|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.|
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.
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.
For example, a Wall Street firm may be "axed" in one particular issue because a client hit their bid on older bonds in order to buy the most recently issued "on the run." So let's say Big Name Asset Manager decides to roll out of a position in the 4.625's of 12/31/2011 (4.625 coupon Treasury note that matures 12/31/11) to go into the new issue two-year note (1% due 3/31/2012) because he or she wants to be in a more liquid issue. That Wall Street firm now has an "axe" to grind in terms of buying the new issue two-year note and selling the 4.625's. Many people on the sales and trading team focused on interest rates and government bonds will have various opinions regarding relative value among all these Treasury securities. They may base their opinions based on what they hear from their clients, what they hear from their peers, or they develop their own sense of value based on their own past experiences. Some might say: "I can't sell premium bonds to my guys," meaning their clients will not buy bonds trading above par, for either credit or accounting reasons. Others might say, "Those bonds are pigs because they mature on a Saturday," meaning the holders don't get paid any interest for the two days from maturity to when they actually receive their principal. Some may even say, "I think the government is doing a shi**y job of managing the federal deficit. ...Treasuries are going to 8%, easy." Does this mean that the Wall Street firm should not sell the bonds? Just as an aside, because I can't resist the delicious irony, what happens if our budget deficit does spiral out of control, the world loses faith in the dollar as the world's reserve currency, and yields here do go up to 10%, 12% or even 14%? Are we going to have a congressional inquiry grilling, "What were you doing selling those shi**y U.S. Treasuries to your clients ... you had people who knew Washington's spendthrift ways would lead to a collapse?" Others on the same desk may think the 4.625's look cheap, that their offered price reflects the concerns over the budget deficit, the two "bad days," and the price above par. These salespeople have clients that are deliberately seeking relative value in the Treasury market. What should those sales people do?
If a client calls up and wants to buy them, should the salesperson who thinks the bonds are "rich" hand the phone to the salesperson who thinks the bonds are "cheap?" What if the desk were simply wrong on the value it ascribed to the 4.625's vs. the on-the-run two-year note and ends up holding them longer than expected --that is, the merchandise has become stale. Is it wrong to charge the salesforce with, "C'mon guys, let's find the price that works to get out of these ... We are in the moving business, not the storage business."? What is the alternative -- sit on the bonds and not turn over inventory? What are the implications of that stance? Maybe the desk has quite a bit of inventory and is worried that the Fed may soon raise rates and it will harm the two-year sector in particular. What should it do with that inventory? Hold it to maturity? Is it OK if they sell those bonds to people who are professional investors and understand the risks associated with the Fed and may think the price will reflects that information? If they can't get out of the 4.625's for whatever reason, is it OK for them to be short another issue to neutralize the interest rate risk? If not, what happens to the liquidity of the 4.625s when another client asks for a bid? If they do sell the 4.625's, do they need to disclose that Big Name Asset Manager sold them the bonds? Is that relevant information? "You didn't tell me BNAM was selling ... of course I wouldn't have bought these Treasuries had I known BNAM was selling!" Of course you probably would only hear that if the securities went down in price. Lastly, I want to talk briefly about fiduciary responsibility. All of the clients that Wall Street firms deal with on the institutional side are fiduciaries themselves. They are paid by others to make decisions and entrusted by others to manage their money. Most of them are highly specialized (i.e., "I am the intermediate Treasury trader for Big Name Asset Manager, and I am looking to trade seeking relative value for intermediate Treasuries; I am my firm's expert on intermediate Treasuries.") They have multiple contacts on the Street and they execute and exchange ideas with all of them. Should that fiduciary only execute trades with those that agree with them? Do they establish the best price execution -- as fiduciaries, mind you, that is part of their job -- with the Wall Street firms that are always going the same way, and not those that are "axed" to buy or sell? As promised, I will not reach a conclusion as this is a "thought piece," after all but I do recognize and I hope you'll agree that there are a variety of opinions out there and, as they say, that is what makes a market.