How Do You Make $100 Million Per Day?

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How do you make $100 million per day? Goldman Sachs did it—and still does it. It even brags about it. Goldman’s net revenues for 2009 were over $45 billion. Most of this—$34.37 billion—came from trading. During the second and third quarters of 2009, Goldman made over $100 million per day on 82 out of 130 trading days. It lost money on only three days during the same period. Goldman explained that they were brighter than other people. They were “doing God’s work,” as Chairman Lloyd Blankfein put it. Well, maybe; it does sound miraculous. But could we have a few details? Goldman is the biggest player in the $600–800 trillion derivatives market. Everyone agrees Goldman is operating with a “too big to fail” taxpayer guarantee. If we are going to have to pay for it when it blows up, we should at least know what is going on.

The derivatives market is huge. The entire world economic output in 2009 was $66 trillion. The derivatives market is perhaps ten times that. And twenty years ago, that market did not even exist.

What is a derivative? In a March 4, 2008, report, the Joint Committee on Taxation gives a technical definition: It is a “bilateral (two-party) executory contract . . . with a limited term (lifespan), the value of which is determined by reference to the price of one or more fungible securities, commodities, rates (such as interest rates), or currencies (an ‘underlier’).”

Essentially, it “is a wager with respect to the change in the price or yield of an underlier.” Derivatives were unenforceable until President Clinton, with bipartisan support, signed the Commodity Futures Modernization Act of 2000, which exempted them from being treated as gambling contracts.

In a February 12 Financial Times interview, former Federal Reserve chairman Paul Volcker frankly admitted he does not understand “all the complications of the financial market.” For that matter, he added, “I don’t know how many of the leaders of these institutions understand it either.” What Volcker did understand is that “it’s very complicated. It has given rise to a great amount of opaqueness which has made it difficult to manage.”

The financial industry usually refers to credit default swaps (an “over the counter” derivative) as “insurance,” but that’s misleading. In insurance, you create a pool and charge each customer a premium based on the total risk of the pool. With credit default swaps there is no insurance pool, no reserves, and no regulator. The credit default swap is a wager.

Goldman and the bankers say the purpose of derivatives is to spread risk. You own x bond but are worried about it, so you can go buy a credit default swap to “insure” against its failing—your counterparty will pay you if it defaults. Of course, the counterparty can make the same assessment you can as to the likelihood of default. Your behavior is obviously not reasonable: If you had lost confidence in the bond, you would sell it. If you bet one horse at the track but changed your mind as post time approached, you could insure against the one horse losing by betting the other seven horses. That would eliminate the risk, but would it be considered rational behavior?

The reader is no doubt startled to learn that taking bets is part of the business of banking. We can thank the U.S. Supreme Court for that. The National Bank Act limited banks to the “business of banking” as defined in section 24(7), which described traditional banking functions. That lasted from 1863 to 1995. In NationsBank of N.C. v. Variable Annuity Life Ins. Co. (1995), the Court held the enumerated banking powers were overly restrictive—they were hamstringing the banks. The comptroller of the currency, at his “reasonable discretion,” could authorize other activities. But his “reasonable discretion” proved to be a slender reed to rely on, and, before long, the banks were heavily engaged in making gambling contracts. At the track, a pari-mutuel ticket is called a bet. At Goldman Sachs, it is called a credit default swap or a CDO or a CMBC. They all have the same social utility—none.

When President Obama took office he hired Wall Street to clean up Wall Street. Now, as one might have guessed, that has not worked out. Nothing was fixed, and none of the fundamental problems were even addressed. Instead the Fed just flooded the system with dollars. That reinflated the stock-market bubble, but the economy continues to lose jobs every month. Columbia professor and Nobel Prize winner Joseph E. Stiglitz writes that the efforts to save the banking system were “so flawed” because those responsible for the trouble—Larry Summers and Tim Geith­ner—were put in charge of the repair by the Bush and Obama administrations. Wall Street created the mess by taking on unmanaged risk and excessive leverage through nontransparent deals that were often hidden off-balance-sheet. The rescue by the Fed, the FDIC, and the Treasury depended on yet more leverage, off-balance-sheet entities, and nontransparent guarantees. In his book Freefall, Stiglitz writes, “When the private markets were at the point of meltdown, all risk was shifted to the government.” The real problem with the rescue effort, of course, is that the banks should not have been rescued. They should have been closed. The IMF reports that U.S. banks had incurred almost two trillion dollars in losses—they were bust. They still are.

