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Winehole23
10-20-2009, 08:50 AM
October 15th, 2009
Letting Goldman roll the dice (http://blogs.reuters.com/rolfe-winkler/2009/10/15/letting-goldman-roll-the-dice/)


(http://blogs.reuters.com/rolfe-winkler/2009/10/15/letting-goldman-roll-the-dice/#respond)
Posted by: Rolfe Winkler (http://blogs.reuters.com/rolfe-winkler/author/rolfewinkler/)

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On this morning’s conference call, David Viniar, Goldman Sachs’ chief financial officer, emphasized the bank’s valuable social role. His bank made markets and provided credit when other financial players were suffering.
But is Goldman really such an indispensible financial intermediary? One look at the firm’s revenue breakdown shows that it’s more casino than anything else, and some of the markets it makes still put the economy in danger. With markets recovering and competitors falling away, Goldman’s trading and principal investment revenue through the first nine months of the year was nearly $24 billion, on pace to break the $30 billion record set in 2007.


(Click chart to enlarge in new window)
[URL="http://blogs.reuters.com/rolfe-winkler/files/2009/10/goldmans-revenue.jpg"]http://blogs.reuters.com/rolfe-winkler/files/2009/10/goldmans-revenue.jpg (http://blogs.reuters.com/rolfe-winkler/category/rolfe-winkler/)
Goldman, in other words, generates most of its revenue trading its own money and earning vigorish on customer transactions. It’s a hybrid hedge fund and bookie, with an investment bank and asset management business thrown in for good measure.


With that in mind, one is left to wonder whether Goldman was really worth saving last year. What have taxpayers received for $50 billion worth of cash and guarantees, for giving Goldman access to the Federal Reserve as its lender of last resort?


Saving Goldman was largely about saving the derivatives market, which is so big and unstable that the death of one counterparty could mean the death of all. With big commercial banks like JPMorgan Chase in deep, saving the derivatives business was as much about protecting depositors and maintaining the integrity of the payment system as it was derivatives themselves.


Many of us didn’t like it — we thought banks like Goldman should have been recapitalized the right way, by wiping out shareholders and forcing subordinated creditors to eat their share of losses. But that ship has sailed. We socialized the risk while privatizing the profit because we were told we had no other choice: The government had to guarantee the biggest banks’ liabilities because they were too unstable to survive bankruptcy or FDIC receivership.


If that’s true, why haven’t we seen any substantial reforms to reduce systemic risk? Congress is kicking around new resolution authority to help resolve failed systemically-important banks. But the goal should be reducing systemic risk to begin with. Yet serious reform of the derivatives market — something that would reduce its size significantly — is nowhere on the radar.


Indeed, Goldman’s trading results suggest that market is coming back with a vengeance. It’s playing in very risky markets with a capital structure that remains vulnerable yet is guaranteed by taxpayers.


To Goldman’s credit, they’ve rebuilt their capital levels faster than anyone. Their leverage ratio has fallen from 35 to 16 in less than two years, despite pressure from equity analysts to juice returns by deploying “excess capital”.
But at $50 billion, the bank’s mark-to-myth, or level 3, assets remain as high as its tangible common equity, the cushion it has to absorb losses. And Lehman proved that conventional definitions of capital aren’t worth much when push comes to shove. On Sept. 1, 2008 the bank was “well-capitalized” according to regulatory measures, two weeks later it declared bankruptcy and was showing negative net worth in the tens of billions.


Derivatives have lead to systemic crises every 10 years or so — portfolio insurance in 1987, Long-Term Capital Management in 1998, the global financial crisis a year ago — yet cosmetic changes are all that is ever offered. The frequency and violence of such events prove that more is necessary to rein in these markets.


Wall Street and its protectors at the Fed and Treasury tell us the bailout was necessary to protect the financial system, to protect Main Street. That may be. But Main Street still owns much of the risk while Wall Street gets all of the profit.


