Monday, March 15, 2010

Area's Sole Water Seller Refuses to Pay for Water at Full Price

Before I link to the article that spurred the above title, I thought it would be beneficial to flesh out exactly what the title refers to. Imagine some type of catastrophe happens, like an earthquake for instance, and it turns out that there is essentially only 1 person in the area who also happens to have an abundance of water for sale. It should be self-evident that the water is probably going to cost more than it would under normal circumstances (demand for water is up and the 1 person only has his limited supply, so the price has to go up to bring supply and demand into equilibrium). In addition, it should be self-evident that if someone else in the area were to have water and offered to sell it to our individual, he should probably turn it down seeing as he has plenty of his own. And finally on top of that, it should be self-evident that if our individual were to actually decide to buy water from someone else, it better be at a significant discount, otherwise why would he of all people buy it?

Now that we worked out some basic assumptions in a metaphorical example, let's get to the article that made all of that randomness come to my mind. Bloomberg is reporting that Goldman Sachs is demanding more collateral from counter-parties than it is willing to put up itself. For example, in derivatives contracts with hedge funds, Goldman Sachs is expecting those funds to put up more cash as collateral than Goldman itself would put up if it entered a similar contract in a similar position as the hedge fund. This has allowed Goldman Sachs to benefit significantly from the arrangement. What is not mentioned in the article, however, is how the hedge funds benefit as well since they are voluntarily choosing to enter this agreement even though the terms to outsiders might appear unequal. Nobody is making the hedge funds work with Goldman Sachs, but they are choosing to do so anyway.

The reason for this seemingly sinister situation is summed up by Richard Lindsey, a former director at the SEC. "If you're seen as a major player and you have a product that people can't get elsewhere, you have the negotiating power." Exactly like the water seller. Goldman is benefiting from its clout, and the hedge funds are benefiting from doing business with a reputable business that is offering terms better than could be found elsewhere in the marketplace. It is entirely possible that without Goldman, those hedge funds would experience even worse terms or might be forced to not engage in derivatives transactions at all.

There is nothing inherently wrong with being in a position of power in the marketplace as long as that position of power is not artificially supported by an extra-market institution (like the government, for instance). And while I would be more than willing to entertain the idea that Goldman Sachs is in fact supported artificially by the government, that topic is beyond the scope of this post. The reason for the remark about artificial support is that as long as the position is not being maintained through any forceful means (like using tax money to support a business which might otherwise not be supported at all), the position of power can only be achieved if it is legitimate and warranted (people voluntarily do business with the company because they want to, not because they are being forced to). Without force, companies cannot grow big and powerful unless they offer better products to buyers. The same way that an individual should look favorably upon the water seller for providing a much-needed commodity in the marketplace during a difficult time (even at a higher price, because nobody else is even willing or has the ability to offer it!), the hedge funds should be thanking Goldman Sachs (and Goldman Sachs should be thanking its customers) for providing a good that they need when few other businesses offer it on the same terms.