Insider's Game

In his latest Bloomberg column on Goldman Sachs, William Cohan makes an important point:

 

“Goldman hasn’t made its internal analysis public, nor does it intend to, but it has showed the documents around town (including to me).”

 

In other words, the answer shall remain secret. Only those deemed worthy by Goldman may see its data, which purportedly refutes the Levin report. The rest of us are kept in the dark. We cannot challenge Goldman’s claims, because we cannot see what they see. They know what they are talking about; we do not. Instead, we must rely on Andrew Ross Sorkin, Holman Jenkins, Dick Bove, and others to reveal the truth.

 

Except you don’t need to read these secret documents to figure out what’s going on. You need simply read the publicly disclosed documents to see how Goldman’s defense is built on sand. Consider Goldman’s accusation, dutifully reported by The Wall Street Journal, that Levin’s subcommittee used “sloppy math and incomplete analysis” too determine Goldman’s net short positions. That’s not really true. Senate staffers used no math and performed no analysis. They simply copied Goldman’s numbers.

 

Copying Goldman’s Numbers

 

The Senate subcommittee referenced Goldman’s own “top sheets,” which were daily reports prepared for the benefit of Goldman’s head of the mortgage unit, Dan Sparks, who wanted a single-page summary of the firm’s most critical mortgage risk concentrations. As the Levin report makes clear, these top sheets represented a comprehensive measure of “the Mortgage Department’s net positions in various asset classes.” Contrary to the false insinuations made in the media, the subcommittee carefully avoided any suggestion that these top sheets captured all of Goldman’s positions in all types of mortgages. Nor did the subcommittee state that the top sheets used the exact same categories of mortgage exposure over time.

 

During the investigation, Goldman made a critical point, which the subcommittee acknowledged in its report. Not all mortgages are created equal. A long position in prime mortgages does not offset a short position in subprime. A triple-A tranche does not offset a triple-B tranche. Therefore, no single dollar amount, long or short, adequately captures all that’s going on in a mortgage portfolio. Goldman trader Josh Birnbaum suggested that the number should be “beta adjusted.” While noting Goldman’s important caveat, the subcommittee also noted that the top sheet totals were regularly referenced in contemporaneous correspondence, and that, at the time, Goldman had no other comparable calculation for companywide exposures. So the subcommittee determined that the internally generated top sheet totals represented the best available proxy for how Dan Sparks was evaluating his firm’s overall long or short positions. Investigators conspicuously declined to apply any math or analysis to put everything on an apples-to-apples basis, which might have invited criticism about manipulating the evidence. Unlike Goldman, the subcommittee was upfront about what it did. It never held anything back.

 

Anyone reviewing the top sheets published by the subcommittee in April 2010 can see that, over time, Sparks wanted additional categories added to his one-page summaries. Some commercial real estate securitizations were added in June 2007, and by September 2007 prime mortgages were added as well. That made sense, because investor distaste for residential securitizations began to spill over into commercial deals. Sparks was very aware that CMBS CDOs are stuffed with subprime bonds and vice versa. In addition, home prices decline throughout 2007 meant that problems in the subprime sector could migrate into prime markets.

 

So the Journal writes, ” For June 25, 2007, Goldman officials believe Senate investigators didn’t take into consideration more than $5 billion of prime, or high-quality, mortgage-backed bonds held by the firm at the time, another document shows.” Andrew Ross Sorkin references the same document, and goes further to impugn the subcommittee:

 

“But in studying the document, the subcommittee may have mixed apples and oranges. It added in $4.1 billion worth of short positions for commercial real estate to residential real estate. And the subcommittee ignored the footnote on the bottom of the document that the ‘top sheet’ had not included long positions in other parts of the business that people close to the firm said were in excess of $5 billion.”

 

As it happened, some staffer made one of those dumb typographical mistakes with regard to this particular top sheet. He accidentally doubled the top sheet total, which showed a net short of just over $6.9 billion, and presented it as $13.9 billion. Embarrassing, especially since the mistake had been hiding in plain sight since April 27, 2010.

 

Net Totals Are For Dummies

 

Birnbaum was right. No singular net number adequately captures all that what is going on. The suggestion that the inclusion or exclusion of prime loans somehow debunks the Levin report or vindicates Goldman is, to put it charitably, a red herring. Suppose gas trader Brian Hunter said: “I have been unfairly maligned by the Levin report, which accuses me of destroying my employer, Amaranth Advisors. The report says I took enormously risky bets on the price of gas, I can point to evidence showing that the opposite was true. Whenever I bought gas futures for January 2007, I simultaneously sold futures for November 2006. In other words, I was fully hedged!”