The busted banks created a problem because Congress, following the public’s reaction to the September 2008 TARP law, would not vote money for any further bank bailouts. The Constitution, of course, gives Congress exclusive control of spending. Nonetheless, both the Bush and the Obama administrations used the Fed, the FDIC, and the Treasury to do an end run around the Constitution. They pursued policies they knew had no democratic legitimacy. After all, as Tammany Hall’s George Washington Plunkitt used to say, “What’s a Constitution among friends?”

The tote board at Aqueduct is transparent—it reports what is being bet on every horse every couple of seconds. Not the derivatives market. Nomi Prins, a former managing director at Goldman, spent two weeks sifting through the financial statements of the major derivatives players. Exasperated by the indecipherable information, she concluded that it is “virtually impossible to get an accurate, or consistent picture of the banks ‘real money’ . . . vs. their ‘play money’ . . . ” Goldman explains that its activities are divided into three segments: Investment Banking, Trading and Principal Investments (including Fixed Income), and Asset Management and Securities Services. Seventy-five percent of their 2009 revenues came from Trading and Principal Investments.

Goldman is a public company. Does the Fed or SEC require it to disclose contingent liabilities, at least in footnotes? Not so much. In an SEC Form 10-Q report (June 26, 2009), Goldman tells us that accounting standards do not require that all derivatives be disclosed: “FIN No. 45 does not require disclosures about derivative contracts if such contracts may be cash settled. . . . If these conditions have been met, the firm has not included such contracts in the tables below.” So the taxpayers don’t know how many risky bets they are backing or how much that backing will cost when the bill comes due. Could it be $100 trillion? It’s possible. It could be more.

“People who know the industry and know Goldman Sachs know that it is a giant hedge fund, but it’s wrapped in an investment banking wrapper,” says Prof. Samuel Hayes of Harvard Business School. He adds that the public “would be horrified to think that their tax dollars were going to a hedge fund.” In a December 21, 2009, story, Peter Solomon, a New York investment banker, agrees: “Everybody thinks they’re a bank, but they’re a hedge fund. . . . The difference is that this year they’re using your money to do it.”

President Obama announced on January 21 what he called the “Volcker Rule”:

[W]e intend to close loopholes that allowed big financial firms to trade risky financial products like credit default swaps and other derivatives without oversight. . . . Never again will the American taxpayer be held hostage by a bank that is “too big to fail.” . . .

First, we should no longer allow banks to stray too far from their central mission of serving their customers. In recent years, too many financial firms have put taxpayer money at risk by operating hedge funds and private equity funds and making riskier investments to reap a quick reward. And these firms have taken these risks while benefiting from special financial privileges that are reserved only for banks.

When does “never again” start? Not one rule has been changed since the financial crisis started. The big banks, within hours of the President’s announcement, said they had already figured out how to get around Obama’s new rule. The main loophole is that the President’s plan permits any transaction with a customer. The banks will say that is largely what they do. One bank said the new rule would affect less than one percent of its overall business. On February 2, Treasury Secretary Geith­ner told the Senate Finance Committee that the Volcker Rule needed to be “sensible and careful and recognize the reality of the way institutions are run.” Geith­ner’s timid approach places him at odds with Volcker, who testified the next day that the bankers knew “very well” what proprietary trading was. Moreover, Volcker said that if the bankers tried to evade the new rules, they should be met with a “strong regulatory response.” In any case, Goldman does not take deposits and, if it gives up its status as a bank holding company, will be completely free of the Volcker Rule. The derivatives they buy and sell all have customers, to the tune of $600-800 trillion.

What caused the crisis? Could these new, exotic, and poorly understood derivatives be the cause? Could a casino taking bets ten times the size of the world’s economic output be a little unstable? Did the leverage and lack of transparency built into the derivatives bring down first the financial system and then the real economy? On December 3 Ben Bernanke testified to the Senate Finance Committee that derivatives, of course, had nothing to do with the Great Depression, but “clearly, in this crisis, they were a big issue.” The only justification for the Fed’s bailout of AIG’s bad bets was that, if it failed to do so, a string of Chinese firecrackers would start going off. And when they were done, all of our financial institutions would probably be bust. The new Obama reforms do not touch derivatives.

