Is it hedging or casino betting when banks go short on products they have created/sold to customers?
by Linda Beale
published on ataxingmatter April 28
Financial reform–the GOP’s “chicken game”; and is it hedging or casino betting when banks go short on products they have created/sold to customers?
Edited to add additional links 4/28/10 at 5:35pm
As the GOP blocked progress on the Senate finance bill for a third time (56-42) in their foolish game of “financial reform chicken”, hearings yesterday with Goldman executives raised many important questions and got lots of rambling answers. See C-SPAN.org, Senate Hearing on Goldman Sachs & the Financial Crisis. Why rambling?–the ABA online journal today notes that one of the principal Goldman lawyers advises that those responding at Congressional hearings take long pauses before answering and give rambling responses to questions–to use up the time of the questioner without advancing the ball in terms of information provided. See Goldman Sachs Lawyer Advises Long Pauses, Rambling Answers, ABA Journal, Apr. 27, 2010.
Re the game of chicken:
The Dems will lose if they blink first in this chicken game. In fact, the best response to the GOP chicken play is to toughen the financial reform rules: legislate a fiduciary duty of broker-dealers to their clients (since they don’t seem to believe they have even quasi duties at this point–see below and see Gerding, The Senate Goldman Hearing: Fiduciary Duties for broker-dealers? and Ribstein’s response that duties just create litigation costs); add a permanent financial institution tax on leverage and assets that will essentially force banks to downsize while appropriately charging them for the cost-of-funds advantage that they enjoy because of their size and the implicit federal guarantee–see, e.g., Leonhardt, A Bank Tax As Insurance for Us All, NY Times, Apr. 27, 2010; add a tough proprietary trading ban that wil return banks to the boring business of being bankers rather than day-traders; remove the “mark-to-model” version of fair value accounting that lets banks invent their own valuations and force them to use market quotes/actual trades for all valuations even in “disrupted” markets–and surely do not allow the FDIC to determine valuations during crisis as the Dodd bill currently does, since that is an invitation to distorted values that are adopted to enhance balance sheets; eliminate tax-free reorganizations for financial institutions; create rules as proposed by Senators Kaufman and Brown that will shrink the banks to manageable size rather than “TBTF” size, through limits on share of deposits (10% of total at insured depository institutions) and nondeposit liabilities (2% of GDP for bank holding companies, 3% of GDP for shadow banks) (the Kaufman April 21, 2010 speech on the proposed legislation is available with summary of bill on wealth.net, here). On the reasons that downsizing banks makes sense, see Alford, Why dismantling too big to fail financial firms makes economic sense, Naked Capitalism, Apr. 27, 2010; Zamarripa, Big Banks Can’t Be Reformed With Small Ideas, Roll Call, Apr. 28, 2010.
Every day that the GOP votes no, add one more tough provision.
re the Goldman hearings and hedging/casino gambling:
The Senate questioners recognized the problem of a bank whose assets and liabilities are sufficiently large that its failure could derail world economies and that has (and uses) ability to create innovative financial products that amount to nothing more than casino bets in which the bank is likely the only party with all the information, but as casino betting is getting more and more popular is important for people to have great places to do it, and is when sites like apostacasa.com can become really useful. The concern here is that these investment banks are performing quasi-public functions (serving as middlemen in the sales of stocks and bonds, helping deals between corporations take place, etc.) but are acting with purely private greed (treating sales as a search for suckers, creating products that are toxic from the start and pawning them off on unsuspecting buyers, using flash trading schemes that permit the bank to make money off its own clients’ trade information).
The banks, of course, see themselves as merely profit-making businesses. It’s “caveat emptor” from day one. And if their risk-taking leads the economy into chaos, they don’t care as long as they come out with profits–they claim no fiduciary duties to customers, no obligations to the public (other than mandated by securities laws, and even there they have a bank-friendly reading of disclosure requirements), only the rationale of making the most bucks possible in whatever way possible. According to the bankers, their shorts are just reasonable “hedges” against loss.
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This issue is central to the financialization of our economy and the need for substantive financial reform even beyond what is currently being proposed in the Senate amid the Republicans’ game of chicken.
End users of wheat are legitimately hedging when they buy futures. Issuers of corporate bonds that pay a floating rate of interest are legitimately hedging when they buy an interest rate swap under which the counterparty accepts a fixed rate of interest and pays the issuer a floating rate that it can then pay over to its bond holders.
