How Goldman Sachs Games the System

Aug.31.09 | About: Goldman Sachs (GS)
In case you missed the weekly Goldman Sachs (NYSE:GS) furor, last week's installation was a Monday morning front page story in the Wall Street Journal which I won't do a full-blown look at, but let me give you the highlights. Actually for the Cliff Notes version, all you need to know is you are being walked on, and Goldman is just smarter than you (by smarter I mean manipulating the system - bending the rules but not breaking them) - hence the 97% winning percentage last quarter. [Aug 5, 2009: Goldman Sachs Q2 Winning Percentage: 97%] It has nothing to do with dominating program trading, flash trading, algorithms, having access to information via political channels, front running internal research, or anything of that nature. Frankly if I were Goldman's CEO, I'd make sure we were (ahem) "making some mistakes" this quarter to get that winning percentage down to say low 80%s...

For a more in depth summary of "this week in Goldman gaming the system" (many times firmly within the rules, if on the sideline boundary), in essence this is a tale of Goldman's research team giving its top clients short term trading calls that at times go against their longer term public views on a stock. One example:
  • Goldman Sachs Group Inc. research analyst Marc Irizarry's published rating on mutual-fund manager Janus Capital Group Inc. was a lackluster "neutral" in early April 2008. But at an internal meeting that month, the analyst told dozens of Goldman's traders the stock was likely to head higher, company documents show.
  • The next day, research-department employees at Goldman called about 50 favored clients of the big securities firm with the same tip, including hedge-fund companies Citadel Investment Group and SAC Capital Advisors, the documents indicate. Readers of Mr. Irizarry's research didn't find out he was bullish until his written report was issued six days later, after Janus shares had jumped 5.8%.

While making short term calls is VERY common at any major financial institution, the "selective disclosure issue" is the massive gray area. Especially since the way Goldman does it, is very different than many peers. For example:
  • At many firms, traders, salespeople and analysts hold early-morning calls to review ratings changes, recommendations and market events.
  • At least one competitor discloses such trading tips much more broadly. Morgan Stanley's research department sends blast emails with short-term views on various stocks to thousands of clients, and posts the information on its Web site. It doesn't call customers to convey the tips, because Morgan Stanley officials decided that could expose the firm to questions about selective disclosure.

Selective disclosure is what it is all about. If you are newer to the markets, Eliot Spitzer used to have a job before "disgraced Governor"; he was New York's AG. His coup de grace was stopping the behavior of "selective disclosure" - that is disseminating information to a select group (who could act on it) before the masses. Which is effectively front running and illegal. Is Goldman doing that now? Technically no or perhaps - maybe? But remember, in a piece last week I said there is "spirit of the law" and "letter of the law"... many rules are placed with the expectation that the spirit of the law will be obeyed.

Meanwhile, a horde of attorneys are pecking through the fine print (and in fact the lobbyists many times help create the "new rules" so the loopholes are already known) to find ways to get around the spirit of the law, without technically breaking the letter of the law. And it's not just in high finance - heck, I'd argue the whole corporate accounting profession is based on this.

  • "The spirit of the law is twofold," says Eric Dinallo, who in 2003, when serving as a deputy to former New York Attorney General Eliot Spitzer, helped negotiate a $1.4 billion stock-research settlement with 10 major Wall Street firms, including Goldman. "Analysts should give consistent advice to all their customers, be they small investors or big trading clients." Any views that differ from an analyst's published rating but are "worth sharing with certain customers," he says, should be made "available to everyone."
So that's the spirit, but surely there are loopholes, which are being duly exploited.
  • The 2003 case involved allegations that Wall Street firms were issuing overly optimistic stock research in order to win more lucrative investment-banking business. The settlement, in which Goldman and the other firms didn't admit or deny wrongdoing, erected walls between research and investment banking.
Now that 2nd bullet point is interesting... this "Chinese Wall" that was put up between research and the investment banking/trading arms of our financial oligarchs was something I assumed was actually working. But there I go again dropping my cynical facade for 1 second, and look at Goldman go! You see, what Goldman is doing by giving information to one group of clients and not the others is only part of the story - and I'd argue the smaller part. Although all the media reports since Monday have focused on THAT piece of the puzzle.

The part I am interested in, is the complete skirting of the Chinese wall... it's an amazing stretch and only a company so arrogant to essentially own the regulators would pull a stunt like this. But it's a financial oligarch country and there is none more powerful than these. Here is the part that should be getting all the attention at the SEC. Not only is the Goldman research team giving short term tips to a small group of their biggest hedge fund, there are some magical men sitting in on those meetings. These men are called "franchise risk managers" - they happen to work for Goldman's trading floor.
  • Every week, Goldman analysts offer stock tips at a gathering the firm calls a "trading huddle."
  • Some Goldman traders who make bets with the firm's own money attend the meetings.
  • ... also included another class of traders called "franchise risk managers," who sit with and advise the traders handling customer orders -- and make bets with Goldman's money.
Do you see where this is heading?
  • Typically, traders who wager firm capital are walled off from those handling customer orders so that they don't take advantage of information about client trading, which securities regulations forbid. Goldman says its franchise risk managers don't trade on client information and must first share trading-huddle tips with clients before acting on the tips themselves.
Notice how that is worded? All the FRM (franchise risk manager) has to do is wait for the information to be shared with clients. But which clients? Only the big ones, because these trading huddles are only for the gorillas of the hedge fund world. Then after the information is shared with them? The real party (potentially) (allegedly) can begin. He/she can then go and trade with Goldman's money (which in effect is now backstopped by the US taxpayer since Goldman was turned into a bank holding company in late 2008). That's a Chinese Wall? Now you might ask so what - both the hedge fund and Goldman traders are in a small loop, and if they buy based on an internal recommendation, what's the big deal?

