Only God and the Banks Are Perfect

Sitting before Congress a few weeks ago, Goldman Sachs (NYSE: GS  ) CFO David Viniar said, "Based on the nature of markets ... we know that we will sometimes incur losses."

Sometimes. In the first quarter, Goldman, JPMorgan Chase (NYSE: JPM  ) , Citigroup (NYSE: C  ) , and Bank of America (NYSE: BAC  ) all scored perfect trading results, making money from their trading divisions every single day. And not just a little money, but piles of it. JPMorgan made an average of $118 million per day, while Goldman made over $100 million on 35 days.

Perfectly suspicious
This might not sound strange. Businesses are supposed to make money, after all. But trading is a horrendously competitive and fickle business. Unless you're acting on inside information or have Miss Cleo on your payroll, trading results should look something like a bell curve: A few days produce large losses, a few days produce large gains, and the bulk of days produce something in between. And that's if you're good.

That's exactly what trading results used to look like. Take this chart, made with data from Goldman's annual report, which shows how many days Goldman's trading division made specific amounts of money in 2003:

Source: Goldman Sachs annual report.












Source: Goldman Sachs annual report.

Again, it looks like a bell curve. Some big losses. Some big gains. Lots of in between. That's what you'd expect. Now compare that with 2009's breakdown of daily trading results:

Source: Goldman Sachs annual report.












Source: Goldman Sachs annual report.

No more bell curve. In 2009, Goldman's trading division made boatloads of money on most days, lots of money on many days, and ... that's about it. Raging success became the norm. In six years flat, the concept of "risk" was seemingly vaporized.

Why? What changed? It's hard to tell because Goldman is unwavering in its quest to keep trading information secret. Some of these results are from old-fashioned client-driven activity where Goldman serves as a market maker. This is inherently safe activity that could produce steady results. But the other part of trading is proprietary activity, where Goldman acts like a hedge fund and trades on its own behalf. That's the risky and controversial side. Details on each segment aren't disclosed.

Goldman has developed a cute habit of beating around the bush when investors and reporters ask about these details. Asked whether the recent trading success was from client-driven or proprietary trading, COO Gary Cohn replied, "Over the last 12 months we have only recorded 11 loss days. It is implausible that a proprietary-driven business model could be right 96 percent of the time."

Well, no it's not, and I'll tell you why. What has changed recently, and what has been a tailwind to banks' proprietary trading operations, are 1) the concept of "too big to fail," and 2) investment banks becoming bank holding companies (as Goldman did in the Fall of 2008), which provides access to the Federal Reserve's safety net.

Money for nothin'
Both of these fairly new developments result in artificially low borrowing costs. Basically, lenders are willing to lend banks money at ridiculously cheap rates because they know the government will bail them out when things go bad. Examples of this happening can be downright amusing. As Rolling Stone columnist Tim Dickinson recently pointed out, "In March ... the rating agency Moody's (NYSE: MCO  ) disclosed that it has upgraded Citi's debt solely because it believes the government will step in to prevent default."

Banks can then use that artificially cheap money to fund their trading divisions. Artificially cheap money leads to artificially high profits, which likely explains why trading has suddenly turned into a foolproof mint. When you can borrow at nearly 0%, losing money becomes a challenge.

And borrowing at nearly 0% isn't exaggerating. Last month, my colleague Alex Dumortier laid out the big banks' borrowing costs from Federal Reserve loans and repurchase agreements. JPMorgan's average borrowing cost on this debt is just 0.08%. Goldman's is 0.45%. Bank of America's is 0.52%. In 2009, Goldman's weighted average cost of unsecured long-term debt was 1.42%. Coca-Cola's (NYSE: KO  ) , for comparison, was 5.3%. This is an enormous subsidy to banks, and it's no wonder they suddenly have money blowing out of their ears.

What you can do about it
The absurdity of banks using the Federal Reserve to borrow money on the cheap for trading purposes, rather than lending to the broader economy, is the foundation of the so-called Volcker Rule proposed earlier this year, named after former Fed chairman Paul Volcker. Under the Volcker Rule, banks tied to the Fed would be banned from proprietary trading. Period.

Congress votes sometime over the next few days on whether to include a version of the Volcker Rule in forthcoming financial regulation bills. If you want to let your Senator know how you feel on this issue, click here for their contact information.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Coca-Cola and Moody's are Motley Fool Inside Value picks. Moody's is a Motley Fool Stock Advisor selection. Coca-Cola is a Motley Fool Income Investor choice. The Fool owns shares of Coca-Cola, and has a disclosure policy.


Read/Post Comments (18) | Recommend This Article (65)

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 May 14, 2010, at 10:26 AM, slpmn wrote:

    I'm going to assume the probability of four giant institutions simultaneously realizing perfect trading quarters "naturally" in a truly efficient market is low to the point of near impossibility. It doesn't mean anything illegal is going on, but it should be a real eye-opener to anyone who insists on clinging to the belief that the investing arena features a level playing field.

  • Report this Comment On May 14, 2010, at 11:26 AM, mtf00l wrote:

    I'll add that with that "free" money, the politicians are bought and paid for and frankly with their lifetime benefits of office there are no amount of letters that will change any of this.

    Sorry for long rambling single sentence.

  • Report this Comment On May 14, 2010, at 12:52 PM, megalong wrote:

    Market making and fixed income arbitrage obviously make up a large majority of their trading profits. The majority of people do not understand this, instead assuming that it is a perfect quarter of proprietary equity trading, which would be ridiculous.

