Sunday, July 19, 2009

Goldman apologia

The following appeared as a comment on my previous post discussing Paul Krugman's anti-Goldman and anti-finance column of last week. The commenter is a (very) senior quant with a PhD in physics. His knowledge of these matters is, I would guess, superior to Krugman's and certainly superior to that of any journalist.

Is Goldman entitled to keep its recently announced gigantic profits, given that they were (perhaps) saved by the government's bailout of AIG? Hear it from the horse's mouth :-)

For more background, click the AIG tag below. [If you are going to comment on this post, please read the earlier one first. Your thoughts might be addressed in the comments there!]

...on AIG - you might wanna check out this developing story.

When large derivative dealers trade with each other they typically agree to exchange margin so that on any given day neither owes anything to the other. Sometimes dealers will disagree on the value of their trades. GS has said that AIG owed them $10bio pre-bailout (in GS's opinion), and had given GS $7.5bio (AIG's opinion of the value) against this exposure. GS had purchased insurance from other large dealers for the $2.5bio balance.

AIG deals with the public too, of course, but the public pays premiums to AIG and holds no collateral. This is all "business as usual".

Now, let's look at what would happened if AIG had defaulted. For GS, the $7.5bio of collateral is "bankruptcy remote" and GS keeps it penny for penny. The insurance contracts pay off $2.5bio to GS and the right to pursue the claim against AIG passes to the counterparties. Mom and Pop who have purchased retail insurance from AIG are left with only a bankruptcy claim. So this is all very ugly, but absent further defaults, GS is left whole - no loss. But have no doubt, someone out there will be eating a big loss.

At this point in the discourse, most people have trouble understanding collateral and that it is bankruptcy remote (is this a skill? I guess so!), but let's say we have this one down. The next point people make is that letting AIG go under would have created a financial system meltdown that would have harmed GS such that GS could not collect all its $2.5bio insurance claim. Well, this is possible, but it is equivalent to saying that a large subset of JP Morgan, DeutscheBank, BNP, SocGen, Citibank, etc... all go bankrupt. However, we probably don't believe that even a full $2.5bio hit to GS would be lethal for it, so it is hard to say that a failure by AIG would have directly taken GS down.

The next point you might make is that if all these other banks went under it might have created a large enough set of other problems for GS so as to take it out. However this final claim, which is frequently made, is specific to GS in no way at all. But if you wanna say "maybe the U.S. bailed out AIG so that the entire world banking system didn't collapse", then yes, GS benefits from that just as does anyone in the economy with any exposure at all - like anyone who purchased Auto Insurance underwritten by AIG. So maybe a smart bailout avoids a situation like the depression which followed the Panic of 1837, but the beneficiaries of the bailout are likely not dominantly the banks. This is why administrations as diverse as G.W. Bush and Barry Obama have reached for identical bailout buckets.

The Kruggy regulation question should be "would compensation reforms stop the sort of loss-making trading that went on at AIG?" - and that may be, I don't know. And might it accidentally stop economically productive trading as well? Krugs sure doesn't think so.


Ian Smith said...

It is ironic that the term "capitalism" is used in connection with the huge losses at so many banks recently.

If these banks were owned by one person or a few people, that is capitalists, rather than by millions of powerless shareholders, all of these problems would never have occured.

The power in operations for very large businesses has passed from the owner in the 19th century to the executive (a hired man). This isn't capitalism.

But what about stock options and the ever present threat of an LBO?
Shouldn't this align the interests of management and owners?

The "owners" still like short term profits. Why???

For the big banks LBOs are not a possibility.

mock turtle said...

it seems to me that LondonYoung argues that one way or another goldman sachs would be made whole via a host of interwoven counterparty agreements except under the remote occurence of systemic meltdown, in which case the governments bailout of aig was no more beneficial to goldman than many other financial institutions

the system is not a zero sum game contrary to the scientists among us who love elegance

the financial system just faced a day of reckoning with ponzi scheme economics...most everybody made money during the last decade off of casino finance, because money was literally being "made" as in fabricated rather than earned

if you doubt this all you have to do is track M3, which of course the federal reserve made very obscure two years ago (why do you think!)

this game of musical chairs the financial system was built upon,of late, was played to the tune of debt and leverage

some institutions leveraged on average 30 or 40 to one, and when the music stopped many were left without a chair

the idea that goldman was more deserving, or smarter, or obeyed more fundamental principles or had a better trading strategy is nonsense

in fact goldman sold securities and hawked them as great investments at the very time they were shorting those same instruments... fiduciary responsibility anyone?

goldman real expertise, or skill was its connectedness to the power structure by way of the rotation in and out of high government office of its executive management

goldman got to the head of the line, or the top of the food chain if you prefer, as an analogy

wikipedia goldman and look at the bottom of the article for the list of goldman and government incestuousness

as for LondonYoungs claim on a previous thread that probably the average middle class american was more the beneficiary of these financial innovations (ha more like schemes) than the elite...

it is intuitively obvious that such a claim makes no sense, but for those who disdain intuition consider this

the top 2 percent wealthiest americans own more than half of everything

financial services ebit accounted for the largest earnings of any corporate sector traded in the new york exchanges, and hedge fund managers are compensated best amongst all "professions" in america

if the system crumbles and we shall see who has farthest to fall

Carson C. Chow said...

