Mystery Meat

The business environment after the summer of 2007 was tough [..]. One solution, according to management, was to go elephant hunting [..] In good times, transparent, flat-fee commission business was steady and paid the bills; it was a volume business. But if the register wasn’t ringing, as was now the case, new types of business had to be found. What could make up the fastest for lost revenue? Products that were quick hits, that had very high margin embedded in them. As a general rule on Wall Street, the less transparent a product is, the more money is in it for the firm. Over-the-counter derivatives (OTC, meaning not listed on an exchange) and structured products (complex, nontransparent derivatives with all sorts of bells and whistles) were the trades to go for [..].

[After the subprime crisis] Goldman didn’t go down. But the storm kept raging. [One way to survive] was to try to convince your clients to buy structured derivative products (black boxes) that might temporarily give them some hope: [..] Since these structured products were created by the bank that sold them and not widely traded, they came with the markup one expects from any bespoke product. These kinds of murky promises were legally okay, because in the twenty pages of disclaimers on the document, somewhere there would be a line that read, “This may or may not be accurate; we may or may not believe what we’re telling you; we may or may not have the opposite view…” [..]

[The derivative -sausage- named] Abacus 2007-AC1 [was prepared for] John Paulson [..] the hedge fund manager who since early 2006 had been raking in huge sums by shorting the mortgage market. [..]  Paulson had personally selected the mortgage securities that went into the product, using a single criterion: which were most likely to fail. [Paulson shortsells this CDO, but Goldman needs a sucker on the other side to buy this, and they were] ABN AMRO and IKB, the two big European banks that lost the $1 billion Paulson gained. [SEC files charges on this shady deal, Goldman settles ..].

After the settlement, a lot of people at Goldman felt relieved. Maybe, they thought, with all this out of the way, we can move on. Yet business didn’t get a lot better: the firm’s reputation had been damaged with some clients. A lot of clients were no longer comfortable taking counterparty risk with Goldman Sachs. They would be willing to trade only listed, transparent products that went through a clearinghouse. That way the clients’ money, and market exposure, would be safe, irrespective of what happened to the bank they were trading with. Not the case with OTC derivatives or structured products, with which you would be subject to the fate of the bank with whom you did the trade [..].

Throughout the 2000s, Wall Street structured complex derivatives to help European governments such as Greece and Italy mask their debt and make their budgets look healthier than they actually were. These deals generated hundreds of millions of dollars in fees for the banks, but ultimately helped these countries kick the can, and their problems, down the road. Failing to address these problems culminated in the European sovereign debt crisis that the world is trying to deal with today [..].

I saw many sales leaders in different product groups [worrying about the question w]hich axes do we need to get off our books?” [..] An axe is a position the firm wants to get rid of or a risky position it wants to shore up. The firm believes, deep down, that one outcome is going to transpire, yet it advises the client to do the opposite, so the firm can then take the other side of the trade and implement its own proprietary bet [..] The axe du jour when I arrived in London in 2011 was getting clients to buy or sell options (puts or calls) on the largest European banks, such as SocGen, BNP Paribas, UniCredit, Intesa [..].  Aside from the obvious dishonesty of continually switching our recommendations to clients based on what our traders wanted to do, I was bothered by the European bank-options axe also because of the impact it was having on markets. (Some of these European banking stocks could move more than 5 percent in a day.)  And these weren’t abstract assets. These were the national banks of sovereign nations, countries with millions of citizens who were depending on their governments to get their shit together. Jerking around the fates of their banks struck me as highly irresponsible [..].

What made matters worse, and even murkier, was the fact that a well-known Goldman Sachs strategist had come out with a semisecret report that went to only a select number of clients. [..] In his commentary, the strategist painted a particularly dire picture and suggested that European banks might need to raise $1 trillion in capital. He suggested some derivatives plays to capitalize on (or hedge against) this turmoil. During the same time period that a Goldman strategist was predicting the implosion of the European banking system, there were many days that our trading desk wanted to convince clients that today is a day to buy [..] It was all too much. We had advised Greece all those years ago how to cover up its debt by trading a derivative. Now that the chickens had come home to roost, we were [advising on how to profit from it ..].

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Smith’s book is a continuation of his op-ed piece on NYT published on the day he left GS.

The arrival of the 3W is causing problems for old financial firms, as concentration, centralization gives way to decentralization, it’s no surprise they start to lose their edge. Electronic brokerages today provide cheap and easy access to markets, anyone can trade equities, options, futures, and even compose their own brand of portfolios. With that kind of competition out there, firms like GS increasingly had to go towards OTC route, became predatory, especially on other “concentrated” institutions such as municipal governments, sovereign banks, but causing risky entanglements in the process that are even more concentrated.