Felix Salmon

Crisis chart of the day: The correlation between severity and probability

Felix Salmon
Jan 14, 2010 20:14 UTC

The World Economic Forum has released its annual Global Risks report, which kicks off with this chart:


There’s a key explaining what all these numbers are, ranging from 1 (food price volatility) to 36 (data fraud/loss). But the really scary thing, for me, is the pretty clear positive correlation between severity and likelihood: the trillion-dollar risks all have a significant probability of happening, with the most severe risk of all — a global asset price collapse — being associated with a probability of well over 20%.

That collapse in asset prices is #6; #7 (developed-country retrenchment from globalization) is just as severe, if not as likely. #2 is a spike in the oil price, #5 is fiscal crises, #31 is chronic diseases, and #4 is a slowing Chinese economy.

The report is being published in the run-up to the WEF’s annual meeting, in Davos, where the great and the good will try to convince themselves that they’re part of the solution rather than being part of the problem. But frankly there’s really nothing they can do about the biggest risk of all, that asset-price collapse. In fact, given how rich they are, they’re likely to bear the brunt of it themselves.


Cute chart, Felix. On page 38 of the report it starts to describe how they generated it:

The Global Risks Landscape

The visualisation of risk on the landscape places risks
by severity of impact (measured in US$) on the vertical
axis and the likelihood of occurrence on the horizontal
axis over a 10-year time horizon. The numerical
assessment of these categories of risks is created
through qualitative assessment by the partners of the
report. The risks which appear in the upper right-hand
corner are those with the highest impact and highest
likelihood and are the focus of the narrative of this

I’m a statistician by trade. Whenever I see a nifty graph, I think: “Wow, how would you generate a graph like that?” This was one of those graphs.

Surveying expert opinion is sometimes the best method for generating data because there is no other reasonable option. But expert opinion is prone to biases — man is a social creature; even scientists are prone to the biases of their peers, much more the rest of us.

As a result, I wouldn’t give this graph too much weight. If the experts are generally right, it will indicate some weak tendency toward the result, but as for numbers, I would be reluctant to put one significant figure, much less two sig figs.

One other note: I think the timespan of the figures in the report are meant to span the next 10 years. That is an aid toward understanding what their hypothetical probabilities mean.

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JP Morgan still financing mountaintop removal mining

Felix Salmon
Jan 14, 2010 18:28 UTC

In the wake of the publication of an extremely high-impact article in Science magazine which says that mountaintop removal mining has enormous environmental impacts which can’t possibly be mitigated, the campaign against JP Morgan Chase’s financing of such activity is heating up again:

JPMorgan Chase has been funding six of the top eight coal mining companies responsible for mountaintop removal coal mining in the United States. Recently, its investment bank underwrote more than $1 billion in new financing to Massey Energy, the largest mountaintop removal coal mining company.

JPMorgan Chase states that its “environmental goal is to make a positive contribution to sustainable business practices by integrating environmental practices into our business model.” Yet, Massey Energy has a deplorable environmental record, having violated the Clean Water Act no fewer than 4,500 times – resulting in a $30 million fine in 2008.

The practice of mountaintop removal mining is egregious in the extreme: the Economist, for instance, has said that “the underlying question is why America allows this practice at all”. And JP Morgan can’t fall back on the “everybody else is going it” argument: BofA pulled all its financing as long ago as 2008, and Wells Fargo has pulled out as well, leaving the field wide open for JP Morgan — which can either charge monopoly rents for such financing, or can do the right thing and withdraw from the field as well.

It makes financial sense for the likes of Massey Energy to destroy the environment in search of cheap coal. That’s what they do. But it’s not JP Morgan’s job to facilitate such activity, in the US or anywhere else. If they want to stop being perceived as evil banksters, they’d be well advised to get out of this business sharpish.


Well, I closed my credit cards from citibank in response to this news. I hope others do the same. I grew up in coal country where the streams run orange and where industry continues to externalize clean up costs to the taxpayers. JP Morgan shareholders should be shamed and should require environmental responsibilities. After all, if the 2% of freshwater continues to be polluted, none of us will have clean water – and as far as I’m concerned – this is a right for all – we can’t drink money.

