Thursday, December 6, 2007

Goldman Sachs and the art of making money in a bust!

It does not require rocket science to make money in a boom. But making money in a bust... well, you will need to turn to Goldman Sachs to learn this skill! In the aftermath of the sub-prime mortgage bubble, even as its competitors have collectively taken mortgage related write-downs of more than $50 bn in the past few months, Goldman has reported profits of $2.89 bn for the third quarter of 2007, up 79%. So what makes the Goldman machine march on so relentlessly?

Even as one after the other, the high and mighty of Wall Street have fallen to the sub-prime mortgage crisis, Goldman has not only survived but also profitted. Unlike the others who plunged headlong into the sub-prime abyss and badly burnt their fingers, Goldman's foray into the mortgage backed securities market was adequately hedged. There is an excellent description of the Goldman modus operandi in the NYT, Goldman Sachs Rakes In Profit in Credit Crisis. It describes Goldman's fundamental position on the mortgage market thus, "the bank should reduce its stockpile of mortgages and mortgage-related securities and buy expensive insurance as protection against further losses".

It goes on, "With its mix of swagger and contrary thinking, it was just the kind of bet that has long defined Goldman’s hard-nosed, go-it-alone style. Most of the firm’s competitors, meanwhile, with the exception of the more specialized Lehman Brothers, appeared to barrel headlong into the mortgage markets. They kept packaging and trading complex securities for high fees without protecting themselves against the positions they were buying. Even Goldman, which saw the problems coming, continued to package risky mortgages to sell to investors. Some of those investors took losses on those securities, while Goldman’s hedges were profitable. When the credit markets seized up in late July, Goldman was in the enviable position of having offloaded the toxic products that Merrill Lynch, Citigroup, UBS, Bear Stearns and Morgan Stanley, among others, had kept buying."

Ben Stein's latest article in the NYT, The long and short of it at Goldman Sachs, brings out the role of Goldman in pumping up the sub-prime bubble and then making money during its collapse. He writes about an article by a Goldman economist Jan Hatzius, who feels that the sub-prime mess could get worse and worse, eventually squeezing bank lending and economic growth. Ben Stein feels that this "selling fear" article is part of the larger Goldman strategy of shorting mortgage loan backed securities, while at the same time selling it. He asks, "If a top economist at Goldman Sachs was saying housing was in trouble, why did Goldman continue to underwrite junk mortgage issues into the market?"

Comparing the firm to KGB, he writes, "(Even) as Goldman was peddling Collateralised Mortgage Obligations (CMOs), it was also shorting the junk on a titanic scale through index sales — showing, at least to me, how horrible a product it believed it was selling... Goldman Sachs was injecting dangerous financial products into the world’s commercial bloodstream for years. It was one of the top 10 sellers of CMO’s for the last two and a half years... It might have sold very roughly $100 billion of the stuff in that period, according to ABAlert."

Stein claims that what Goldman is doing is no different from what Henry Blodget, Mary Meeker and Co did during the dotcom bubble in pumping up tech shares, while personally shorting them and advising friends to do the same. Stein sets the cat amongst the pigeons by questioning Hank Paulson's role in this, given a large part of Goldman's strategy was put in place during his tenure at the top of Goldman.

To conclude, let me offer a parable. Imagine there is this Financial Institution (FI), whose trading arm aggressively sells a financial security to investors, while its investment banking or hedge fund arm internally shorts the same security. After taking substantial short positions on such securities, the FI stands to benefit enormously from further declines in the security. Therefore, it would seem natural and in its interest for the FI to precipitate a decline. Now replace this FI with Goldman Sachs or any other Wall Street luminaries and we have a classic moral hazard problem on our hands. That this is a major source of income for many investment banks and hedge funds only underlines the gravity of the problem.

This begs a lot of questions. Is there not a need for stricter oversight to ensure that an investment bank is not shorting the very shares it is underwriting because it feels that the stock is junk? Should there not be any consistency between the actions of the investment advisory and trading arms and the investment banking arms of any FI? Plain and simple, is this not tantamount to cheating?

Update 1
See this Times story of how Goldman betted against mortgage securities even as it was packaging and peddling instruments based on them (like the CDOs) to its clients.

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