Financial Regulatory Forum

What are the odds on a three-legged horse?

April 28, 2010

Senators quizzing Goldman Sachs executives yesterday seemed at least as concerned about the wider ethical issues of investment banking as they did about the actual charges that the SEC has laid against Goldman, writes John Manley.
Senators forcefully argued that bankers should place the interests of their clients – and even perhaps the national interest – above their own interests.
One senator even cited an earlier senate committee report on the Great Crash of 1929 to press the case that clients come first. “Investors must believe,” he quoted, “that their investment bankers would not offer them the bonds unless the banker believed they would succeed.”
 That sounds fair. It’s the rule that governs the sale of consumer goods. If the store sells you a lawn mower, it should do so in the belief that it will cut your grass. And if it doesn’t work, the store has to sort out the problem.
But can this doctrine really extend to modern derivative markets where investors are trading risk, rather than the underlying assets? 
Instruments like the synthetic CDO in the Goldman case are designed to attract investors to both sides of the deal. Some will short the instrument, some will go long. They will all invest at a price that reflects the risk they think they’re taking.
If the price goes up, investors who went long will cash in. If the price falls, the short sellers will win.
But what is the investment bank in the middle of this see-saw meant to do? Whichever way the price moves, one bunch of investors is going to see the issue as a success, and the other bunch will see it as a failure. Do the senators think the losing side should be able to sue the issuing bank for selling them an instrument that was designed to fail?
Senator Claire McCaskill was not trying to compliment the Goldman Sachs executives when she likened them to bookmakers. And the guys from Goldman clearly felt the slight. Obviously unamused, one of them said he preferred “bid offer spread” to McCaskill’s gambling term, “the vig”.
But in this case, despite the blow to their self-esteem, it is a simile that the Goldman guys should welcome. 
If I tried to bet on a three legged horse, and the bookie offered me odds of 10-1; I’d think it a bit expensive, and refuse the bet.
But if he offered me odds of 500-1, I’d take the bet – after all, there’s a slim chance that all the other horses in the race could fall, leaving my hopalong nag to limp home alone.
What I wouldn’t do is complain that the bookie had sold me a bet on a horse he knew was going to fail.

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