Thursday, May 19, 2011

Cohan, Money and Power

Goldman Sachs is not exactly the number one brand in the world. Admittedly, it’s hard to beat Apple these days in popularity contests. But Goldman doesn’t even come close: on the contrary, it’s a firm that people love to hate. William D. Cohan’s Money and Power: How Goldman Sachs Came to Rule the World (Doubleday, 2011) provides fodder for the Goldman haters, exposing among other things a long history of conflicts of interest.

Cohan’s long book is not, however, the stuff that tabloids (or Rolling Stone—think of Matt Taibbi’s piece, later expanded into
Griftopia) are made of. It’s carefully researched, with well-crafted portraits of Goldman’s leading players, definitely worth reading.

Since Cohan's book has been extensively reviewed, for this post I decided to extract some lessons for individual traders from Goldman’s successes and failures. And Goldman, lest we forget, had a lot of failures.

One lesson is to exploit the weaknesses (or laziness) of others. For instance, a Goldman trader recalled that his boss always called Friday “Goldman Sachs Day,” the rationale being that traders at other firms were goofing off on Friday. If the Goldman traders came in on Friday intent on actually doing something while others had their guard down and were less competitive, their focused energy could make a big difference.

A second lesson is to set high goals. For instance, John Whitehead said that “when a department head accepted a higher goal, he worked harder and smarter to achieve success.” Or there’s the story of the near-disastrous acquisition of J. Aron, the commodities firm. In 1982 its profits were half of what they were the year before; by 1983, there were no profits at all. Robert Rubin was given the job of turning Aron around. He in turn handed the day-to-day management over to Mark Winkelman. Winkelman presented Rubin with a business plan that called for Aron to make $10 million, “a meaningful rebound toward profitability after years of slippage.” Rubin was not impressed. He said: “Mark, ten million dollars is not why we bought J. Aron. Tell us what we need to do to make a profit of one hundred million dollars this year.” The much higher goal meant, among other things, a major restructuring, an expansion of trading vehicles, and a significant upward shift in J. Aron’s risk profile. (Previously, they ran an essentially risk-free business.)

A third lesson is to push your bet when there is an obvious moneymaking opportunity but cut back when the opportunity disappears. Of course, easier said than done. Goldman pushed hard with its currency trades in 1992 and 1993. At one point in 1993 there were 500-plus prop traders at Goldman in London, all with basically the same position and all making wads of money. But in December 1993 the dynamic began to change. For instance, a single trader had made a massive bet (over a billion pounds) that the British pound would rise against the yen. In February 1994 disaster struck; in fifteen trading days the pound lost ten percent of its value against the yen and by the time the trade was closed this lone trader had lost somewhere between $100 million and $200 million. The losses overall in the London office had spiraled out of control. One problem was that “the culture at the time—and this was throughout the trading culture—was that you don’t tell a trader what to do.” Goldman soon enough started to put sophisticated controls in place with the creation of a proprietary system that gave the firm an enormous advantage in the assessment and monitoring of risk.

Goldman’s risk management is renowned. And, of course, its complexity goes far beyond what an individual trader would ever need. But one partner explained it, at least in part, in layman’s terms: “You need to look at everything in terms of the size. You know Bob Rubin always talked about small but deep holes. You can’t afford to lose a lot of money even if the odds are very low. You just have to protect yourself.”

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