How does Goldman make money? The question is simple but the answer elusive. Goldman Sachs explains it is

offering broad market-making . . . on a global basis. . . . Our willingness to make markets, commit capital and take risk in a broad range of fixed income, currency, commodity and equity products and their derivatives is crucial to our client relationships and to support our underwriting business by providing secondary market liquidity.

Trading net revenues come from “spreads” that are “modest” in large, highly liquid markets and “generally larger” in less liquid markets.

Goldman—and the other big banks—describe their activities as “market-making,” but that is a deceptive label. A market maker, for example, is a dealer in the over-the-counter stock market. He stands ready to buy and sell x stock: He will buy your x stock at $100 (the ask price), and he will sell x stock to someone else at $102 (the bid price). The two-dollar difference is the “spread.” The market maker’s risk is that the market will break sharply against what he is holding, and the spread is to cover that risk. But Goldman and the other banks are not dealing in x stock; they are dealing in their own obligations. They are liable on all the bets just as your regular bookie is. J.P. Morgan is committed to pay $25 trillion on various bets. Goldman is the major player in the market, so it may well be obliged to pay $100 trillion on its bets. Or it may be trying to collect $100 trillion from counterparties who can’t pay. If Goldman disagrees with the $100 trillion estimate, it is free to make public the actual number. We all look forward to that.

Goldman tries to offset its bets by making bets the other way, thus laying the risk off on others. Assuming it can place an offsetting bet, Goldman’s only risk is “counterparty risk,” which means that, while Goldman remains liable on its bets, someone (like AIG) who owes them money can’t pay. The Goldman counterparties, on the other hand, have to worry about Goldman’s ability to pay. The offsetting bets are, of course, pointless if they are made at the same odds. Goldman can book a nice profit by taking a bet that Greek bonds will default for a premium of $100,000 per year for five years to cover $1 million of bonds if it can turn around and lay off that bet for $90,000. The risks, though, are at least three: Goldman may fail and not pay on its bet; Goldman may not be able to find a counterparty to make the offsetting bet profitable; and Goldman’s counterparty may not pay.

The wider the spread, the greater the profit. And the wide spread is where we find the $100 million per day. Derivatives generate huge profits, but they are likely to destabilize our economy again as they did in September 2008.

Goldman’s role as the major derivatives dealer means it knows which way the bets are going. Its unique position provides information not available to its competitors, and many profitable opportunities. The derivatives market is an oligopoly consisting of Goldman and the big banks. Competitors are discouraged by a huge barrier to entry—i.e., the bettor has to believe the bookie will pay a $50 billion bet. Who would you trust to pay $50 billion except an entity deemed “too big to fail,” with its implied taxpayer guarantee?

A racetrack bet is simple. Derivatives are not. They are very seldom traded, and the original TARP idea—the government would buy the banks’ toxic assets—was abandoned because they are so complicated that they are impossible to price.

Derivatives, having brought down our economy, are now bringing down the euro. Goldman’s derivatives helped Greece hide her excessive borrowing from the European Union. In the 1990’s Japanese companies used derivatives to hide losses, a practice they called tobashi—“to make fly away.” Derivatives are used to evade accounting, banking, securities, and tax regulation. Indeed, all financial reporting since derivatives have showed up has become problematic.

The U.S. economy prospered without derivatives. It has not prospered since they were legalized in 2000. Paul Volck­er recently noted,

I have found very little evidence that vast amounts of innovation in financial markets in recent years have had a visible effect on the productivity of the economy. Maybe you can show me that I am wrong. All I know is that the economy was rising very nicely in the 1950s and 1960s without all of these innovations. Indeed, it was quite good in the 1980s without credit-default swaps and without securitization and without CDOs. . . . I do not know if something happened that suddenly made these innovations essential for growth. In fact, we had greater speed of growth and particularly did not put the whole economy at risk of collapse. That is the main concern that I think we all need to have.

President Obama should move to repeal the 2000 law legalizing derivatives. That law is propping up a volatile $600-$800 trillion casino. And the next time it fails, the taxpayer will not prop it up; our resources and patience are exhausted.

The President is said to admire Teddy Roosevelt. He should take a page from Teddy’s book and start busting up the banks. The Big Five should become the Very Large Twenty. That would be a start. “Too big to fail” must be killed.

This article first appeared in the May 2010 issue of Chronicles: A Magazine of American Culture.  Janek Kazmierski and Andrew deHoll, third-year law students, gave invaluable assistance in its preparation.

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