Even as Goldman reported results that reflected in part the resurgence in derivatives, the House Financial Services Committee passed legislation that would increase derivatives regulation. But the bill is riddled with loopholes that Wall Street can easily exploit. A much tougher line is necessary.

101A
10-20-2009, 11:16 AM
Thanks for posting these WH - as much as they are leading me to eventually mix up a batch of purple, and swill it down with friends and family, they provide good info.

Winehole23
10-20-2009, 11:27 AM
Making wine, 101?

MannyIsGod
10-20-2009, 11:53 AM
I think they're making a huge mistake thinking that they've got some kind of permanent get out of jail free card. There will be very little political will to do this again even if it means saving our economy.

Winehole23
10-20-2009, 12:00 PM
I think they're making a huge mistake thinking that they've got some kind of permanent get out of jail free card. There will be very little political will to do this again even if it means saving our economy.If we don't do something soon to insure it doesn't happen again, the markets will price in the omission as an implicit guarantee.

The understanding that a government backstop exists for the largest players will create asset bubbles, for which, once they become a systemic threat -- or there is another *unexpected* downturn -- the risk will again be socialized.

And yet again, the companies who put the economy in jeopardy will receive public money, and the US taxpayer will receive the risk.

Lather. Rinse. Repeat.

DarkReign
10-20-2009, 12:10 PM
If we don't do something soon to insure it doesn't happen again, the markets will price in the omission as an implicit guarantee.

The understanding that a government backstop exists for the largest players will create asset bubbles, for which, once they become a systemic threat -- or there is another *unexpected* downturn -- the risk will again be socialized.

Lather. Rinse. Repeat.

I dont agree. TARP legislation (and subsequent expansions) was passed with no understanding from Joe Public.

I dont believe Joe Public, for as dumb and predictable as we are, has the stomach for any sort of future bailout.

Or should I say, I sincerely hope we do not.

Winehole23
10-20-2009, 12:20 PM
I hope you're right.

I'm skeptical that Joe Public is well prepared for the deflationary crash a la 1930-1933, that telling megabanks, bank receivers and broker-dealers to all get bent next time, might entail.

EVAY
10-20-2009, 12:25 PM
I'm afraid that the only way to stop the trading in derivatives is to outlaw them, i.e., require that any traded 'derivative' be no more than 1 step removed from the underlying asset that it seeks to represent. This would still allow a certain level of 'risk-spread', but require that the asset's own risk remain part of the risk assessment for evaluation purposes.

Now I realize that what I have just described is essentially doing away with derivatives. But allowing them to stay the way they are now is just inviting the same kind of debacle we are trying to get out of right now. The way they are structured nowadays so misaligns the true risk measure that noone, including the developers of the derivatives and the traders in them, have any clue whatsoever as to the real risk. They use purely academic, statistical models to say that 'theoretically, if you add this factor and this factor and this factor then you have balanced the risk of the total derivative portfolio to be, 'theoretically' much lower than would be the case if the underlying asset class was traded purely on its own risk merits. What results from this mathematical masturbation is a 'tradable theory'. That is all a derivative really is. They are supposed to represent a class of underlying assets that have a variety of risk characteristics, but which when grouped together lose the worst risk of the bad assets and therefore assets which would otherwise be 'untradable' get to be marketed.

If any of the above sounds sickeningly familiar, think of the 'tranches' that were supposed to offset the risks of subprime mortgages that sat at the bottom of those mortgage derivatives that destroyed the banks that invested in them. What they amounted to was a group of derivatives of groups of derivatives of groups of different kinds of mortgages, some good, some prime, some subprime.

It is my position that financial classes in business schools across America have so overinterpreted the statistic used to measure risk, i.e. beta, that analysts and traders no longer know what they are looking at.