But if we allow investment banks to create synthetic CDOS and other complex financial products that are purely casino bets (I would urge that we should just not, but it is not clear Congress has the guts to implement the kinds of severe changes that are needed here), should we allow them to claim that shorting their own products is merely a “hedge” like other end users purchase? I don’t think so. One way to disincentivize the creation of complex financial products and the endless financialization of the economy that ultimately adds no jobs and does nothing for quality of life (except for the wealthy traders and quants that create the products) is to change the risk appetite of banks. No bank should be permitted to be net short on any product it creates or any product that it sells to customers. But not being short is not enough. Banks need to be bear sufficient risk for the products they create . So we might also require banks that create and sell financial products to 1) retain a sufficient share of the interests issued to provide a reasonable equity cushion below the products sold –around 15-20% and 2) not be permitted to “hedge” those products by shifting the risk of loss off to another bank or financial entity. Odds are their appetites for creating risky would diminish significantly if they bore the risk they created and there was no prospect for bailout (another item that needs to be strengthened in the current bill and that the GOP “no” vote makes possible to do).
By the way, a letter to the editor in the Times Friedberg, Goldman Deal and the Financial Market, Apr. 27, 2010, suggests that such naked bets are “good” for the market because they help pricing. Would you claim that a bunch of people laying down a bet on “red 21” helped one know whether red 21 was a good bet and accurately priced? Certainly not. The naked credit default swap is probably not much better at predicting real value–for years, the CDS prices on even the worst subprime deal were really really low (that’s why John Paulson could make so much money off his short). Irrational bets on the long or short don’t do anything except increase volatility and increase the size of the bubble market. Pricing information gained is either too insignificant in that mix or misinformation that adds to the problem.
Craps allows bettors to choose between a bet of pass or don’t pass bet. Roulette enables betting on either red or black. Same with Synthetic CDOs. Theoretically, would “the house” have a greater fiduciary responsibility to those betting pass/red than to those betting don’t pass/black?
As attractive as they sound at first blush, proposals to extend “fiduciary duty” are generally bad ideas. Let’s look at the various roles vis a vis other parties that brokers have and examine what sorts of standards we should impose on each type of role.
Clearly we don’t want to insert fiduciary standards into trading markets — the whole point there is that each side of a trade has a different “view” of value/risk/price. As long as each side delivers what the other bargained for (frex, shares against cash), the deal is done. There’s no second-guessing the merits of the trade afterwards. (That’s not to say that if one side was manipulating the market somehow that we can’t go after them for evil-doing, but that’s quite separate and apart from market finality of the trade itself.)
And market-makers qua market-makers are simply serving as either buyer or seller in order to make an orderly market. They make their money on the spread and so are indifferent in a broad sense as to how an investment performs. So again, they have no responsiblities to those on the other side of the trade other than to make an orderly market, and we have no reason to want to impose fiduciary duties on them.
But what about salesmen? Don’t they have some sort of obligation to their clients? Sure. At the bare minimum, they have the obligation not to lie or mislead the buyer. That’s garden-variety fraud. And it seems to me that some of the actions by GS salemen when they were dumping junk on their European clients may measure up to that standard. Just depends on what they said or implied or failed to say in response to client queries when they were pitching the junk.
But how about adding a fiduciary duty of the salesman to the client? That would mean the salesman stands in effect in the shoes of the buyer — so the salesman would be responsible for only selling things that he would be willing to buy at the stated price. We don’t expect that of the clerk at Bloomingdales, do we? Now we’re faced with the problem that any time a buyer loses money on an investment, he could go back to the salesman and claim the salesman didn’t perform his duty as a fiduciary. And even though there was no evidence of false or misleading statements by the salesman, it would be up to a judge to sort out the state of mind of the salesman at the moment the sale was made (exactly what did he know, or should have known, when, etc.), and the reasonableness of that state of mind. This is not what courts do well. And it would severely undermine an important economic function of markets which we value highly — finality.
It’s true, we do impose higher standards on brokers when they’re selling to retail clients — the know-your-customer and suitability requirements. Those rules don’t provide for second-guessing the quality of a particular sale — that is, was it a good deal or over-priced at the time it was made. Rather, they discourage brokers from selling types of investments they should have known were inappropriate for someone in the client’s financial position and with the client’s financial goals and expectations. To show a violation usually requries the salesman to have engaged in a pattern of unsuitable sales — unless, of course, a single sale represents a significant portion of the client’s investable capital. These are much more objective standards that a court can evaluate than “fiduciary duty”, which involves among other things determining what the salesman thought about the future performance of a security at the time he pitched it to the buyer. As I understand the proposed reforms, they intend to tighten up on those consumer protections, especially by targetting the operation of the mandatory arbitration system which overly-privileges the financial […]
Goldman Sachs sold poison as medicine and then bought life insurance policies on the people they sold the poison to. Lets not bullshit ourselves into believing thats capitalism. Its a crime and should be treated as such.
