Former Executive Director of Goldman Sachs Explains How Wall Street Rigs the Game

Yes they can see people's orders and they do SHORT TERM price manipulations, but they aren't somehow magically rigging the game against investors. It's annoying for traders like myself and it forces me to use different order types, but it's not as if they have a magic device that can see my thoughts or see the future.

High frequency trading and investing are 2 completely different games. Yes HFT needs to be regulated better, but you shouldn't even worry about it if you are an investor.

I'd worry more about making sure companies are completely transparent. I'd also worry a lot more about the too big to fail mandate and mega banks being too big. Yes I would like to see rules changed for HFTs, because they are breaking certain market rules in my opinion. However, I think if we are worrying about American finance then I think investors should be much more concerned about getting the govt. to break up the mega banks rather than worrying about the high frequency trading noise.

Got a little off topic, but this HFT stuff just isn't that big of a deal and it sounds more insidious than it really is.

 

I think a lot of that profit just comes from market making and filling customer orders if I am remembering correctly.

 

Could you explain more? I think preventing institutions from being 'too big to fail' would prevent a future crash like we had in 2008. When the next huge bubble pops (and it will), we can more easily let institutions fail as they should, rather than have them hold us hostage and write up another TARP for them.

However, I don't know about any proposed mandates/bills or the language in them. Please feel free to say more on this because I think Too Big to Fail cuts to the heart of the matter.

 

I think the problem you're alluding to is front running client money...which is already a pretty big no-no in finance regulations. It's the big reason why you have Chinese walls between those who deal with clients and those who don't in a bank. Whether those walls are followed is a good question (especially as we saw in Barclays' case), but this is relatively well-covered ground in securities regulations.

The bigger problem is that too big to fail banks like Goldman make a ton of money in encouraging systematic risk, and they do so by creating opaque markets that can crash the system. Goldman was making a lot of "riskless profits" skimming off the top and bridging AIG FP with willing credit default swap buyers.

The problem is that AIG FP were idiots whose risk valuation strategy amounted to "housing prices will go down...NEVER." (Sadly, this was prevalent throughout Wall Street). Granted, this all started with an original idiot, but Goldman earning riskless fees matching buyer with seller made things a bit too much to handle. AIG FP didn't put its' foot down, but Goldman sure as hell didn't stop finding more and more buyers. They and the major Wall Street banks held a handle on the market size and prices. It was an obscure product that few average Americans would touch, but there was a point where basically Goldman and maybe a few others determined prices for the market with little to no scrutiny. And they thrived in this market. They expanded it recklessly.

The thing about synthetics is that you don't actually need any product in reality for them to operate. Sure, there has to be an original pool that it derives value from, but after you've sold your first few lot of subprimes, you don't actually have to create more subprimes (and go through the trouble of finding all those questionable FICO credit scores) to bet on the subprime market if you're dealing with credit default swap derivatives. The potential to leverage yourself with these products that can appear out of thin air is terrifying, and explains why a titan like AIG could fail.

The only risk Goldman had was AIG failing to pay up on the credit-default swaps and fees, or counter-party risk. You can stand on the top of the mountain, but your paper is worthless if everyone else is dead. Fortunately, the government took care of that risk by paying AIG and making them pay Goldman 100 cents on the dollar.

So, you have too big to fail banks with even more incentive to create systematic risk, since they sure as hell aren't seeing the downside of that. Market making truly becomes a "no-loss" game if ALL risks are taken care of.

These issues are things that are not well-covered in securities regulations, and how to handle these issues may well dominate the next decade or so of economic thought.

 

The language is a bit ambiguous, but I believe Mr. Smith refers to the trading business as the prop trading desks, and not the sales/market-making functions of the bank on behalf of clients (which realistically, you have a much lower chance of losing out on).

I could be wrong. In either case, I don't think his argument is particularly strong without looking at the actual rates of return and the risks taken. I can make money 90 days in a row borrowing from the Fed and piling into Canadian t-bills, that doesn't really tell you anything.

 

I was referring more to Robbie's quote of the BOA 1.000 batting record. It makes sense to me that he would be referring only to the prop trading in terms of trying to make the numbers pop in that specific quote. If you add market making and sales/complying with client orders, winning most of the time kinda becomes routine.

As for your secondary point, I understand what you are trying to say, but at the same time, there already are rules to regulate that situation. It is possible, in fact probable that Wall Street firms don't follow them however. Correct me if I'm wrong (I haven't read Mr. Smith's book), but he brings no smoking gun to indicate that this is the case, or beyond what we already know from public record. So I'm hesitant to stick too much on that angle unless there is LIBOR-like proof Goldman is engaging in illegal practices.

 

I don't think there will be a push to break up the big banks even though I think it should happen. IF IT DOES HAPPEN...buy every big bank that is getting broken up and hold it for the next decade in an IRA or whatever investment vehicle you have.

 

Front running happens everyday and that's how HFTs make their money. It isn't for customer orders, but I consider it front running at the least and market manipulation at the worst. HFTs putting out bs bids and offers with shares that they never intend on filling and being able to back away from quotes simply because they are located closer to the exchange is crap. They should put in limits on how quickly bids and offers can update. They are basically acting like market makers, but are fulfilling none of the liquidity requirements of a market maker.