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The very real moral-hazard trade

Felix Salmon
Jan 14, 2010 17:23 UTC

Ezra Klein takes Jamie Dimon at face value when Dimon told the FCIC yesterday that the market didn’t consider bank debt to be risk-free, and that therefore there wasn’t a moral hazard too-big-to-fail trade.

But America’s biggest banks are too big to fail, and there is (and was) a moral-hazard trade. The key here is to look not at the risk-free yield on Treasury bills, but rather the cost of funds for small-enough-to-fail banks. If you do that, as James Kwak notes, you find that TBTF banks have a cost of funds 78bp lower than their smaller brethren.

Kwak concludes, reasonably enough, that the problem with the bank tax is that it’s far too small: TBTF banks are still much better off paying a 15bp tax and having a 78bp discount on their cost of funds than they would be if they had to lose both. In fact, the tax is lower than 15bp, since it’s not paid on deposits: Kwak calculates that for most banks it’ll be closer to 7bp.

Meanwhile, Jim Surowiecki has managed to convince himself that the moral-hazard trade doesn’t exist at all. But he’s looking for it in the wrong place. It’s not bank executives who put on this trade, it’s the institutional investors who lent to the banks. By reducing the banks’ cost of funds, they naturally enabled the banks to take on more risk.

Specifically, because the banks’ cost of funds was lower than the interest rate on the triple-A tranches of subprime CDOs, the banks had a huge incentive to borrow as much money as they could and invest the proceeds in those supposedly risk-free bonds. If the banks’ cost of funds reflected their real riskiness and wasn’t artificially kept down by the moral hazard trade, it’s unlikely that the CDOs would have looked nearly as attractive.

The moral-hazard trade is real, then, and it’s dangerous, and the bank tax doesn’t make it go away. For that, we’re going to have to look to regulatory reform, and specifically to significantly higher capital ratios for TBTF banks. There’s a good chance that will actually happen, but it’s by no means a done deal.


I have over 95 articles on the Obama Blog and I’ve specifically talked about for the last 18 years about the growing derivatives market, from $5 trillion to $681 trillion, which are sold by hedge fund dealers that don’t want to pay any federal income tax. Our president said when he ran for office that he was going to tax them. Just like Hillary Clinton when I met her in Madison, Wisconsin wearing a T-shirt that said “TAX HEDGE FUND DEALERS!” on it. You could tell last night on the news that the bankers have the attitude that they deserve their yearly $10 million bonuses and look where it has gotten us–a dollar that’s declining and a trade gap that’s widening. The local Commercial Banks and the loan officers are what made our country great, NOT INVESTMENT BANKERS. I liked your comments on PBS News Hour. I also write on Twitter, MySpace and Facebook. If we can’t reinstate the GLASS-STEAGALL ACT, THEN BREAK UP THE BIG BANKS!
LaVern Isely, Overtaxed Middle Class Taxpayer and Public Citizen Member

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Why the bank tax is necessary

Felix Salmon
Jan 14, 2010 16:26 UTC

Tim Fernholz links to the official government factsheet on the bank tax, which gives a lot more detail on how it’s structured. One thing that jumped out at me is that something along these lines is actually required by law:

The EESA statute that created the TARP requires that by 2013 the President put forward a plan “that recoups from the financial industry an amount equal to the shortfall in order to ensure that the Troubled Asset Relief Program does not add to the deficit or national debt.”

In other words, TARP recipients should have known all along that this was coming, and it’s a bit rich for them to start complaining now.

Other details in the factsheet include the $50 billion cut-off in terms of total assets: if you have fewer assets than that, the fee doesn’t apply to you. $50 billion is not Too Big To Fail, but it’s still large enough, the factsheet points out, to exclude anything which could reasonably be considered a community bank. The factsheet also makes it clear that the fee will apply to the US subsidiaries of foreign banks as well as to the foreign subsidiaries of US banks. Does that put US banks at a slight competitive disadvantage globally? Yes, but not enough that you’d notice.

