Monday, August 3, 2009

How Wall Street Is Generating Trading Profits

The more alert blogs have finally figured out how Goldman Sachs, et. al. are creating enormous trading profits, especially at a time when trading volumns in most securities have seriously declined. These Wall Street firms are buying toxic, illiquid garbage which institutional investors (read: your pension fund or insurance company) have marked at low levels (yet still not low enough) and selling these securities into the Fed at the Fed's inflated bid levels. This is one way in which the Fed is injecting liquidity into the big banks - at the taxpayers' and pension investors' expense. It is also a primary reason the Fed refuses to disclose what it its paying for these toxic assets and why the Fed is spending millions in lobbying to prevent an audit.

Here's the mechanics, and it's a trading ruse that was being used when I was trading junk bonds back in the 1990's: Naive pension fund has toxic crap asset marked down to 20 cents. Snake Wall Street firm has bid from the Fed at 50 cents. Pension fund trader has no idea who the buyer is and what the general bid is in the market, because this asset hasn't traded in over a year. The 20 cent mark is based on Markit's "guesstimate." Snake Trader tells Pension Trader "look, I can pay you 10 cents for this asset, it's the only bid in the market and I'm not even sure where I'll re-trade this thing, but I'm willing to take some risk at .10. Pension Trader, in somewhat panic and somewhat gratitude sells the asset to Snake Trader. Snake Trader turns around sells it to the Fed for 50 cents. A 40 cent spread on a bond with $10 million face is $4 million dollars. WE know the Fed is eventually investing over $1 trillion to buy this toxic crap. If firms like Goldman and B of A (Merrill) and JP Morgan can average a 20 cent spread on $1 trillion, that will eventually be $200 billion injected into the banks at the expense of everyone else.

Is a 20 cent spread, on average, unrealistic? I know for a fact that it is not because we averaged 10-20 cent spreads in trading junk bonds out of the RTC and into investors back in the 1990's. Given that these toxic asset-backed bonds are even more toxic and less liquid than junk bonds were, I'd say an average of a 20 cent spread overall may actually be conservative.

Think about how this works the next time you look at your pension or 401k statement and then you see Goldman et. al. reporting massive trading profits. Those profits are nothing more than these Wall Street firms ripping off the whole system. And one more point, some of the blogs reporting this activity are speculating that the Fed does not know how much mark-up is being taken by Wall Street on these trades. I beg to differ and would suggest that Bernanke and his cohorts have a very good idea how much is being made on this trade.

Here is the link to the Financial Times article which originally reported what is going on:

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