Did Goldman Sachs Overstep in Criminally Charging Its Ex-Programmer?

Michael Lewis’s latest piece for Vanity Fair is an 11,000 examination of how Goldman Sachs acted after finding that one of its ex-programmers, Sergey Aleynikov, allegedly stole computer code. There was a federal trial, and the 41-year-old father of three was sentenced to eight years in federal prison. Investigating Aleynikov’s case, Michael Lewis holds a second trial. The entire piece is worth reading, especially the interviews with Aleynikov in which he presents his views on life (quoted at the bottom in this post).

First, this was an interesting anecdote on why Russians are the best programmers on Wall Street:

He’d been surprised to find that in at least one way he fit in: more than half the programmers at Goldman were Russians. Russians had a reputation for being the best programmers on Wall Street, and Serge thought he knew why: they had been forced to learn programming without the luxury of endless computer time. “In Russia, time on the computer was measured in minutes,” he says. “When you write a program, you are given a tiny time slot to make it work. Consequently we learned to write the code in a way that minimized the amount of debugging. And so you had to think about it a lot before you committed it to paper. . . . The ready availability of computer time creates this mode of working where you just have an idea and type it and maybe erase it 10 times. Good Russian programmers, they tend to have had that one experience at some time in the past: the experience of limited access to computer time.”

A new rule created by the SEC in 2007 called Regulation NMS led to the proliferation of high frequency trading (HFTs):

For reasons not entirely obvious (yet another question for another day), the new rule stimulated a huge amount of stock-market trading. Much of the new volume was generated not by old-fashioned investors but by extremely fast computers controlled by high-frequency-trading firms, like Getco and Citadel and D. E. Shaw and Renaissance Capital, and the high-frequency-trading divisions of big Wall Street firms, especially Goldman Sachs. Essentially, the more places there were to trade stocks, the greater the opportunity there was for high-frequency traders to interpose themselves between buyers on one exchange and sellers on another. This was perverse. The initial promise of computer technology was to remove the intermediary from the financial market, or at least reduce the amount he could scalp from that market. The reality has turned out to be a boom in financial intermediation and an estimated take for Wall Street of somewhere between $10 and $20 billion a year, depending on whose estimates you wish to believe.

Goldman decided to hire Serge Aleynikov to beef up their algorithms to compete with the likes of big hedge funds like Citadel:

A lot of the moneymaking strategies were of the winner-take-all variety. When every player is trying to buy Pepsi after Coke’s stock has popped, the player whose computers can take in data and spit out the obvious response to it first gets all the money. In the various races being run, Goldman was seldom first. That is why they had sought out Serge Aleynikov: to improve the speed of their system.

The article explains how Goldman is a money-making machine, but the appearance of black swan events led many Wall Street firms to lose millions of dollars at the height of the financial crisis, Goldman included:

Day after volatile day in September 2008, Goldman’s supposedly brilliant traders were losing tens of millions of dollars. “All of the expectations didn’t work,” recalls Serge. “They thought they controlled the market, but it was an illusion. Everyone would come into work and were blown away by the fact that they couldn’t control anything at all. . . . Finance is a gambling game for people who enjoy gambling.”

This was probably the most damning paragraph in the piece about Goldman’s relationship with open source software:

But most of his time was spent simply patching the old code. To do this he and the other Goldman programmers resorted, every day, to open-source software, available free to anyone for any purpose. The tools and components they used were not specifically designed for financial markets, but they could be adapted to repair Goldman’s plumbing.

Serge quickly discovered, to his surprise, that Goldman had a one-way relationship with open source. They took huge amounts of free software off the Web, but they did not return it after he had modified it, even when his modifications were very slight and of general rather than financial use. “Once I took some open-source components, repackaged them to come up with a component that was not even used at Goldman Sachs,” he says. “It was basically a way to make two computers look like one, so if one went down the other could jump in and perform the task.” 

On the individualistic (selfish) nature of competition at Goldman, even when efforts were collaborative in nature:

It made no sense to him the way people were paid individually for achievements that were essentially collective. “It was quite competitive. Everyone’s trying to show how good their individual contribution to the team is. Because the team doesn’t get the bonus, the individual does.”

And then we get to the meat of the piece, where Michael Lewis invites people in the HFT industry to come up with their own verdict of whether Serge Aleynikov did something nefarious and/or illegal:

Our system of justice was a poor tool for digging out a rich truth. What was really needed, it seemed to me, was for Serge Aleynikov to be forced to explain what he had done, and why, to people able to understand the explanation and judge it. Goldman Sachs had never asked him to explain himself, and the F.B.I. had not sought help from someone who actually knew anything at all about computers or the high-frequency-trading business. And so over two nights, in a private room of a Wall Street restaurant, I convened a kind of second trial. To serve as both jury and prosecution, I invited half a dozen people intimately familiar with Goldman Sachs, high-frequency trading, and computer programming.

