Felix Salmon

Why Goldman could go short mortgages

By Felix Salmon
December 24, 2009

Blake Hounshell asks (of me specifically, no less) why “other banks didn’t follow Goldman’s lead when in December 2006 the firm turned bearish on the mortgage sector”.

The answer is that Goldman never had much in the way of net mortgage exposure to begin with, and could therefore turn bearish quite easily. Banks which had tens of billions of dollars of illiquid mortgage bonds on their balance sheets, by contrast, had no real way to put on a bearish bet.

More generally, pure investment banks, like Goldman, always claim to be in the moving business as opposed to the storage business. Today’s NYT story shows that there are limits to how true that is — Goldman had significant long-term mortgage exposure which it hedged by building up a short position in synthetic CDOs. But at least its net position stayed very small.

Competitors like Merrill Lynch, by contrast, found themselves taking enormous amounts of mortgage-bond exposure onto their own balance sheets just because no one else was willing to buy the lowest-yielding tranches of their mortgage bonds. It was that exposure which ultimately doomed the bank. Merrill might have been talking the moving-not-storage talk, but in practice it was acting as a waste dump for all manner of risky paper that the bond desks couldn’t move.

And big commercial banks with investment-banking arms, like Citigroup and UBS, never even claimed to be movers rather than storers: they actively sought out high-yielding triple-A paper as part of their business model. So long as the yields were higher than their own internal cost of funds, they considered such a position to be inherently profitable — and the bigger the position, the more profitable it would be.

There was also a difference in the type of mortgage paper which each bank had in its long portfolio. While Merrill, Citi, et al were stocking up on the lowest-yielding debt, Goldman I suspect had mainly the equity tranches of the bonds it underwrote: the highest-yielding, riskiest paper. Because the equity tranche is inherently extremely risky, even in good times, it’s only natural for any bank owning such paper to want to hedge that exposure.

And this is where I think that Goldman might have gotten a little lucky. Because equity tranches can all go to zero very quickly, you need a fair amount of CDS insurance to hedge that exposure. But once you’ve bought that CDS insurance, it will continue to rise in value as the housing market implodes, long after your original equity tranche has been wiped out.

Let’s say the housing market is at 100, and you have $3 million of bonds which will get wiped out if the market drops to 97. So you hedge that exposure by buying credit default swaps which pay out $1 million for each point that the housing market drops. (This is massively oversimplifying, but work with me here.) If the market falls to 97, then you lose $3 million on your bonds, while making $3 million on your CDS — you’re even. But if the market falls even further, to 70, then you still lose only $3 million on your bonds, while making $30 million on your CDS — gravy! You don’t even need to buy any more insurance to make that extra money, you just need to keep holding the insurance you already own.

On the other hand, let’s say the housing market is at 100 and you have $50 million of bonds which will get wiped out if the market drops past 75. At that point, the temptation is to do nothing at all, since hedging costs money and your models tell you that the market will never fall that far. And by the time that the market starts falling, insurance is so expensive that you can’t afford it any longer.

More generally, if you’re starting from a market-neutral position, it’s easy to go short. But if you’re starting from a large net long position, it’s much, much harder to do that. Almost impossible, really, especially when the market seizes up and there’s no liquidity any more.

And while I’m on the subject, there’s one thing worth adding: that none of this would have happened if Goldman hadn’t been so mind-bogglingly enormous. Goldman could hold on to the short side of all the synthetic CDOs it was underwriting precisely because in some distant other arm of the Goldman empire, a mortgage desk had managed to make money by introducing lots of mortgage-backed bonds onto the bank’s balance sheet. So the logical thing to do was to create a new desk which could make money by introducing lots of mortgage CDS onto the balance sheet. That way Goldman made money on both trades, while its balance sheet was hedged and canceled itself out.

If however there was a cap on bank size, or punitive capital requirements on balance sheets above $100 billion, then those kind of shenanigans would be much harder to pull off. Goldman would then do neither the original mortgage deals nor the subsequent synthetic CDOs, and the world would be a better place.

4 comments so far | RSS Comments RSS

Isn’t the real reason Goldman could go short mortgages AIG?

Beyond that, I don’t think Goldman’s successful hedging is an argument against bank size. The inability of their competitors to hedge (since the positions they needed would have moved the market) is a much better one.

Posted by Anonymous | Report as abusive

Good article Felix. If Goldman had used a straight CDS against the held mortgage exposure why should it continue to keep paying? I suspect they bought a different instrument that is as you suggest linked to an index, and that’s where the genius of those Goldman execs lies…

Posted by SLJ | Report as abusive

As against John Paulson straight bet against the market, he just stocked on to the CDS’s, Goldman actually played with much lower risks and as you say made money on both fronts, selling CDO’s and creating this unique mix of holding high tranch CDO’s with index based hedging.

Posted by SLJ | Report as abusive

We know Goldman nearly bankrupted AIG (huffingtonpost…)

With collapsing mortgage markets, insurers were getting in big time trouble. However, some knew how to pull the string …

1. In July 08, SCA a bond insurer settled contracts for 13 cents on the dollar.
2. In Aug 08, Calyon a French bank also involved with AIG, settled financial guarantees for 10 cents on the dollar.
3. Ambac another bond insurer cancelled similar trades for 10 cents on the dollar.

I remember watching CNN with Mr. Bush saying, ‘Hank walks into the room and says we have to save AIG otherwise there will be a financial meltdown’. So to prevent this meltdown emergency meetings happen and AIG gets huge funds.

So compared to the other bond insurers, how much did the Feds pay, 100 cents on the dollar. Goldman avoids 22 billion dollars in losses.

A side note – Hank Paulson had a very successful career with Goldman with an estimated compensation of 35 million in ‘05

Posted by SLJ | Report as abusive

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