It seems pretty obvious at this point that the arguments against the tax are very weak indeed. Jamie Dimon, for instance, has complained that “using tax policy to punish people is a bad idea” — but he’s going to have to spell out his thesis a lot more clearly than that before he gets anybody but the most knee-jerk anti-tax Republicans on his side. (He’s also damaging his chances of ever becoming Treasury secretary, which I’m happy about: the last thing we need is another Treasury secretary coming straight into the office from the CEO position at a major Wall Street bank.)

The only thing I’m mildly worried about is that the fee is large enough to be passed on to consumers, but small enough that they won’t react by moving their money to a smaller bank. My guess is though that the big banks are maximizing the fees they charge already. Might they lend a little less? That’s possible — but, on the other hand, maybe the fee will force them to lend a little more, and hold less money in cash.

Overall, any harm done by this tax will be minimal, while the benefit is likely to reach a good $100 billion or so. I call that a no-brainer.


The banks have already or are in the process of repaying TARP. Why aren’t the auto companies, Fannie and Freddie, AIG also subject to the tax?

The tax will lead to shrinking balance sheets, which means less lending. Is that what the administration seeks? The author notes this in passing, but the absence of lending is a mjor risk to the economy.

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The bank tax emerges

Felix Salmon
Jan 14, 2010 14:02 UTC

Jackie Calmes has the broad outlines of the new bank tax, and I like the way it looks: essentially, it’s a 0.15% tax on bank liabilities excluding deposits (which already come with an FDIC fee attached). It would be paid by roughly 50 firms, including GE Capital, and would raise something on the order of $90 billion over 10 years. That’s an average of $180 million per firm per year, which seems eminently affordable to me.

US subsidiaries of foreign banks like HSBC and Deutsche Bank will be taxed; it’s unclear whether foreign subsidiaries of US banks will be as well. The aim of the tax is to ensure that the entire TARP fund gets repaid in full — not just the money lent to the banks directly, but also the money lent to the banks indirectly, through the AIG bailout. The tax is not, however, designed to repay the cost of rescuing Fannie and Freddie.

I like the way the tax is structured: it’s simple, and the liabilities-minus-deposits formula naturally puts more of the onus on investment banks than commercial banks. It also encourages banks to fund themselves with equity rather than debt.

Will the fee be passed on to bank customers? Well, it doesn’t apply to deposits, so retail banking customers shouldn’t be affected, but you never know. If they are, at the margin that might be no bad thing, if it encourages bank customers to move their money to small-enough-to-fail banks and credit unions.

Critics of the tax are certain to focus in on the rhetoric surrounding the announcement, and to denounce it as politically-motivated populism. Which might even be true. But just because a policy is popular doesn’t necessarily make it a bad idea. And this one makes a lot of sense.


Do you see auto companies paying out million dollar bonuses to their employees?

To take bailout money on one hand is bad enough, but might be OK if it’s necessary for our collectively benefits; but to give out huge bonuses on the other hand, is just monstrous. It’s not only morally wrong, it’s economically wrong too (hence all the buzz about ‘moral hazard’).

And yes, this is a response to “ArdvarkMaster”. That said, I have to say I agree with “ArdvarkMaster” that it’s spacious to put all the onus on receipts of bailout funds; when it’s painfully clear that the government didn’t demand enough ‘flesh’ or ‘blood’, BEFORE they handed the money out. You know what, when it’s not your money, it’s just so much easier to give away! In that sense, I’m afraid to say that, heaven forbid, I see where the tea-baggers were coming from and I share some of their frustration.

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Felix Salmon
Jan 14, 2010 06:46 UTC

Wi-Fi on Acela! — Economist

Jon Stewart on bank bonuses: great stuff — Daily Show

Why wasn’t Pandit at the FCIC hearings? Is the real reason that he’s about to get fired? — The Deal

Time for NBC boss Zucker to go — Gawker

Gawker will pay $100,000 to play with the iTablet for an hour — Valleywag

Does this mean that TheDeal.com is now disappearing entirely behind a paywall? Sad if so — The Deal

What I Learned By Not Getting into a Car for a Year — Time

John Paulson’s high-risk hubris

Felix Salmon
Jan 14, 2010 06:17 UTC

Malcom Gladwell is no particular expert on financial markets. But he has said, according to Moe Tkacik, that of all the people he has interviewed, he most identifies with Nassim Nicholas Taleb — in a 7,800-word profile which explains just how hard it is to invest in markets when your strategy involves losing money every day and waiting for a tail event.

