Where the bonds are.

Photographer: Eric Thayer/Bloomberg

Goldman Bond Trader Made Customers Feel Guilty for Nothing

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Today the Securities and Exchange Commission barred Edwin Chin, a former mortgage-bond trader at Goldman Sachs, from the securities industry for lying about the prices that he paid for some mortgage bonds.  Chin, who settled the case, also agreed to pay the SEC $400,000. If you have followed the case of Jesse Litvak -- the former Jefferies mortgage-bond trader who was prosecuted for lying about the prices that he paid for some bonds -- then nothing in the SEC's order will come as much of a surprise to you. Still it is an edifying and entertaining read; for one thing, you can learn a lot of bond-trader jargon to drop at your next cocktail party or instant-messenger chat:

(In industry parlance, “going subject on us” means making a take-it or leave-it offer and “bid away” means an offer from another bidder.)

And:

(In industry parlance, “fok” is short for “fill or kill,” meaning a take-it-or-leave-it offer.)

And:

(In industry parlance, “brb” is short for “be right back.”)

I want to pause here to savor the amazing linguistic moment that we find ourselves in. Twenty years ago, no one went around using texting abbreviations, so no court documents ever had to explain them. Twenty years from now, they will be a fully integrated part of the language, and it won't occur to lawyers to explain what "brb" means any more than it would occur to them to explain what "means" means today. But now we are in a liminal period when everyone says "brb," and everyone knows what it means, but the SEC has to explain it anyway. And call it "industry parlance."

Anyway here's the sort of stuff that Chin allegedly did:

At approximately 3:42 p.m. on July 9, 2012, Chin agreed to purchase a $14 million RMBS with the ticker symbol AMSI 05R2 M4 (“AMSI”) from a Goldman customer at a price of 45. Over half an hour later (4:16 p.m.), Chin falsely described to the Customer A representative supposed negotiations with the seller that were ongoing:

"[S]howed him 45…got a 46-28 counter. i don’t think he has any real room…46-16 might get something done…might take 46-24."

At approximately 4:17 p.m., the Customer A representative told Chin to offer the seller 46. During the next 20 minutes, Chin made statements to the Customer A representative via instant message such as “i’m trying not to appear too eager,” and “he needs a few mins . . . to clear with his boss . . . brb.” At approximately 4:40 p.m., Chin falsely informed the Customer A representative that the seller agreed to 46. The Customer A representative offered to pay Goldman 20 ticks on the trade as compensation, bringing Customer A’s total purchase price to 46-20.

The short version of that is that he bought some bonds for 45, told the customer that he'd bought them for 46, and sold them to the customer at 46.625 (that is, 46 and 20 ticks, or 32nds of a point). You are not supposed to do that. Bond traders act as principals, not agents: Chin was selling the bonds from his own (well, Goldman's) account, and he was allowed to charge whatever he wanted. His markup was, in a sense, none of the customer's business; 20 ticks or 52 ticks would both be equally legal. But he's not supposed to lie about it. He could have said "I will sell you some bonds for 46-20, if you want 'em," and that would have been fine. But once he said that he'd bought them for 46, that was bad.

The rest of it -- the fake negotiations, the trying not to appear too eager -- was just decoration, a way to create the impression that Chin was working hard on the customer's behalf, so that the customer would feel good about paying him more. There were more elaborate variations, including a trade where Chin bought bonds at 67-28, told a customer that he could get them at 69-04, got the customer to agree to pay 69-06 for them, and then guilted the customer into paying 69-08. That transcript is frankly painful to read:

Chin: I don’t have 5 mins…I think he’s going to trade it away… he’s gotten that bid.

Customer B: will he pay u?

Chin: I don’t know.

Customer B: 69 was where I ran out of rm but don’t wanna miss trd for 4 tics… if I can get em at 69-04 I’ll buy em.

Chin: you can’t pay us 2 ticks?

Customer B: sure I can take em at 69-06.

Chin: …ok …he said he had a better than 69-04 bid in hand – so he’s not paying me …which is fine…he wanted us to kill it…the trade is done …

Customer B: so u make 2 tics from my end but nothing from him?

Chin: no, he said he was doing us a favor… he could have gotten it higher away . . . so nice buy for you

Customer B: I don’t wanna operate that way…I can pay u 4 tics, wish it could be more but I really dont have room…I’ll take em at 69-08…is that cool?

Chin: I appreciate it…thx…69-08 is great

The customer was so nice and generous, so committed to making sure that Chin was paid fairly for his market-making services. And Chin just mercilessly took advantage.

