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How Long Can Uncle Sam Rig the Game?

Posted by Larry Doyle on May 13, 2010 5:32 PM |

Is the market rigged?

Actually, the question of whether our markets are rigged or not is becoming less and less a question and more widely accepted as fact. This reality is evidenced by the totally incredulous evidence that four major banks on Wall Street had perfect (not one negative trading day) first quarters.

Some may think this is good for our economy. I am not one of them. Why? The losses embedded in our banks are being underwritten by those who did not bear the risks. That violation of moral hazard has untold costs in terms of future economic behaviors. The costs are borne by our children. What kind of legacy is that? Oh, plenty of people will tell you otherwise, but I see the wealth transfer and income redistribution programs currently in place as a travesty. Additionally, I believe these programs will severely prolong our underlying economic anxiety.

Back to my original question, “Is the market rigged?” Let’s review the thoughts of Bloomberg’s Jonathan Weil who writes, Rigged-Market Theory Scores a Perfect Quarter:

Score another triumph for the rigged-market theory.

In a feat that would seem to defy the odds, Goldman Sachs, JPMorgan Chase and Bank of America this week each said its trading desk made money every day of the first quarter. Goldman said its daily net trading revenue topped $100 million 35 times last quarter out of 63 trading days. JPMorgan and Bank of America disclosed similar eye-popping stats. Citigroup, too, recorded a profit on each trading day, Bloomberg News reported, citing unnamed people who knew the results.

The intrigue is high. If a too-big-to-fail bank’s traders were able to make money every day of a quarter, were they really trading in any normal sense of the word? Or would vacuuming be a more accurate term? What kinds of risks do such incredible profits entail, for the banks and the rest of us taxpayers? And are results such as these too good to be true?

There seems to be no satisfying way to answer those questions, or even the more basic inquiry: How exactly do these banks’ trading divisions make money? Reading the companies’ impenetrable financial reports is of little help. However they did it, the data suggest it was as easy last quarter as hitting the side of a barn with a baseball from three feet away.

This isn’t the way “trading” works in the real world. A simple exercise in measuring probabilities is instructive here.

Long Odds

Let’s say you manage a highly leveraged, diversified investment fund, and have become so skilled at playing the markets that you have a 70 percent probability of making money any given trading day. This would be a remarkable achievement in most markets. The odds that you would post a daily net gain 63 times in a row, though, would be about one in 5.7 billion. The formula for calculating this is: 1/(0.70 to the 63rd power).

Even if you had a 95 percent likelihood of a winning day, you would have only a 3.9 percent chance of doing it 63 trading sessions in a row.

Now consider that four of the biggest U.S. banks just pulled off a quarter-long win streak — all in the same quarter. Why would any of them even want to? Do they think the public doesn’t despise them enough? Surely it would have been easy to tweak the values of some illiquid “Level 3” assets lower for a day if they had been so inclined, just enough to avoid looking perfect. Yet none of them did.

These banks have the advantage of an unlevel playing field, of course. They can borrow money for next to nothing at current rates and lend it for more, simply by buying longer-term Treasuries. They have access to information that their clients lack. They have computer-trading platforms that operate in milliseconds. There’s less competition now that Lehman Brothers and Bear Stearns are gone. Yet even taken together, these factors don’t offer a satisfactory explanation for last quarter’s amazing streaks.

Wrong Question

Asking how these four banks did it may even be the wrong question. A better question might be: How did Morgan Stanley’s traders somehow manage to lose money on four days last quarter? Or perhaps the winning streaks were a sign of a perfect calm, just before another perfect storm. It turns out Morgan Stanley posted net trading gains every day during the second quarter of 2007, right before the credit crisis began to hit full-steam.

Goldman’s chief operating officer, Gary Cohn, this week said his bank’s infrequent trading losses — 11 losing days in the past 12 months — are evidence that Goldman’s traders don’t depend on proprietary trading to generate revenue. The simple answer, he said, is that Goldman’s trading operations “are largely global market-making businesses.”

