Wednesday, April 28, 2010

Goldman's Senate Testimony Was Not Laughable Or Obscene

The following is a comment I posted on "Making markets" by Mark Crosby on Core Economics Blog:
Goldman's testimony about market making is neither obscene nor laughable. I do not see the import of Goldman's view of the product. On one side, a party asks Goldman for an investment product with a yield higher than US treasuries and with a good credit agency rating. On the other side, the party asks for a product that is inversely linked (shortable) to high-risk residential mortgages. In between the two parties is Abacus Synthetic CDO. Both parties at the time of investment got what they wanted. Yes, at times the market maker is approached by one side of a transaction and has to find and sell the other side to complete a deal. No one forced IKB, ACA and others to buy into the deal. A salesperson called investors likely to be interested, described the product as all salespersons describe products, and they took the long side. They invested. Market makers are not investment advisers. The investing firms have their own analytical ability. Goldman is an intermediary, a finder, a matchmaker.

There were only 90 mortgages in the synthetic CDO. Did any long investor ask for the credit scores or geographical locations of the homes? Did any investor analysts look at available data for residential mortgage default rates in the areas of the homes?

Suppose a restaurant customer asks the chef to heavily salt, overcook (extremely well done, crispy, burnt), and add lots of Tabasco sauce to hide the flavor of the chef's specialty fish dish. When served, the customer says it is exactly what he wanted. Is it important to know that the chef in the kitchen says the dish will be crap and he would not eat it? Suppose the chef thinks pasta is best al dente and lightly sauced but many customers complain and ask for over cooked pasta that is drowned in sauce, and the restaurant regularly serves the pasta heavily sauced and overcooked to attract customers and make money. Who cares if the chef would not eat it that way?

A market maker matches a long investor with a short investor. It is impossible for the market maker to agree with both parties' opposite investment outlooks. If the product is crap for one side, it is a great investment for the other side. Sometimes, the quantities on both sides do not match and the intermediary, the market maker, takes a position so the both sides of the transaction can be completed. Furthermore, the risk management part of the company might short the same instruments because it is aware that the firm tends to hold long positions as part of transactions.

Suppose Goldman instead of saying the deal was crap, say it was great for the long investors and it bought long positions for itself. Did Goldman then deceive Paulson for whom it created the synthetic CDO?

Either Goldman deceived Paulson or ACA and IKB by your point of view. Market makers are in the middle, match longs and shorts and do not deceive either party, no matter what the market maker's point of view of the transaction is.

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