In Wall Street trading, if a trader makes one dollar, it is only because some other poor bloke loses exactly and precisely one dollar. It is a zero-sum game.
Who then is the optimal trading partner in this zero-sum game? He has three characteristics. First, he should be particularly clueless. Conveniently for traders, cluelessness is contextual: A partner can be smart about traditional products but clueless about a crazy new one that you create. Second, he should be deep-pocketed—that is, able to lose lots and lots of money because the amount of money that you cause him to lose defines the amount of money that you can make. Third, he shouldn't take losses too seriously.
How could the latter be? Doesn't everybody take losing money seriously? No, not really. People generally take seriously the thought of losing their own money, but not so much losing other peoples' money. So optimally the partner should be managing someone else's money—a so-called fiduciary institution, preferably a big pension fund. And if we want to get particular, there is a further preference on this front. The money manager hired by the fiduciary institution should be on a "2-and-20" compensation formula, which pays the manager 2 percent of assets under management regardless of how terribly he performs, plus 20 percent of the upside in case he does well. This payoff structure encourages managers to swing for the fences with their clients' money rather than actually take care of it—i.e. hit a home run and you are mega-rich; strike out and you are merely very rich.
So it was pretty simple, the Goldman traders needed clueless, deep-pocketed fiduciary institutions managed by folks swinging for the fences on the other side of their trades in order for Goldman to make maximal money.
Goldman created a product, ABACUS, which was attractive to clueless, deep-pocketed fiduciary institutions that were managed by folks swinging for the fences and then merrily traded with those partners and made gobs of money. This is not rocket science. It is tantalizingly simple.
Let me be clear: I think it is utterly disgusting and appalling if the allegations are proven. But it is not even minimally surprising.
This kind of behavior will continue to march forward until the rules of the game are changed. Under the current ones, the folks who make the most money in America create zero value. These traders just shuffle existing value from one entity to another; they don't build net value. Yet our society rewards them most; more than we reward builders of value.
And these traders will continue to have their way with pension fund managers as long as we force millions of Americans to place their pension dollars with monopolist managers who like being fêted and stroked by hedge-fund managers more than they like being prudent for their pensioners. Remember for John Paulson's firm to make a reported $15 billion in trading profits, it needed clueless fiduciary agents to waste $15 billion of their clients' savings—and waste it they did. If we don't like monopolies in America, why do we allow so many pension funds to have the monopoly right to serve large employee groups, such as the public employees of entire states?
It may feel good to see the SEC spank Goldman Sachs, but to prevent this from happening again in a couple of years, more fundamental changes need to be made. First, we need to impose stiff taxes on short-term trading profits to shift the balance away from trading as the single most profitable activity in America. And second, every pensioner needs to be given a choice in who manages their pension because monopolists operate for their own benefit, not their 'clients'.
Investor beware! It is your money, your decision, your investment, and your financial security that is at stake. Take the time to look before you leap. Investigate your 401(k) portfolio options and those who manage them. Why spend so much time researching your next consumer product, yet allow someone (stranger no less) to handle your money?
Take these steps:
- Research
- Investigate
- Decide
- Invest
The vast majority of stocks today are by credible businesses have great value, even in this economy. However, there are those who make money on your earnings and losses. Don't leap on the next "great" idea without doing your homework. If you are not willing to do your homework, then don't invest--in anything!
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