You have to read the piece for the conclusion. As one of the jurors assembled by Michael Lewis says: it was nauseating how Sergey was treated.

One last bit in the informal jury process that caught my attention was Serge’s demeanor and approach to life. Take things as they come; negativity is pointless:

At one point one of the people at the table stopped the conversation about computer code and asked, “Why aren’t you angry?” Serge just smiled back at him. “No, really,” said the other. “How do you stay so calm? I’d be fucking going crazy.” Serge smiled again. “But what does craziness give you?” he said. “What does negative demeanor give you as a person? It doesn’t give you anything. You know that something happened. Your life happened to go in that particular route. If you know that you’re innocent, know it. But at the same time, you know you are in trouble and this is how it’s going to be.” To which he added, “To some extent I’m glad this happened to me. I think it strengthened my understanding of what living is all about.”

What are your thoughts?

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There’s a very interesting addendum in Vanity Fair in which Michael Lewis is interviewed about his piece. Here, he shares his personal thoughts on Sergey’s time in prison:

Q: For the past 200, 250 years, prison has been an essential part of the Russian experience. Like Dostoyevsky and other Russian authors, and their heroes, Serge found some sense of purpose in his incarceration. Do you think an American could have come away from the experience with that same perspective?

[Michael Lewis]: In the 1950s, European filmmakers, when their films were going to be made for both a Russian and American audience, would change the ending. They would make a happy ending for the American audience and a tragic one for the Russian audience. There’s a photographer named Tacita Dean who has done a series of photographs called “Russian Endings” where she has played on this. I would say that in some ways, there’s something in the water in Russia that enables you to derive a kind of pleasure from a tragic experience. That is not in the water in America. A kind of richness from a tragic experience. And whatever chemical is in the water, Serge drank plenty of it. He is very persuasive on the subject that this was not an all-together bad experience for him. It woke him up to many aspects of life that he had previously been asleep to. I believe him. I don’t think it’s just superficial rationalizing.

When you’re with him, it’s shocking how without anger or bitterness he is. You would never guess, at the dinners I had, that he was one who spent time in jail. You would have picked every other person there.

Also worth highlighting is financial blogger Felix Salmon on his reaction to Lewis’s piece:

I’m increasingly coming to the conclusion that America’s system of jurisprudence simply isn’t up to the task of holding banks and bankers accountable for their actions. The only people who ever get prosecuted are small fry and insider traders, rather than the people who really caused the biggest damage. And the lesson of Sergei Aleynikov is that if and when the laws get beefed up, the banks will simply end up taking advantage of those laws for their own vindictive purposes, rather than becoming victims of them. Given the ease with which Goldman got the FBI to do its bidding, one has to assume that, most of the time, the government will be working on the same side as the big banks, rather than working against them. Do we really want to give those banks ever more powerful weapons?

Post-Scarcity Economics by Tom Streihorst

Tom Streihorst, a filmmaker and writer who publishes articles on finance and economics, pens an excellent essay titled “Post-Scarcity Economics” in The Los Angeles Review of Books:

We fly across oceans in airplanes, we eat tropical fruit in December, we have machines that sing us songs, clean our house, take pictures of Mars. Much the total accumulated knowledge of our species can fit on a hard drive that fits in our pocket. Even the poorest among us own electronic toys that millionaires and kings would have lusted for a decade ago. Our ancestors would be amazed. For most of our time on the planet, humans lived on the knife-edge of survival. A crop failure could mean starvation and even in good times, we worked from sun up to sundown to earn our daily bread. In 1600, a typical workman spent almost half his income on nourishment, and that food wasn’t crème brûlée with passion fruit or organically raised filet mignon, it was gruel and the occasional turnip. Send us back to ancient Greece with an AK-47, a home brewing kit, or a battery-powered vibrator, and startled peasants would worship at our feet.

And yet we are not happy, we expected more, we were promised better. Our economy is a shambles, millions are out of work, and few of us think things are going to get better soon. When I graduated high school, in 1975, I assumed that whatever I did, I would end up somewhere in the great American middle class, and that I would live better than my father, who lived better than his. Today, my son doesn’t have nearly the same confidence. Back in those days, you could go off to India for seven years, sit around in an ashram, smoke pot and seek spiritual fulfilment, and still come home and get a good job as a copywriter at Ogilvy and Mather. Today kids need a spectacular resume just to get an unpaid internship at IBM. Our children fear any moment not on a career path could ruin their prospects for a successful future. Back in the 1970s, pop stars sang songs about of the tedium and anomie of factory work. Today the sons of laid-off autoworkers would trade anything for that security and steady wage.

