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Playground of the Rich: Goldman, Others Game the Market with New Gimmicks and Old Fashioned Insider Trading

When the Madoff scandal hit, the disgraced Henry Blodgett reported this:

…[W]e’re hearing that the smart money KNEW Bernie had to be cheating, because the returns he was generating were impossibly good. Many Wall Streeters suspected the wrong rigged game, though: They thought it was insider trading, not a Ponzi scheme. And here’s the best part: That’s why they invested with him.

There’s a lot of that, so much that it makes it hard to understand why anyone thinks their money is safe in the stock market. Here are some more recent examples.

The Wall Street Journal begins an explanation of a fairly new security, the Leveraged ETF, with this:

At 3 p.m., do you get queasy just thinking about the toll that the final hour of trading might take on your portfolio?

That’s not very reassuring, is it? A Leveraged ETF is a exchange traded fund that tries to return twice the change in the value of a market index, like the Dow or the S&P 500. This bizarre instrument operates with a combination of total return swaps, index futures, and index options. They have high expenses, and, despite their name, they can’t return twice the market rate for any extended period of time. And that’s the good news. The author of a recent study is quoted in the WSJ:

Mr. Madhavan estimates that if a market index moves 15% in a day, leveraged ETFs could constitute 75% of all volume at the close of trading. Remember, the Dow fell 23% on Oct. 19, 1987. A major move could send volatility through the roof, and prices through the floor, in a day’s final minutes.

These securities account for a substantial part of end-of-day trading on various exchanges, and Madhavan’s paper tells us:

As leveraged and inverse ETFs gather more assets, the impact of their daily re-leveraging on public equity markets is raising concerns. Many commentators have cited leveraged and inverse ETF re-balancing activity as a factor behind increased volatility at the close.

The WSJ then tells us that brokers send blast faxes showing whether these dogs are going to be buying or selling, so their favored clients can “trade ahead” of the Leveraged ETFs. That is not fair.

Goldman Sachs recently released its earnings for the first quarter. It refused to acknowledge December, 2008, when it lost $1.3bn pre-tax, which Barry Ritzholz refers to as an Orphan Month. Then, it announced a profit in the first quarter of 2009. This is from the 8-K:

The ratio of compensation and benefits to net revenues was 50.0%, compared with 48.0% for the first quarter of 2008.

GS had net revenues of $9.43bn during that quarter, so compensation and benefits swallowed $4.7bn. After other expenses and charges, GS left shareholders $1.81bn. Insiders got 2.6 times as much as the people who provide the money the insiders are playing with, and they kept the $1.82bn for their games. That stinks. Even so, GS was able to sell $5bn more common stock. That, of course, hurt the existing shareholders by diluting their ownership share.

And here is a chilling story from Zero Hedge at Naked Capitalism. A number of Real Estate Investment Trusts have been selling stock, lately, and using the money to pay off their lenders. One such is Weingarten Realty, which raised $399mn, through a syndicate of brokers, several of which are owned by banks, including Merrill Lynch (Bank of America), Wachovia Capital Markets (Wells Fargo), and J.P. Morgan Chase. Weingarten intends to use some part of those proceeds to pay off those bank affiliates. Zero Hedge explains that the proceeds of every single REIT stock sale have been used to pay down banks.

Compare that with this description, from Multinational Monitor, a D & B publication, of one of the findings of the Pecora Commission:

First National City Bank (now Citigroup) and its securities affiliate, the National City Company, had 2,000 brokers selling securities. Those brokers had repackaged the bank’s Latin American loans and sold them to investors as new securities (today, this is known as "securitization") without disclosing to customers the bank’s confidential findings that the loans posed an adverse risk. Peruvian government bonds were sold even though the bank’s staff had confidentially warned that "no further national loan can be safely made" to Peru.

This and related findings led to the enactment of the much-lamented Glass Steagall Act.

Nobody is telling us how to front run leveraged ETFs, or helping us unload questionable loans. Those FDIC insured CDs are starting to look pretty good.

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