Goldman’s Quasi-Monopoly Earnings Report
Goldman Sachs (GS) – you know Goldman Sachs. They came out with an earnings report today. But first a little background.
Goldman gave us Robert Rubin, former Chairman of Goldman. He is the gentleman President Clinton called on to be Secretary Treasurer of the United States in 1995. During his tenure he orchestrated the bailout of Mexico, Asia, Long Term Capital Management, and Y2K. He is no stranger to moral hazard. His actions show that he actually embraced it. I think he was also responsible for Federal Reserve Chairman Greenspan to change his ways. After Greenspan uttered those famous words - “irrational exuberance” and knocked the equity markets for a loop in 1996, Greenspan became much more respectful of those that kept him in power. I thought that Greenspan meant what he said at the time with strong foundation, but his actions afterwards where of a different tune. Enough so that he bowed to the whims of both the Clinton and Bush administrations, taking irrational exuberance to bubble proportions.
Goldman also gave us John Thain. John is now CEO of the New York Stock Exchange. Mr. Thain helped to complete the reverse takeover of the NYSE by Archipelago in 2005. As you may have guessed – Archipelago’s largest owner - Goldman Sachs.
Well, who is the current Secretary Treasurer of the United States? It is Henry Paulson, former CEO and Chairman of Goldman Sachs. Mr. Paulson took the reins in early 2006. Yet another Goldman guy.
Everyday the Federal Reserve operates an open market operation to add and subtract liquidity from our financial system. This is where the big NYSE member banks go to get additional funds. I can’t think of another person that may be more important to a financial firm like Goldman Sachs on a daily basis. I am sure the Federal Reserve looked far and wide for someone to run this very important unit as it oversees domestic open market and foreign exchange trading operations as well as the provisions of account services to foreign central banks.
They picked Goldman Sachs former Chief Economist, William Dudley. An ‘economist’ for a trading operation? I know, it doesn’t sound right to me but maybe he takes direction well. William took this post in late 2006.
World Bank, you ask? Who runs the World Bank? The President of the World Bank is Robert Zoellick. Mr. Zoellick spent most of his career working for various governmental agencies. No Goldman connection here? Almost. He resigned in June 2006 to join Goldman. After a one year stint of indoctrination of how things work at Goldman, and who truly butters his bread, he was appointed World Bank President in June of 07’.
So, former Goldman people are in place as the United States Secretary Treasurer, the head of the NYSE, the head of the trading operations at the Federal Reserve (an economist at that), and President of the World Bank. Big deal? It gets better.
Just after the 1987 stock market crash the President of the US signed an executive order forming a committee of government and private individuals to monitor the financial markets. This group was named the ‘Working Group’. We traders have nicknamed this group the Plunge Protection Team – the PPT. Their mandate was to make sure all steps were taken to make sure nothing like that crash would happen again.
In 1998 the financial world was shaken by the financial shenanigans of a hedge fund named Long Term Capital Management. ( ‘Long Term’ lol!) After which time the US President’s Working Group approached the major NYSE member banks and said, “hey guys, listen, we ain’t suppose to let things like this happen. You guys need to get your act together.”
These banks formed the Counterparty Risk Management Policy Group (CRMPG) The members are the top NYSE member banks, General Motors, a couple of hedge funds, and some well connected law firms and accounting firms. The group met and produced a document but was asked again in 2004 by the Working Group to come with more defined policy procedure. This effort resulted in the publication titled ‘Toward Greater Financial Stability: A Private Sector Perspective’.
Who was the leader of this group? Gerald Corrigan, Chairman of Goldman Sachs. Who was the transmittal letter addressed to at the opening of the report? Henry Paulson, then CEO and Chairman of Goldman Sachs, now US Secretary Treasurer. Who developed the policy? Well here is an excerpt from the transmittal letter; “I want to express to you my sincere gratitude for the time and effort devoted to this project by Craig Broderick who served as a Member of the Policy Group and the others from Goldman Sachs who participated in the project and are named in the Report.”
