Sucker Me Once, Shame on You ...

Are you sick of hearing about Goldman Sachs (NYSE: GS  ) yet?

The company has been dominating the news lately thanks to the fraud lawsuit filed by the SEC. And while the overwhelming amount of coverage may seem like overkill, the hype from the case could (hopefully) push us toward some much-needed reform on Wall Street.

In fact, just yesterday, debate over the financial reform package finally opened in the Senate. Is the timing in relation to Goldman a coincidence? Not a chance.

Many of us here at The Motley Fool are hoping that Congress bears down to make the tough decisions needed to put our financial system on firmer ground. There's a slew of specific issues to be dealt with -- too big to fail, shadow banking, and everything else in between -- but those specifics can get a little overwhelming.

What's particularly interesting about the Goldman case is that it highlights one of the broader root causes of the problems on Wall Street.

Who's the sucker?
The SEC case against Goldman involves a synthetic collateralized debt obligation (CDO) and credit default swaps (CDS) written against that CDO. If that sounds like gibberish to you, that's OK, the important thing to understand is that none of those products mentioned are financing anything. They're all derivatives, or bets placed on something that was a financing transaction.

In these kinds of bets there is always a winner and a loser. In the case of the Goldman transaction in question, ABN Amro (now owned in part by Royal Bank of Scotland) and IKB Industriebank were the losers, while hedge fund Paulson & Co. was the big winner. ABN and IKB bet on a successful outcome for the CDO, while Paulson bet on failure.

If it all sounds a lot like wagers placed in Las Vegas -- "I'll bet that the next spin will come up red!" -- it's because it is. And as any good gambler on or off The Strip knows, bets are more easily cashed when you find a sucker to take the other side.

If only ABN and IKB had paid heed to Matt Damon's famous line from the movie Rounders: "If you can't spot the sucker in your first half-hour at the table, then you are the sucker."

It wasn't always like this
In the past, the financiers on Wall Street actually lived up to their name. That is, they were primarily concerned with helping entities procure financing. Now that they're facing tough questions about the nature of their business, executives are trying to claim that this is still the core of their business.

Just yesterday, on NPR's "All Things Considered," I listened to Goldman CEO Lloyd Blankfein defend Goldman's economic contribution by touting its capital-raising work. That'd be nice if it were true, but for most of the big banks, capital raising is small potatoes when compared to the much more lucrative business of trading.

Company

First-Quarter
Investment Banking Revenue

First-Quarter
Trading Revenue

Goldman Sachs

$1.2 billion

$9.7 billion

Morgan Stanley (NYSE: MS  )

$887.0 million

$4.1 billion

JPMorgan Chase (NYSE: JPM  )

$1.4 billion

$6.9 billion

Citigroup (NYSE: C  )

$1.1 billion

$6.3 billion

Bank of America (NYSE: BAC  )

$1.2 billion

$7.5 billion

Source: Company filings.

There's a significant difference between the two activities. Capital-raising activities are largely not zero-sum -- they help companies expand and drive broader economic growth. The trading activities, on the other hand, are largely zero-sum. That is, there is a winner and a loser, and the winner is better off to exactly the same extent that the loser is worse off.

And when big banks take their own stakes in these transactions, you have them putting their own capital base at risk on the outcome of a series of gambles.

Gamble away!
As a Las Vegas resident, I have no problem with gambling. But problems arise when the companies that are doing the gambling are huge institutions that are crucial to the functioning of our financial system.

So as we watch Congress try to come to terms with how to best reform the financial system, one of the key things I'll be watching is whether they put their foot down when it comes to separating the gambling functions of the big banks from the parts of those banks essential to our banking system. The banks in question will fight hard against it -- after all, these reforms would seriously cut down on paychecks to the C-suite -- but major banks like Wells Fargo (NYSE: WFC  ) and US Bancorp (NYSE: USB  ) have shown that it's possible to be very successful without a giant financial gambling arm.

In the end, there's definitely truth to the saying, "A fool and his money are soon parted." But when it comes to the financiers on Wall Street, our financial system will be safer if they spend more time financing and less time looking for the next sucker.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy assures you no Wookiees were harmed in the making of this article.


Read/Post Comments (9) | Recommend This Article (17)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 30, 2010, at 6:42 PM, FinnMcCoolIRA wrote:

    If one calls ones bookie to bet on a particular horse and someone else bets on a different horse, each bettor KNOWS that only one horse will win!

    The bookie taking the bet HAS NO IMPACT on the outcome of the race. He - rightly so - is concerned only about his 'vig'.

    DON'T BLAME THE BOOKIE BECAUSE YOU CAN'T PICK THE 'HORSE'.

    The loosers should stop whining!

  • Report this Comment On April 30, 2010, at 6:55 PM, TMFKopp wrote:

    When the bookies come close to failing because they've been made the suckers and they threaten to bring down the whole system, then it becomes everyone's problem.

    Besides, the horse racing bookies that you're referring to aren't getting cheap government money or guarantees (via the Fed and FDIC). It's entirely inappropriate to have these federally insured institutions playing casino.

    Matt

  • Report this Comment On April 30, 2010, at 7:29 PM, FinnMcCoolIRA wrote:

    @TMFKopp:

    1. The bookies are NEVER the suckers;

    2. Nothing the bookies did could bring down the system since they were playing with 'fake horses' [i.e.-NOT MORTGAGES]

    3. The solution then is to NOT vote anyone into office who gives (forces?) ANY money to ANY bookie: If the bookie gets sick, let him die!