Most of us are working harder, for less money and with no job security. My father and I both worked at the same large corporation but there was a difference, a difference determined by our respective eras: he was staff, I was freelance. When he got sick, the company found him doctors, paid his salary, put considerable effort into his recovery. Had I ever gotten sick, they would have simply forgotten my name. He yelled at the CEO habitually without any fear of losing his job. I mouthed off once to a middle manager and was never hired again. He had a defined benefit pension paid for by the corporation, the government gave me a tax break should I choose to save for my own retirement. The company had legal and moral responsibilities to him, which both he and they viewed as sacrosanct. All they owed me was a day’s pay for a day’s work. His generation gave their you to a corporation, and the corporation took care of them in their old age. Today loyalty, if it exists at all, goes just one way. Many of my college buddies, are unemployed at 50, or earning less than they did ten years ago.

He discusses economics in the context of Paul Krugman, Keynes, and Alan Greenspan. Worth a read.

Joining Wall Street to Save the World

The Washington Post profiles a 25-year-old Jason Trigg, who’s decided to join a high frequency trading firm to make the most amount of money as he can. But why? So he can give a lot of it away. He figures it’s a better bet than going into academia:

He’s figured out just how to take measure of his contribution. His outlet of choice is the Against Malaria Foundation, considered one of the world’s most effective charities. It estimates that a $2,500 donation can save one life. A quantitative analyst at Trigg’s hedge fund can earn well more than $100,000 a year. By giving away half of a high finance salary, Trigg says, he can save many more lives than he could on an academic’s salary.

In many ways, his life still resembles that of a graduate student. He lives with three roommates. He walks to work. And he doesn’t feel in any way deprived. “I wouldn’t know how to spend a large amount of money,” he says.

While some of his peers have shunned Wall Street as the land of the morally bankrupt, Trigg’s moral code steered him there. And he’s not alone. To an emerging class of young professionals in America and Britain, making gobs of money is the surest way to save the world. When you ask Trigg where he got the idea, his answer is a common refrain among this crowd: “I feel like I’d read stuff by Peter Singer.”

Interesting, to say the least.

Warren Buffett: Women are Key To America’s Future Prosperity

Warren Buffett joined Twitter today. To coincide with that move, he also penned a piece in CNN/Fortune, in which he explains how women are key to America’s prosperity:

Start with the fact that our country’s progress since 1776 has been mind-blowing, like nothing the world has ever seen. Our secret sauce has been a political and economic system that unleashes human potential to an extraordinary degree. As a result Americans today enjoy an abundance of goods and services that no one could have dreamed of just a few centuries ago.

But that’s not the half of it — or, rather, it’s just about the half of it. America has forged this success while utilizing, in large part, only half of the country’s talent. For most of our history, women — whatever their abilities — have been relegated to the sidelines. Only in recent years have we begun to correct that problem.

Despite the inspiring “all men are created equal” assertion in the Declaration of Independence, male supremacy quickly became enshrined in the Constitution. In Article II, dealing with the presidency, the 39 delegates who signed the document — all men, naturally — repeatedly used male pronouns. In poker, they call that a “tell.”

Finally, 133 years later, in 1920, the U.S. softened its discrimination against women via the 19th Amendment, which gave them the right to vote. But that law scarcely budged attitudes and behaviors. In its wake, 33 men rose to the Supreme Court before Sandra Day O’Connor made the grade — 61 years after the amendment was ratified. For those of you who like numbers, the odds against that procession of males occurring by chance are more than 8 billion to one.

I couldn’t agree more. Go Warren go!

A Fortune for No One

The New York Times profiles the story of Roman Blum, a Holocaust survivor who died last year but left no will. He had a fortune of more than $40 million, the largest unclaimed estate in the history of New York state:

Much about Mr. Blum’s life was shrouded in mystery: He always claimed he was from Warsaw, although many who knew him said he actually came from Chelm, in southeast Poland. Several people close to Mr. Blum said that before World War II, in Poland, he had a wife and child who perished in the Holocaust, though Mr. Blum seems never to have talked of them, and the International Tracing Service in Bad Arolsen, Germany, has no record of them in its database. Even his birth date is in question. Records here give it as Sept. 16, 1914; identity cards from a German displaced persons camp have it as Sept. 15.