With a few notable exceptions, like the few days when the market reopened after September 11th — Empirica has done nothing but lose money since last April. “We cannot blow up, we can only bleed to death,” Taleb says, and bleeding to death, absorbing the pain of steady losses, is precisely what human beings are hardwired to avoid. “Say you’ve got a guy who is long on Russian bonds,” Savery says. “He’s making money every day. One day, lightning strikes and he loses five times what he made. Still, on three hundred and sixty-four out of three hundred and sixty-five days he was very happily making money. It’s much harder to be the other guy, the guy losing money three hundred and sixty-four days out of three hundred and sixty-five, because you start questioning yourself. Am I ever going to make it back? Am I really right? What if it takes ten years? Will I even be sane ten years from now?” What the normal trader gets from his daily winnings is feedback, the pleasing illusion of progress. At Empirica, there is no feedback. “It’s like you’re playing the piano for ten years and you still can’t play chopsticks,” Spitznagel say, “and the only thing you have to keep you going is the belief that one day you’ll wake up and play like Rachmaninoff.”

So I was very puzzled to pick up this week’s New Yorker to find Gladwell write about John Paulson in very different terms. (The story is behind a firewall; it’s not particularly worth paying for, although the magazine as a whole is a fantastic value.)

Gladwell in this essay characterizes Paulson as “The most successful entrepreneur on Wall Street — certainly of the past decade and perhaps even of the postwar era”. I think this involves a very narrow criterion of what makes successful entrepreneur. Later in the essay Gladwell talks about how “people who work for themselves are far happier than the rest of us”, and in my experience hedge-fund managers — who do after all work primarily for their clients — are not in fact particularly happy people. They might not have a single boss telling them what to do, but the pressures of managing other people’s money are immense.

What’s more, any hedge fund manager playing a version of the negative-carry trade has it much worse than most of his peers. Warren Buffett says that the first rule of running other people’s money is don’t lose it; the second rule is “don’t forget the first rule”. One of the reasons Taleb gave for giving up running money day-to-day was precisely the incredible toll it takes when you’re losing money almost every day. Andrew Lahde, another huge winner from the subprime crisis, also quit the business, citing the way in which the stress of the job destroyed his health. Gladwell himself talks about how successful entrepreneurs will deliberately harm their own reputation if it means improving their risk-adjusted returns. That’s not a route to happiness.

And in any event, although success is often measured in dollars on Wall Street, even Wall Streeters don’t end the analysis there. Is Paulson really a more successful entrepreneur than, say, Charles Schwab, just because he arguably has more money? For that matter, Mike Bloomberg has not only founded a hugely successful company which can run very well without his presence; has also made more money than Paulson. Even if Paulson does count as an entrepreneur, it’s not at all obvious how he counts as being more successful than Bloomberg.

But I digress. The point is that Paulson, like Taleb, is a negative-carry kind of guy. Positive-carry investing can take you a very long way, and indeed it’s the foundation of the entire global banking industry, but it’s negative-carry trades which have the ability to score enormous home runs like Paulson’s. Many big hedge-fund managers avoid negative-carry trades, because they feel too much like a gambling habit: you pay out money every day in the hope of scoring a huge jackpot. That’s not the kind of strategy most investors in hedge funds particularly like, and indeed the likes of Taleb take great care to sell their funds as hedging devices — a place to put a small amount of your net worth for insurance purposes — much more than as absolute-return vehicles.

Paulson is no Taleb: his clients are pretty typical hedge-fund investors, including rich individuals who really hate losing money. Which means that his negative-carry trade — buying credit default swaps which obligated him to pay out millions of dollars in annual premiums, with no income attached at all — was extremely risky, from a business point of view. Gladwell quotes Greg Zuckerman explaining that “the most an investor could lose would be 8 percent a year”, while the upside (as we saw) turned out to be astronomical. But it doesn’t take many years of 8% losses — or any losses at all, for that matter — for clients to pull all their money out of your hedge fund.

