Doomsday, Goldman Sachs and a tiny thing called ‘proprietary book’

By Branko Brkic 16 January 2010

The new year has begun, the recession may be over and a huge sense of relief has returned to financial markets around the world. But there is still one tiny, little, small niggling problem: How do we stop it all from happening again?

This is the issue which ought to be keeping regulators awake at night, not only in the US and Europe, but in South Africa too. Behind this little problem is something called “the proprietary book” or “prop book”.

South African banks largely escaped the financial fallout caused by the bubble in housing markets around the world, yet the root of the crisis exists locally as much as it does elsewhere. It vests in a half-lit world in which banks take a market position that may or may not be the same as the position they are recommending to their clients.

In essence, this is the outstanding issue of the crisis. What should regulators be doing, if anything, about proprietary trading? Do investment banks have any kind of obligation to inform their clients if they take a position contrary to the one they are recommending to clients?

Almost by definition, we know virtually nothing about the market positions adopted by banks when they are acting for themselves – not even how big the positions are, never mind what they are.

You see, proprietary trading is, well, proprietary.

What we do know is that almost every investment bank in South Africa has one, and that includes the investment banking divisions of retail banks such as FNB and Standard Bank.

The point about a trading position is that, in order to win, someone else must, generally speaking, lose. In a world that is perpetually in flux, trading positions change fast and no bank is just going to alert the market to what they are investing in at any particular time.

But the bank, acting as agent for its clients will, again generally speaking, act on the instructions of that client, and it’s not the bank’s responsibility to countermand the instructions of its clients, usually via a different division anyway, even if they privately think the decision is wrong.

Yet, the aftermath of the financial crisis – and particularly the bizarre victory of the big daddy of investment banks, Goldman Sachs – is raising questions about this conventional business methodology.

Thanks to the crisis, a tiny torchlight is being shone into the dark well that constitutes proprietary trading, and even the little we can see by this light is pretty ugly. The whole picture is complicated by government bailouts of American and European banks. But even without these in SA, a worrying picture is beginning to emerge.

The advent of hedge funds may be causing position-taking with the proprietary books, forcing ordinary banks to become much larger and much more aggressive than ever before.

In case you think this is a minor issue in SA, recall what happened to perhaps the most glossed-over local financial scandal of 2009: FirstRand’s spectacular losses in its equity trading division. At one point, it seemed these losses might amount to R1,5 billion, but ultimately they came in at R782 million.

The losses of the trading division were amalgamated with other losses, including the Dealstream collapse, seemingly blurring the responsibility. But the truth is it was one of the largest losses we know about that was recorded in a trading division. Yet nobody high up in the bank seemed to take responsibility for this disaster, perhaps partly because trading had proved so lucrative in the past.

One of the things that played in FirstRand’s favour was that, however much the losses might have been, they paled into insignificance compared to the international comparison.

Strangely enough, it is actually not the losses that are causing the biggest problem from a public relations point of view; it’s the profits. And the biggest problem here comes back again to the big enchilada: Goldman Sachs. It is now becoming clear that Goldman benefited hugely from the crisis, some estimate as much as $13 billion, from a bailout of its client, the large insurance company American International Group (AIG).

Vanity Fair magazine captures the story neatly, noting wryly that with $16 billion bonus pool already set aside for the 2009 financial year, Goldman Sachs behaves almost as though financial Armageddon was precisely what the company needed.

Others have not been so kind.  Rolling Stone famously described the investment bank as a “great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money”.

What happened was that in 2007, Goldman, unusually and presciently (though the US housing market was in a bubble) decided to bet against the market. The “prop book” kicked into action. It effectively shorted the market by buying insurance from AIG in large quantities, about $20 billion, that AIG would be forced to pay over should the housing market decline. And decline it did.

AIG was saved by the US taxpayer and paid over about $7 billion to Goldman. When the dust settled, it became clear that government assistance to AIG was, in effect, a windfall benefit for Goldman. On top of it all, Goldman utilised other government assistance as well, including the Troubled Asset Relief Programme (Tarp).

Hence, the public outrage, for which Goldman actually apologised, although not exactly sincerely, unleashing a torrent of sarcasm. Yet, amid all the storm over whether an institution designed to make money and which deals almost exclusively with people with money, can or ever should apologise for making money, one issue remains unsolved: What about the proprietary book?

This is an issue for South African regulators as much as for any other country around the world. Good luck to them.

By Tim Cohen

Read more: Vanity Fair, Rolling Stone

Photo: Lloyd Blankfein, chief executive of Goldman Sachs Group, testifies before the Financial Crisis Inquiry Commission in Washington January 13, 2010. The top executives of four big U.S. banks testified Wednesday at the hearing. The 10-member panel was created by the U.S. Congress to examine the causes of the 2008 financial meltdown and is holding a two-day public hearing this week. REUTERS/Kevin Lamarque


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