Maybe it is a better and more efficient way to operate, but it's annoying as **** when I see a stock like Walmart with 25,000+ shares displayed on the bid or ask and I know that if I want to buy or sell those shares that I won't get filled on those displayed shares. If I try to buy 10,000 of those shares it is almost guaranteed that I will maybe get filled on 5,000 to 6,000 shares before the displayed order backs away from the price they are at. Oh well I live with it and use other routes rather than displayed orders if at all possible.

I see no problem with Goldman providing liquidity to a market of buyers and sellers as long as they are not abusing their position as a market maker or trading on inside info. A lot of people make really poor decisions in manic times like the housing bubble or tech bubble or airline bubble or railroad bubble or whatever bubble you want to talk about. If Goldman purely acts as a finder/market maker for a buyer and seller then they are doing their job and they are helping to provide liquidity.

Well you do need a real product for the derivative to work. There is no way around it. The options and futures markets are 2 excellent examples of great and extremely successful uses of derivative products.

The problem with the derivatives of the subprime market was primarily that people didn't even know what the original product really was. People just bought cause housing was never going down so why not buy an income producing product that was based off of mortgages for assets that never decline in value! When they realized what the product really was and that it wasn't producing the AAA-rated income was when things imploded for these markets.

I honestly don't think the big banks will ever plan on a govt bailout to save them. I don't think their business strategies remotely involve the thought of the govt backstopping all of their operations if they do take too much risk. People got out of control and regulations on banks got relaxed. This created a race for big banks to amass assets to control market share which ended up creating "too big to fail" banks. I don't think there was any foresight that expected that as the end game during that manic time and I can't see banks being able to return to those risky overlevered positions that they were in for probably the rest of my lifetime.

 

I'll put it simply...They don't and no one knows all that.

The equity market simply does not give people the ability to track things that well. The options market you can track things better due to certain flags that go along with order fills, but you still wouldn't know the person's strategy or underlying positions that they maybe hedging.

If this were true then the markets might be a much more efficient pricing mechanism, but they aren't. The markets are still heavily subjected to human emotion and banks are not psychic.

 

There is evidence that Goldman was abusing its' position as a market maker. It won't be a big controversy because the people trading their products were all deep in the investing world, but at a certain point, even when subprime mortgages were defaulting, CDS prices held steady (which makes no sense). Market makers were quoting prices that they would never execute. That market really was a f**king mess.

The problem with Goldman as market maker for opaque products is the following; Goldman has no incentive to rein in the amount of sales. In this case, they were actively looking for consumers to satisfy AIG FP's idiotic desire to sell a "riskless" product. More sales, more commissions. Unfortunately, more sales also equaled a f**kload more risk for the system. Providing market liquidity is all well and good, until you load one of your counterparties up with so many liabilities that they explode, killing liquidity not only in these opaque CDS markets, but in the repo markets, in corporate debt markets etc. Not to mention the fact that CDS were a shoddy product and markets for them were shoddy as well. With no spotlight, and no regulation, all kinds of cowboy things were happening in these markets. Private incentives led Goldman to pursue an unlimited amount of these sales, while social incentives (of not having a financial system that could explode) dovetailed the other way.

You need an original pool of products for derivatives to function, of course. However, my allusion was to the fact that after you have the original pool, you do not need to produce anymore of the original product to bet on it. So with stocks and stock options, yes, you do need shares outstanding to bet on a company, but after the provision of options, you don't actually have to buy a share or care about the company to bet on its' future.

So it was with subprime and the synthetics in this market. As maligned as subprime mortgages were, they were at least something tangible of public record with some rules. If you did your homework, you could understand what went in the products. CDOs and CDS were about as opaque a market as you could get, with no rules. Essentially, CDOs obscured an already haphazard market, and leveraged risk throughout the system by making it so much easier to bet on outcomes within this shoddy market without actually going out and making new subprime mortgages. It hid the number of players betting on the market and their exposures to loss. It allowed an infinite amount of system risk without there being any tangible smoking gun. Trust me, if you had produced the number of subprime mortgages to satisfy the actual demand for betting on these products, more people would have noticed how bad the actual market was.

Derivatives were like the side room, that allowed bets that could destabilize the financial system go to and fro without detection.

As an aside, options markets are actually seriously f**ked in some respects, or they were at least when Black-Scholes was in vogue. Extreme risk at the ends was not taken into account. You could make a killing on extreme volatility. My two cents.

Yeah, I don't think Goldman ever predicted AIG would fail either, but at the same time, if they didn't think the government would backstop them then, they sure as hell do now. They thought it was riskless before because they didn't take into account some risks, now they know it's truly riskless now, because whatever risks they can't think of, daddy government will take care of eventually.

I wouldn't bet on the second. After the Great Depression, we had a government that actually kicked ass and pushed forward a new financial regulatory system, and it took what, less than sixty years for everyone to forget the lessons (I look to the eighties when all this craziness began).

The next financial generation will probably do the same.

 

Goldman is everyone's little darling, they were late to the bets against CDOs. Check out what Mike Burry did. Firms like Goldman are salesmen, and they were selling very complicated investment products. Many of the people they sold to had no idea what they were buying.

Donald Shackleford said to a Congressional committee during the S&L crises "What Wall Street is doing out in the open is almost indecipherable…the only guy that’s going to make money is the salesman, because you can’t figure out what you’re doing”.

Besides, there were some simple rules of thumb people could have used to understand why CDO prices would decline.