Lets adopt the pre big bang system in the UK, a broker takes client orders and does no trading on its account, a jobber just trades. Clearly the hedge funds masquerading as proprietary trading desks need to be run as hedge funds. The compliant will be that this will be inefficient that for example big institutional clients wont be able to unload their position because there will be no one with enough capital to take the temp position (which was Goldmans first step down the road to play the spread between the big block and the smaller blocks). Of course today the institution a bunch of small sales is not the big deal it was before the computer. With programmed trading you could set it up to sell a % of the block every so often.
Then you could also get rid of the salesmen peddling their wares, just post the offering document on the web, and a summary page listing the offers you have outstanding if an underwriter. If underwriters are really needed anymore, the web and a reverse auction might eliminate the need for the capital of the underwriter. (That is people who want to buy or sell the security as the case may be make a bid and a number of shares. Then if the security is being sold, you start at the top price and sum shares until the quantity is met, if being bought you start and the bottom price and work your way up, with a posted reserve price in each case). Presto the underwriter needs no capital for the deal as it no longer holds the security even for a few seconds.
Nadezhda:
Do you understand the “reasonable man” rule of law? What would a reasonable man expect to happen. This premise is what guides the Uniform Commercial Code.
“If whatever a man’s real intention may be, he so conducts himself that a reasonable man would believe that he was assenting to terms proposed by the other party and that other party, upon that belief, enters into a contract with him, the man thus conducting himself would be equally bound as if he had agreed to the other person’s terms.” Smith v. Hughes
Fiduciary duty already existed as one side made a contact with the other and had an obligation to act in the best interest of the contracted party. There was a special trust placed in GS based upon their expertise and reputation in the market place. Inturn, they used this trust to act in their own best interests.
What would a reasonable man expect? A fairness in reporting of the positions held by Goldman Sachs so a reasonable man could determine whether they wish to be a part of this transaction. Goldman Sachs withheld this information from people investing in their CDO, CDS, etc., hence they acted outside of what a reasonable man might expect . . . full disclosure of their positions.
What would have solved the dilemma of derivatives?
“’Well, Brooksley, I guess you and I will never agree about fraud,’” Born, in a recent interview, remembers Greenspan saying.
‘What is there not to agree on?’ Born says she replied.
‘Well, you probably will always believe there should be laws against fraud, and I don’t think there is any need for a law against fraud,’ she recalls. Greenspan, Born says, believed the market would take care of itself.
For the incoming regulator, the meeting was a wake-up call. ‘That underscored to me how absolutist Alan was in his opposition to any regulation,’ she said in the interview.”
Nadezhda, what would have made it easier for a reasonable man to determine whether they wanted to bea part of a particular transaction? How about full disclosure of the positions taken bu Goldman Sachs for an against the derivatives being sold? Born had suggestd all derivatives going forward be listed and registered. This was stopped by Summers, Levitt, Rubin, and Greenspan. The reasonable man never received the information he required to make a decision on the risk of a particular investment and what part Goldman Sachs was playing in the transaction.
– Make all derivatives tansparent and list who holds what and force sellers to reveal those positions. I would tax them anyway as there is nothing of value created here other than asset appreciation which is not a product or a service and has no Labor.
– Split Investment banks such as Goldmans and Depository Banks such as Wells Fargo. Another Glass Steagall.
– Force Goldmans and others to decide whether they wish to be a bank or an investment firm. They should not have access to cheap government loans to invest.
Fair Dealing is Fiduciary responsibility under the UCC.
In a forward contract there is a short and a long. If the client wants to go long then the investment bank would have to go short to make the contract work. This investment bank might want to find someone else to sell the short position to or they might hold the position. The point is that taking the short positions against your partner in a derivatives contract is a typical way of doing business. Moreover, if the investment banks sees a profit opportunity they should try to exploit it by taking a position in it. Exploiting mispriced assets is the motivation that keep the market reasonably efficient.
***Financial reform–the GOP’s “chicken game”; and is it hedging or casino betting when banks go short on products they have created/sold to customers?***
I think that the answer to that is yes. It might be either.
