Simple Answers To Simple Questions

To answer Kevin, finance is incredibly profitable because the finance sector has a greater information asymmetry between buyers and the sellers than almost any other sector on Earth. Even today most customers more or less take it on faith that the people selling them financial instruments are dealing on good faith. They do it because from FDR until the 70’s or so that was true. Financial instruments were less complicated and oversight was much stronger. That is to say that it was harder to cheat and more cheaters got caught. They also do it because they have to; if you don’t want to take your bank’s word for it then you can either keep a lawyer on retainer, or else live in a cave on public land. Too bad for us that assumption is no longer remotely true. Computers became a commodity and investors started making more bets on other people’s bets. That is to say, cheating got a lot easier because most people could no longer understand what their banks were up to. At the same time deregulation made it that much harder to catch cheaters and also opened vast new opportunities for semi-legal schemes as well as the nakedly illegal kind.

The lack of any real risk premium (after all, we’re all hostages if they fail) certainly pads the bottom line, but the meat and potatoes for Goldman and BofA is the vast gulf between how well they understand what they’re doing versus how well their customers understand it. They don’t even need to understand their own business that well. The sizable fortune that they made and kept over mortgage derivatives just emphasizes how important it is to know more than your customers, who largely had no idea about the flyblown shit that Goldman and company shoveled into each AAA-rated MBS.

These days Goldman has a supercomputer that sits on the main trading network and jumps everyone else’s bid by milliseconds. Nobody seems to care. If that isn’t a straw comfortably stuck in the social till then I don’t know what is.

45 replies
  1. 1
    The Moar You Know says:

    Goldman drinks our milkshake. They drink it up.

  2. 2

    John Cassidy’s New Yorker piece, “What Good Is Wall Street?”, is an excellent read on this topic.

    FWIW.

  3. 3
    Breezeblock says:

    Read “Liar’s Poker” by Michael Lewis. The whole goal of bond salesmen/women is to screw the customer and maximize profits to their firm. Maybe not by outright lying, but as close as you can without going over the line.

  4. 4
    Culture of Truth says:

    Richard Pryor had a similar scam in Superman III

  5. 5
  6. 6
    Sloegin says:

    The Invisible Hand of the market is wearing a latex glove.

  7. 7
    p.a. says:

    Oh you DFHs, it was dark-skinned people and their awesome mind control powers that forced the banksters to do that. I know this because of Occam’s razor, Limbaugh’s butter knife.

  8. 8
    D. Mason says:

    What I’m most curious about is how being able to observe the metaphorical line being formed to buy a stock and subsequently being able to cut in line anywhere you like is anything but insider trading.

  9. 9
    El Cid says:

    The incomprehensibility of derivatives (along with no regulation) was its main feature, not a defect.

  10. 10
    El Cid says:

    @p.a.: Again, this will likely be the formal view of part of the House panel investigating the financial crisis. Jimmy Carter, Fannie-Freddie, and the n******.

    Probably..

    The four Republicans appointed to the commission investigating the root causes of the financial crisis plan to bypass the bipartisan panel and release their own report Wednesday, according to people familiar with the commission’s work.
    __
    The Republicans, led by the commission’s vice chairman, former congressman and chair of the House Ways and Means Committee Bill Thomas, will likely focus their report on the explosive growth of subprime mortgages and the heavy role played by the federal government in pushing mortgage giants Fannie Mae and Freddie Mac to purchase and insure them. They’ll also likely focus on the Community Reinvestment Act, a 1977 law that encourages banks to lend to underserved communities, these people said.

    .

  11. 11
    Chyron HR says:

    @p.a.:

    I wonder if anyone will dare point out who else blamed his country’s economic woes on ethnic minorities (and homosexuals)?

  12. 12
    ChrisS says:

    Meh, who gives a shit. This war is fucking over.

  13. 13
    WereBear says:

    At some point, people do either wise up or get fed up. But it takes a while, and it’s never fast enough for the people who are already there.

  14. 14
    Zifnab says:

    These days Goldman has a supercomputer that sits on the main trading network and jumps everyone else’s bid by milliseconds. Nobody seems to care.

    I’ve got a friend that works for a small hedge fund. He’s a value investor and he waffles between not giving a shit about the micro-trading and loving it.

    Why? Because he doesn’t turn over stocks once a day. He invests in stocks that he considers deeply undervalued, not several pennies under what some other guy will pay for them in ten minutes. Sometimes the micro-traders go crazy and cause his stocks to swing violently. That can create stellar deals, but the short duration leaves little footprint on his standing portfolio.

    Micro trading has always existed. It’s never been particularly well regulated. Now it just gets performed by computers in a fraction of a second rather than in a boiler room inside an hour. But it really shouldn’t impact 99.9% of modern investors because your average 401(k) holder shouldn’t be trading stocks at that speed anyway.