 

No gas trader would be stupid enough to believe that, and no mortgage trader would be stupid enough to believe, as Goldman now suggests, that a long position in prime mortgages represented any kind of hedge against a short position in subprime mortgages. As noted here earlier, the difference between prime mortgages and subprime mortgages is like night and day.

 

It’s All About The Triple-Bs, Stupid

But there’s a far more salient point, which Birnbaum noted and which Goldman’s defenders now choose to overlook. Even within the same subprime mortgage securitization, a long position on the triple-A tranche can never effectively hedge a short position on the triple-B tranche. A lot of these “correlation trades” are oxymoronic. The triple-B tranches are heavily reliant on excess spread, which can be wiped out in a heartbeat. (Excess spread is the cash left over after: (a) the interest coupon for all the tranches is fully paid, and (b) all the principal for the 94% of all debt senior to the triple-Bs is fully paid.) Subprime deals were set up so that the size of the initial equity cushion below the triple-Bs was always smaller than the expected losses on the collateral. If the mortgage pools prepaid faster than expected, or if delinquencies spiked faster than expected, the excess spread got wiped out, so that the triple-Bs got wiped out. Conversely, the triple-As, with at least six times the equity cushion of the triple-Bs, had almost no prepayment risk; early prepayments meant these investors got their cash back sooner rather than later.

 

All this media noise distracts away from the important evidence about Goldman’s role in cornering the market for mortgage synthetics. Remember, The Big Short–which paid off handsomely for Goldman, John Paulson, Greg Lippmann, Magnetar, Blue Mountain Capital, Steve Eisman, and others–was concentrated almost exclusively in those deeply subordinated–but still investment-grade–tranches of subprime mortgage bonds, the triple-Bs (BBB+, BBB or BBB-). The way the math worked, to be discussed elsewhere, the payout became a sure thing as soon as the real estate bubble ended. It didn’t matter if the housing bubble were followed by a crash or the gentlest of soft landings; the triple-B defaults were a virtual certainty. (Yes, it was an open secret that the credit ratings were bogus.)

 

During 2005 and 2006, there were about $900 billion in subprime mortgage securitizations, of which a tiny 3% sliver, maybe $30 billion, were tranches rated, either BBB+, BBB or BBB-. And about 90% of those triple-B tranches were unavailable to be traded; they were taken off the market and stuffed into CDOs. And that would have been the end of it. The economic damage from those toxic triple-B subprime investments, either as bonds or repackaged into CDOs, could never have been more than $30 billion, give or take a couple of billion, had it not been the schemes devised and spearheaded by Goldman.

 

As Goldman is quick to remind everyone, the firm was only a single player in the market. Though it frequently acted as a market maker, it wasn’t the entire market. But consider the activity of this single player in the market for triple-Bs. Look at Goldman’s top sheet for September 25, 2007, (Footnote exhibits page 3778), which drills down a bit further to show both the long and short positions within different categories. In the category that lumps together subprime and 2nd lien mortgages, Goldman had insured $31.7 worth triple-Bs, and held swaps insuring $34.5 worth of triple-Bs, or trades totaling $66.2 billion. More than three-quarters of all credit default swaps in the subprime/2nd lien category were concentrated in the triple-Bs.

 

Or consider the schedule titled, “RMBS CDS Trade History 19-Han06 – 19Mar07,” prepared for Birnbaum (Footnote Exhibits – Page 4147). Again, more than three-quarters of the trading volume, $34.5 billion out of $43.3 billion, was concentrated in that tiny sliver of the RMBS capital structure, the triple-B and triple-B-minus tranches. The triple-Bs were where the action was.

 

Or consider the dollar amounts compiled by ProPublica with regard to the mezzanine CDOs (i.e. triple-B portfolios) issued from May 2006, when it became obvious that real estate bubble had stopped expanding, through July 2007, when Moody’s announced the first wave of downgrades and shut the subprime market down. That’s $114 billion worth of toxic CDOs, which never would have been issued but for the schemes spearheaded by Goldman Sachs.

 

Goldman Invented and Cornered the Market in Housing Shorts

Contrary to the myth prevailing in some circles, the “market” for synthetic mortgage products was not something that predated the real estate bubble. Nor was it ever something that grew organically out the normal dynamics of supply and demand. Goldman invented this market and it cornered this market in order to short triple-B bonds on a massive scale.

