Market Makers Shouldn’t Participate In Their Own Markets

There was a bit of questioning of the Risk Management Manager that when added to that of the CFO led to some very interesting insights into Goldman Sachs. The market making staff has the ability to hold or sell items that are taken opposite those of  the customers at a time and place that maximizes the profits for Goldman Sachs.

Goldman Sachs as a firm has internal views into almost every market there is. Seeing both sides of trades as well as the demand for creation of new products. The Manager would not say that internal talk among different groups wasn’t used in the determination on how to handle products that Goldman itself held. He squirmed out of taking any position.

The clear implication that you can take from these different data points is that Goldman Sachs has the ability to hold any product that they like and sell those that they don’t. They are not a neutral market making entity. They don’t see selling products that they don’t like to their own clients as a conflict of interest. Customers of Goldman Sachs need to ask themselves why the firm is selling any product. Because, if the item up for sale was worth holding, Goldman itself would hold it and not sell to the customer.

Goldman Sach’s ability to take positions and to be a market maker should be stripped. There should be a requirement that they can’t profit by taking positions as a market maker. There is no way to separate the conflict of interest otherwise.

Thoughts on Goldman Sachs Testimony

I’m watching the testimony live on Bloomberg TV right now and a couple things are sticking out.

  1. The question is coming up about the ability for a party to be a market maker and to also take part in the market. With highly liquid stocks, it seems like this is OK since there is a fair amount of visibility into the market. There isn’t an information gap between different parties. But with illiquid assets like the CDOs, knowing who is involved and moving in which direction gives you a huge advantage over other players. It would only take a little bit of info to shift the advantage dramatically. If the Senators are smart they’ll see that with these types of assets market makers shouldn’t be allowed to take part in the market. It’s back door insider trading.
  2. There is another line of questions on rating the CDO. Goldman Sachs is sticking with the line that everyone was a big boy and should have been able to look at the security and determine the risk. The problem is that this has been proven to be completely false. No one was able to accurately determine the risk of these items. The fact that they allowed Paulson to pick the contents and then short the CDO gave him a huge advantage in the deal. Whether this was illegal or not isn’t clear, it should not be allowed to happen again.
  3. The Goldman Employees referenced the mathematical models that allowed rating agencies to take BBB+ sub-prime mortgages and rate them as a group as AAA. It’s shocking how far from reality this model was. It’s these types of models and economic thinking that has spurred my interest in this area. How can the supposed top economic minds get things so wrong?

The Myth Of The Rational Market

financeI just finished reading an excellent book on finance, The Myth Of The Rational Market by Justin Fox. This book will blow away a lot of what you learned in Econ 101 or have heard on the news. It turns out that many of the core ideas and theories of finance and economics have been under fire for decades.  The issue is that several of these core ideas were easy to conceptualize and remember, like the efficient marketplace, but have been shown to be oversimplifications and poor models of reality.

Definitely worth a read if you have any interest in the history of financial theory.

I had started studying finance because I was curious about why different stocks had different values. It appeared to me that certain stock’s values were solely based on the “Bigger Fool Principle”, that the only way you could make money was if you could find a bigger fool than yourself to take if off your hands. With billions at risk in different markets I felt that there had to be more to it than this. How could growth stocks with no plans of ever returning profits to investors be worth the multiple that people paid for them.

This led me to the capital structure irrelevance principle as what appeared to be at the root of my confusion. This theory was initially proposed by Modigliani and Miller in 1958. The first part asserts that the value of a corporation is unaffected by the source of the corporations finance. So if a corporation needed money it didn’t matter to the value of the stock as to whether the company sold more stock or borrowed the needed money. This part seems to make sense, I can understand why if a corporation all of a sudden needed new financing that that could affect the price of the stock, but not which source of money it decides to use to fill that need.

But a second part that came out of the theory had to do with dividends and that the value of a stock was independent of the dividend plan. So according to Modigliani and Miller, a stock’s value was not connected to whether it paid out profits as dividends. This just didn’t seem correct to me at all and I kept searching and searching for something that would refute this. However, it appears that this aspect of the theory is still standing.

As a very simple model I can see how you could say that it wouldn’t make a difference if you distribute profits to investors as dividends or you use those profits to fund further growth. In fact I think Warren Buffet’s life makes an incredibly compelling case that in the right hands keeping free cash flow within a corporation and using it to fund future growth is advantageous. However as an investor this assumes that my goals and the company’s goals are aligned.  But if the goal of an investment is to use profits to fund some other aspect of my life such as buying a house or paying for college for kids then the simple return of a dividend is more advantageous and valuable. But more to the aspect of the theory it makes the assumption that managers of a company, given profits will be able to turn them into more profits or that the company will even continue to exist. I believe that there is risk in putting off returns for greater future returns that doesn’t seem to be calculated correctly into current stock prices.