It is not unreasonable for a bank to hedge a bet. If, for example, a bank bankrolls some sort of investment with the intent of selling it off in shares, it would be perfectly reasonable for the bank to buy insurance against the contingency that the shares become unmarketable in the interval between creation and sale. My impression is that physical delivery CDSs would fill that need, but maybe not or maybe there is a better way.
I’m pretty sure that the financial community does not need complete license to do whatever they damn well please in order to function. IMHO, those people are dangerous, arrogant, obnoxious, questionably competent, and clearly need a keeper.
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Technically, I don’t think a bank can short sell it’s own product because my understanding is short selling involves borrowing an asset from a second party then selling it to a third with a promise to fix it all up later. I’m unlcear how a bank can borrow from itself. But there isn’t much doubt that a bank can find some way to bet that the value of an asset will drop even it the mechanism isn’t short selling.
***Exploiting mispriced assets is the motivation that keep the market reasonably efficient.***
I haven’t seen much sign that the financial markets should be described as “reasonably efficient” Given the repeated debacles over the past two centuries due to massive mispricing of assets, perhaps we should reconsider the thesis that efficiency in markets is a particularly important consideration. Perhaps we should think a little about whether honesty, integrity, transparency, and simplicity should be the driving concerns. Who knows, maybe if we had honest bankers and brokers, passed some laws with teeth regarding misrepresentation and false advertising, and generally cleaned up our act, efficiency would take care of itself.
Hedging is speculation. Speculation is gambling. Financial transactions (e.g., buying stocks on margin), are a leakage in national income accounting. FUCK Goldman Sachs.
VtCodger,
I don’t know what you mean by assets being mispriced. An asset is worth what someone else is willing to pay for it. Value is determined by exchange. Values and perceptions of future values can change in ways that are not smooth. However, this is not a sign of inefficiency.
flow5,
Actually hedging is the opposite of gambling because those doing it are trying to lock in a fixed price at a future date rather than leaving them exposed to the vicissitude of market prices.
If hedging as you state is what is happening (I have my doubts) on whole, then it is cost control. But, hedging was unleashed (if I have learned properly) to those who have no intention or need to be the end user of the product being hedged. Thus, hedging against a group of pieces of mortgages when you are not the one who took out the mortgages own your own property is nothing more than playing the mortgage market that is made up of other peoples real efforts to control costs. Gambling on other peoples markets.
Linda thinks the Democrats actually want “tough provisions” if they wanted tough provisions they would reinstate Glass Steagall (a 17 page bill) and repeal the Commodities Modernization Act.
They dont want reform.
Dodd is a Wall Street flunky and many of the deregulatory measures that caused this fiasco were initiated by Democrats.
They all work for Wall Street
Interesting week so far in Washington DC.
There is news of both the Senate and the House holding hearings on Automakers after the recent acceleration problems with Toyota. They are asking for braking systems that will over ride the accelerate by wire systems when the car is operating at full throttle for a period of time. Congress is also asking for stiffer penalties and the removal of caps on those penalties. Finally, Congress is looking into installing crash recorders, the black boxes, in new cars to record events leading up to a crash. It doesn’t appear to be much opposition in either the Senate or the House on getting tough with auromakers.
Meanwhile, the Senate is “still” parsing the new proposed regulations for Wall Street. It appears the Repubs are pushing back on the Dodd Bill in unison by denying the Dems the one vote needed to pass the bill. The Dodd Bill is in response to the Wall Street crash in the second half of 2008. Unrecorded and risky derivatives trading is still occuring and no one can track who holds what. It would be nice if the Senate could take a hint and act in the same expedient manner when the auto industry failed to react to problems immediately with drive by wire over acceleration, But then, this is Wall Street we are talking about and not auto manufacturing.
A thought did occur. Maybe we can install “black boxes” for trades on Wall Street of derivatives. We would then know who holds what. Wait a minute, didn’t someone named Brooksley Born suggest such transparency in 1999? If everyone knew who held what and what the other guy was doing, it would take all of the fun out of Wall Street.
Divorcedone,
I think it’s safe to assume that few would have an issue if [Large Pension Fund] rebalanced to treasuries by selling a large block of Mortgage Loans they thought were overvalued. So why is it “gambling” for [Small Hedge Fund] to sell (i.e, short) a similar block of Mortgage Loans that they believe are overvalued, to fund a purchase of treasuries?