 

As we learned from Michael Lewis’s book, hedge fund manager Dr. Michael Burry was the pioneer who bought naked shorts on triple-B subprime bonds in early 2005. At that point, banks were unable to replicate that strategy on a larger scale, because mortgage securities are not like corporate bonds.

 

If a corporation becomes insolvent, it is forced to declare bankruptcy, at which point all bonds immediately become due and payable, meaning they are in default. But mortgage securitizations do not file for bankruptcy. When it becomes obvious that the mortgage pool will run out of cash before all the investors are repaid, nothing happens. Or at least, nothing happens for a long time. All of these private label deals were set up so that no principal becomes due and payable for at least 30 years. The way their cash waterfalls work, it can take years and years, long past the point when everyone knows that the subordinate tranches will lose every dime of principal, before a subordinate tranche formally defaults on an amount that is due and payable.

 

Generally, if you buy a naked short on a bond, you don’t want to wait years and years to collect on your payout. So Goldman invented a new type of “credit default” swap, one that provided a payout before the mortgage bond actually defaulted. It came to be known as the “pay as you go” or PAUG credit default swap, and the standardized ISDA template was first published on June 21, 2005.

 

Goldman didn’t invent the PAUG all by itself. Thanks to the pioneering reporting of the late great Mark Pittman, we know that in February 2005 Rajiv Kamilla of Goldman Sachs sat down over Chinese food with Greg Lippmann of Deutsche Bank and Todd Kushman of Bear Stearns, along with bankers from Citigroup and JPMorgan, to hammer out the form and structure of the PAUG CDS. Without the PAUG, Goldman’s massive trading operation in mortgage synthetics–credit default swaps on individual bonds, plus CDOs comprised of PAUG swaps, plus swaps referencing market indices– would not have been possible.

 

Soon after the PAUG template went live, Goldman went into action, selling billions of dollars of PAUG CDS to AIG. The swaps were embedded within synthetic CDOs that insured subprime mortgage bonds and subordinate tranches of CDOs. The first of these deals, Abacus 2004-1, closed on August 8, 2005.

 

Simultaneously, Greg Lippmann was putting the finishing touches on his famous flipbook presentation, “Shorting Home Equity Mezzanine Tranches,” which he proceeded to hand out to a couple of hundred hedge fund managers. And, wouldn’t you know, it turns out that the secret schemes designed to enrich hedge funds like Paulson & Co. and Magnetar became the norm in the CDO market. The majority of CDOs issued immediately after the end of the real estate bubble, during the last half of 2006, were arranged so that the hedge fund investing in the tiny equity tranche would also, secretly, take a much larger short on the rated tranches.

 

The Organizing Principle of Modern Credit Markets Is Secrecy

So let’s circle back to William Cohan’s column, which makes a passing reference to Goldman’s attempt to trash the Levin report by relying on secrecy. This is more than a metaphor. Goldman’s business model is designed around the exploitation of secrecy. Secrecy is organizing principle that governs modern credit markets. Credit default swaps, privately placed structured securitizations (e.g. CDOs), and hedge funds have all flourished– they dominate the debt markets–because they are all designed to exploit secrecy. They all create extraordinary profits by keeping the rest of us in the dark.

 

So in late 2006, if you wanted to find out what was happening in this newly created synthetic RMBS market, you couldn’t find out much of anything. You couldn’t find out anything about who bought or sold any CDO, or what was in any CDO, or how any CDO performed, unless Goldman or some other CDO underwriter deemed you sufficiently worthy of their selective disclosures. You couldn’t learn anything from the sales or trading activity of mortgage bonds, because the related trading in credit default swaps was kept hidden beneath the surface. You didn’t know anything about the trading activity related to the ABX indices, since that, also, was kept secret. And since the privately-held company that owned the ABX, CDS IndexCo LLC, operated in total secrecy, and since the privately-held company that published the price of the ABX, Markit Group Limited , operated in total secrecy, you had no way of knowing the extent to which the price of the ABX was manipulated through round-tripping, side deals with synthetic CDOs, or anything else. The only thing you knew, your only link to the illusory “reality ” of market sentiment, was the quoted price of the ABX. And you might happen to know that the Chairman of CDS IndexCo was Brad Levy, a managing director at Goldman, which, along with a handful of other banks, controlled CDS IndexCo and Markit Group.

 

Both the FCIC and the Levin subcommittee disclosed a wealth of information that others with a more skeptical bent can scrutinize in depth. This information poses a direct challenge to Goldman’s dissembling, and to the moral hazard of access journalism, which is no substitute for the full transparency of a free and open marketplace of ideas.