Paulson was not actively trying to burst the bubble, in the way that George Soros pushed the pound out of the European exchange-rate mechanism with his legendary 1992 negative-carry trade. Instead, he was just the biggest of a long line of investors who saw that there was a housing bubble and tried to find a way to go short. Those who were right but too early disappeared into the footnotes of finance — if they were lucky to get even that. They learned the hard way that “the market can stay irrational longer than you can stay solvent”. Paulson was like them: he felt certain that the bubble was going to burst, but he didn’t — couldn’t — know when, and he simply had to pray that it would happen before his investors deserted him.

What’s more, there was no guarantee that even if the housing bubble did burst, that Paulson was going to make lots of money. To be sure, he had a lovely model, put together by his colleague Paolo Pellegrini, showing that if house prices stopped rising, subprime mortgages were going to suffer enormous losses. But on the other hand, all the banks and credit-rating agencies also had models, showing that the bonds that Paulson was betting against had almost no chance of defaulting. When your model shows one thing, and everybody else’s models show something else entirely, there’s a very good chance that your model is flawed.

Gladwell’s thesis, in this essay, is that Paulson is actually very risk-averse, rather than being a big risk-taker. “Would we so revere risk-taking,” he asks right before introducing Paulson as Exhibit A, “if we realized that the people who are supposedly taking bold risks in the cause of entrepreneurship are actually doing no such thing?”

The fact is that Paulson did take bold risks, on factors which were entirely out of his control: When would the bubble burst? How long could he hold out before his investors deserted him? Indeed, Paulson’s strategy had a Ponzi aspect to it, where he would try to make up losses with new investments: “He bought CDS contracts by the truckload,” Gladwell writes, “and, when he ran out of money, he found new investors, raising billions of new dollars so he could buy even more.”

Warren Buffett has described his most recent mega-acquisition, that of Burlington Northern, as a huge bet on the long-term health of the US economy. That kind of bet has made him more billions than even Paulson can dream of, and it’s a bet made in the positive-sum game of the equity markets. Stocks can and do rise over time, and a well diversified stock-market investor has been able to reasonably expect to see some kind of profit over the long term.

Paulson, by contrast, was playing in the zero-sum derivatives markets. In order for him to make any money at all, somebody else had to lose. If I bought a random basket of derivatives contracts and held them over the long term, my expectation would be that I would end up with less money than when I started.

The amount of sheer hubris involved in Paulson’s trade, then, is enormous. He had to have an unshakeable faith in the infallibility of his own models, in a world where no model is infallible. He had to have entirely irrational confidence that the bubble would burst before he ran out of cash. And he had to do all of this with other people’s money: while he was already personally set for life when he entered into the bet, he couldn’t say the same thing about all of his clients, who didn’t necessarily share his shoot-for-the-moon risk profile.

After all, Paulson’s clients had invested their money with a manager whose returns, Gladwell quotes Zuckerman as saying, were solid, careful, and decidedly unspectacular. Did Paulson decide to put them into a risky derivatives trade with a negative carry just because he’d already made lots of money and was now aiming for posterity? I’m sure all those clients are very happy with Paulson today. But if you’d told them about his strategy while the bubble was still inflating, they might have had a very different opinion indeed.

Update: Zuckerman responds, in the comments.


I thought I’d weigh in on Salmon’s interesting piece, given that it concerns John Paulson, and my recent book, The Greatest Trade Ever.

Were there risks to Paulson’s trade? For sure. Losses of 8% a year for a few years certainly add up. Then there was the reputation risk—if the trade hadn’t worked, Paulson would have been know as the guy who bet foolishly against mortgages after the experts warned him not to. Paulson likely wouldn’t have been able to try anything similar ever again. Further, when the trade finally started to pay off in early 2007 and Paulson piled up billions, he held on to most of his positions rather than cash out, transforming the trade, in my view, into a riskier one. He suddenly sat on huge profits that easily could have evaporated (as some of them did when the subprime market rallied in the summer of 2007).

But the dangers to Paulson’s trade weren’t outsized and it’s fair to say that he wasn’t acting an “extremely risky” fashion. So I disagree with the thrust of the Salmon piece.