Link to the report; www.crmpolicygroup.org/docs/CRMPG-II.pdf
Here is what the CRMPG stated as their primary purpose; “The primary purpose of CRMPG II — building on the 1999 report of CRMPG I — is to examine what additional steps should be taken by the private sector to promote the efficiency, effectiveness and stability of the global financial system. As practitioners, the members of CRMPG II recognize that periodic financial disruptions and shocks are inevitable. However, the Policy Group also believes that it is possible to take steps that would be capable of reducing the frequency of such shocks and, especially, to reduce the risk that such shocks would take on the contagion features that can produce systemic damage to the financial system and the real economy.”
Again it appears the CRMPG mandate is to control the markets. How else are they to reduce the frequency of periodic financial disruptions.
CRMPG: “since we know that financial disturbances and even financial shocks will occur in the future, and we know that no approaches to risk management or official supervision are fail-safe, we also know that we must preserve and strengthen the institutional arrangements whereby, at the point of crisis, industry groups and industry leaders, as well as supervisors, are prepared to work together in order to serve the larger and shared goal of financial stability.”
We need to work together for financial stability? What does that mean for the public or retail investor? Obviously every trade has a counterparty. If these firms get in trouble with sub-prime loans, is it their idea to transfer that risk to the public to insure their financial stability and therefore the stability of the US economy as what they represent, as we can not have failing banks and a strong economy. But it would be acceptable to have a block of retail investors (small counterparties) suffering financial disruptions as long as it did not affect the general public or the greater good of the large NYSE money center banks?
Former Federal Reserve Chairman Greenspan acknowledges the CRMPG and their collective “eye” on the market in a speech he gave in 2002; “In today's markets there is an increased reliance on private counterparty surveillance as the primary means of financial control. Governments supplement private surveillance when they judge that market imperfections could lead to sub-optimal economic performance.” Link to speech; http://www.federalreserve.gov/boarddocs/speeches/2002/200209252/default.htm
That leads me to Program Trading. Program trading ran about 16 to 19% of all shares traded on the NYSE from 1987 to 1998 when the Long Term Capital diabolical hit. Since that it has climbed to 65-75% of all shares traded on the NYSE.
The NYSE stock exchange issues a weekly report on Program Trading. For the week ending August 31st, program trading accounted for 73% of all shares traded on the NYSE. Now you will look at this report and see that it says 36.5%. What gives? Well, the NYSE formerly reported program trading as both sides of the trade. They did this for a couple of decades, or the inception of program trading. (Program trading is defined as a trade of 15 or more issues with a value over one million dollars.) Then in June of 2006, shortly after the Goldman guy took over, they changed the reporting to just one side of the trade. In addition, they deleted all past reports from their news archives. One day they were there, the next they were all gone. The old way of reporting worked for many years giving a more accurate summation of total program trading. I continue to use that number as it is more truthful. Link to recent report; http://www.nyse.com/pdfs/PT082707.pdf
Now you may suspect who the top program trader is. Well, sometimes it is Goldman but lately it has been Lehman Brothers. However, if you look at program trades made as the broker being the principal and not acting as an agent for others, Goldman does indeed take the top spot. For the referenced report they accounted for 25% of all program trades made as principal. Looking farther we see that the top six firms accounted for 69% of all program trades, or 50% of ALL shares traded on the NYSE. 50% of all shares traded in the hands of program traders of just six firms that are all members of the CRMPG, with the goal working together for the greater good? How would you like to be on the other side of those trades?
Again Greenspan in his speech of 2002 says it best.” To require disclosure of the structure of the innovative product either before or after its introduction would immediately eliminate the quasi-monopoly return and discourage future endeavors to innovate in that area.”
Quasi-monopoly returns! That, my friends, leads me to Goldman’s third quarter earnings release today. Earnings were up an eye-popping 88% from last year. It was as though Goldman was on the right side of every trade.
But how could this be? We saw the headlines;
‘Goldman's Exclusive Hedge Fund Drops By 10%’
‘Goldman hedge fund falls 22.5 pct in Aug’
Well, you see, Goldman doesn’t manage OTHER peoples money quite like it manages it’s own.
From the report - Asset Management (money they manage for others), Goldman: “Asset Management net revenues were $1.20 billion, 31% higher than the third quarter of 2006, reflecting a 40% increase in management and other fees, partially offset by lower incentive fees.”
Lower incentive fees? Fees were down 52% from last year. Incentive fees reflect doing a good job. Looks like their performance was lacking from last year.
