Wednesday, May 19, 2010

In praise of Goldman Sachs: Goldman Sachs Hands Clients Losses in 'Top Trades'

There was a great article on Bloomberg entitled "Goldman Sachs Hands Clients Losses in 'Top Trades'" about how the trading ideas that Goldman Sachs gives to clients are so crappy while they themselves make billions on trading. The article starts out:

Goldman Sachs Group Inc. racked up trading profits for itself every day last quarter. Clients who followed the firm's investment advice fared far worse.

...

Seven of the investment bank's nine "recommended top trades for 2010" have been money losers for investors who adopted the New York-based firm's advice, according to data compiled by Bloomberg from a Goldman Sachs research note sent yesterday. Clients who used the tips lost 14 percent buying the Polish zloty versus the Japanese yen, 9.4 percent buying Chinese stocks in Hong Kong and 9.8 percent trading the British pound against the New Zealand dollar.

In an interesting twist, the article then goes on to downplay the role of so-called prop trading (proprietary trading using house money):

Goldman Sachs's trading profits come from capturing bid- offer spreads when its traders act as intermediaries for clients, Gary Cohn, the firm's president and chief operating officer, said last week in New York. Proprietary trading isn't a main driver of earnings, he said.

...

Cohn told investors at a May 11 conference in New York that the firm lost money on only 11 days in the last 12 months. He said that uncanny streak of success refutes suspicions that the bank depends on proprietary bets with its own money.

"It is implausible that a proprietary-driven business model could be right 96 percent of the time," Cohn said. Instead, he said the "simple answer" is that the firm makes money by capturing bid-offer spreads when acting as an intermediary for client trades.

My hunch is that there is a little bit more to it that that.

The article also tells us that:

Goldman Sachs executives have grappled before with questions about whether they're better at making money for the firm than for their clients, according to an internal e-mail dated Sept. 26, 2007, that was released by a U.S. Senate subcommittee last month.

U.S. Lawsuit

The e-mail to Chief Executive Officer Lloyd Blankfein from Peter Kraus, who was then co-head of the company's investment- management division, explains that individual investors, unlike institutional clients, occasionally make "comments like ur good at making money for urself but not us."

What the article does not say is how much of Goldman's trading activity is proprietary. I am willing to believe that they do in fact make a lot of bad proprietary trades (maybe even following the advice they give their customers). It may net out to not being a big addition to profits, but the issue for the financial crisis is whether a lot of that proprietary activity adds to market volatility and sharp declines in values of financial assets.

The article also does not say how many of their prop trades that do add to net profits are taken opposite their advice to clients.

Personally, I think that short-term trading is a corrosive force in our society and adds little in the way of productive value, so anything that Goldman does to "stick it" to traders is actually a good thing. The problem is that Goldman is encouraging trading since they do make so much money just from taking a "cut" from every transaction.

We should have regulations that forbid market makers from offering advice and having an active sales force that is effectively doing the same. In other words, separate true investment banking (which can be a positive force in society if not corroded by trading and the motive to profit from trading) from both market making and prop trading. Do that and there won't be any problem combining commercial banking and investment banking.

-- Jack Krupansky

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