    4. In the 'casino' called 'America', the bookies and players should determine how/when to waste their money - NOT the 'horse trainer'

  • Report this Comment On April 30, 2010, at 10:18 PM, TMFKopp wrote:

    @FinnMcCoolIRA

    "1. The bookies are NEVER the suckers;"

    It seems to me that Lehman, Merrill, and Bear were major bookies and major suckers at the same time.

    "2. Nothing the bookies did could bring down the system since they were playing with 'fake horses' [i.e.-NOT MORTGAGES]"

    If only that were true... the failure of Lehman showed exactly how much there was at stake if major financial firms started falling. It doesn't matter whether they're playing with synthetics or the real thing, losses are losses.

    "3. The solution then is to NOT vote anyone into office who gives (forces?) ANY money to ANY bookie: If the bookie gets sick, let him die!"

    The "just let them fail" is a popular rally cry, but it ignores the damage that massive financial failures wreak on the economy. What we need to do is put regulations in place so that "just let them fail" is a reasonable position. Right now it's not.

    "4. In the 'casino' called 'America', the bookies and players should determine how/when to waste their money - NOT the 'horse trainer'"

    I think you took your metaphor a little too far here. But the bottom line is that I think you have too much faith in the invisible hand.

    Matt

  • Report this Comment On May 01, 2010, at 6:45 AM, bijay64 wrote:

    Matt

    Good arguments.

    FinnMcCool - read John Cassidy’s “How Markets Fail”. It recounts the story of America’s housing boom and bust, arguing that its roots lie in the “Utopian” idea that society is best served when individuals are left to pursue their self-interest by means of free markets.

    Actually, Adam Smith's 'invisible hand' theory is very misunderstood. In 'The Wealth of Nations' he outlines very clearly, the environment that need to be in place for 'the invisible hand' to work, and he would have been firmly on the side of regulation in the case of the banking system!

    Bijay

  • Report this Comment On May 01, 2010, at 1:42 PM, ChrisBern wrote:

    @bijay64--

    In saying that America's housing boom and bust was caused by individuals serving their own self-interest, I believe you are underestimating or not considering the incredible and ultimately perverse incentives that the Fed, HUD, FNMA, etc. gave to these same individuals to purchase houses at ever-increasing prices.

    I agree, people typically do as they are incented to do, and this was no exception. I don't know what the percentage is now, but in early 2008, almost 60% of U.S. mortgages were either held by or guaranteed by Fannie or Freddie. Think about that for a minute! Add in the mortgage interest tax deduction, homebuyer tax credits, abnormally low interest rates for the first half of the decade, etc., and OF COURSE the housing market is going to go into a bubble. It would have only been surprising if it hadn't!

    Let's pretend for a minute that the government was completely out of the mortgage industry starting in 1995--so there's no Fed control (suppression) of interest rates, there's no HUD, no FHA, there's no mortgage interest tax deduction, no homebuyer's credit, no Community Reinvestment Act, etc. etc. etc. Are you suggesting that there still would have been a housing boom from 2000 to 2006? Yes, it's possible, but HIGHLY unlikely in my opinion. If the market were to be left alone, the likelihood of a housing boom drops significantly. Take the fuel away from the housing boom fire and there's likely never a meltdown recession such as the one we're recovering from now.

    Were individuals, rating agencies, lenders, and Wall Street companies at least somewhat to blame? Absolutely. But I find it inarguable that a true "free market" of mortgage lending such as I've described above would've ever ended in the bust that we've seen the past few years.

  • Report this Comment On May 01, 2010, at 10:14 PM, xetn wrote:

    TMFKoFF: "When the bookies come close to failing because they've been made the suckers and they threaten to bring down the whole system, then it becomes everyone's problem."

    That is what is called socialism and it is patently wrong. It is only the problem of the "suckers" Why should I or any other taxpayer care what mistakes you care to make or how big your loss is? That is your problem and your responsibility, not ours (the collective ours).

    Try understanding the real problem: regulation. Just read this (which I poster elsewhere):

    http://annistonstar.com/view/full_story/7236861/article-Trou...

    ChrisBern: You are right on!

  • Report this Comment On May 03, 2010, at 1:57 PM, TMFKopp wrote:

    @xetn

    What country or historical example would you model this new anti-regulatory approach on?

    Matt

  • Report this Comment On May 08, 2010, at 7:17 PM, gnorton100 wrote:

    Look for the Financial Reform to be another mess, just like healthcare.

    The politicians will insist on doing a massive overhaul package and, when it's looked at closely, NOTHING will truly change for those currently responsible for the mess.

    Like all massive "anything" that politicians do, this reform will merely hide the new graft, corruption and sweetheart deals AND leave huge loopholes to protect the people and businesses and activities that were the cause of the "reform" in the first place.

    I really wish the American public could require that reform be done incrementally.

    Incremental reform would force transparency and make it obvious which politicians are the shills for big business and big money.

    As you probably guessed, I have no belief or trust that the politicians will bite the hand that feeds them.

    Bend over taxpayers, here it comes again.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1170378, ~/Articles/ArticleHandler.aspx, 12/21/2014 6:34:22 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement