Wall Street Profits Highlight Case for Derivatives Reform

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Tuesday, April 20, 2010 at 9:43 am

Last week, J.P. Morgan announced that it made a first-quarter profit of $3.3 billion on revenue of $28.2 billion, meaning for every dollar of business the bank did, it kept 12 cents as profit. This morning, Goldman Sachs — the Wall Street giant charged by the Securities and Exchange Commission with defrauding customers with mortgage-backed financial products last week — released its first-quarter earnings statement as well. It made $3.46 billion in profit from $12.78 billion of revenue — meaning for every dollar of business it did, it kept 27 cents.

This is not quite a picture of a healthy industry. In a competitive marketplace, prices and fees at Wall Street firms should fall and margins should become thinner. On the one hand, Wall Street firms like J.P. Morgan and Goldman Sachs have seen a number of their competitors die in the past two years, and have absorbed business from the failed Lehmans and Bear Sterns of the world. But on the other hand, Wall Street profit margins have remained sky high except for a short blip during the worst of the credit crunch. And, an economist would tell you, such sustained levels of high profitability point to anti-competitive behavior.

Consider another high-profit company in a competitive industry — say, Exxon Mobil. Last year, it made about $19 billion in profit on $300 billion in turnover, giving it a margin of six percent. WalMart? It is in the low-margin grocery and retail business, and managed a profit margin of around 3.5 percent. In the first quarter, Goldman’s margin was just two percentage points below Google’s — and consider how dominant Google is in its industry.

In short, the profits point to a lack of competition. That is one thing the Dodd bill — via derivatives regulation — attempts to fix. Right now, Wall Street firms do not bid for big derivatives contracts — they simply quote a price and work over-the-counter. For that reason, derivatives are wildly profitable for the companies. The Dodd bill will force derivatives pricing to become public to the market, driving down margins as companies compete.

Recently, J.P. Morgan’s chairman, Jamie Dimon, put a number on how much that might cost his firm — $700 million to a “couple” billion dollars — less than a quarter or a tenth of his company’s annual profits.

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andrew graham
Comment posted April 21, 2010 @ 3:41 pm

The Dodd bill will force derivatives pricing to become public to the market, driving down margins as companies compete.

The opaque nature of derivatives is precisely what makes them an alluring financial product when used properly. Consider corporate treasuries, which commonly use over-the-counter derivatives to hedge business risks that are beyond their control. These transactions aren't speculative. They're more like an economic utility for many corporations that aren't in the business of investment banking.

Putting all derivatives on an exchange or something like an exchange, which is the only way I know of to force their pricing to become public to the market, takes this option away from the many market participants that use the instruments in productive ways. While I appreciate the good intentions, is it really good policy?


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