If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase. In one of the greatest investment markets in the world, namely, New York, the influence of speculation (in the above sense) is enormous. Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market. It is rare, one is told, for an American to invest, as many Englishmen still do, “for income”; and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that, when he purchases an investment, the American is attaching his hopes, not so much to its prospective yield, as to a favourable change in the conventional basis of valuation, i.e. that he is, in the above sense, a speculator. Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism — which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object.
It's hard to follow the Goldman Sachs hearings without thinking of this. The standard ideological defense for the finance industry is that it matches savings with investment opportunities and leads to a more productive use of capital for the benefit of society as a whole. But the financial crisis and its string of revelations about what Wall Street was actually up to makes that notion seem ludicrous and naive.
What the financial innovators were doing seems a lot like bookmaking. Ryan Avent points approvingly to this passage from The New Yorker's James Surowiecki:
No one on any side of this debate appreciates the casino analogy, but I think it’s still the most useful way to think about this question: when you place a bet on the Super Bowl, the casino is taking the other side of that bet. In many cases, it’ll balance the bets it makes on both sides of the trade, so that it’s exposed to no risk and it collects the certain profit from the spread. Regardless, though, any individual bettor knows that if he wins, the casino loses, and vice versa. That is, he knows the casino is on the other side of the trade. Levin seems to be saying that this means there’s a conflict of interest between the casino and the bettor, and that it’s illegitimate for the casino to take the bet. But there’s no conflict, because everyone knows what the deal is. And as long as the bet’s honest, and as long as the price is fair, the casino is doing right by the customer, because the customer is getting exactly what he wants: a chance to speculate.
That Wall Street was running a casino for speculators seems exactly right, and who cares whether it bothers bankers? Call it what it is. When you make synthetic CDOs, you are basically facilitating gambling -- these instruments didn't contribute much to encouraging socially beneficial investing. (At Interfluidity, Steve Waldman sheds some light on what function synthetic CDOs originally served for banks -- basically it allowed for regulatory capital arbitrage.) (UPDATE: This NYT discussion looks at the social worth of CDOs. All the contributions are worth reading.)
The point Surowiecki wants to make here is apt, but the analogy he uses is wrong. His explanation doesn't read like an accurate description of how sports books work. As I understand it, Vegas bookmakers always try to balance bets on both sides of a game by adjusting the odds or the point spread to even out the action. Your bet for a team is matched with that of someone who has the other side. No one bets against the casino at all, unless the bookmakers have badly botched their job. (I think the Scorsese film Casino actually details some of this; De Niro's character, if I am remembering right, is an expert line setter.) The casino is trying assiduously to avoid having action. It doesn't make bets at all. (Unlike Goldman.) The casino collects the vig -- the percent it gets for matching the action (similar to the rake in a casino poker game) regardless of the outcome -- and orchestrates the orderly payouts to winners. But it doesn't care who wins the game, only that it gets played. Like Jay-Z, the casino will not lose ever and all but the most ignorant sports gamblers understand that. They are trying not to beat the casino (by definition impossible), but to beat collective wisdom that has misjudged a likely outcome, or they are trying to get action at a favorable spread before lines move or odds change.
So if Goldman was really like a bookie, its behavior would be sort of excusable -- it was providing a way for gamblers to find one another and gamble and taking its established cut. But if I understand correctly, it was making others responsible for basically bearing the risks of paying off the outcomes of the wagers, and shirking the responsibility of running a fair game that it is supposed to assume to earn its money. As Waldman explains: "When Goldman is shifting risk that it did not wish to bear or hedge to an underwriting client, it is not acting as a market maker. Rather it is acting as an agent for a client wishing to take a position, while imposing the burden of liquidity provision on uncompensated and uninformed underwriting clients. When a bank arranges and underwrites deals to meet its own hedging needs, or especially to take an opposing speculative position, that is also ethically questionable if not plainly disclosed." (That quote probably makes no sense out of context, but I hope it will prompt you to read Waldman's post, which is dense and complex but will reward careful attention if you are curious about what investment banks are actually supposed do when they are not operating like hedge funds.)
And as Surowiecki points out, the legal issue with what Goldman stems not from their bookmaking (though that is arguably the larger moral problem with all of Wall Street in recent years), but from their fraud. Perhaps the appropriate analogy for the allegations regarding the Abacus deal is this: Goldman knew Paulson had fixed the Super Bowl, yet worked hard to make sure enough people were betting on the losing team to fund the payoff on Paulson's inevitably winning bet. The question is whether Goldman should have taken this game off the board.
UPDATE: Subsequent posts by Waldman and Ezra Klein have made me reconsider my analogy. Klein argues that Goldman, like a casino or a bookie, has no obligation to tell bettors its opinion of their bets, even when it knows they are bad bets. It just takes the action. Waldman explains that the Abacus deal did not put Goldman in the position of bookie, and why the bookie metaphor may be altogether inapt:
Goldman wasn’t structuring a trade between two clients, as far as IKB and ACA were concerned. It was working to form a business entity called ABACUS 2007-AC1, LTD and underwriting an issue of securities by that entity. The only clients formally involved were IKB and ACA, and they were on the same side of the deal.Then he adds what seems to me the key point to remember with regard to "market making": "Goldman was unwilling to make a market for Paulson at a price he would have accepted, so it manufactured an entity willing to do so. Investors in that entity were not informed that they were dealing with an active, involved adversary. And Goldman has the nerve to call both sides of the arrangement 'customers.' "
If this had been an adversarial deal, Goldman would have had no obligation to inform the side that wasn’t paying it whether they were making a good trade. But if this had been an adversarial deal, Goldman would have been advising one party or the other. Both parties could not have been its customers.
Imagine you are trying to buy a house. It is contentious. Disputes arise over price, warranties, settlement terms, etc. You would hire an agent, and the other party would hire an agent. Those agents would be different people. The hazards of relying on the same advisor in a difficult negotiation are obvious.
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