Paulson was using credit-default swaps, which have a much more limited downside than a short position on equities or many other negative bets. The embrace of CDS was a sign that Paulson was indeed risk-averse. And it is unlikely that Paulson ever would have faced 8% annual losses for an extended period. If he was wrong on his trade and housing held up or kept rising, most of those who took out risky mortgages would have refinanced their loans (most of which had 2-year teaser rates), ending his CDS trade.

Just as important, Paulson was smart enough — and risk-averse enough — to place most of his subprime bets in a separate fund and lock his investors up for two years in that fund. That way, if he was wrong, it wouldn’t cripple his entire firm. That was good business sense, but also another sign of watching the downside

It’s a misunderstanding to say that Paulson “simply had to pray that it would happen before his investors deserted him.” As I note, they were locked up for two years, at least those in Paulson’s credit funds. And they were well aware of the potential downside, it was all spelled out and quite obvious, since they were buying CDS contracts with set payments. I’m not sure betting billions on the health of the rail industry, a la Buffett, is less risky — or suggests less “hubris” — than entering into CDS contracts with set costs to buy insurance on toxic mortgages.

And to say there’s a “Ponzi aspect” to what Paulson was doing is a bit silly. It’s sort of like saying Pimco is running a huge Ponzi scheme because it takes in money from investors each day, and – get this — uses it to buy investments that the firm likes. Even if new money came it, the returns to Paulson’s investors would have been based on their initial investment and when it was made.

Oh, and Andrew Lahde did complain about his back, and the stresses of his job as a hedge-fund manager. But that’s not why he quit the business. He simply enjoys spending time on the beach with beautiful women. Thanks for taking the time to read my book and for the interesting discussion! Greg Zuckerman

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Those weak sovereign credits

Felix Salmon
Jan 13, 2010 22:42 UTC

Is there any sovereign credit which looks remotely attractive these days? I feel like a bit of a heel talking about fiscal distress even as the attention of the world is rightly concentrated on much more pressing real distress in Haiti. But the drumbeat is getting hard to ignore.

Alex Dalmady has a good overview of Venezuelan debt, which has been soaring of late and which might yet continue to go up. If you’re a short-term momentum trader, it looks great. But buy-and-hold types have no business being in Venezuela:

Buying Venezuelan debt is like lending money to a wealthy, eccentric and partly insane uncle. You kind of figure he’s good for it, but there’s a good chance he’ll blow his fortune buying real estate on the moon or something and leave you hanging out to dry…

Corruption, deliberate misinformation and ineptness merge together to form an incomprehensible mess. There isn’t an official figure that can be trusted… the Central Bank puts FX reserves at $35 billion. Really?…

Alex concludes that while the opportunity cost of not being invested in Venezuelan debt is hight, a crunch of some description is “inevitable”. And therefore he just avoids the country altogether, which makes sense to me.

He should probably avoid Argentina too, while he’s at it. The debt situation there has never been messier: the president wants the central bank to transfer $6.6 billion into an account ring-fenced for paying private creditors. When the central bank governor refused, he was fired by the president, reinstated by an Argentine judge, and then seemingly confirmed in his decision by a US judge, who has frozen the central bank’s account in New York.

Right now the account only has $1.7 million in it, but as Goldman Sachs analyst Alberto Ramos says in a research note today, “the political and institutional implications of this preliminary court order could potentially be large and eventually lead the government to back off from insisting of getting the $6.6 billion from the central bank”. After all, if the $1.7 million is subject to attachment by holdout creditors, they’ll probably be able to go after any disbursements from the $6.6 billion fund as well.

The Argentine economy minister is still adamant that the country’s bond exchange is going ahead as scheduled, but there’s no way that’s actually going to happen if a puppet is in charge of the central bank or if there’s serious doubt about the ability of the government to get the contents of the $6.6 billion fund to bondholders without the money getting hijacked along the way. Certainly the bond market doesn’t think much of the Argentine credit these days.