One Answer

Of course, no matter what the question is these days, it seems the answer from Goldman always is: We’re a market maker. When senators ask about e-mails that show Goldman telling its sales army to dump crappy mortgage bonds from its warehouse on its clients? Market maker. When the e-mails show Goldman created the crappy deals? Market maker. By Goldman’s definition, an Amway salesman pitching energy drinks to old ladies in nursing homes would qualify as a market maker. It’s all just matching buyers and sellers to create liquidity, you know.

So let’s forget about the how and focus on the why. Why were these banks able to make so much money with such uncanny consistency? One logical answer is that America’s political leaders obviously want it this way.

Otherwise, for example, the government already would have begun to liquidate Fannie Mae and Freddie Mac and let the crash in housing prices and mortgage-backed securities run its course. To encourage personal savings, the Federal Reserve would have raised interest rates and turned off the banking industry’s easy-money spigot. And the White House would be throwing a fit over the International Monetary Fund’s use of U.S. taxpayer dollars to help bail out Greece and its ilk, along with the European banks that own their debt.

Americans don’t want the immediate pain such steps would bring, though. So our government keeps trying to stretch it out through massive subsidies for the financial-services industry, which means traders at America’s largest too-big-to-fail banks get to keep making their killings and bonuses, for now. What nobody knows yet is how long the government can keep up the rig.

How long? Will the rug pull in the equity markets on May 6th occur again? I believe it will. Why? Debt cripples. Excessive debt is fatal. The last year has been all about incurring more and more debt. At some point, the margin call will be made. What then?


  • Franz

    Timing is everything in life. All the right trades but at the wrong times or if you get stopped out will still render you a loser.

    In terms of how long can the government rig the game? Well, much like what the Lord said to Noah, “how long can you tread water?”

    Build yourself an ark, because the debt-filled waters they be arising.

  • Fred

    A better question: who was on the other side of all that trading, who lost all that money that the banks made?

    At the end of every paper trail of every trade made by every big institution is the “little guy”; the taxpayer who actually makes something by doing real work and then saves some and assumes “real” risk of loss to achieve a better return to send his kids to college, buy a house, or save for a better retirement. Thru deficit spending, institutions are even able to take $ from our children and grandchildren.

  • Vin


    I don’t know if its already been written about, but I would like to know a couple of things. I believe about 85% of earnings revenue in the first quarter from the big banks came from trading in fixed income. Could it be possible that a ton of level three assets were sold to FNM and FRE at close to par everyday? Maybe that could account for some of the “perfect trading”?
    Also, there is alot being written about since the 1000 point decline a couple of weeks ago. From what I can read, there were huge losses to retail investors who use simple stop orders. When elected, they go to market orders, and obviously, the “market makers” love those types of orders. Larry, isn’t it obvious that the quant models at these institutions can “see” the stop orders already in place? And can calcualate how many shares, capital to elect them? Could it be possible these quant models are also able to “see” ALL the positions in their Prime Brokerage accounts? I know they say there are chinese walls, but do you know if this has ever been investigated? It would explain constant counter intuitive movements, especially large unexplained “gap” movements in sectors and stocks overnight and immediately before the opening every day. And I am not counting the rigged system of ratings and upgrade/downgrade fraud that occurs daily.
    In finishing, I read Greg Zuckerman’s article on the SEC’s documentation on GS. I have been complaing about it since the day it happened and that is the tens of thousands of puts that were bought on BSC the couple of days before the collapse. And these were all listed options, not counting what was going on behind the scenes. When BSC was trading at $67, someone contacted all the exchanges and had them add 30, 25, 20, 15 and even $10 strikes. And with only 8 days to go before expiration! Thousands were immediately bought right on the open on all the lower strikes. The SEC might not be able to find the “culprits” on the 1000 point decline (probably because they already know), but I could find out who bought those puts in one day! And now its 2-3 years later. That is inside, material information whoever bought them. And don’t tell me you were “hedging counterparty risk”. And thats not even mentioning the same things in AIG, FNM, FRE, WM, LEH, etc., etc.

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