Does Goldman Profit from Its Clients' Losses?

The New York Times reports that a Goldman Sachs Group (GS) email to clients reveals that the firm places trades before recommending them to clients, and sometimes even bets against clients' positions -- presumably when it thinks those positions are money losers. The Times quotes an email to clients from Thomas C. Mazarakis, the head of Goldman's fundamental strategies group: "We may trade, and may have existing positions, based on trading ideas before we have discussed those trading ideas with you."In light of this disclosure, Congress's Financial Crisis Inquiry Commission should use this email as ammunition as it grills Wall Street executives Wednesday. Specifically, Congress should ask Goldman CEO Lloyd Blankfein whether Goldman created the Collateralized Debt Obligations (CDOs) that it sold to clients and then profited from betting the CDOs would plummet in value, as the Times has suggested.

While there are plenty of unanswered questions --including exactly how much of Goldman's profit depends on betting against the interests of its clients -- the dollar figures are just a nit. The basic reality, which Goldman believes it has the legal right to create, is that Goldman manages to attract and maintain clients even though it uses the knowledge of their investment strategies to profit for its own account.

'Insidery' Information

At its core, then, Goldman makes money through the use of what is, in effect, inside information. However, thanks to limits in how the legal system defines inside information -- market-moving, non-public information from a corporate insider -- Goldman appears to have gotten away with the use of 'insidery' information which appears to fit the intent though not the letter of the law. This helps Goldman profit on the long and short side.

To be clear about it -- when Goldman places a trade and then advises a client to place the same trade, the subsequent client capital going into that trade is likely to boost the value of Goldman's initial trade. That kind of trading is akin to front-running and it's a risk-free way for Goldman to profit. Goldman evidently thinks that the Mazarakis email absolves it because its clients should know Goldman is in concept front-running their trades.

And if it's true that Goldman created CDOs knowing they were full of financial toxic waste and profited by betting against them, then it also benefited here from the use of insidery information -- to the greater detriment of its CDO-buying clients. I would like to see whether there are any internal Goldman emails in which its traders snicker at the foolish clients who bought the CDOs while matching those up to the details of the bets that Goldman made against those CDO holders.

Congress instructed the new Financial Crisis Inquiry Commission to explore "22 issues, ranging from the effect of monetary policy on terms of credit to bank compensation structures" according to the Associated Press. As Goldman prepares to pay itself record bonuses of $23 billion, the new commission should be sure to explore how much of the "profit" on which it bases these bonuses comes from insidery information (as I wrote earlier, it is difficult to understand exactly how Goldman makes money).

This is important because if investors are to participate in the market, they need to know that they are efficient. And with the definition of insider information being murky at best, Wall Street firms like Goldman may be profiting mightily from the opacity, to the detriment of its clients. It would be a great improvement to market efficiency if Congress outlawed insidery information.

Ultimately this raises a simple question: If clients know Goldman bets against them, why do they keep doing business with the firm? My guess: Goldman appears to have so much control over the markets that clients have concluded that the cost of Goldman's double-dealing is less than the benefit of having access to those markets through Goldman.

Peter Cohan has no financial interest in the securities mentioned.

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