Modern Investing by David Schneider

Author:David Schneider
Language: eng
Format: azw3, epub
ISBN: 9781537747262
Publisher: The Writingale Publishing
Published: 2016-09-30T04:00:00+00:00

CHAPTER 9

PUTTING IT ALL TOGETHER

“That some minority on Wall Street is getting rich by exploiting a screwed-up financial system is no longer news.”

– Michael Lewis

Let me tell you a story about the early prop desks on Wall Street. Robert Rubin, Treasury Secretary under Bill Clinton and former COO of Citigroup, was part of a prop trading team at Goldman Sachs in the 70s. At that time, he worked, by today’s standards, a fairly elementary trading strategy called M&A Arbitrage or Risk Arbitrage.

Imagine Company A announces that it’s going to buy Company B in three months. In order to entice shareholders of B to sell their shares, company A usually offers a substantial premium to current share prices. The share price shoots up (sometimes dramatically). But there usually remains a price differential between market price and offering price, the price that the bidding company offers to shareholders of company B. This is called a spread and reflects the market’s view of how likely the deal will be completed successfully. The spread can be positive or negative, depending on how likely the market considers a positive outcome. The higher the risk of a failing deal, due to regulatory or antitrust issues, the higher the spread. The spread shrinks with each passing day until the predetermined date is reached and cash flows from company A to shareholders of company B. The deal is completed and the player who traded that spread made a nice profit. It’s a fantastic trading strategy if you pick the best deals and the best spreads. But it is not risk-free, as deals do get canceled, and in that case, the prices drop dramatically back to the level before the takeover bid.

This was the strategy Robert Rubin practiced and it taught him to think in probabilistic terms– a bit like a gambler calculating and assessing his odds. The interesting thing was that, at that time, Goldman Sachs wasn’t that active in sourcing their own M&A deals as a traditional merchant bank. It seems that they truly aimed at avoiding any potential conflicts of interest between their own trading activities and their fee business. Goldman Sachs was still a partnership back then and required all partners to hold their private fortune against all possible losses and lawsuits. Only later did they become a global M&A powerhouse, with a giant internal hedge fund attached and a public corporate structure designed for profit maximization. They went public in 1999 in the middle of an epic tech bubble, making their partners wealthy beyond the wildest dreams of any of Goldman’s founders.

Goldman Sachs is a good example of how Wall Street institutions changed and transformed themselves from the late 70s to today. In his revelations Why I Left Goldman Sachs published in October 2012, former Goldman Sachs senior trader Greg Smith describes vividly how the firm’s former culture of serving the clients first turned into a culture of dog-eat-dog and bonus fetishization. Smith concludes that this cultural change is irreversible unless it is stopped from the outside.

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