Is it any surprise that Wall Street went a bit off the deep end with the (admittedly barmy, but that’s a separate issue) Blanche Lincoln proposal to spin off derivatives desks? Derivatives, which are now deeply integrated in how dealer banks devise customer transactions and how they manage their own risks, are a large proportion of total transaction activity. And to illustrate how important they are in total, Liz Rappaport of the Wall Street Journal (hat tip Rolfe Winkler) reports that Goldman just told the Financial Crisis Inquiry Commission that derivatives transactions provided 25% to 35% of its revenues in the last two years.
If you excluded the retail businesses of other major financial firms, I doubt the percent of total business attributable to derivatives would differ much from Goldman’s level. Derivatives (ranging from not-terribly-lucrative “plain vanilla” interest rate and foreign exchange swaps to highly profitable customized trades of various sorts) are now a bread and butter business of all the major firms.
But the fact that this revelation rises to the level of a news story points up another issue: the opaque, impenetrable accounting of the major dealers. At best, investors understand only aspects of their operations, putting them in the position of blind men trying to sus out an elephant (which might instead be a camel…..).
From the Wall Street Journal:
Goldman Sachs Group Inc. told the Financial Crisis Inquiry Commission that 25% to 35% of its revenue comes from derivatives-based businesses, according to a person familiar with the situation…
A memo sent to the panel Thursday night by the New York company included an analysis of derivatives-based revenue at Goldman from 2006 through 2009, said the person familiar with the matter. Based on the percentages provided by Goldman, such businesses generated $11.3 billion to $15.9 billion of the company’s $45.17 billion in net revenue for 2009….
Goldman’s analysis reflects all derivatives products, ranging from credit to equity to interest rates, traded on and off exchanges, said the person familiar with the situation.
Goldman said it doesn’t conduct its businesses in a way that delineates revenue from derivatives transactions or other types of trading….
For example, Goldman cited credit-trading desks that are separated by industry group, adding that traders are indifferent to whether they are selling clients a bond or a credit derivative. As a result, separating the revenue among the two product lines is useless, Goldman told the FCIC. The firm also said its technology systems firm-wide don’t single out derivatives transactions.
The analysis was based on a “best guess” of the main type of trading on each Goldman trading desk at the firm, said the person familiar with the matter. The numbers vary widely, with the company’s fixed-income unit getting much more of its revenue from derivatives than investment banking, where no revenue is tied to derivatives.
Yves here. Goldman’s inability to produce a tidy derivatives number is not “not credible.” I’ve always marveled at how a perennial aspect of McKinsey’s business is that financial firms are set up (typically because it reflects organizational structures) to do a good job of reporting revenues and profits by customer or by product, and be pretty incapable of providing the other view. McKinsey therefore inevitably finds good cause for believing that the understanding the missing perspective would add value, and gets to throw bodies at rejiggering the numbers.
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Hi Yves:
I’m probably brainwashed and this comment probably discounts everything you’ve been trying to say, but if is cheaper to obtain an option to buy or if it is cheaper to buy insurance against a certain outcome than it is to buy the security outright, would you not expect the industry to grow exponentially? I said I was brainwashed because on a cost basis, it just seems cheaper to hedge than to hold the risk.
This in no way undermines the argument against how hidden risks arise from this system, it just is an attempt to delineate why the system has grown as a business opportunity to Goldman, assymetric info aside. I just don’t see how an insurance company with actuaries buying interest rate swaps is assymetric information unless you factor in counter party risk which those actuaries are not aware of because they have a false sense of security. Both sides are pricing with “sophisticated” models. It devolves from there, which I’ll give you but not all parties are ignorant.
My cassandra question is what happens when everyone holds options and no one holds the actual securities? Is that evolutionary finance or is that just a ponzi? We’re all so keen on the next event in human history that we don’t want to commit and in the end we all own nothing?
Am I correct in dimly recalling that the FCIC finally issued subpeona’s over this matter with GS, after getting jerked around and stalled?