Goldman: “During the quarter, assets under management increased $38 billion to $796 billion, reflecting money market net inflows of $31 billion, non-money market net inflows of $19 billion spread across all asset classes, and net market depreciation of $12 billion, reflecting depreciation in equity and alternative investment assets, partially offset by appreciation in fixed income assets.”
Increase of $38 billion. That’s a lot of money but still just 5% increase. But with $38 billion in net inflows after depreciation it appears that they had negative organic return on the assets that manage.
All on all, the money they manage for OTHERS had a bad quarter.
Now look at their proprietary trading unit – THEIR money. Trading and Principal Investments were $8.23 billion, 70% higher than the third quarter of 2006. Equity trading revenues were up a mind boggling 154%. This is in quarter were we saw a rough drop of about 3% in the S&P500.
Goldman: “Significant losses on non-prime loans and securities were more than offset by gains on short mortgage positions.”
They shorted mortgage positions with THEIR money! Shorting mortgages – a bet that citizens will default on their loans and possibly lose their homes. Goldman made money when things were good by pushing these sub-prime loans, now they win again when they go sour.
OTHER peoples money (OTM); NEW YORK, Sept 13 (Reuters) – “Goldman Sachs Group's Global Alpha hedge fund fell 22.5 percent in August on losses from currency and stock trades, Bloomberg News reported, citing an update sent to investors.”
Goldman has the largest collection of hedge funds in the world. How is it that they receive 75% of their revenues from trading, but the hedge funds they manage for other people’s money under-perform the returns Goldman receives on its OWN money? When Goldman’s hedge funds are long sub-prime, why did not the shorting of mortgages strategy that they used for THEIR money save some of the OTHER people’s money? Trading is a zero sum gain. Did Goldman need someone to take the other side of the trade?
Greenspan said this in the same speech above; “Most financial innovations in over-the-counter derivatives involve new ways to disperse risk. Moreover, our constantly changing financial environment supplies a steady stream of new opportunities for innovation to address market imperfections. Innovative products temporarily earn a quasi-monopoly rent.”
I think everyone would have to agree that Goldman has been very innovative in benefiting from market imperfections. They place their former executives in high positions of public power. They manage the CRMPG that allows them insight into the inside workings of their competitors. They have been aggressive in their managed hedge funds by establishing a counter-party to their trades. They certainly are getting their share on THEIR money with “quasi-monopoly rent”.
And they are getting paid well to do it.
Goldman: “Compensation and benefits expenses were $5.92 billion, 68% higher than the third quarter of 2006” The number employees increased only 7%. Nice raise guys!
So how does Goldman get away with this? Obviously the influence peddling is there. Why is the financial community of the slightly less connected not out there screaming about the potential for collusion and manipulation by these large member banks with their CRMPG association? Trading is a zero sum game. Why are so many willing to take a bullet for Goldman on an un-level playing field?
I just read a commentary from Bill Bonner expressing some of what I mention here. He wrote this after a similar stunning Goldman report in June of 06’;
“Well, how is it possible that a company like Goldman – with thousands of traders – can make 75% of its revenues from trading? You'd think their lucky trades would be balanced out by their unlucky trades. They can't all be lucky. And they can't all be geniuses. As Buffett says, there aren't that many geniuses around.”
"Or to put it another way, here's a company making billions, mostly by trading. Who's on the other side of these trades? Who's losing? Where does the money come from? How is it possible for so many traders to have a result that is so far beyond equilibrium...it seems to defy gravity." Bill Bonner
So why do I care about all of this?
Greenspan (same speech) said this; “No one can deny that fully informed market participants will generate the most efficient pricing of resources and the most efficient allocation of capital. Moreover, it could be argued that, if all information held by individual buyers or sellers became available to all participants, the pricing structure would more closely reflect the underlying balance of supply and demand. Thus full information would appear to be the unambiguous objective. But should it be?”
“But should it be?” Hell yes it should be. Fully informed market participates is central to a free market. Allowing Goldman and the CRMPG, with the blessings of the Federal Reserve to sway the markets in the direction that benefits them most, in the name of financial stability is a bullet to the chest of capitalism. Who was Chairman Greenspan helping when he suggested adjustable rate mortgages at interest rate bottoms? Some kind of innovative sub-prime scheme perhaps? The time to save our free markets is now. The complacency bullshat needs to stop!