Finance

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

Debt-trading revenues tend to be volatile. That's normal. But something was abnormal about how disappointing Goldman Sachs's fixed-income trading results were in the first three months of 2017.

Goldman is typically a powerhouse in this lucrative business, and yet the New York bank was the only one of its peers to miss analysts' debt-trading estimates for the quarter. The firm's explanation that credit trading in particular was weak made little sense because volumes set records, and other banks cited that area as notably strong.

Share Dive
Goldman Sachs shares fell after it reported disappointing first-quarter results
Source: Bloomberg

Bloomberg News reporters uncovered the real reason in an article on Monday: Goldman traders bet big on specific distressed credits, including Peabody Energy Corp., Energy Future Holdings Corp. and Claire's Stores Inc., and those wagers went belly up.

Soured Stores
Goldman's traders reportedly got burned on some retailers' debt, including Claire's
Source: Finra's Trace, Bloomberg
The prices shown are for an actively traded Claire's bond, not necessarily one that Goldman is known to have traded.

There's a broadly held belief that Goldman's traders are given more leeway to make bold bets than their peers at other big banks, and this revelation only cements that impression. Just remember how Goldman's Tom Malafronte earned profits of more than $200 million trading junk bonds last year. How did he do that unless he was taking substantial risk?

And this brings us to the hot debate of the moment, about just how far banking regulations adopted after the 2008 financial crisis ought to be rolled back. There's a growing chorus of analysts and politicians calling for a repeal of the so-called Volcker Rule in particular, with an International Monetary Fund official recently saying that the provision,which prohibits banks from proprietary trading, drained liquidity from the U.S. banking system and was overly difficult to enforce.

Goldman's first-quarter performance illustrates why banks and their investors should seek to keep some of these trading restrictions in place. Bank of America Corp., JPMorgan Chase & Co. and Morgan Stanley did well in debt trading in the first quarter. They beat estimates. They demonstrated their ability to profit from normal volumes.

Debt Disappointment
Goldman Sachs stands out for posting the smallest year-over-year Q1 increase
Source: Company filings

Goldman, however, showed the potential downside of bold wagers. The bank reported a mere 1 percent gain in year-over-year debt-trading revenues, compared with a 17 percent gain in the business at JPMorgan and a 29 percent increase at Bank of America.

Goldman does have a somewhat different mix of business than other big banks. It caters to a greater proportion of hedge funds, and it's understandable that it would want to create value for those clients by enabling larger, riskier wagers. But investors have more information than ever, especially as they seek more accurate and timely sources of pricing information. This puts big-bank traders at more of a disadvantage than before the crisis.

Meanwhile, plenty of questions remain about just how constrained banks truly are when it comes to trading with their own money. Proprietary trading can be difficult to distinguish from market-making. Banks typically need to use some of their own money to help move bigger chunks of less-traded bonds from one investor to another without significantly disrupting market prices.

By almost all accounts, it has become more difficult to trade larger amounts of speculative-grade debt without moving markets, and it's plausible that banking regulations are the culprit. But the solution isn't necessarily to allow banks to go back to taking large, speculative positions. Not only can that pose systemic risks to the financial system, but as Goldman just demonstrated, this practice can be an unreliable business model. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net