But perhaps the greatest mystery surrounding Mr. Blum is why a successful developer, who built hundreds of houses around Staten Island and left behind an estate valued at almost $40 million, would die without a will.

Read the rest.

Who Are the Bitcoin Millionaires?

Business Week profiles three people who are paper millionaires for having invested in Bitcoin:

Owners store their Bitcoins in electronic wallets, which are identified by a long string of letters and numbers. The wallet 1933phfhK3ZgFQNLGSDXvqCn32k2buXY8a, for example, currently owns 111,111 Bitcoins, which amounts to more than $15 million sitting on someone’s hard drive. Whose hard drive is a mystery: While anyone can view the wallets, the owners’ identities are not public. As of April 2, there were about 250 wallets with more than $1 million worth of Bitcoins. The number of Bitcoin millionaires, though, is uncertain—people can have more than one wallet.

Charlie Shrem, 23, discovered Bitcoins on a website in early 2011, when he was a senior at Brooklyn College. Shrem didn’t mine coins himself but bought them on Tradehill. His first purchase was 500 coins at about $3 or $4 each; he bought thousands more when the price hit $20. When he was still in college, Shrem started BitInstant, a company that allows its customers to purchase the digital currency from more than 700,000 stores, including Wal-Mart Stores and Duane Reade. Shrem wears a ring engraved with a code that gives him access to the electronic wallet on his computer. Friends tease him that a thief could cut off his finger to get the ring. “They started calling me four-finger Charlie,” he says.

My take: if they’re still invested in BitCoin, they might lose it all come next month. They better cash out quick. Oh wait, they can’t at the moment…

The Great Norwegian Diaper Arbitrage

Matthew O’Brien reports on an interesting scheme going on in Europe: people from certain European countries are driving to Norway and emptying store shelves of diapers. Why? Because they can resell these diapers in their home countries for double the price.

There are lots of ways supermarkets can get customers in the door, and away from the competition. But in parts of Norway, cut-rate diapers have become the preferred lure. It’s set off something of a price war, which would be great news for Norwegian parents if they could actually find diapers in stock. They can’t. As Reuters reports, prices are so enticingly low that foreigners, mostly Poles and Lithuanians, have started trekking to Norway for the sole purpose of buying up every last diaper they can find. 
Here’s how the arbitrage math adds up. The ferry costs approximately $275 round trip, and gas is about $8 a gallon in Sweden, which, if we assume our car gets around 30 miles per gallon, gives us $435 in expenses. Throw in food, lodging, and other miscellaneous costs, and the total should come in around $600 or so. Remember, diapers costs more than twice as much in Lithuania as they do in Norway, so we only need to buy that much to break even. In other words, if we buy just $600 worth, which we can resell in Lithuania for double, we can cover our basic costs — and we can make enough profit to make the whole trip worth our while if we buy another couple hundred dollars worth. Of course, $1,000 worth isn’t very much when it comes to diaper arbitrage; Norwegian customs officials have seen people pack their cars with as much as $9,000 worth — good for more than $8,000 of profit. Not too shabby.
I don’t see how these prices can remain at such low levels in Norway for the foreseeable future…
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Duke Students on a Portfolio That Pays

Over the past year, I’ve been reading up on all kinds of investments and trying to determine where I can find some yield. So I enjoyed this New York Times story on Duke students who’ve come up with a “portfolio that pays.” The winning portfolio:

They were bullish on United States stocks, especially those of large companies, based on their predictions of a continuing recovery in housing, rising consumer confidence, strong retail sales and the continuing impact of the Fed’s quantitative easing program. They were also optimistic that Congress would avoid the so-called fiscal cliff and other threatened political calamities. But they were pessimistic about Europe and emerging markets, given the euro zone crisis and what they saw as slowing growth in countries like China and Brazil.

The team’s contest entry called for allocating 43 percent to United States stocks — 30.3 percent to a Russell 2000 index fund and 12.7 percent to a Russell 2000 fund that invests in midsize companies. They made no allocation to international stocks. Like more traditional models, they maintained a large allocation to fixed income, but weighted it heavily toward Treasury inflation-protected securities, or TIPS, whose yields rise with inflation. They allocated 32.1 percent to TIPS and 24.9 percent to an aggregate bond fund.

The result was a 9.7 percent projected annual return, with less volatility than the model funds they examined.

Personally, I think it’s a mistake they’re neglecting the international sector (especially emerging markets). I am also not as bullish on TIPS as these students. I do like the allocation to a more diversified Russell 2000 index than the broader S&P 500 index. Anyway, food for thought.

Amazon as a Charitable Organization

Following the dismal 4th quarter earnings announcements by Amazon, detailed below, Amazon’s share price shot up by more than 10%.