Gosh - this is where the true (alleged) (potential) front running can begin. In fact, out in the plain open we have 2 examples in the Wall Street Journal story - just imagine how often this happens? Day after day? Week after week? Suddenly you are talking real money - see below:

Say for example in a "trading huddle" - as in the case with Janus Capital - an analyst recommends a stock to the "wink wink" hedge fund crowd and his franchise risk manager (wink wink), allowing hedge funds and FRM to buy the stock. (of course FRM won't talk to anyone else in the firm on the trading floor either but keep his purchases a secret...right) Then 6 days later Goldman Sachs recommends Janus publicly, allowing hedge funds and FRM (and all his trader friends on the other side of the Chinese wall) to sell the stock to the ravenous public who is joyous Goldman issued a "buy!".

Or if Janus bores you, try it with Metlife.
  • At the same April 2 trading huddle, Goldman analyst Thomas Cholnoky said he favored MetLife Inc. over other insurers, according to notes from the meeting. Internal documents indicate he believed the stock would rise over the short run.
  • Hours after the meeting, Mr. Cholnoky released a research report that reiterated his "neutral" rating on MetLife, saying he hadn't changed his estimates.
Sounds good up to that point.
  • A week later, Mr. Cholnoky boosted his rating on MetLife to a buy, and Goldman added the stock to its "America's Buy List" of top stock recommendations.
Uh oh! So, the day I highlighted MetLife in a "huddle" I reiterated a neutral so that the buying of the stock by top hedge funds in America, and my own firm's traders, would not stoke the price. Then after allowing these "favored" clients (and my own firm) to accumulate the stock over the next week; I had a miracle changing of my views - I decided to upgrade Metlife to buy, surely increasing the price as "Goldman's word is king" - and the firm added it to the America's Buy List!

Surely Goldman's traders and the hedge funds were not selling into that surge of retail (and smaller institutional) lemming "buy" and "America's Buy List" euphoria. That would never happen - nope. But we'll never know, will we? Because the data is surely hidden in some third party dark pools which we are told are good for us. They provide liquidity. And they leave no track record for regulators.

Readers - I don't know what you call that scheme, in which WSJ showed 2 clear examples of front running a new recommendation anything other than... well, "front running". I am sure the apologists will say "we're just adding liquidity to the market" which seems to be the talking point for any scam that takes money from Joe Schmoe Investor or his mutual fund and gives to the select few financial firms at the top of the food chain.

Now you tell me how this is any different than the typical activity seen in some of the more shady business models you've ever heard of? And how it is different than what Spitzer fought to get banned. Don't worry - Goldman has plenty of explanations of why it's ok. But despite those explanations, the other countless Goldman clients not in the top select group of 10 to 50 who get the "secret wink wink code", appear to be raising a fuss. (They want to scam the rest of the investing world too!) Which is surprising considering Goldman says everything is just fine with this practice. I just want you to see 1 of I am sure many "walking on the gray line" things Goldman can do to help their winning ways, which they explain to us as simply being the smartest guys in the room. Ahem.

As I said last week: We (the collective) only see the tip of the iceberg when we think we know what is going on in these markets. We find out new things every month, quarter, and year of the policies and practices. Some get "fixed", some don't. Even those that get "fixed" get worked around. The regulators are like the drug testing officials using technology that is 10 years old. The top select financial firms are like BALCO - except when they get caught, they get slapped with a cursory fine that is akin to 1 day of trading profits (while of course never admitting they did anything wrong).

It has always been a rigged game; you know that walking in. But the degree of "it's fixed" is now at levels that are jaw dropping.

Wake up, will ya pal? If you're not inside, you're outside, OK? And I'm not talking a $400,000 a year working Wall Street stiff flying first class and being comfortable, I'm talking about liquid. - Gordon Gekko


It's actually a very good "inside baseball" read and I laud the Wall Street Journal for posting it; this is like the old school WSJ.

Now the fact the SEC has no clue about what is going on inside the firms it is regulating is no surprise... I mean c'mon now; their purpose is to regulate - would you expect them to know the practices of those they oversee? That would be... too logical. But (sound the trumpets!!!) with a newspaper doing their work, the SEC is on the case now!! They will protect you from the foxes dear hens! And when the next newspaper breaks the next potential impropriety, well the SEC will get on that one too. They have your back!