even the most successful honest traders rarely average a 65% success rate on their trades. Various other large investment banks also declared a loss-free quarter, confirming that Wall Street has become expert at tilting the odds so much in its favour that their customers will always loose.
I first became aware of Goldman’s trading techniques over twenty years ago as an agency broker when dealing in the South African gold share market after-hours in New York. In those days it was every London broker’s ethos and duty to obtain the best possible terms for his client, so he would approach the jobber or market-maker that in his judgement was right for the deal. The negotiations would go something like this: What are you calling XYZ?” “500 to 505.” “What is your size?” “Half a million.” On this information, the broker would then proceed to negotiate a deal, or back off without having disclosed his intention.
My conversation with the Goldman dealer was different. At the outset, he wanted to know whether I was a buyer or a seller and the size of my order, so that he could load the terms in his favour. As it happens, I refused to open my book and by standing my ground got the deal I wanted. This is one way in which market-makers now load the price in their favour on large orders. I was also always suspicious of the American habit of placing stop-loss orders. Such an order shows either a lack of conviction about an investment, or signals speculation in unaffordable size. For this reason, it was not surprising to see Wall Street mysteriously slump by 1,000 points on 6 May, taking out stop-losses, followed by a miraculous recovery in prices. It is the easiest 10% any market maker can make.
Wall Street investment banks also use computer trading techniques, such as high frequency trading. Typically, the computer will place small orders on an “immediate or cancel” basis to flush out the price limits on large orders. It is therefore virtually impossible for a client with a genuine order to improve on price. It is estimated that over 70% of the trades in the US markets are now conducted between computers through high frequency trading and similar techniques.
An agency broker is paid to protect a client from this sort of practice, and a good broker is worth every penny of his commission. But these investment banks are also dealing directly with investing institutions, commission-free or charging a commission if they can get away with it. Their financial resources are so large that they are impossible to squeeze. The idea that professional investors are capable of dealing on a caveat emptor basis is plainly wrong, when they are up against the investment banks.
The Goldmans of this world do not confine themselves to these lucrative dealing practices. They also initiate deals which are then aggressively marketed, as evidenced by the construction of synthetic CDOs such as ABACUS 2007-AC1. The big investment banks have stuffed other banks and even local authorities and municipalities all round Europe with many hundred billions in highly toxic derivatives, which often culminate in an option exercisable against the client. Many of these clients are now reneging on these deals, because they had little or no understanding of their true cost.[i] And it has now dawned on governments throughout Europe that Goldman is not actually their friend, and the firm is now excluded by Greece, Spain, Italy and France from leading roles in government debt financings.
The reality is that stock and bond markets no longer serve honest investors and speculators. Markets now exist so that a small number of very large, powerful financial organisations can consistently make unimaginable sums at everyone else’s expense. They have developed over-the-counter derivative markets that escape regulation that are even more lucrative than dealing in listed securities. These organisations are so powerful that no government, no central bank and no corporation can stand up to them. The Lehman experience confirms they are too big to fail, and so are even insulated from the systemic risk they have conspired to create. That $500m fine is a small price for Goldman to pay to remain in the game, being only one week’s trading profits.
The whole thing has a feeling of decadence about it: a financial fin de siècle one hundred years on. The investment banks are like leeches feeding off the credit bubble. And the less that genuine industry wants money to invest, the more there is for the investment banks to punt. This is best illustrated by the value of all over-the-counter derivatives, which last year grew by 12% to $615 trillion[ii], contrasting with bank lending to real people and businesses, which generally contracted.
This is a problem for the central banks: injections of credit into the system do not end up expanding the balance sheets of commercial banks, they merely fuel the activities of Goldman Sachs, JPMorganChase, Deutsche Bank et al. But continued growth of these activities depends to a large degree on economic recovery, or at least the prospect of it. With leading indicators in the US now pointing towards a renewed economic slump, the Chinese property bubble at extremes of over-valuation, and the Southern European banks completely shut out of bond markets, the risks are moving firmly towards a second phase of the global economic crisis. If this happens, counterparties to all those derivatives will mutate from insolvent to bankrupt. Dealing with a second crisis will be very different from the first.
Prompt action at the time of the Lehman failure saved the financial world from melt-down. By rescuing AIG the Fed managed to stop the crisis undermining counterparty relationships within the derivative markets. But the basic difference was that the Fed’s task then was to prevent systemic failure; this time we are walking towards a failure of customers to honour their obligations because their financial position has deteriorated significantly. The Fed cannot force the City of Milan to honour its derivative obligations.
And that may be the calamitous end of the Masters of the Universe, because they have actually become far too big to save. How can the Fed back-stop the $226 trillion in derivatives on the Wall Street banks balance sheets alone?
[i] See my original article on the SEC case linked here.
[ii] This is eight times global GDP of $77 trillion.