I shall not today attempt further to define the kinds of material I understand to be embraced within that shorthand description ["hard-core pornography"]; and perhaps I could never succeed in intelligibly doing so. But I know it when I see it, and the motion picture involved in this case is not that.
— Justice Potter Stewart
Jesse Eisinger put up an interesting piece yesterday at DealBook, reporting on a series of transactions conducted by Goldman Sachs in 2008 and 2010. He uses it to illustrate what he and many other people seem to view as an insoluble dilemma: how to distinguish between market-making by investment banks and proprietary trading. The distinction is an important one, as Mr. Eisinger explains, because the so-called Volcker Rule in the new Dodd-Frank financial regulation regime severely limits investment banks' proprietary trading and investment activities.
I will let Mr. Eisinger explain:
The story starts in summer 2008. Bear Stearns had collapsed. The housing bubble was bursting. So was another bubble, in loans to high-risk companies. Banks, which had doled out overly generous loans to high-risk corporations, would get stuck with losses on many of these.
During this period, Goldman Sachs bundled a bunch of these loans into a special concoction called CELF Partnership — or CELF-interested.
Of the 1.5 billion euro deal (about $2 billion today), 1.2 billion euros came from Goldman’s own balance sheet. Goldman whipped the deal out the door in July 2008.
Just two months later, the financial crisis roared to a boil and the assets backing the CELF bonds, like all such investments, wilted. Those who bought into the CELF deal were sitting on paper losses.
The CELF deal got interesting this year. The big investor in the deal, a Dutch pension fund, wanted out. It owned the triple-A rated portion of the CELF deal.
The investor went back to the underwriter, Goldman, and after an auction, the firm bought it from its client. Because the market had declined, the investor took a loss.
In addition to buying the triple-A position, Goldman also bought some of the equity, or the bottom part of the deal. The equity carried ownership rights. Goldman bought enough equity to become the majority holder of the deal.
As majority equity owner, Goldman unwound the securitization and liquidated the securities.
Goldman made a bundle on the trade. Even though the CELF assets aren’t worth today what they were in 2008, there was enough money that in unwinding the trade, all the debt holders — including Goldman — got paid off in full. The holders of the equity were left with cents on the dollar. For Goldman, the trick was that it was worth a small loss on the equity to make a big gain on the debt.
So Goldman made money and some of its clients took a loss. At this point, few would be surprised by that.
Now, I am not personally familiar with this transaction, but I must say Mr. Eisinger obscures at least as much as he uncovers by the way he glosses over some of the key details in the story. I think it would be instructive to unpack his narrative. Perhaps we can learn a little more than we expect to about the distinction between market making and proprietary trading, after all.
First of all, we need to tease apart the various different roles Goldman Sachs played in this little drama. The fact that one firm played multiple roles does not prevent us from distinguishing among them, or pointing out the important differences each has.
The first clue comes from the fact that €1.2 billion of the corporate loans underlying the securities in question "came from Goldman's own balance sheet." This means one of two things: either Goldman purchased these corporate loans from the original lenders (or secondary market holders) for its own account, or it loaned the money itself to those corporations.1 Now, whether you loan money directly or purchase loans from others, the economic upshot is the same: you are a lender. Also, and more to the point, you are an economic principal. A principal invests its own money for its own account. It puts its own capital at risk in pursuit of investment return, whether that takes the form of lending money to borrowers; buying and holding long-term, illiquid assets; or trading securities, commodities, and other financial instruments for investment gain. That last is commonly known as proprietary trading.
The second distinct role Goldman played in the transaction was to bundle its own loans (and €300 million from other parties) into the CELF securitization, slice the underlying loans into separate classes of security with different priority claims on the underlying pool of loans, and sell those securities to investors. These activities and their analogues are known in the trade as structured finance. They can be performed on behalf of an unrelated third party, in which case the structured financier acts as an agent, or they can be performed for yourself as principal, as in the case of Goldman's CELFs. Usually the firm which acts as structuring agent also sells the resulting securities to outside investors. Selling newly issued securities on behalf of another party—related or unrelated—is known as underwriting.