    This is a huge game of inside baseball, so I am surprised not at all that the SEC and the government at large sits on their hands. Eventually, Megabank A will throw down with Mega Investor B, and better rules will be hashed out between them. That’s their problem.

    Now, that AAA shit WAS some dirty pool. And I absolutely agree that Moody’s and the S&P and the rest of those jokers should be tarred, feathered, and run out of Wall Street. But there’s a big difference between Enron-style shell games and modern micro-trading. I’m much more concerned about the latter than the former.

  15. 15
    D. Mason says:

    @ChrisS:

    It’s been over for more than 30 years. Which is to say my entire life and then some.

  16. 16
    debbie says:

    Slightly off-topic, but Richard Cordray, soon-to-be-gone Attorney General, has just been appointed to help enforce the consumer protection bureau. This can only be good news.

    http://www.reuters.com/article.....YE20101215

  17. 17
    fourlegsgood says:

    I worked on Wall Street for 10 years. Believe me, a good part of their business depends on treating their clients like mushrooms. The same goes for retail brokers.

    As for microtrading, sorry, but that doesn’t add anything of value to the market. They argue that they add liquidity, but I call bullshit. I’m not sure that it’s actually dangerous, but to me, there’s something wrong in the fact that there are guys sitting in a room making money for absolutely nothing. It’s like most of Wall Street, which these days is all about creating profits, which lead to big bonuses, or commissions.

    Serving their clients? don’t make me laugh.

  18. 18
    The Republic of Stupidity says:

    @Sloegin:

    And cheaping on the lubricant to boot…

    And it’s cold… too… also…

  19. 19
    Keifus says:

    Also, they are in a position to influence the rules that govern them. There’s a simple power assymetry too. My vote doesn’t get quite the sway of Tim Geithner’s, say. My industry, depending on how you draw the Venn diagram, might have a pipsqueak voice, and struggles every year lately to prevent getting pushed away from the government feed trough by the favored few, but it’s nothing like the say that finance commands among our legislators. Nor does my industry include a semi-private entity with exclusive permission to create money according to loosely-followed mandates.

    (If I choose to generalize what I do to as “defense contracting,” however, then there are counterarguments.)

    Also, finance is, by definition, positioned where all the money is. There are fewer opportunies to make a mint in palmistry, floppy disk research, or clothing homeless people, if you know what I mean. There are lots of rich lawyers and financiers because rich people need top-notch lawyers and financiers in order to stay rich.

  20. 20
    jl says:

    @El Cid: Another attempt to blame the CRA for all our money troubles. That will be fun. I guess that CRA caused all the problems with housing bubbles in the US, and Ireland, and Estonia, and Spain, and the UK, and NZ, and….

    It was a truly evil thing. See what awful things happen when you try to help poor people.

    And GW Bush’s ‘ownership economy’ push had nothing to do with it.

    Krugman has a post on this very topic this morning in the NY Times, and link to a Barry Ritholtz post with a graph of the world housing bubble, which is a nice picture.

  21. 21
    Danny says:

    I’ve been saying for ages that the reason financial firms make so much money is imperfect information allowing them to skim a lot off the top. The only thing I don’t get is where is the proverbial straw? Is it just that everyone outside the system is being overcharged to make trades? This seems unlikely, but maybe I’m wrong. There’s no doubt these firms are stealing from their customers, I just don’t understand how….

  22. 22
    Danny says:

    I’ve been saying for ages that the reason financial firms make so much money is imperfect information allowing them to skim a lot off the top. The only thing I don’t get is where is the proverbial straw? Is it just that everyone outside the system is being overcharged to make trades? This seems unlikely, but maybe I’m wrong. There’s no doubt these firms are stealing from their customers, I just don’t understand how….

  23. 23
    The Republic of Stupidity says:

    @Keifus:

    There are lots of rich lawyers and financiers because rich people need top-notch lawyers and financiers in order to stay rich.

    And out of jail… don’t forget the all important ‘out of jail’ part…

  24. 24
    The Republic of Stupidity says:

    @Danny:

    Read ‘The Big Short’, by Michael Lewis, or ‘Liar’s Poker’, for starters…

  25. 25
    patrick II says:

    @Zifnab:
    There is no value added by these microtrades, but large value is extracted because of the huge volume. It is a hidden but significant fee that siphons off money from entities doing what the market is supposed to do — making value judgments and investing capital for profit — to other entities merely skimming money by what should be illegal control of the process. It adds up, steals significant money in very small bites, and distorts the market.

  26. 26
    fasteddie9318 says:

    As soon as you figure out that insider trading, price-fixing, and collusion are legal if you’re rich enough to matter to the political powers that be, the sooner you realize it’s their world and we’re just renting space in it, the sooner you can transition over into that “aw, fuck it” stage where your quality of life stays the same, but your blood pressure improves.