Meanwhile, Greek debt is looking increasingly shaky, as Moody’s talks about the country suffering a “slow death” and Desmond Lachman says that Greek might as well leave the euro zone now, since it’s going to have to do so sooner or later in any case, and the longer it waits the more painful the process will be. Further east still, Barclays is reckoning that Nakheel debt in Dubai will ultimately recover less than half its face value. And of course other sovereign nations are having major problems too, from Iceland to the Pequot nation of Mashantucket.

This time last year, Paul Kedrosky and I wondered if 2009 was going to be the year of sovereign defaults. It wasn’t, and things look better now than they did back then: the number of countries with EMBI spreads of more than 1,000bp over Treasuries has gone from 14 to just one (Belize). That move, however, has happened without any real improvement in sovereign fundamentals. As a result, I fear that the main thing the rally has achieved is just to increase the downside of a sovereign-debt crisis, and minimize the upside should the world manage somehow to muddle through.

(HT: Otto)

Goldman’s conflicts

Felix Salmon
Jan 13, 2010 17:01 UTC

Andrew Ross Sorkin has got his hands on what looks for all the world like a pro-forma piece of legal CYA out of Goldman Sachs, and is trying to turn it into a story:

For years, Wall Street whispered that Goldman Sachs profited handsomely by trading ahead of — or even against — its own clients.

On Tuesday, a Goldman executive made an unusual admission that, in some cases, the rumors were true.

In an e-mail message to select clients, Thomas C. Mazarakis, the head of Goldman’s fundamental strategies group, acknowledged that his unit often provided investment ideas that the firm had already traded on. Sometimes Goldman has even taken the opposite approach, betting against particular instruments that the group has recommended.

The good news is that Sorkin is enough of a blogger to actually publish the email in question. But weirdly I can see nothing at all in the email saying that Goldman ever trades against its own clients, or bets against instruments it’s recommending. Here’s the relevant bit:

We may trade, and may have existing positions, based on Trading Ideas before we have discussed those Trading Ideas with you. We may continue to act on Trading Ideas, and may trade out of any position, based on Trading Ideas, at any time after we have discussed them with you.

Now it’s conceivably possible that when Goldman makes a trade “based on” one of its Ideas it actually takes the opposite position to that implied by the Idea. But there’s nothing in the email to indicate that ever happens, or has ever happened — which means that it’s very hard to see how Sorkin can characterize the email as “an unusual admission” that sometimes Goldman bets against instruments it’s recommending.

I suspect that Sorkin might be looking at the “may trade out of any position” language — but of course when Goldman trades into a position it will necessarily trade out of that position at some point. Doing so will involve selling what was previously bought, or buying what was previously sold, so yes I suppose that if it’s selling while its clients are buying, then you could say it’s trading against its clients. On the other hand, any time a Goldman client buys a position from Goldman, or sells one to them, Goldman is by definition trading against that client. And that’s exactly what the client wants!

Alternatively, there’s a Clintonian reading of Sorkin’s story, in which it’s literally true but actually doesn’t mean what you think it means. The “unusual admission”, on this reading, is just that Goldman sometimes trades ahead of its clients, not that it ever trades against them. And the bit of the story saying that sometimes Goldman bets against instruments it’s recommended comes not from the Goldman email but rather from previous NYT reporting.

Either way, I think there’s a lot less to this story than meets the eye. The email is clearly legal boilerplate, and not an “unusual admission” of anything at all. Goldman will continue to share trading ideas with its biggest clients, and those clients will judge those ideas on their own merits, rather than entering into them just because they come from Goldman. Sometimes, the clients will decide to trade against the ideas. They’re all big boys, and they make their own decisions.

The idea that Goldman is conflicted because it trades with and against clients is ridiculous — that’s its job. It’s a broker-dealer, not some kind of fiduciary. I do think that Goldman is too big, but I don’t believe it’s remotely constructive to start attacking the fundamental role of any broker-dealer, which is to make markets by trading in and out of lots of positions with lots of clients. That’s one of the few ways in which Goldman actually makes the world a better place.


I don’t believe this is really news. Goldman and all of the other brokers have ‘desk analysts’ whose job it is to search out opportunities to benefit the trading desk, not clients. When you speak to a ‘desk analyst’ or a sales person, one has to assume their recommendations are conflicted. That is the way it works.

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