  • Q4 revenue of $21.27 billion missed expectations of $22.23 billion
  • Q1 EPS of $0.21 missed expectations of $0.27;
  • The firm guided top-line lower, seeing Q1 sales of $15-$16 billion, below the estimate of $16.5 billion
  • The firm guided operating income much lower, seeing Q1 op income of ($285)-$65 Million on expectations of $261.4 MM
  • The firm said the its physical books sales had the lowest growth in 17 years
  • Total employees grew by 7,000 in the quarter and 32,200 Y/Y to a record 88,400
  • Worldwide net sales Y/Y growth was the slowest in years at 23%, down from 30% in Q3 and 34% a year ago
  • And, last and certainly least, LTM Net Income is now officially negative, or ($49) meaning as of this moment the firm with the idiotically high PE has an even more idiotic N/M PE.

The question is why? Matthew Yglesias has a great thought: Amazon is a charitable organization. To wit:

The company’s shares are down a bit today, but the company’s stock is taking a much less catastrophic plunge in already-meager profits than Apple, whose stock plunged simply because its Q4 profits increased at an unexpectedly slow rate. That’s because Amazon, as best I can tell, is a charitable organization being run by elements of the investment community for the benefit of consumers. The shareholders put up the equity, and instead of owning a claim on a steady stream of fat profits, they get a claim on a mighty engine of consumer surplus. Amazon sells things to people at prices that seem impossible because it actually is impossible to make money that way. And the competitive pressure of needing to square off against Amazon cuts profit margins at other companies, thus benefiting people who don’t even buy anything from Amazon.

It’s a truly remarkable American success story. But if you own a competing firm, you should be terrified. Competition is always scary, but competition against a juggernaut that seems to have permission from its shareholders to not turn any profits is really frightening.

Sometimes (often) the markets are a fool’s game.

Risk Management at JPMorgan: Relying on Excel Spreadsheets

I spent some time this morning reading the recently published “JPMorgan Chase & Co. Management Task Force Regarding 2012 CIO Losses,” a 129-page report on how and why the Chief Investment Office (CIO) lost more than $6 billion for the company in 2012. The media has been quick to point the finger at Bruno Iksil, the so-called “London Whale” responsible for executing the trades. As Felix Salmon notes, the executive summary on the first 17 pages of the report is well-written and provides the context behind this trading disaster for JPMorgan.

I went through the other portions of the document and wanted to highlight that the Risk Management, particularly in the CIO, wasn’t up to snuff. First, this was a huge red flag:

The Firm’s Chief Investment Officer did not receive (or ask for) regular reports on the positions in the Synthetic Credit Portfolio or on any other portfolio under her management, andinstead focused on VaR, Stress VaR, and mark-to-market losses. As a result, she does not appear to have had any direct visibility into the trading activity, and thus did not understand in real time
what the traders were doing or how the portfolio was changing. And for his part, given the magnitude of the positions and risks in the Synthetic Credit Portfolio, CIO’s CFO should havetaken steps to ensure that CIO management had reports providing information sufficient to fully understand the trading activity, and that he understood the magnitude of the positions and what
was driving the performance (including profits and losses) of the Synthetic Credit Portfolio.

But the big question: why did it take so long for JP Morgan to discover that these trades were losing money for the company? Turns out, it had to do with rudimentary platforms in place to measure/track risk on a daily basis. Alas, they were relying on Microsoft Excel!

During the review process, additional operational issues became apparent. For example, the model operated through a series of Excel spreadsheets, which had to be completed manually, by a process of copying and pasting data from one spreadsheet to another. In addition, many of the tranches were less liquid, and therefore, the same price was given for those tranches on multiple consecutive days, leading the model to convey a lack of volatility. While there was some effort to map less liquid instruments to more liquid ones (i.e., calculate price changes in the less liquid instruments derived from price changes in more liquid ones), this effort was not organized or consistent.

In addition to these risk-related controls, the Task Force has also concluded that the Firm and, in particular, the CIO Finance function, failed to ensure that the CIO VCG (Valuation Control Group) price-testing procedures – an important financial control – were operating effectively. As a result, in the first quarter of 2012, the CIO VCG price-testing procedures suffered from a number of operational deficiencies. For example, CIO VCG did not have documentation of price-testing thresholds. In addition, the price-testing process relied on the use of spreadsheets that were not vetted by CIO VCG (or Finance) management, and required time-consuming manual inputs to entries and formulas, which increased the potential for errors.

Yikes!

If you’re into risk management at all (like I am), the entire report is worth perusing.