  27. 27
    Tsulagi says:

    customers more or less take it on faith that the people selling them financial instruments are dealing on good faith.

    Seriously? I’ve always had about as much faith and belief in good will in those salesmen as I’ve had in sky faeries who have died for my sins or are holding 72 virgins in a trust account for me.

  28. 28
    Martin says:

    @Zifnab: The small trading adds up – particularly in the derivatives market where the real action is. There’s action because everything tends to be highly leveraged, so small movements yields big results.

    But even skimming a fraction of a penny off of a billion shares traded per day is going to add up to real money. These guys aren’t so stupid as to invest all of that time and money in the mechanism if it’s not paying off.

  29. 29
    Paris says:

    The relaxation of usury limits allowed better returns in the finance area as opposed to manufacturing. Money followed the returns. Then they had to make up shit (derivatives,’innovative financial products’) to justify their existence.

  30. 30
    Paris says:

    @El Cid:
    It gets better:

    During a private commission meeting last week, all four Republicans voted in favor of banning the phrases “Wall Street” and “shadow banking” and the words “interconnection” and “deregulation” from the panel’s final report, according to a person familiar with the matter and confirmed by Brooksley E. Born, one of the six commissioners who voted against the proposal.

  31. 31
    goblue72 says:

    @Paris: They even called it “financial engineering” to make it sound like they were actually building bridges to the 21st century…or the 19th.

    Personally, I think we should burn their houses to the ground. Literally. Find their houses, apply torches, cheer, rinse, repeat. Either that or bring back the guillotine.

  32. 32
    jl says:

    As for the Cowan article and the comment by Drum, I did not learn much.

    A big piece of the puzzle seems missing to me, and that is that I think much of finance sector profits consist of fees for services.

    I remember a saying when I worked for a short time in financial consulting: when everything is going well, everyone is genius and they pay us to execute their brilliant ideas. When everything is going bad, there isn’t much anyone can do, but they pay us to hold their hand while they liquidate.

    Just like in any other business, in finance there is an eagle eye on the profit and loss margin on any line. Doing one off research projects or development projects is for the losers and chumps or the very rich who can absorb the losses (and that includes for example, original and new investigations of the fundamentals of risky and innovative investment opportunities).

    What makes money as a regular line of business is some kind of assembly line for a physical project or service. That brings in the profits.

    So, say, in forensic economic consulting, you price lives, or income streams lost to illness or injury. The lawyer person calls up and you spend fiftenn minutes running the numbers, then spend twenty minutes hectoring a flunky to make up a really cool looking ppt presentation, and charge the client for an hour.

    If you are an investment bank, your live off of transaction fees for the deals you put together, or off the percentage of the money you manage for investments. You may ask about all these long tailed distributions, Dutch books and money pumps all you want, but the fact is that in the short run everything is so random it makes no difference, 99% of the investors look the same. In the long run, all the correlations go to one during booms and slumps, so unless you have loser who watches Glen Beck and is totally long 100% in gold and non hybrid seeds, everyone does the same in terms of equity and bond investments, if they go to competent manager.

    What keeps the profits going is probably, as people say, asymmetric information, which produce very high entry costs to the industry, especially for the deal making function of large investment banks. So you have lack of entry and cartelization, and some market power by important actors, either nationally or regionally in setting transaction fees.

    And the value added of financial services has been increasingly measured by counting up the fees in national income accounting, rather than imputing the value added by comparing the return on investment to the value of comparable income flows. For example, in real estate the value added of the industry has been increasingly valued by looking at the prices paid (often in very thin markets) or fees for brokerage services, rather than looking at the value of housing and housing transactions by comparing equivalent flow of services using rents.

    So, transaction fees are important part of the picture, seems to me.

  33. 33
    The Republic of Stupidity says:

    @Paris:

    Yes… I read that late last night and had my blood pressure go up quite a few points, rather quickly…

    And once again, Republicans feel entitled to their own facts…

  34. 34
    jl says:

    It is interesting that neither Cowan nor Drum mentioned the profit opportunities, and systematic crisis opportunities created by high leverage, but I did not have time to read the articles that carefully.

  35. 35
    jl says:

    The problem with financial engineering, and derivatives markets, in my opinion, is that all those fancy formulas work OK, and can be jiggered to work pretty well when adjusted using empirical rules of thumb.

    The problem is that all those formulas depend on how the prices of the fundamental securities or goods squiggle around. And those depend on how many people are using what formulas. And no one understands the general equilibrium of investors using the formulas and trading strategies, the price squiggles of fundamental securities as affected by the trading strategies determined by the formulas, and how the resulting price squiggles of the fundamentals feed back into the formulas for pricing the derivatives, executing portfolio insurance strategies, etc.