It seems to me that the high compensation for finance is directly related to a barrier to entry into the banking/finance system, which restricts competition to drive compensation downward. Now if this barrier is purely due to limited brain power, abilities or only a small subset can handle the pressure then I say all the power to them. However, I suspect that there are other factors that are giving financial institutions an ability to maintain an advantage. I think for commercial banking there are regulatory hurdles that give banks some monopoly power but then they are strictly regulated in return. What is the advantage that investment banks and hedge funds have?

Siddharth Sharma said...

"economically productive trading"

is there any reasonably rigorous proof (comprehensive enough to prove how it happens in the real world, not in some ideal, constrained toy model) that the macro effects of complex derivative markets are productive in some way.

i don't know of it and would like to see it.

mock turtle said...

yes i too would like to hear from LondonYoung or prof Hsu or any other person in defense of goldman about the observation LondonYoung made at the end of his comment speculating that the regulation krugman advocates might impare or halt "economically productive trading"

how about an explanation for just two of these "economically productive trading" schemes which i believe amount to nothing more than a casino model of modern finance

first question, how can a derivative market that dwarfs the volume and value of the real, underlying, market be justified?

whether it is gold, soybeans, oil or mortgage backed securities, when those who neither produce, nor process, nor market nor consume a commodity or product are able to deal contracts, sometimes buying and selling in seconds or less volumes many times the "real" market and then bubble, or crash a market... tell me... where is the economically productive trading

number two is the credit default swap, the so called insurance...not

since when can a person buy or sell insurance when they have NO insurable interest it would be like me buying an insurance policy on professor hsu's house from LondonYoung when niether of us live there, pay rent, make mortgage payments or have any identifiable fiduciary interest

but that is just what concerns were able to place bets (buy fire insurance) on securities they did not own, taking out insurance policies (credit defualt swaps,CDS), from other financial concerns , who , it came to pass did not have the ability to pay in the case of a "fire"

the so called innovation was a dangerous numbers game invented by very smart people, and marketed by very aggressive alpha male CEO types who thought they had it all figured out

well, they didnt and the system is seriously messed up

thanks to people who thought they could play games with debt, leverage, and derivatives

why to hear some talk of it, we could all quite our day jobs and just make a living off of day trading...why we could all be millionaires, right?

this what krugman and others are decrying...the banking oligarchs have levied a tax upon the productive society...they demand a lions share of goods and services by way of their exorbitant compensation while doing less and less of real value

we are in this financial crisis because the richest most powerful financial firms played fast and loose with our financial system

the very crux of the point is that the goldman sachs of the world..and goldman is far from alone...mis-allocated capital to non productive, highly leveraged, very risky "investments" and their bets didnt pay off so now they enjoy government bailouts but refuse regulation

so again i ask those who embrace the apologia of goldman to justify the explosive growth in notional amounts of derivatives and exotic securitizations

and when you get that number, which is in the hundreds of trillions, a factor many times the worlds GDP, then tell me in an approximate dollar amount the value these geniuses have visited upon our society with their "innovations"

btw dont tell me about how the notional values all work out to zero and so theres no harm...the fees and salaries paid to originate these deals are huge, i.e. these guys get big bonuses

and if the notional value didnt matter then the way out of the crisis isnt to unwind all these securities etc, rather, the government could just decree that all derivatives are worth zero and all premiums are halted

that aint gonna happen

Peter said...

The 2.5B post-bailout collateral also shows up on page 1 here:

I don't understand what the payments to GS of 5.6B on page 2, and 4.8B on page 4 mean...

Nicolas said...

"first question, how can a derivative market that dwarfs the volume and value of the real, underlying, market be justified?"

for some derivative products, like futures, there is no difference in nature between the derivative and the "real" market. one arbitrages the other close to perferction.

the economic value added here is that it enables to lower the financing fees. Sure I could buy a basket of stocks, but for that I would need to borrow money, and my lender will want collateral for that.

It is just way more easier to buy a future, and be cleared through the exchange. all the lenders are in competition to give the best price, because it gets reflected in the one single price of the future.
This is a very efficient system.

I see what you mean though but you misspecify the problem.

the good question would be "how can a INDEPENDANT derivative market that dwarfs the volume and value of the real, underlying, market be justified?"

for instance, in credit related market, where the net oustanding nominal is more that the underlying debt.... I have no answer for that and I agree

Siddharth Sharma said...