Beta is a statistic used in many disciplines as a measure of covariance. In finance, it measures the extent to which one variable ( the price of a stock) increases or decreases in the same direction and at approximately the same rate of movement as the stock market price as a whole. So, a beta of 1 is said to carry the same risk as the market, since it will move along with the market. Stocks that move more rapidly than the full market moves will have a beta greater than 1 and will be interpreted to be more risky than the market because they will exhibit more volatility than the market as a whole, and because volatility=uncertainty and uncertainty=risk to an investor, the stock that has a beta factor greater than 1 is considered riskier, and investors require higher returns in order to take the risk to invest in them.
(All this means they are tougher to sell).

However, if you combine enough different examples of substrata of the assets in question, you can 'smooth' the high risk of the worst performing assets by grouping them with higher quality (i.e. lower beta, less volatile assets). You can end up with a calculable 'beta' statistic that becomes close enough to 1 so that the derivative is salable at a price that does not really reflect the risk inherent in some of the substrata. This is just pure mathematical posturing. The risk has not gone away, as evidenced clearly in the losses in the mortgage businesses.

Derivatives cannot be meaningfully traded in my estimation because their risk assessment is a calculation so far removed from the reality of the asset comprising the derivative's base as to render them the equivalent of a crap shoot. literally.

Too many people don't know how dangerous these things are, or I assume they would be outlawed, or at least modified in ways similar to what I proposed in my first paragraph.

DarkReign
10-20-2009, 12:28 PM
I hope you're right.

I'm skeptical that Joe Public is well prepared for the deflationary crash a la 1930-1933, that telling megabanks, bank receivers and broker-dealers to all get bent next time, would entail.

The public was unprepared for the bailout in every sense of the word. Has our world moved on with no real serious decline?

Yes....so far.

As your other threads have exposed, the debt-to-money-supply within the Fed is harrowing. They have to get out from under the extreme liquidity they created or hyperinflation ensues.

Point is, TARP and its ilk have effectively postponed or outright mutated the underlying problem. Joe Public is not out of the woods as it pertains to the ramifications associated with "The Bailout".

Hypothetical:

IF large banks and financial institutions need another bailout or face receivership, I would think the American public would choose bankruptcy for them.

Sure, millions are going to bathe in losses, companies heavily invested in High Yield, High Risk trading like CDSs and ARM mortgages are going to close, jobs will be lost and people might even start to regret their decision as time goes on.

But I, like the government and TARP beneficiaries, am counting on Joe Public being dumb and reactionary. This wouldnt be the first time that this trait would serve our interests best in the longterm (WW2).

RandomGuy
10-20-2009, 12:31 PM
If we don't do something soon to insure it doesn't happen again, the markets will price in the omission as an implicit guarantee.

The understanding that a government backstop exists for the largest players will create asset bubbles, for which, once they become a systemic threat -- or there is another *unexpected* downturn -- the risk will again be socialized.

And yet again, the companies who put the economy in jeopardy will receive public money, and the US taxpayer will receive the risk.

Lather. Rinse. Repeat.

I agree. We need to really let the market eat some of these big banks and let them die.

The bailout, although necessary, MUST MUST MUST be followed up with some very heavy duty reform to make sure there is a solid wall of responsibility between what we collectivly will subsidize through bailouts and what we will not.

The general sense that I get is that a lot of investors have started to factor in the implicit guarantee of bailouts as part of the thinking going forward.

That is more dangerous than any Iranian nuke...

Winehole23
10-20-2009, 12:32 PM
However, if you combine enough different examples of substrata of the assets in question, you can 'smooth' the high risk of the worst performing assets by grouping them with higher quality (i.e. lower beta, less volatile assets). You can end up with a calculable 'beta' statistic that becomes close enough to 1 so that the derivative is salable at a price that does not really reflect the risk inherent in some of the substrata. This is just pure mathematical posturing. The risk has not gone away, as evidenced clearly in the losses in the mortgage businesses.I think I just saw something related on BoingBoing ...

here it is: http://www.boingboing.net/2009/10/15/complex-derivatives.html

RandomGuy
10-20-2009, 12:37 PM
I think I just saw something related on BoingBoing ...

here it is: http://www.boingboing.net/2009/10/15/complex-derivatives.html

I effing hate derivatives for that reason. (lack of transparency)

If it is so complex that it is not readily undestandable to the average layperson, or even the average accounting undergrad student, it should simply not be legal.