As for this:
Okay, so it doesn’t ‘delineate revenue’ that comes from A, or B, or C, or D.
I’m baffled, I admit, at how those huge bonuses are justified if the company is not actually able to track which revenue stream is actually performing.
Or did I fail to properly admire the Emperor’s Beautiful, Well-Embroidered Garments yet again…?
Don’t you just love bald-faced defiance?
“Goldman cited credit-trading desks that are separated by industry group, adding that traders are indifferent to whether they are selling clients a bond or a credit derivative. ”
Since it wouldn’t be the traders who tracked the kind of instrument that went out the door, rather bookkeeping or a fulfillment center, they’re avoiding an answer by asking the wrong people. This is put-on incompetence amounting to sabotage. Upscale malingering. I wonder what kind of stooge nodding the FCIC crowd did in response.
“The firm also said its technology systems firm-wide don’t single out derivatives transactions.”
No, you just need the trading system. Dump instruments by type, say, separate on the basis of how the yield is figured. Simple operation, a couple of minutes and then sum up. This is not that hard. Once again, asking the wrong people to get no answer.
It’s easy to imagine this response delivered with a smart-ass grin.
“For example, Goldman cited credit-trading desks that are separated by industry group, adding that traders are indifferent to whether they are selling clients a bond or a credit derivative. As a result, separating the revenue among the two product lines is useless, Goldman told the FCIC. The firm also said its technology systems firm-wide don’t single out derivatives transactions.”
This seems hard to believe. One would think that in order for GS to get through the annual audit process they have to show a strong system of Internal Control. One component of I/C is risk assessment. Management’s responsibilities for risk assessment include having systems in place that identify, analyze and manage risks. The purchase or sale of a CDS would be much more risky than the sale of a bond. They must already have IT systems that capture all necessary data by product line for risk assessment purposes, or else their I/C system would have a control deficiency that would be considered either significant deficiency or material weakness This would further lead to serious complications for them during the audit process.
Assuming they already have the above bases well covered, by being able to manage risks by product line, then it seems it should be relatively easy for them to capture revenues by product line. But they’re choosing just not to do that. In essence then , aren’t they saying that they’re not doing any kind of risk vs. reward analysis by product line? Could be wrong but that would be extraordinarily hard to believe.
I have a lot of trouble with Goldman’s claims that the information is unavailable.
It’s basic accounting. The derivatives revenues are segregated by account.
The argument that any analysis of the pure derivatives revenues is of little value has merit, but the ‘info is not available’ line is bogus.
There’s no need for any ‘best guess estimates’ The books are the books and the ‘guesses’ can be supported/debunked by the accounts.
If I read Yves’s last paragraph correctly, and “not “not credible”” is not a typo, she believes that Goldman’s is telling the truth and its accounting simply does not capture the information exactly (does it “by customer”, not “by product”). If so, I agree, and I doubt Goldman could easily lie about it anyway.
But I wonder what it would mean to identify purely derivative revenues. In the simplest case, that of an equity covered call, the customer (or trader) holds the stock and writes calls on it. Suppose she writes the at the money call for $2, and the stock goes up $20. The trader may keep holding the stock but buy back the call before expiration for about $20. That would be an $18 loss on the option, but the whole position is profitable, because of the rise of the stock. Reporting the option revenue (loss in this case) would offer the wrong insight. And the risk in this position comes from holding the stock, not from selling the option.
One might say that the option plus stock position is the entire derivative trade that should be reported, but this produces other problems — including the fact that the stock and the option positions may not be opened and closed at the same time. Furthermore, some people hold individual stocks but sell index options — etc.
So the concept of separating out revenue from derivatives, as well as of separating derivative risk from that of underlying positions, doesn’t seem straightforward to me.
I thought GS’ van Praag set the record straight, once and for all, here:
http://www.zerohedge.com/article/goldman-responds-zero-hedge-musings-segregation-cash-and-derivative-pl