Thursday, October 28, 2010

IF WILL ROGERS WAS ALIVE AND LOOKING AT PROPRIETARY TRADING TODAY ...

"A holding company is a thing
where you hand an accomplice the
goods while the policeman searches you."

- Will Rogers

If it's true that a holding company is a place to stash the goods after you've ripped off the joint - and few can doubt Rogers' logic in this market environment - then what are we to make of the actual theft that occurs through proprietary trading?


In this article by Michael Lewis, author of exceptionally clever and Will Rogers-like Liar's Poker, we learn how Wall Street's biggest banks are renaming their proprietary trading groups. They're doing this because they want to avoid government scrutiny coming down the pike because of recent legislation designed to protect investor accounts.

As a reminder, and in oversimplified terms, proprietary trading occurs when big Wall Street firms gamble invest in stocks and bonds they're also selling to clients.

So, for example, if I have one client that wants to sell 10,000 shares of IBM at $100,000 I have two options. In Option 1, I can try to sell the shares immediately. With Option 2, I can hold or buy them for the firm because I know that another firm client wants to buy IBM stock. If I'm smart, and want to make money for the firm, my real goal is to buy or hold the shares until I can get the other client to agree to pay, say, $140,000 for the shares.

Guess which option Wall Street's biggest firms have been picking over the past few years?

But the real trick lies in how firms allow brokers/traders to use their client's capital - and not bank funds - to make purchases. The best way to conceptualize how this works is to imagine outlaws and highway robbers using the money they get from their heists to gamble in town, and then returning the money only if they win big. Only, in this case, Wall Street's highway robbers don't get prosecuted after robbing the stage coach. They get bonuses.


As you can imagine, proprietary trading is a phenomenal windfall - and source of income - for Wall Street firms that know how to play the game right. You see, Wall Street - like the house in Las Vegas - already bank on steady commissions, specific rules, and simple client carelessness and stupidity to make money. In Vegas this is called the House Advantage.

But, unlike Las Vegas, Wall Street's biggest players got tired of making chump change on the House Advantage. Simply servicing customers wasn't profitable enough. So, confident in the knowledge that they knew what their clients wanted to buy and sell, they decided to get in the game themselves, with their clients capital no less. Michael Lewis explains when this began to happen, and what followed:


Beginning in the mid- 1980s, the Wall Street investment bank, seeing less and less profit in the mere servicing of customers, ceased to organize itself around its customers’ needs, and began to build itself around its own big and often abstruse gambles ... the signature traits of modern Wall Street [now] follows from the willingness of the big firms to allow small groups of traders to make giant bets with shareholders’ capital, which the shareholders themselves don’t and can’t understand.

Over time, Wall Street figured out more complex and opaque ways to extract their client's wealth (they're not creating it), which led them to create ponzi-like schemes (CDS/CDO squared) that regulations and government regulators could neither catch up with or understand.

As we have learned, in the lead up to the 2008 market collapse, many of these the investment products were created (or purchased) with the idea of dumping them on unwitting and gullible clients. If government regulators didn't understand the products, and if gullible or clueless clients trusted your name - and you could say "it was legal" or that failed investments were tied to "unforeseen market forces" - why not take advantage of the situation, and create and sell as much as you can?

In a few words, Wall Street lured people out, took their money, and left them and the American taxpayer holding the bag. Kind of like door-bell ditch, for America's biggest financial institutions. As you can imagine, trading fees and bonuses exploded - whether their clients made money or not.


Today Wall Street wants to avoid government scrutiny. They know that the biggest banks, which now include Merrill Lynch and Goldman Sachs, among others (thank you favorable legislation made possible by the 2008 bailout environment), made lots of money selling toxic investment products (that they knew were toxic) to trusting or clueless clients, and don't want the game exposed.

Because the practice was so blatant, the Federal Reserve now wants banks to buy back some of the toxic deals they sold, while Goldman Sachs and Bank of America have had to pay almost $600 million between them for dumping toxic crap on investors. And these are just deals that were so blatant that regulators couldn't ignore them. Not that any of this matters.

After being made whole, with 100 cents on the dollar bailouts for their toxic deals, Wall Street has skimmed billions in make believe profits and real bonuses, and can afford to pay what amounts to nuisance fines for them.


At the end of the day, because Wall Street continues to profit from doing exactly what they did before the market collapse you can bet your last dollar (or let Wall Street do it for you) that they will fight government scrutiny and oversight any way they can. If that means hiding or calling their proprietary trading divisions another name, so be it.

Proprietary trading, as Will Rogers might say, is really the art of using other people's money to rob Peter to pay Paul. As you can imagine, Paul is laughing all the way to the bank.

- Mark

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