  • Report this Comment On May 14, 2010, at 12:56 PM, TMFHousel wrote:

    "Market making and fixed income arbitrage obviously make up a large majority of their trading profits."

    I don't think anyone has ever said equity prop trading was the cause. FI arbitrage is a mint w/ low interest rates. The question is whether that's fair.

  • Report this Comment On May 14, 2010, at 2:40 PM, JoergL wrote:

    The bell curve might appear to the right of the published diagram? What is GS' average trading profit? Is it over $100 millions already? In this case, the chart simply shows the wrong region.

  • Report this Comment On May 14, 2010, at 2:58 PM, park94 wrote:

    So What's new? Everybody knows the stock market is manipulated. The only surprise is that GS's corruption has gone public, but everybody with a brain at least suspects they're involved in market manipulation and inside trading.

  • Report this Comment On May 14, 2010, at 3:11 PM, megalong wrote:

    "I don't think anyone has ever said equity prop trading was the cause."

    In the last week there have been 4 or so blog posts on CAPS with comments saying this exactly. In contrast your article is very good although I'm still skeptical of the shading and emphasis.

    I agree with you that the interest rate and regulatory environment is unfair and dangerous to the economy. But I view that as a totally separate issue from market making and prop trading.

  • Report this Comment On May 14, 2010, at 7:46 PM, randomwalkaway wrote:

    I think you are underestimating the contribution of agency business compared to prop : that is, the fees and brokerage these companies receive when buying/selling on the request of clients. There is no risk for the banks on this, they are simply connecting buyers and sellers. The revenue from this goes up with volume. The volume in the market is very high at the moment, and there are fewer big-league players, so the agency profits are large : The figures that the "trading division" made money every day do not imply they made 100% accurate trading decisions nor that the market is manipulated, just that volume is high and dwarfs profits ( or losses ) in prop trading.

  • Report this Comment On May 14, 2010, at 8:39 PM, TMFHousel wrote:

    "There is no risk for the banks on this, they are simply connecting buyers and sellers"

    Market making is far less risky than most prop trading, but it's certainly not risk-free. There can be substantial risk in holding inventory, which is actually Goldman's main defense in the Abacus deal. If this weren't the case, the concept of VAR would be irrelevant (and it might be, actually, but that's another story).

    "The figures that the "trading division" made money every day do not imply they made 100% accurate trading decisions nor that the market is manipulated, just that volume is high and dwarfs profits ( or losses ) in prop trading."

    I'm not suggesting the market's manipulated in the sense of fraud; only in the sense of unreasonably low borrowing costs.

  • Report this Comment On May 14, 2010, at 9:39 PM, D2009 wrote:

    What's worse is, who is on the other side of the banks' trades made with all that nearly-free money?

    If the banks are taking free fed money and loaning it right back to the government at higher interest via treasuries -- an "elegant form of theft", to quote Michael Lewis -- then I, as a taxpayer, have a problem with that.

  • Report this Comment On May 15, 2010, at 10:44 AM, BMFPitt wrote:

    Why doesn't Moody's just go ahead and give GS a Aaa Sovereign?

  • Report this Comment On May 16, 2010, at 2:06 AM, junaidfarooq wrote:

    I don't think trading results for 2003 and 2009 are comparable simply because 2009 was followed by a terrible 2008 and a lot of what shows up as porfit is simply a massively positive market beta which gets multiplied by leverage of these institutions.

  • Report this Comment On May 16, 2010, at 2:02 PM, TMFHousel wrote:

    "I don't think trading results for 2003 and 2009 are comparable simply because 2009 was followed by a terrible 2008 and a lot of what shows up as porfit is simply a massively positive market beta which gets multiplied by leverage of these institutions."

    Fair enough. Results from 2001, 2002, 2004, 2005, and 2006 produce largely the same curve.

  • Report this Comment On May 16, 2010, at 7:16 PM, plange01 wrote:

    only the banks are perfect with the exeception of goldman they get to go to jail....

  • Report this Comment On May 17, 2010, at 12:50 AM, grusilag wrote:

    I think this Daily Show clip sums the situation up the best:

    http://www.thedailyshow.com/watch/thu-may-13-2010/hoarders

    It amazes me that the banks are allowed to borrow from the Federal Reserve and then buy treasuries with that money. How???? How can they borrow from the Fed and then lend that money right back to the gov't at higher interest? There are so many implications here.. about the Fed, about the gov't about banking.. but for now I just want to take the time to just plain old be mad and yell at someone. I'll think about the duplicity in our money system a little later.

  • Report this Comment On May 17, 2010, at 7:20 AM, ragedmaximus wrote:

    so they can pour money into any monkey stock pump it praise it upgrade it and when enough joe q dummies buy it they can dump it. so in essence they need to steal from average joe stock trader to make their money.They should have their fingers mushed in a meat grinder!

  • Report this Comment On May 21, 2010, at 12:18 PM, edstocking wrote:

    I have an issue with the 2009 chart in this article. The chart is supposed to show how the trading results no longer follow a bell curve. However, with all the days stacked up in the >100 bar, I'm wondering if the lack of bell curve is only due to artificially compressing the right side of the chart.

    This doesn't necessarily contradict the main part of the article, as the bell curve would have shifted to the right and the number of negative trading days decreased by about 75%. I would also note that the 2003 chart is not centered on 0, as is the 2009 chart. I think that the two charts are not appropriately comparable.

  • Report this Comment On May 21, 2010, at 12:26 PM, scootrnc wrote:

    Lose the god thing. Talk about your other delusions...this one is really tired and should be put to rest!

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