Underwriting is one of the oldest functions of investment banks. Traditionally, it took the form of pure agency business: an investment bank would work with the issuer of new securities to shape them into a form and value attractive to the market, would arrange and assist the issuer in marketing the new securities to investors, and, in the end, would purchase the securities in bulk and then resell them to investors which it had already determined wished to buy them. The underwriter does in fact put its own balance sheet on the line, if only temporarily, by buying the securities and then reselling them. In this way, an underwriter does act as a principal. However, if it does its job properly, and develops and identifies adequate demand among third party investors for the securities prior to purchasing them, its risk is distinctly limited and quite fleeting. Underwriting is therefore properly understood primarily as an agency business. As an agent, the underwriter's primary obligation is to the issuer, to help create, market, and sell its new securities in such a way that the issuer can accomplish its financing objectives.
However, it is important to realize that the underwriter's success—and privileged position in the market as a trusted vendor of issuers' new securities offerings—depends heavily on its prior record in placing securities with third party investors. An investment bank which becomes known for underwriting low quality paper, crappy issuers, or overpriced securities can become a pariah with the investors who normally purchase such securities. They will not buy its offerings, or they will only buy them with heavy price discounts. This gets around to corporate issuers, and those companies will choose different investment banks to place their securities the next time they want to finance. Accordingly, you must understand that a traditional underwriter's interests—when it acts as a pure agent, or hired gun—are never 100% aligned with those of its issuer client. In many cases (not all), an issuer simply wants to receive the highest price possible for its securities. But the underwriter wants to sell securities that will make its clients on the other side of the Chinese wall—buy-side investors—happy, too. The underwriter, as pure middleman, must play a long game, and its success depends on pleasing both sides of the table. Usually that means displeasing each of them—issuer and investor alike—equally.
In addition, an underwriter usually bears at least an implicit obligation to investors to not only underwrite quality, reasonably priced securities but also to support those securities in aftermarket trading. In practice, this means offering an acceptable bid when an investor wants to sell the securities a bank has underwritten and, to a lesser extent, an acceptable offering price for future purchases. Supporting newly issued securities in the aftermarket leads neatly into the concept of market making.
Market making is the process through which an investment bank makes a two-way market in various securities and markets. In other words, it stands ready at all times to buy securities at an advertised purchase price and to sell those selfsame securities at an advertised selling price (which, understandably, in almost every instance is higher than the price at which it offers to buy). There are many reasons why investors want investment banks to perform this function, even in the age of fully automated electronic matching markets. The simplest is anonymity. Investor A usually does not want Investor B (or C or Z) to know it is liquidating its entire 50,000 share position of IBM. It can sell its shares to X Bank at 11:07:17 am and X can turn around and sell them all to Investor B at 11:07:32. Another is that markets for certain securities can be relatively illiquid. There may be no buyer for security Z for hours, days, or even weeks. Investor A can sell its Z to X Bank today, which will take those securities into inventory for eventual sale when a buyer materializes. A third is that many securities trading in the market—like the various tranches of the CELF offering—are relatively obscure or customized, and only the investment bank which underwrote them fully understands which other investors in the market buy and sell such securities, and at what price.
Now, unlike underwriting new securities, where an investment bank earns a fixed, predetermined percentage of the offering proceeds for its labor no matter what price the securities sell for, a market-making bank only profits to the extent it can sell securities in its market making operations for more than it purchases them for (adjusted, as always, for funding costs). Furthermore, a market-making bank cannot reduce its uncertainty about the securities' eventual selling price by pre-marketing them to investors like it does in a new issue offering. Just like underwriting, however, the market-making bank must use its capital to purchase securities and hold them in inventory until it can sell them. Market making is risky. Market making is a principal activity.
