The repeated appeals to the market-maker excuse for Goldman’s CDO sales merits a rant. (Note: inspired by zerobeta tweets).
The secondary market for CDOs has always been very thin. Basically the bank that issued the CDO stood ready theoretically to buy the CDO back, but, well, it almost never happened.
So when people claim that banks were making markets in CDOs, I think the question is: “Well, then, where was your CDO trading inventory?” CDO trading inventory — as I am using the term — can only include CDOs that were placed by the issuing investment bank with an investor and were subsequently repurchased by the same or another investment bank. Such trading inventory is entirely distinct from the CDO inventory that was created by issuing new CDO securities and failing to sell them. (Citigroup, Merrill Lynch and UBS were chock of new issue CDO inventory).
Now, maybe somebody will correct me, but it’s my understanding that there really wasn’t any secondary market to speak of in CDOs and that the investment banks held minuscule quantities, if any, of second-hand CDOs in their trading inventories. If this understanding of the market is correct, I would like to know how anybody can claim that investment banks “made markets” in CDOs. They may have originated CDOs, issued CDOs and placed CDOs, but unless they carried trading inventories in second-hand CDOs, the investment banks can not claim to have made markets in CDOs in any meaningful sense of the word.
Using models to give theoretic prices to clients who need to mark their CDOs to market is not market making — for the simple reason that these prices are not tested by the market unless transactions are actually taking place at these prices. Unless we have the evidence of a transaction to demonstrate that the market maker was willing to take the CDO onto it’s books at the price in question, the price quoted has very, very limited meaning in a market economy.
In short, one of the biggest failures of the investment banks in the CDO market was precisely the failure to make markets in CDOs. The creation of an illiquid, untradeable product that the issuers themselves did not want to hold in trading inventory on their books was a disaster. And for these same investment banks to turn around now and claim market making as a shield in their defense is almost beyond belief.