2016-10-20 4pm EDT  |  #Volcker Rule #Goldman Sachs #junk bonds

I find Goldman Sachs’ sanctimonious “doing God’s work” bullshit just as nauseating as the next guy. Although I appreciate that the financial industry plays a much more important societal role than its reputation commands, it’s not like we are curing cancer or tending orphans.

I also understand why Goldman Sachs is the lightning rod for our industry. It’s easy to hate them. They make ungodly amounts of money (which makes Blankfein’s inopportune comment all the more idiotic). They never seem to make a mistake (apart from public relations). And they are always on the right side of a trade.

I wouldn’t want my kids to work there, but I have a deep respect for the firm now often nicknamed the Vampire Squid. There is a real problem with the fact that too often firms like Goldman are portrayed as some sort of scourge on society. And I am especially concerned the regulators are busy outlawing practices that are beneficial to the market while doing nothing to expose the true problems.

Take this week’s WSJ story about a Goldman Sachs’ trader that recently made $100 million on a series of junk bond bets:

How One Goldman Sachs Trader Made More Than $100 Million

One junk-bond trader at Goldman Sachs Group Inc. earned more than $100 million in trading profits for the firm earlier this year, an unusual gain at a time when new regulations have pushed Wall Street to take fewer risks.

The gains were the work of Tom Malafronte, a managing director on the bank’s high-yield-bond desk in New York. The 34-year-old trader bought billions of dollars in junk corporate debt on the cheap starting in January, then locked in profits as prices recovered, according to people familiar with the matter.

The windfall is a throwback to a previous era on Wall Street, when big banks were more eager to step in as markets turned and bond traders took bigger risks. Those bets have become less common since the crisis. Hoping to make the financial system safer, Congress passed rules that curbed banks’ ability to wager with their own money and required them to hold more capital.

Wall Street responded by shutting down its proprietary-trading desks and shrinking inventories of securities like bonds. The government allowed banks to continue trading securities in their capacity as market makers, serving as intermediaries between buyers and sellers. Regulators have said banks must show that the amount of bonds and other securities they hold on their balance sheets don’t exceed what they need to meet “reasonably expected near-term demand.”

As a market maker, Mr. Malafronte bought the bonds from clients anxious to sell them and ultimately lined up other investors to buy themat a higher price. Goldman profited from the difference, people familiar with the matter said.

It is difficultif not impossibleto define clearly the difference between trades made to meet clients’ demands and those conducted just to make money, said Hal Scott, a professor with Harvard Law School who has testified before Congress about efforts to regulate the banking industry.

“No one has been able to distinguish between market making and prop trading,” Mr. Scott said.

Critics have argued that the postcrisis rules on trading have made it harder for the biggest Wall Street banks to buy bonds from investors in times of stress and hold them until markets calm.

Mr. Malafronte’s haul lands squarely in the center of a debate about the role of banks, which are eager to show that they are putting clients’ interests ahead of their own while at the same time scrambling to capitalize on a dwindling number of profit-making opportunities.

Goldman Sachs confirmed investors’ expectations of a strong third quarter earnings report Tuesday, after key rivals reported strong trading revenue in recent days. WSJ’s Lee Hawkins explains. A Goldman spokeswoman declined to comment on the nature of Mr. Malafronte’s trades but added, “We have made a concerted effort to grow our market making franchise across credit, and remain focused on meeting the diverse needs of our clients.”

Mr. Malafronte didn’t return calls seeking comment.

The prospect of profits remains an important incentive in market making, encouraging banks to step in when markets turn rocky. Their appetite for bonds in volatile times can limit the size of price swings.

Wall Street banks have less room to maneuver than before. Notable profits or losses on trades often provoke a more detailed conversation with the Federal Reserve or other regulators.

Let’s take a moment to explore this Goldman Sachs trade.

The Wall Street Journal is reporting this $100 million dollar number like it’s a big deal. Let me break it to them - it’s not even close. Although it’s not chump change, 100 bucks used to be a regular P&L swing for a Wall Street prop trader. Twenty years ago I met a New York equity index volatility trader that had $50+ million of vega (the amount his P&L would move for every 1% move in volatility - and let me assure you, he wasn’t lugging around a long gamma position.) So even though the WSJ thinks this is a big trade, it used to be a regular occurrence.

Some of you probably think it’s a good thing these Wall Street firms are not allowed to swing around that sort of P&L anymore and we should rein in these loose cannons at Goldman Sachs. Well, that argument is nothing but a load of bananas.

Too many people think this $100 million Goldman Sachs profit is money straight out of some poor institution’s pocket. They imagine Goldman is busy stealing money from some teachers’ union pension plan.

Here’s how it really works. Prop traders are continually looking for anomalies where something is cheap or expensive. Regardless of their trading time frame, I had never met a successful institutional prop trader that front ran liquidity. They were always supplying liquidity. If you want to trade a size that makes a difference to your P&L, institutional prop traders needed to take the other side of some other large trader’s position. The recent Goldman Sachs trade is a perfect example. From the same WSJ article:

Mr. Malafronte began by buying bonds issued by Freeport-McMoRan Inc. and Teck Resources Ltd., two mining companies that endured debt-rating downgrades earlier this year. He also snapped up debt issued by retailer Toys “R” Us Inc., Gymboree Corp. and Avon Products Inc., along with a handful of other companies, as investors’ appetite for riskier securities nose-dived early in 2016, people familiar with the matter said. Concerns about an economic slowdown in China and the U.S., falling commodities prices and the uncertain direction of interest rates were roiling global markets.

