How Goldman Sachs Games the System

In case you missed the weekly Goldman Sachs (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!

Comments

[Michael Clark:]

They get a huge stash of campaign contributions so they can keep their day-jobs. (And probably a bit more. Plus, they don't end up like Eliot Spitzer, who had his character assassinated when he was investigating AIG (and GS) corruption.) It's a dirty game they all play.


On Aug 31 09:29 AM doubleguns wrote:

> A mugging by GS leaves the victims no better off than one by a gun
> totting thug.
>
> Our present problem is the govt has hired these muggers and unleashed
> them amongst us.
>
> Wonder what cut the govt gets!!!

Aug 31 09:36 AM

[wobatus:]

If you aren't a client of Goldman Sachs at all I can't see how any of this behavior would bother you. It has no long term effect on the value of a company. Ben Graham, Charlie Munger and Warren Buffett would all tell you to ignore the daily market ticks anyway.

The sooner we get back to straight caveat emptor the better. I know I get negative recs for saying these things, and the easist thing in the world is just to bash this behavior. Frankly, it just doesn't matter in the long run. Essentially, what you are asking for is not only all information from the company to be equally shared, but also all opinions of all people must be equally shared at the same time. That's daft.

Aug 31 10:30 AM

[RainmanRam:]

The way to play the game is to ignore the analysts. The only reason GS can do this is because they hold the shepard's hook. The sheep (greater fools) aren't required to follow. IMO, analysts recommendations are, by nature, a conflict of interest.

Aug 31 12:00 PM

[TraderMark:]

I disagree

when you have a research arm and a trading arm and they comingle that is against what Spitzer fought for

Especially when the research arm is upgrading stocks a week after upgrading them in "trading huddles" that gets Goldman's traders and top customers into the stock. Its simply gaming the system when it gets to that point.

Oops, I mean its "adding liquidity".


On Aug 31 07:38 AM wobatus wrote:

> There's no good reason why this should be against the law. No one
> forces anyone to buy or sell these equities. When arguing about the
> spirit of the law, one should question why there is a law at all.
> If GS promised to give information to one client at the same time
> as, or ahead of, another, that's a contractual issue. Otherwise,
> no one buying or selling stocks should care. If you like the price
> buy or sell, if you don't, don't. Stick to that and the rest shouldn't
> hurt you. It is traders might not like this. Investors won't care.
> Ask Warren Buffett.

Aug 31 12:17 PM

[TraderMark:]

Great movie

doesnt get the publicity of Wall Street but just a great movie...


On Aug 31 08:59 AM John Galt wrote:

> On Aug 31 08:30 AM Fulcanelli wrote:

Aug 31 12:20 PM

[buyitcheap:]

Truly, Madoff-like returns.

Aug 31 12:21 PM

[Burton A. J...:]

Maybe you should solicit a statement from Hillary Clinton, the Queen of Front Running.

Do you remember how she ran $1,000 into $100,00 in one year trading commodity futures when she was a young, struggling lawyer and her husband was governor? GS only made 97%.

Burton A. Johnson
valueinvesting.com

Aug 31 12:34 PM

[ex- bond tr...:]

I wonder if Kathleen Sebelius is going to mandate mandatory swine flu, a.k.a. H1N1 vaccinations for all Goldman Sachs employees.
That would be an answer to getting rid of a real pandemic.

Aug 31 01:30 PM

[H. T. Love:]

Actually, worse off. The thug obtains only what is on the victim's person at the time. GS gets what's not on the victim's person.

HardToLove


On Aug 31 09:29 AM doubleguns wrote:

> A mugging by GS leaves the victims no better off than one by a gun
> totting thug.
>
> Our present problem is the govt has hired these muggers and unleashed
> them amongst us.
>
> Wonder what cut the govt gets!!!

Aug 31 01:31 PM

[Steak:]

Retirement savings (pensions, SS, 401ks) are not held in cash. Those assets are held in some sort of investment purchased on some sort of market (real estate, equities, bonds). So unless you suggest it is a rational option to hold all one's retirement savings in cash then anyone seeking to retire will have to be involved in markets. And the markets should have referees.


On Aug 31 07:38 AM wobatus wrote:

> There's no good reason why this should be against the law. No one
> forces anyone to buy or sell these equities. When arguing about the
> spirit of the law, one should question why there is a law at all.
> If GS promised to give information to one client at the same time
> as, or ahead of, another, that's a contractual issue. Otherwise,
> no one buying or selling stocks should care. If you like the price
> buy or sell, if you don't, don't. Stick to that and the rest shouldn't
> hurt you. It is traders might not like this. Investors won't care.
> Ask Warren Buffett.

Aug 31 01:37 PM

[jimmy46:]

Another reason for regulations to be "principles based" rather than "rules based".