    It is simply not true that there is good understanding of how finance and the real economy interact. Anyone who does either does not know what they are talking about, or is making stuff up.

    I guess if you are a tenured economics professor, it is easy to just say it is all complex, and no matter how much hardship financial problems cause, it is safer to just do nothing.

    If you have a two earner household one paycheck away from disaster, it is maybe is not good enough.

    Then you have the real business cycle people, whose philosophy seems to run policy these days, who say that all finance is an epiphenomenon, that causes exactly nothing. It just reacts to changes in the real economy induced by unexpected random shocks to the aggregate production function, and you can just ignore it completely.

  36. 36
    BR says:

    Everyone who hasn’t seen Inside Job needs to go see it, and take along some friends while you’re at it. (I took along some apolitical friends, and while they were a bit bored, they learned something.)

  37. 37
    Odie Hugh Manatee says:

    No wonder the government was cracking down on the Mafia in the 70’s and 80’s, they were afraid of the competition. I think the Mafia would do a better job of regulating Wall Street than our government does.

    At least Wall Street would finally be scared shitless of the regulators.

  38. 38
    agrippa says:

    It is true that they do not even need to understand their own business. They are insulated from consequences.

  39. 39
    Ruckus says:

    @goblue72:
    Can I vote for both?

  40. 40
    Chris says:

    @Zifnab: I am not a hedge fund but that is the same sort of thing I (try to) do (with probably not as much success as the hedge fund; after all, I am only just barely a millionaire :-) ).

  41. 41
    patrick II says:

    @jl:
    I agree. To put it another way, people think of the “free market” as a closed system whose rules are unaffected by what the system does — kind of like physics with money — that reaches a natural equilibrium. It is not. It is an open system whose rules and facts are affected by consequent decisions.
    For example, in the Gaussian copula formula used by the Wall street firms to structure derivatives used historical mortgage data as input to determine the reliability of mortgage derivatives. That mortgage data was accumulated before there were mortgage derivatives. After derivatives, local lenders no longer kept and manage mortgages themselves but resold them — to be used in mortgage derivatives that were made possible by the use of the Gaussian copula formula. The formula itself created the conditons that rendered it conclusions incorrect.

  42. 42
    D. Mason says:

    @patrick II: That might be the mist delicious bit of irony I’ve seen related to this whole mess…

  43. 43
    Larry R says:

    No, nothing to do with information assymetry.

    Finance is profitable, that is, throws off lots of money, because it’s stock in trade is money. In any business, the stock in trade of the business becomes available at wholesale or cheaper.

    For example, if you work in a restaurant, you can get free food. Work for a clothing store, get free clothes. Work at a garage, get your car fixed free. Work at a publishing house, get free books. Work in the theater, get to see shows free.

    Work at a bank, get free money. Because it’s what banks have. They don’t need suffer any friction converting their stock in trade to money — because it IS money.

    It’s obvious once you think about it.

  44. 44
    NYT says:

    Information assymetry is just one of the ways the industry is so profitable. There are other more important factors:

    1. Access to cheap credit. Goldman Sachs (and Morgan Stanley) was given access to the Fed window as punishment for blowing up the world in 2008. Last year, one of the riskiest businesses in the world (if it didnt have an implicit government backstop), paid interest at a rate of just 1.5% on $500 billion of borrowings. For a business with little disclosure of what assets they hold and a murky business model, that is simply unreal.

    Do you wonder why GS and MS are reporting strong profits in 2009/2010 in spite of there being little investment bank activity? Its because they can borrow from the government at 0% then use that money buy treasuries (lend to government) yielding 4%. The only risk they take is the bonds decline in value if rates rise, but the goverment has to bail them out if this trade causes another implosion.

    2. Implicit – ok explicit, government backstop.

    3. HFT which is legalized frontrunning.

    4. Corrupted buyers. THe buy side are not all naive as your post implies. If you look at the recent NY and California pensions funds, it seems the buy side is being bribed to place funds with certain hedge funds. Steve Rattner even got a slap on the wrist for this.
    Even the regular treatment of buyers by Wall street – with lavish entertainment and gifts is a form of legalized bribery. Just imagine how long a Walmart buyer would remain in his position if he accepted golf trips to Hawaii etc from a supplier. Yet this is tolerated by pension and mutual funds.

  45. 45
    Nylund says:

    Many years ago my friend in finance told me something along the lines of:

    “Its very hard to make money by selling something if everyone knows what its worth. It impedes you from selling something for more than what you paid for it. The only way to make real profits is for there to be confusion over the value of whatever it is your selling. Purposely creating something that people find confusing is a good way to achieve this. Just make sure you’re not the one who owns it once people figure out what its actually worth.”

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