Again, the issues here are not really any different from the Jesse Litvak case. But they are hard issues, harder than they seem at first glance. Sure, it seems wrong to lie to your customers. But a certain amount of fudging of the truth is traditional in many markets. The key question is whether these sorts of lies -- creating elaborate stories about how much you paid for the bonds that you're selling -- are material misrepresentations, or whether they're just regular haggling, the sort of meaningless background noise that any reasonable customer would discount. There are plenty of markets in the world, not necessarily financial markets, where "you are killing me, how can I afford to feed my family if I sell to you at this price" is just an opening gambit in negotiations, not a statement that anyone takes literally.

The SEC maintains that the market for residential mortgage-backed securities isn't like that, and that "there is an emphasis on establishing relationships, building trust, and having a good reputation within the industry."  But how do you keep the market honest? One answer is that the customers could enforce honesty themselves, by putting dishonest brokers in the "penalty box" and not trading with them, or by complaining to their bosses. That is hard in an opaque market, though; the customers may never notice. 

So the SEC and federal prosecutors get involved. But there's a big difference between the SEC and the prosecutors. Jesse Litvak and Edwin Chin did pretty similar things, making up negotiations with fictional counterparties to inflate the markups they could charge on mortgage bonds. Litvak was prosecuted criminally and sentenced to two years in prison, though that was reversed on appeal. Chin settled a civil case for $400,000 and an industry ban. Probably someone else out there did much the same thing and is still trading. Peter Henning said about insider trading: "What makes one case more susceptible to a prosecution than another remains something of a mystery." I mentioned this morning that that's not limited to insider trading. Turns out that it applies to fictitious-bond-markup cases, too.

Why are all these cases coming up now? There is an obvious answer: After the financial crisis, people are angry about dishonesty on Wall Street, much angrier than they are about dishonesty in other haggling-based industries. And regulators and prosecutors have spent a lot of time looking into residential mortgage-backed securities markets.

But I wonder if the shift in bond-market liquidity has also created more opportunities for this sort of behavior, while also making it more controversial. To oversimplify the story, bond traders at banks used to buy bonds for their own accounts, taking risks to provide liquidity for customers. Now, they are much more likely to just line up trades between customers in exchange for a small markup. "If the trader doesn’t have the other side of the deal lined up, the bank isn’t going to stick its neck out."

That shift makes bond trading less risky for banks, but it also makes it less fun, and less profitable. If you are trading for your own account, every so often you will buy a bond at 45, sell it a few hours later for 50, and run around high-fiving everyone. If you are just lining up buyers and sellers, they are just paying you for your service, and the going rate for that is a few ticks.

And if that's the normal procedure -- if investors expect that you're just an agent helping buyers find sellers and vice versa -- then they will care more about their markups. In a market where banks normally trade as principals, their markups should in some sense be irrelevant to their customers : The bank took a risk to buy the bonds, and now, like any other owner of an asset, it's trying to sell them for the highest price it can get. In a market where banks normally trade as, essentially, agents, the markup is the central fact of the trade, and customers will be very focused on it.

Which makes it hard to make a lot of money on the trades where you are a principal, and do take balance-sheet risk: The customer will want to know what you paid, and give you a couple of ticks on top of that for your trouble, because that's the kind of transaction that the customer has come to expect. And so you might oblige him by inventing that sort of agency transaction, and embellishing it with details of your negotiations with the fictitious investor on the other side. And you might oblige yourself by making up a high price.

  1. Let's put the usual disclosures/disclaimers here:

    1. I used to work at Goldman Sachs.
    2. Nothing here is ever legal advice. 
  2. There are some rules and quasi-rules against excessive markups in some markets, but 1.625 points on an illiquid mortgage-backed security does not seem anywhere close to an illegal excessive markup.

  3. From the order:

    The market for secondary trading in RMBS operates through relationships between customers, who buy and sell the bonds, and broker-dealers, like Goldman, that identify interested buyers and sellers and arrange the trades. Customers seek to pay the lowest price for purchases and get the highest price on sales. It is not unusual for a customer’s information about the current market price for a security to come from the firm that is arranging the sale of the security. Because of this, there is an emphasis on establishing relationships, building trust, and having a good reputation within the industry. In part because of the opacity of the market, and because investment advisers owe fiduciary duties to their underlying clients, customers seek to avoid broker-dealers who are not honest with them.

  4. Not literally. As I said about the Litvak case:

    The reasonable investor, even in mortgage-backed securities, doesn't decide what price she'll pay based purely on introspection. There is a market out there, with prices, and those prices might offer a clue about value. And so lies about those prices might deceive investors about value.

    Or just more practically, whatever you believe a bond is worth, and however sure you are of your beliefs, you still might have to sell it. So knowing where the market is will always be of interest to any reasonable investor.

    But the dealer's cost basis is still less relevant, because the dealer is just an owner of bonds like anyone else.

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

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net