Aug 31 02:37 PM

[wobatus:]

I understand what Spitzer fought against, and I know what you are describing does not sound ethical. However, banning it is esentially saying you are not allowed to sell your opinions or repuation as you see fit. I am not arguing that it adds to liquidity.

If I am in the marketplace for a stock, I make my decisions based on what i think a fair price should be. I have to expect smeone else may know more, or that the stock is up because someone else is recommending it, and that people may be taking advantage of that recommendation and subsequent move in the price to sell their shares, and they may even have acquired the stock and known the opinion was forthcoming. Hell, I would go so far as the opinion could be completely bogus.

You have to make your decisions based on what you know about the company's prospects and price and finances.

The sooner you deal with the market straight caveta emptor, the better off everyone will be. Everyone should learn that and act accordingly.

Perhaps GS will lose clients due to revelationssuch as this. or no one will listen to their calls. They may suffer reputational damage (like they haven't already).

But someone here talked about enforcing the regulatory principle, not just the rule. That is a very slippery slope, and there is far from much evidence that even enforcing the regs as they exist really makes much sense. A good case can be made that insider trading should be legal as well.

There is always someone else on the other end of the trade and there is always informational asymmetry. You wouldn't buy from the other guy unless you thought it was going to go up more than he does, all things being equal.


On Aug 31 12:17 PM TraderMark wrote:

> I disagree
>
> when you have a research arm and a trading arm and they comingle
> that is against what Spitzer fought for
>
> Especially when the research arm is upgrading stocks a week after
> upgrading them in "trading huddles" that gets Goldman's traders and
> top customers into the stock. Its simply gaming the system when it
> gets to that point.
>
> Oops, I mean its "adding liquidity".

Aug 31 03:13 PM

[lower98th:]

I have been in and around this market for 25 years. I have been elated, I have been crushed, I have been enriched, and I have been humbled.......But this is the first time I have ever been just disgusted.

Aug 31 06:40 PM

[Up Yours SP500:]

Mark, you forgot to emphasize that the only fools that get played are the fools who believe Goldman in the first place.

As a rule of thumb, what ever Goldman recommends, know that they have made their money on it already, they are just looking to get out when the suckers start buying. GS caters to the rich, and when the rest of the country is worrying about their next paycheck, healthcare, or simply keeping food on the table, these guys are scheming as to what political donations will keep their games going, so that they can pillage from the middle class until the well runs dry. That's how it is now and how it will be in the future.

Spitzer was a good AG, its a shame he brought himself down. Cheating on one person is not the same as cheating on several million.

Aug 31 11:13 PM

[31October:]

They did call. You were tied up, so Trader Mark took the call.


On Aug 31 08:37 AM Ferdinand E. Banks wrote:

> I'm glad that nobody called and asked me what I think about Goldman
> Sachs. If he did I would say that when I was teaching finance I couldn't
> praise them enough, and I told everyone in my classes that if they
> ever found themselves in the US and needed some heavy bread, go in
> and have a talk with the GS bosses and ask for a job.
>
> Of course, they might be doing a few things that they shouldn't do,
> but so did Big Bill Clinton and George W., and you hardly hear any
> any bitching and moaning on this site about them.

Sep 01 09:42 AM

[Sacandaga:]

Selective disclosure is only a crime when companies do it, because they presumably know what they're talking about.
But GS's purported decision to provide its investment advice to some clients before others is perhaps a bad business practice, but not a crime, because even GS's advice is opinion, not fact (if the latter, they're really in trouble).
Those who are paying for it but getting it later than others should protest or fire GS.
I'm no defender of GS, and I think the WSJ article has substance. But this rehash is a pile of conjecture piled on other people's real investigation adds nothing to the WSJ article.

Sep 01 11:18 AM

[wobatus:]

Sacandaga, you get it.


On Sep 01 11:18 AM Sacandaga wrote:

>
> Selective disclosure is only a crime when companies do it, because
> they presumably know what they're talking about.
> But GS's purported decision to provide its investment advice to some
> clients before others is perhaps a bad business practice, but not
> a crime, because even GS's advice is opinion, not fact (if the latter,
> they're really in trouble).
> Those who are paying for it but getting it later than others should
> protest or fire GS.
> I'm no defender of GS, and I think the WSJ article has substance.
> But this rehash is a pile of conjecture piled on other people's real
> investigation adds nothing to the WSJ article.

Sep 02 01:47 PM

[bobbybutte:]

I think the article is excellent

But the fact is that the Us economy is a 35% partner in every big company in collecting taxes

You pays your money you take your chances IMO

Sep 02 02:21 PM

[Graham and ...:]

One should need a license to trade like Goldman does. Specialists had it, because they performed a public service. But why should Goldman.

Sep 04 09:25 AM

[Graham and ...:]

Welcome aboard (with a thumbs up). You sound like Graham and Dodd Investor.


On Aug 31 12:21 PM buyitcheap wrote:

> Truly, Madoff-like returns.

Sep 04 09:28 AM