And yet, investment banks traditionally thought of market making as a client service. An agency business. We put our capital at risk to facilitate the trading of our investing clients. In exchange, we earned a small commission, the occasional chance to put our capital to work in longer-term trades where we thought we had an edge, and—most importantly—priceless insight into the daily operations of particular securities markets, including the appetites, biases, and weaknesses of countless third party market participants. This insight is incredibly valuable, not only in market making itself, but also in making the investment bank possessing it a better informed underwriter for new securities. Securities markets are hotbeds of asymmetric information. The party with the best information has the greatest power. Market making can provide that power.
Now, historically what prevented investment banks from exploiting their privileged market position as the possessors of the best and most complete information to the fullest was relatively thin capitalization. But as markets got bigger and broader, and securities (and derivatives) got more complex, customized, and illiquid, investment banks' demand for capital became ever larger. In part, this was driven by their clients, who demanded they make markets in all the exotic new goodies their underwriting arms were frantically pushing out the front door. First they converted from private partnerships to publicly traded entities. Next, they merged with or converted into universal banks active across all markets: fixed income, equities, commodities, derivatives, currencies, etc. Complexity in particular—exemplified by exploding volumes in derivatives and structured securities—drastically increased the number and profitability of opportunities for the best positioned insiders—investment banks, natch—to profit from asymmetric information. Our clients demanded it, and we saw the opportunity. Large scale proprietary trading was born.
Enough with the history lecture. The major point you should take away from the dissertation above is that everything an investment bank normally does in securities markets requires it to put capital at risk. Low-risk, agency type businesses like underwriting and traditional market making lie on the same spectrum as full-blown proprietary trading, if only at different ends. There is no bright line between market making and prop trading, if only because a market maker may unintentionally take securities into inventory for a long time, because no buyer happens to be available, whereas a prop trader may make money by scalping basis points in high speed trading of liquid markets.
But the blurry line between market making and proprietary trading doesn't mean we can't identify proprietary investing—or, more specifically, acting like a principal investor—when we see it. The only time Goldman Sachs acted remotely like an agent in the scenario Jesse Eisinger described above was when it underwrote the original CELF securities offering in 2008. Even then, its client was Goldman Sachs itself, which sold the vast majority of loans underlying CELF to the securitization vehicle as principal. How interested do you think Goldman was in selling those securities to investors for an attractive price? Can you imagine its concerns as underwriter might have been subordinated to its interest as seller in getting the highest price? I can.
In any event, Goldman's actions in 2010 bear absolutely no resemblance to behaving like an agent when it purchased the outstanding CELF securities and liquidated them. It did not behave like a normal market maker, buying securities from one investor and selling them to another. It paid an arm's length price, determined after an auction run by a third party, to the investor it originally sold the AAA rated tranche to. It then triggered the liquidation of the securitization by purchasing a majority stake in its equity. With respect to the seller of the AAA tranche, it acted as a pure trading counterparty. A principal.
Therefore, Goldman's attempt to wrap its behavior in the holy shroud of client service:
"Our client decided to sell its investment," the firm said in a statement. "It took independent advice and ran a competitive sale process. We offered the highest price. This is a good example of helping a client achieve its objective, and underscores the critical importance banks play in using their capital to facilitate transactions on behalf of clients."
is nothing more than a patently disingenuous dodge.
By the same reasoning, my local pharmacist becomes my client every time I buy Preparation H to soothe the ass chapping Goldman Sachs gives me when they spout such pure, unadulterated horseshit.
I don't think so.
1 It is a relatively recent development (within the last 15 years or so) that corporate loans have become widely traded. It used to be a bank which loaned the money to a corporate client kept the loan as an interest-earning asset on its balance sheet until maturity. The bank originated the loan and retained full risk exposure to the timely repayment of interest and principal by its debtor. Nowadays, banks and investment banks still originate such loans, but they often dispose of most if not all of the risk exposure by selling those loans or derivatives tied to them to third party investors. Some argue that this has materially weakened the credit risk underwriting process for corporate lending, since the banks which originate and quickly sell such paper have little incentive to truly determine the long-term creditworthiness of their borrowers. I cannot disagree.
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