Freeport’s bonds due in 2022 dropped to 40 cents on the dollar on Jan. 28, the day after Moody’s Investors Service cut the company’s debt ratings to junk, according to data compiled by IHS Markit. By the start of March, those same bonds had snapped back above 70 cents, IHS Markit said. They traded above 90 cents this week.

On certain days in that period, Mr. Malafronte accounted for more than a third of all trading volume in some bonds, the people said.

Mr. Malafronte unloaded some bonds within a day of buying them as bond prices rebounded on higher oil prices and better economic data, the people said. In other instances, Goldman held the bonds for weeks. By the end of June, Mr. Malafronte had locked in profits of more than $100 million for Goldman over several months, the people said.

During the junk bond mini-rout earlier this year, the Goldman Sachs trading desk stood in there and bought the corporate debt institutional sellers were pitching.

Imagine Goldman had been completely banned from purchasing any securities for its own account. Would the market have been more efficient, or less? Would these institutional clients that were busy selling into the hole have gotten a better, or worse price?

I contend the sell off would have been worse. The institutions that were demanding liquidity to unload their bonds would have caused the sell off to fall even farther.

The same dynamic occurred once the market recovered, just in reverse. When market conditions ameliorated and Goldman Sachs was busy selling their bonds to investors, they once again provided liquidity by selling at a lower price than if they didn’t own the bonds from the previous trade. The institutions that were demanding liquidity the other way were once again better served due to Goldmans’ proprietary trading (let’s just hope it wasn’t the same institutions on both sides of the trade).

Some of you might claim this Goldman trade is proof the Volcker rule limiting proprietary trading is working. After all, isn’t this an example highlighting how Goldman helped make the market more efficient by providing liquidity?

By demonizing proprietary trading, the clueless officials in the government are weakening markets. Goldman Sachs is limited to providing liquidity specifically to its clients, but why shouldn’t they improve all markets for everyone? Take this trade at its extreme and assume Goldman Sachs was unable to find the clients demanding liquidity. In that case, Goldman Sachs would have been unable to put the trade on and the markets would have gone lower and higher than need be.

Institutional proprietary trading makes the entire market more efficient, not just for the firm’s clients, but for everyone.

In my days as a prop trader on an institutional desk I often tried to find mispriced securities, and then profit on them by providing liquidity and waiting for them to be properly priced. That was my job. It wasn’t something to be ashamed of - it was something to be encouraged. It allowed capital to be allocated in a more efficient manner. It wasn’t worthy of a Lloyd Blankfein spiritual accolade, but neither was it something that should be outlawed.

But wait a minute - didn’t this proprietary trading cause the 2008 financial crisis? I contend the regular type of prop trading didn’t bring down Bear Stearns and Lehman Brothers. The stupid shit these bozos stuck on their balance sheet weren’t trades - they were leveraged insanity. I think Lehman even owned entire apartment blocks!

If there is a problem that officials should have corrected it was the lack of transparency and the overuse of opaque OTC derivatives. I am sure to anger some of my sell side readership, but after years of watching the markets, I have concluded that too many customized OTC derivatives are simply tools to obscure either:

  • leverage (allow the investor to achieve a payoff profile larger than it appears)
  • ownership (allow the investor to conceal the true asset that he/she has exposure to)
  • tax (allow the investor to sidestep taxes by having another entity own the asset)

Yeah, I am sure there are examples where this isn’t the case, but too often OTC derivatives have fairly nefarious reasons for their existence. Think back to the 2008 crisis. Did the problem originate from listed derivatives? Not a chance. The entire panic emanated from crazed murky mortgage backed derivatives dreamed up by mad scientists. Most traders could not even get a quote, let alone trade them. In fact the listed markets did a great job of providing liquidity for the firms whose stupidity had gotten them into trouble in the OTC market.

I have a lot of respect for Volcker as a Fed Chairman, but I think he stumbled badly with the legislation that now bears his name. The Volcker rule that limits proprietary trading hurts our markets.

Yeah maybe these laws will make sure 2008 will never happen again, but the markets would have already taken care of that. Do you really think we needed to legislate investment firms against taking so much risk? Seeing some of their competitors go bankrupt has an odd way of focusing the attention of the survivors. The Volcker rule is like passing a law that cows can’t leave the barn when they are already out in the field.

Instead what the government should be passing are laws to make trading and positions more transparent. Don’t allow investment banks to put on massive leverage through arcane derivatives that are merely a footnote on a balance sheet. Make them disclose those positions. Force more derivatives to exchanges. In this day and age, surely there are no technological problems with having more listed products. Sunlight is the best disinfectant. The government should be working on creating transparent and fair markets, instead they are busy regulating out some of the best parts.

I don’t begrudge the Goldman Sachs’ trader’s $100 million profit. In fact, I think it’s great. He made our markets better. Instead of the common notion he took that amount out of someone’s pocket, he actually improved another institution’s fill price, thus saving them money. We need to stop thinking that investment banks are the root of all evil and tying their hands.

Government actions are creating hollow inefficient markets, while doing nothing to create more transparency and openness. They need to ensure a fair playing field and get out of the way. Unfortunately they are doing anything but…

Thanks for reading,
Kevin Muir
the MacroTourist