Jonathan Weil: Rigged-market theory scores a perfect quarter

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By Jonathan Weil
Bloomberg News
Thursday, May 13, 2010

http://www.bloomberg.com/apps/news?pid=20601039&sid=ax0kTsl0dBXw

Score another triumph for the rigged-market theory.

In a feat that would seem to defy the odds, Goldman Sachs, JPMorgan Chase, and Bank of America this week each said its trading desk made money every day of the first quarter. Goldman said its daily net trading revenue topped $100 million 35 times last quarter out of 63 trading days. JPMorgan and Bank of America disclosed similar eye-popping stats. Citigroup too recorded a profit on each trading day, Bloomberg News reported, citing unnamed people who knew the results.

The intrigue is high. If a too-big-to-fail bank's traders were able to make money every day of a quarter, were they really trading in any normal sense of the word? Or would "vacuuming" be a more accurate term? What kinds of risks do such incredible profits entail, for the banks and the rest of us taxpayers? And are results such as these too good to be true?

... Dispatch continues below ...



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There seems to be no satisfying way to answer those questions, or even the more basic inquiry: How exactly do these banks’ trading divisions make money? Reading the companies' impenetrable financial reports is of little help. However they did it, the data suggest it was as easy last quarter as hitting the side of a barn with a baseball from 3 feet away.

This isn't the way "trading" works in the real world. A simple exercise in measuring probabilities is instructive here.

Let's say you manage a highly leveraged, diversified investment fund and have become so skilled at playing the markets that you have a 70 percent probability of making money any given trading day. This would be a remarkable achievement in most markets. But the odds that you would post a daily net gain 63 times in a row would be about one in 5.7 billion. The formula for calculating this is: 1/(0.70 to the 63rd power).

Even if you had a 95 percent likelihood of a winning day, you would have only a 3.9 percent chance of doing it 63 trading sessions in a row.

Now consider that four of the biggest U.S. banks just pulled off a quarter-long win streak -- all in the same quarter. Why would any of them even want to? Do they think the public doesn't despise them enough? Surely it would have been easy to tweak the values of some illiquid “Level 3” assets lower for a day if they had been so inclined, just enough to avoid looking perfect. Yet none of them did.

These banks have the advantage of an unlevel playing field, of course. They can borrow money for next to nothing at current rates and lend it for more, simply by buying longer-term Treasuries. They have access to information that their clients lack. They have computer-trading platforms that operate in milliseconds. There's less competition now that Lehman Brothers and Bear Stearns are gone. Yet even taken together, these factors don't offer a satisfactory explanation for last quarter’s amazing streaks.

Asking how these four banks did it may even be the wrong question. A better question might be: How did Morgan Stanley's traders somehow manage to lose money on four days last quarter? Or perhaps the winning streaks were a sign of a perfect calm, just before another perfect storm. It turns out Morgan Stanley posted net trading gains every day during the second quarter of 2007, right before the credit crisis began to hit full-steam.

Goldman's chief operating officer, Gary Cohn, this week said his bank's infrequent trading losses -- 11 losing days in the past 12 months -- are evidence that Goldman's traders don't depend on proprietary trading to generate revenue. The simple answer, he said, is that Goldman’s trading operations "are largely global market-making businesses."

Of course, no matter what the question is these days, it seems the answer from Goldman always is: We're a market maker. When senators ask about e-mails that show Goldman telling its sales army to dump crappy mortgage bonds from its warehouse on its clients? Market maker. When the e-mails show Goldman created the crappy deals? Market maker. By Goldman's definition, an Amway salesman pitching energy drinks to old ladies in nursing homes would qualify as a market maker. It's all just matching buyers and sellers to create liquidity, you know.

So let's forget about the how and focus on the why. Why were these banks able to make so much money with such uncanny consistency?

One logical answer is that America's political leaders obviously want it this way.

Otherwise, for example, the government already would have begun to liquidate Fannie Mae and Freddie Mac and let the crash in housing prices and mortgage-backed securities run its course.

To encourage personal savings, the Federal Reserve would have raised interest rates and turned off the banking industry's easy-money spigot. And the White House would be throwing a fit over the International Monetary Fund's use of U.S. taxpayer dollars to help bail out Greece and its ilk, along with the European banks that own their debt.

Americans don't want the immediate pain such steps would bring, though. So our government keeps trying to stretch it out through massive subsidies for the financial-services industry, which means traders at America's largest too-big-to-fail banks get to keep making their killings and bonuses, for now. What nobody knows yet is how long the government can keep up the rig.

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Jonathan Weil is a Bloomberg News columnist. The opinions expressed are his own.



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