Sense on Cents

Goldman Sachs remains the focus of media attention. How do these wizards of Wall Street make so much money? What goes on inside 85 Broad Street? Is everything on the up and up? Are they smarter than everybody else on Wall Street? Does Goldman have better systems?

I addressed the Goldman business model on July 6th when I wrote, “How Does Goldman Sachs Operate?” I specifically highlighted:

Goldman decided to utilize its capital and balance sheet less so for origination capabilities and much more for principal trading (that is, making bets and taking positions with its own capital). Effectively, Goldman decided to operate much more like a large multi-strategy hedge fund. Goldman took enormous risks both in their proprietary books but also in their trading activity with customers. Goldman made a concerted decision to dominate the markets in which they chose to play.

If a firm is going to take large principal risk positions both within proprietary books and customer books (trading accounts used to trade with clients), two factors are of overwelming importance: information and relationships.

Goldman worked both of these angles very, very hard. Goldman developed extremely close relationships with the largest customers in the market and the largest power brokers in Washington and around the globe.

Many of Goldman’s relationships are with very active trading hedge funds. These funds know one goal–making money. Are rules violated? I’m sure they have been.

This morning, The Wall Street Journal reports Goldman’s Trading Tips Rewards Its Biggest Clients:

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%.

Every week, Goldman analysts offer stock tips at a gathering the firm calls a “trading huddle.” But few of the thousands of clients who receive Goldman’s written research reports ever hear about the recommendations.

At the meetings, Goldman analysts identify stocks they think are likely to rise or fall due to earnings announcements, the direction of the overall market or other short-term developments. Some of their recommendations differ from ratings printed in Goldman’s widely circulated research reports. Some Goldman traders who make bets with the firm’s own money attend the meetings.

Critics complain that Goldman’s distribution of the trading ideas only to its own traders and key clients hurts other customers who aren’t given the opportunity to trade on the information.

Securities laws require firms like Goldman to engage in “fair dealing with customers,” and prohibit analysts from issuing opinions that are at odds with their true beliefs about a stock. Steven Strongin, Goldman’s stock research chief, says no one gains an unfair advantage from its trading huddles, and that the short-term-trading ideas are not contrary to the longer-term stock forecasts in its written research.

Former Goldman client George Klopfer of Park City, Utah, who was unaware of the trading tips until recently, says the practice is unfair. “When I joined Goldman as a client, I got all these fancy brochures saying they put the client first,” he says. “I just don’t want to have to worry about them or big clients trading on stuff like this. I was at the end of the food chain.” He says he pulled out most of the $20 million in his account earlier this year after losing money on several Goldman funds. Goldman says individual clients like Mr. Klopfer typically have a long-term investing approach and are not focused on individual stocks.

I take the following away from this WSJ commentary:

1. Emphasis on short-term trading currently dominates Wall Street in general and Goldman Sachs specifically. High frequency trading is widely regarded to represent close to 70% of overall stock exchange volume.

2. One needs to question whether Goldman is running a version of the ‘pump and dump’ scheme under the guise of ‘short term trading.’

3. Although Goldman admits to running specific ‘trading huddles’ for only the last two years, the fact is Goldman has utilized this business model for a lot longer than that.

4. Goldman is treading very closely on the regulatory line which addresses the dissemination of information to the investing public. No surprise here as Goldman has always operated on the edge.

In order to navigate our own personal economic landscapes, we need to understand how the large financial players operate. This WSJ article is totally consistent with my views of Goldman’s operation.

LD

This entry was posted on Monday, August 24th, 2009 at 7:57 AM and is filed under General, Goldman Sachs. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.