Goldman’s trading secret

July 22, 2009

LONDON, July 22 (Reuters) – Goldman Sachs last week reported record net revenues from trading and principal investments ($10.8 billion) during the three months ending June, with the major contribution coming from the fixed income, currencies and commodities segment ($6.8 billion).

Most commentators ascribe the firm’s stunning performance, and strong results reported by some of its peers to luck (a rising market lifts all boats); brilliance (trading strategies that are just smarter than everyone else); being one of the last men standing (benefiting from the lessening of competition in many of the markets in which Goldman operates); or some combination of all three.

BlackRock chief executive Larry Fink has attributed Wall Street banks’ profits to the fact there are fewer players left and is quoted as saying those remain are “just taking the spread between the bid and ask and they are making luxurious returns”.

While all these factors have played a part, the reality is more prosaic. Like other financial intermediaries with privileged access to cheap funding in the interbank market, and now discount borrowing facilities at the Federal Reserve Bank of New York, Goldman and the other major banks are benefiting from an subsidy in the form of cheap (and guaranteed) funding from the central bank to carry riskier and far more profitable trading positions.

Both commercial and investment banks make a substantial part of their revenues from “maturity transformation” — borrowing short-term funds to make longer-term loans and other advances at a higher rate, pocketing the difference. The inherent risk in this strategy is offset by the lender of last resort (LOLR) protection they receive from the central bank. Since the guarantee is normally provided free, or substantially below cost, holders of a banking licence have a very valuable right to make money at taxpayers’ expense.

Naturally, the revenues derived from maturity transformation are greatest when the yield curve is steepest, as at present.

Price of Money Is ‘Special’

Unlike other commodities, money itself is far too important for its value to be set in a free market. Since the late 19th and early 20th centuries, central banks have controlled its price (at least short-term funds) through their ability to create money in unlimited amounts.

In a free market, the price of short-term funds, and hence interest rates, would have been very high during H1 2009, reflecting massively increased demand for liquidity from households and firms as a result of the crisis and recession. In practice, though, the Fed and other central banks have pushed the cost close to zero by flooding the market with newly created liquidity.

But the cost of funds is not zero for everybody. Only “insiders” with access to the interbank market and the Fed’s discount lending facilities are able to obtain such cheap funds. For other banks, businesses and households, “outsiders”, the cost of borrowing has been far higher. By arbitraging between these two markets, financial intermediaries have been able to massively increase their revenues.

While the arbitrage opportunity is most obvious for commercial bank lending activities, it is implicit in most investment banking and trading as well.

I have pointed out elsewhere that the steep contango in crude oil and other commodity markets (where futures are higher than spot prices) is a licence to print money for those market participants with access to cheap finance (banks) or cheap storage (tank farm and warehouse owners) who can therefore buy, store and fund physical positions at far cheaper rates than those embedded in the forward price structure

But the same is true of all fixed income, commodity and currency positions. In every case, the cost of funding is embedded in the structure of futures and options prices, both simple ones and more exotic structures. So the artificially low cost of funds in the central bank/interbank market is creating a strong arbitrage opportunity.

At least in part, trading books can be funded on the cheap from the central bank and other market intermediaries brimming with excess liquidity, while customers can be charged prices “as if” funds were much scarcer. The reduction in competition is obviously important here, but it is the cheap subsidised funding that creates the real profit opportunity.

Profits Rooted in Cheap Rates

To be clear, it is not that Goldman or any of the other banks are funding the whole of their long-term obligations at the short end of the market. The risk would be too great, and the strategy would be quickly shut off by the Fed and other central banks as an overly blatant abuse of the system.

But if we think of Goldman’s mass of individual positions and trades as simply one large aggregate position that needs to be funded, then some portion of that requirement can be funded at the short end at artificially cheap rates — rates which are certainly much lower than the ones being charged out to customers and implied in the cost of the trading positions.

Rather than trading commodities, bonds, currencies and equities, Goldman and the other banks really trade “liquidity”. In an environment where central banks and governments have artificially driven down the cost of liquidity, but only for some borrowers, all banks have an exceptional arbitrage opportunity, and should be expected to make exceptional profits from it.

White House economic chief Lawrence Summers admitted last week the record trading revenues reported by Goldman and strong results from other institutions would not have been possible without aid from the taxpayer.

But while policymakers and bank chiefs are embarrassed to dwell on the issue (because millions of small savers now earning a pittance on their deposits are effectively boosting profits for banks large and small) the aid was quite deliberate. Low rates were always designed to help rescue the shattered banking system as much as keep overstretched borrowers in their homes and provide cheap financing for business.

So while politicians may be uncomfortable about the investment and commercial banks at the root of the crisis now reporting record operating and trading revenues in some segments , it was always an integral part of nursing the sector back to health by helping it absorb massive write-downs, and thereby promote a longer-term recovery in both lending and economic activity.

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