There is a common business phrase called “Eating your own dog food” which basically says that you are using the same systems, products or processes as your customers. In this sense you are in the same situation as your customer, taking the same risks, and suffering the same negative outcomes (should they occur). This behavior generally aligns the interests of the company with that of its customers.
Recently collateralized debt obligations have been in the news. These products were created by Wall Street firms and then pitched to their customers as low-risk ways to get a higher return than traditional “vanilla” bonds, CD’s and T bills. A number of asset based mortgages, for example, were grouped into a single security and sold in “tranches”, with each tranche having different risk characteristics and corresponding returns.
Unless you don’t have access to media of any type you’ve probably heard about the great credit crunch that is occurring right now. Many CDO’s are stuck in the pipeline of the various companies or off-balance sheet entities that were selling them because demand dried up overnight; those that are already sold are being re-rated by the debt rating agencies at much lower credit levels (one recently fell all the way from “AAA” to “junk” in a single swoop) causing many customers and many Wall Street firms to swallow big losses.
The third quarter financial results have been released and everyone was holding their breath to see how big the write-downs would be. Merrill Lynch initially said they’d have about a $5B loss but then it was raised up to $8B a few weeks later when results were finalized. Why did Merrill have such big losses? Because not only did Merrill package these (terrible) products on to customers (who are now feeling the losses), they ALSO held some of these products in their own inventory (eating their own dog food, so to speak) and now suffering losses alongside their customers.
Not so Goldman Sachs… while the other Wall Street firms trotted out their losses, Goldman Sachs MADE money for themselves while pushing these products onto their clients. Goldman apparently shorted the mortgage instruments, betting on sub-prime losses and that these instruments would decline in credit quality, which happened (big time). To give Goldman a bit of credit, they weren’t nearly as big a player in this market as Merrill.
Back when I first started investing semi-seriously in stocks I was talking to a friend about the 2002 meltdown and he laughed at my naivety… I implied that these firms lost money along with their customers in the NASDAQ crash. He said that these firms make money no matter what happens to the markets – long on the way up, short on the way down.
Cross posted at LITGM