Congress, Let's Play Make a Market

I recognize that for the vast majority of the populace, defending Goldman Sachs (GS) is a no win situation -- so I will not attempt to do so. Both the complaint and congressional inquiry deal with many very complex products -- CDOs, synthetics, derivatives, securitizations, resecuritizations, static deals, managed deals, and so forth -- as well as what appears to a lot of people to be murky behavior.

Sen. Carl Levin, center, huddles with Sen. John McCain as Sen. Tom Coburn looks at notes during Tuesday's Senate panel questioning Goldman Sachs executives about the firm's trading of derivatives of subprime mortgages.

The complexity itself is confusing, so we must be aware of the dangers of stringing a bunch of data points together to paint a picture because we are unfamiliar with a particular element. Like any complex issue, it is usually enlightening to break down into its component parts. I want to focus today on the subject of behavior of a market maker (and touch on the notion of fiduciary responsibility) -- I will have a longer piece on securitization later. I will not leave the reader with a conclusion, but instead will allow the reader to do so.

I also realize that opinion is based on perspective. For the vast majority of the population, perspective is typically framed around the equity markets, where principal vs. agency transactions rarely come into play. They also have a perspective on suitability and fiduciary responsibility, largely framed by their relationship with their own financial adviser.

So looking at the fixed-income markets, which is typically a principal based business (meaning that a market-maker is almost always on the other side of a transaction) dealing with institutional clients, may seem a little foreign. But by segmenting apart from the discussion the complex structured products, I hope we can gain a better perspective on this one aspect. (And as I said we will come back to ABS in a later piece because the issue of credit bubble, and securitization playing a role in that is a discussion-worthy topic).

Instead of ABS or subprime or securitizations or synthetics or CDOs, let's just call the products in question "U.S. Treasuries." A Wall Street firm will typically make markets in Treasuries. They may be long, they may be short, any individual issue. Chances are very high that they will have some of these securities lying around in inventory given they participate in regular Treasury auctions and are designated as"primary dealers in the product. But the given inventory will change around during any given day based on facilitation of client enquiry.