People blather on about "financial innovation". Fuck that. We don't need "financial innovation" to manage risk. We need prudent, transparent business decisions.

EVAY
10-20-2009, 12:48 PM
I think I just saw something related on BoingBoing ...

here it is: http://www.boingboing.net/2009/10/15/complex-derivatives.html

yes, you are right. My description was simply the way that the lack of transparency occurs, i.e., the betas of betas producing a gigo risk assessment measure.

The real question becomes, why isn't anyone preparing to stop this stuff?

EVAY
10-20-2009, 12:52 PM
I effing hate derivatives for that reason. (lack of transparency)

We don't need "financial innovation" to manage risk. We need prudent, transparent business decisions.

:toast

Winehole23
10-20-2009, 12:59 PM
The real question becomes, why isn't anyone preparing to stop this stuff?Because the firms which hold them have marked their values to a non-existent market; if they ever have to write down the true prices, insolvency might come back into the picture with a vengeance. We still haven't dealt with a very considerable portion of toxic MBSs.

At this point, I'm more or less convinced the present plan of recovery depends somewhat on us having a very imprecise picture of the true financial condition of banking and finance. In order to muddle through, we are letting the lords of financial rapine operate in the dark again.

Letting "legacy assets" continue to be "marked to fantasy" for awhile longer is consistent with muddling through: hoping large infusions of public money will eventually make the balance sheets of the essentially bankrupt banking and finance sectors, whole again.

EVAY
10-20-2009, 01:07 PM
Because the firms which hold them have marked their values to a non-existent market; if they ever have to write down the true prices, insolvency might come back into the picture with a vengeance.

At this point, I'm more or less convinced the present plan of recovery depends somewhat on having a very imprecise picture of the true financial condition of banking and finance. In order to muddle through, we are letting the lords of financial rapine operate in the dark again.

You are right again, of course, both about the insolvency probability unless there is some kind of 'permanent' accounting 'amnesty', as well as the the 'lords of financial rapine' operating in the dark again. And I wouldn't advise the accounting 'amnesty' write-off unless it was accompanied by some stringent rules regarding transparency. But I don't think it will happen.

Someone asked me recently what advice I had about the market. I told them I no longer predict the market, much less its timing. What I didn't tell them is that I'm terrified and have no idea where to put money anymore. I'll tell you one thing, though...it's not going into hedge funds that are derivative-based.

ElNono
10-20-2009, 01:14 PM
When I think of derivatives, only one word comes to mind:

CCcCzj_yRtk

LnGrrrR
10-20-2009, 01:15 PM
It really seems to me that the whole banking industry was caught up in an "Emperor has no clothes on!" moment.

Some guy comes up with this 'risk-reduction' theory, that by taking on a whole LOAD full of high risks and putting them together, at least one or two will pay it off each month, thereby always ensuring some money, thereby reducing risk, is stupid on its face. But combine a stupid theory with a way to make money, and you'll have a lot of people looking at it.

101A
10-20-2009, 03:08 PM
I hope you're right.

I'm skeptical that Joe Public is well prepared for the deflationary crash a la 1930-1933, that telling megabanks, bank receivers and broker-dealers to all get bent next time, might entail.

I think Joe Public's pleasure of watching big shots in Manhattan take solo headers from the 73rd floor because they have been denied what they thought a birthright, would be damned cathartic.

Winehole23
10-20-2009, 04:50 PM
Yeah. That would be pretty sweet.

Winehole23
10-20-2009, 04:51 PM
What are the chances?