Monday, April 19, 2010

GS Case Begs the Volcker Rules (and Blankfein a lesson in asymmetry)

The core of the SEC’s case is based on the view that one of our employees misled these two professional investors by failing to disclose the role of another market participant in the transaction, namely Paulson & Co., and that the employee thereby orchestrated the creation of materially defective offering materials for which the firm bears responsibility. Goldman Responds

Using methods from theoretical computer science this paper shows that derivatives can actually amplify the costs of asymmetric information instead of reducing them. Working Paper on Information Assymmetry

As Mark Thoma explains in a recent post, the SEC's case against Goldman Sachs (assuming a strict reading of the statute) rests on the issue of asymmetric information- did GS disclose enough information about the offering such that the collateral manager of the CDO "knew or should have known that Paulson was on the other side of the transaction."

There is another aspect of the case, in light of the implicit support of TBTF financial institutions, that begs the Volcker Rules of proprietary trading separation from government supported activities, namely commercial banking, to which I'll return.

Asymmetric information is one of those phrases that makes common people hate economists. Uneven, deceptive or lying captures the essence of the issue.

To indulge a fantasy occasioned by the Goldman fraud, and explain the issue, let's imagine I found out that Mr. Blankfein liked to play a bit of ice hockey from time to time-nothing too strenuous, just for fun. Imagine, upon hearing the news, I invited him up for a skate with my spring hockey crew. "It's just a pick-up, no refs, no checking, lots of fun," I could tell him- "for us," I might say to my friends after hanging up the phone.

Imagine he comes up, suits up and hits the ice. At that point (or as soon as the first puck whizzes by his head), he'll realize that he's on the ice with 1-2 ex-Pros, quite a few ex-College players and we all play all year round, 4-5 times per week in the winter. There's no checking (well, almost, it gets you 2 minutes in the box), but there's quite a bit of contact. Slap shots are coming anywhere from 60-90 mph.

That's a little lesson in asymmetry I'd like to give Mr. Blankfein. Of course, there would be nothing sportsman-like about it. He'd be outclassed (but it would be fun).  It also would be entirely legal, as we may find to be the case with GS.

Getting back to reality, GS will argue that the collateral manager knew or should have known what he was getting into. We'll have to wait for the evidence to be presented to see if that claim is true.

The second issue I raised about such dealings begging the Volcker rules may prove quite important in the financial regulation debate. Currently, all public markets for finance are open to all, and, apparently, deserving of government support. Even if the collateral manager should have known the security was designed to fail, that such a security could be created strongly suggests to me that such dealings have no place in publically supported markets.

All participants in my men's hockey league sign waivers taking personal responsibility for injuries caused on ice. We cannot sue the rink, or the town, etc. We all love the game, so it's not a problem. Imposing costs on the rest of society for the risks we take would not be fair.  It would be assymmetric (if hockey players used such language).

Equally, it seems to me, trading activities such as are detailed in the GS case, should never lead to increased social costs. Not only, in my view, does socializing the costs of such trading activities negate their social virtue (price discovery becomes state sponsored price enforcement) such support drifts ever closer to tax funded gambling. What's next, tax credits for the losers in next year's World Series of Poker?

When a security can be designed to fail, it's time to separate the financial markets into socially protected and unprotected divisions. Just as I play socially unprotected hockey, I'm all in favor of socially unprotected trading- I just don't think my neighbors should have to pay when the risks become real.  Nor should the rink be shut down because we made a mistake.

I'll close with an ice hockey tip for the boys at Goldman: Keep Your Head Up Out There, Boys!