Goldman’s more than a Wall Street toll collector

By Matthew Goldstein – Analysis

NEW YORK (BestGrowthStock) – Market maker.

Time and time again, that is how top officials with Goldman Sachs Group (GS.N: ) on Tuesday described their primary role in arranging and selling subprime mortgage-linked securities to institutional investors.

In nearly 11 hours of testimony before the Senate Permanent Subcommittee on Investigations, the phrase “market marker” was uttered nearly twice as often as an expletive used by a former Goldman executive to describe one of the busted subprime-backed securities it sold to investors in early 2007.

Goldman Chief Executive Lloyd Blankfein told the Senate panel that on any given day the investment company stands as a market maker on “hundreds of thousands, if not millions of transactions.”

He said the firm’s only real obligation is to make sure that a transaction is “suitable” for clients based on their level of sophistication and financial means.

There is truth to Goldman’s defense that much of what it does in markets for bonds, stocks, commodities, currencies and other asset classes is to act as a middleman in transactions between sophisticated buyers and sellers.

But fees associated with making a market tell only a part of the story when it comes to how big investment companies like Goldman make money — especially on esoteric products like collateralized debt obligations.


After all, Goldman is not paying its 31,000 employees $500,000 a year, on average, simply to serve as Wall Street’s version of a glorified toll collector.

Far more of Goldman’s annual income comes from the trades or hedges it does every day to offset the risk it takes on as a market maker. And those hedges aren’t simply designed to take a neutral position on a stock or bond. Sometimes they are intended to place a directional bet as well.

During Tuesday’s hearing, Senator Carl Levin, the subcommittee chairman, tried to get Blankfein and other Goldman officials to admit that in shorting subprime mortgage debt in 2007, the investment company had taken unfair advantage of customers who were buying the subprime debt the bank was peddling.

Wall Street historian Charles Geisst said senators on the panel should have pointed out that if all Goldman was doing was hedging itself, it wouldn’t have profited so handsomely from its short bets on subprime debt.

“If you have a perfectly balanced hedge then you shouldn’t be making all that money,” said Geisst, a professor of finance at Manhattan College.

Indeed, the distinction between trades that are done to hedge an exposure and trades that end-up generating a profit can and do get blurry. It’s one reason investment firms do not break out specific revenue figures for proprietary trading — trades done with a firm’s own capital.

“There are two roles that Goldman plays,” said Frank Partnoy, a former Morgan Stanley derivatives trader and law professor. “One is to make riskless fee income. And the other is to do proprietary bets, and the proprietary bets have become much more important than the fee piece.”


During the hearing, Senator Levin also strongly suggested there was something morally wrong with Goldman creating so-called synthetic collateralized debt obligations, which were used as vehicles for the investment firm and others to effectively lay wagers on the fate of the U.S. housing market.

But Blankfein & Co didn’t cede any ground on that point either. In producing synthetic CDOs, the company’s executives said they were merely responding to a demand from customers for more ways to bet on the housing market.

And in providing that customer service, the Goldman was forced to balance out its potential exposure with short bets.

However, a former top derivatives trader for a European bank, who now works for a hedge fund, said Goldman’s market maker defense is nothing more than a “cover story.” The trader, who declined to be identified because he still works in the financial industry, said he sent a letter last night to Levin in which he took issue with Goldman’s defense.

In the letter, the trader said: “If the market-making desk is allowed to run huge net exposures for more than minutes or hours, that is proprietary trading.” He added, “A client expects the market-maker to act in good faith and not be warehousing the exposure.”

A person familiar with Goldman’s thinking but who didn’t want to be identified said that from time to time an investment bank may need to be net long or net short a particular asset in order to manage for unexpected trades or client requests.


Another issue with Goldman’s market-maker defense is that complex structured products like CDOs are not natural byproducts of a vibrant capital market such as is the case with stocks or bonds.

Structured products are investment vehicles that Wall Street financial engineers create to sell as high-yield alternatives to stocks and plain vanilla corporate bonds.

One such product was auction rate securities, which attracted wealthy investors after Wall Street banks began peddling them as an alternative to traditional money market funds.

Early in the financial crisis, investors who put money into ARS deals lost billions when banks stopped making a market in them and investors found the securities were largely illiquid.

Attorney Jacob Zamansky — who generally represents plaintiffs suing companies on behalf of investors — said Wall Street banks like Goldman owe a higher duty of fair dealing with their customers when they create structured products.

“They have a greater responsibility,” said Zamansky. “Certainly more than when they stand in the middle of a stock trade,” said Zamansky.

Stock Market Report

(Reported by Matthew Goldstein; Editing by Steve Orlofsky)

Goldman’s more than a Wall Street toll collector