"the economic value added here is that it enables to lower the financing fees"

I don't know if that really helps the real economy in all cases.

It is becoming quite clear that capital markets are getting more efficient in the sense of "no free lunch", but not in the sense of "correct price".

Steve Hsu said...

SS: That's a nice way of putting it. Most financial economists tend to use "no arbitrage" as the criteria for efficiency, but no arb does not imply that resources are efficiently allocated over the economy -- it could just mean that no one really knows the "correct" price. On the other hand, if no one knows the correct price, then perhaps society can't do any better (i.e., bubbles and mispricings are inevitable)?

Steinn said...

it is also possible that GS is [s]lying[/s] providing an excessively optimistic picture of how well they had hedged their losses and that getting everything from AIG was critical to their short term profitability

Nicolas said...

I see one way where the case against Goldman makes sense, which seems ignored by this "senior" quant.

If you agree that finance has failed (a broad statement) and that Goldman just happened to be the best at sticking losses at other banks, that could be a valid case against them: they are just making profit because of governement's money backing the others.

I personnally think it would not be a bulletproof case because the said failure lies not in finance in general, but in credit market, appetite for debt (states first), and (orchestrated) stupidity of homebuyers.

Nicolas said...

"It is becoming quite clear that capital markets are getting more efficient in the sense of "no free lunch", but not in the sense of "correct price"."

I agree with you. I would argue though that diminishing the fees are a worthy goal, if not a grand one. It is definitely economically productive if you end up paying less for the same service.

For the grand one, "the correct price" it would be hard to give it a definition.

You can't draw a utility function and a nice chart. you don't know the function (is there just one?) of the different participant (they don't know it themselves btw), you don't know the distribution characteristics of the underlying (is it even meaningless to represent a non stationnary process as a "distribution" ?) etc, etc...

On top of that, when you really think about it, the building block of modern finance, the common share, is an fantastically complex piece of paper to evaluate. I tend to think this is precisely where lies the problem.

Anonymous said...

These so-called "profits" are really just laundered tax dollars. There are several more profitable quarters to come.

Some say that Goldman Sachs should be broken into pieces, because it is too big to fail. The truth is that it is a parasitic worm that should be completely legislated out of existence. And any employees who can be caught should be jailed. I'm sure much of what they were doing was legal. It was the same with Enron. But I think you can get them for the small stuff, like Al Capone.

Of course this economic terrorist organization is so entwined with the government that that will never happen.

Siddharth Sharma said...

"I agree with you. I would argue though that diminishing the fees are a worthy goal, if not a grand one. It is definitely economically productive if you end up paying less for the same service."

I think no arb efficiency is welcome as long as multi trillion contracts aren't written and exchanged with implicit taxpayer backstops to the balance sheets of these firms.

I'd reiterate that the key issue is accounting. There is so much uncertainty on a finance balance sheet that it is hard to say if the actions of the management over a given quarter or year were any good for the long run. These profit numbers ARE bogus. And no one seems to take this issue seriously.

In finance firms , i am sure > 50% of the accounting is forward looking (apart from direct revenues / expenses and closed p/l).

Can someone with the technical know how explain to me why these accounting practices are not broken.

Ian Smith said...

Such a person could not give an explanation only a justification.

The demand for accountants is completly factitious. They along with GS are economic rentiers.

Nicolas said...

"I think no arb efficiency is welcome as long as multi trillion contracts aren't written and exchanged with implicit taxpayer backstops to the balance sheets of these firms."

In my remark I don't talk of no arb efficiency, but of fees. Actually, they act precisely in opposite direction, as higher fees enforces stronger "no arb"...

Originally you asked of an positive economic impact of trading, I just gave you one. Lower lockup from your finance shop, open competition on prices. A big chunk of finance is coming from that (interest rates swaps comes to mind)

The issue you raise are real, although I don't locate them (only) on accounting, cf my paragraph in last post on price distributions.

Anonymous said...

One thing Goldman Sachs could do to improve its image would be to start announcing regulatory changes itself. The current disconnect to the government employees who announce Goldman Sachs's policies makes the government seem weak and indecisive. A little decisiveness would reduce uncertainty, help the economy, and probably assuage the concerns of people concerned about putting millionaires on welfare.

Instead of laundering our tax dollars, Goldman Sachs could just make periodic announcements: "We are redistributing your tax dollars to all our millionaire employees." This would also be more efficient, and no doubt save money.

There is just something very dumb about a company that receives $14 billion in welfare payments announcing only a $4 billion profit. Maybe like how we pay farmers not to overproduce, we could pay Goldman Sachs employees to stay home?

Seth said...

We need to come up with a gold-plated euphemism for the new "line of business" which Goldman is using to "earn" money these days. I kind of like the sound of "Sovereign Policy Arbitrage." Any other suggestions?

Of course "monopoly" may also apply given the recently reduced competition in the bond underwriting business.

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