I’ve been having a debate with Glenn Yago on this blog about financial innovation, so it was good to be able to sit down with him and talk face-to-face:
When Goldman Sachs noticed a pattern of regular losses in its mortgage book at the end of 2006, it decided to start going short, in a move which helped to position it as the most successful bank in the financial crisis. The markets have learned their lesson: now that Greece and Portugal have been downgraded, the rush to the exits is palpable: the flight to quality is on, and bond yields in the European periphery are going stratospheric.
Greece’s bonds can still be used as collateral at the ECB: Moody’s hasn’t (yet) downgraded them. But S&P’s sovereign-ceiling principles mean that all of Greece’s banks now have a junk rating, and it’s surely now only a matter of time until Moody’s and Fitch follow S&P’s lead and Greek debt becomes a speculative credit instrument rather a government bond which is safe in anybody’s eyes.
The trick about going short an imploding asset class, of course, is that it only works if you’re in the minority. If everybody is doing it, you just get overshooting asset markets and chaos — which is what we’re seeing now. As far as the financial markets are concerned, if any bailout comes now, it’ll be too late: no country can sustain Greece’s combination of funding costs and debt-to-GDP ratio, no matter how much German money it burns through. Plug 13% yields into my Greek debt calculator, and the results aren’t pretty, even if they don’t have any effect at all on all the other optimistic assumptions.
This is the problem with the way in which the EU insisted that Greece reach a point of desperation, exhausting all other funding opportunities, before it turned to Europe for help. At that point, it might be too late. And it’s going to be really hard to persuade Germany and the rest of Europe that lending new money at low rates to a country in this kind of fiscal situation makes any sense at all.
The Goldman Sachs hearings today are making for fascinating theater. The official Goldman statements are strong, especially that of Fabrice Tourre:
I never told ACA, the portfolio selection agent, that Paulson & Company would be an equity investor in the AC-1 transaction or would take any long position in the deal. Although I don’t recall the exact words that I used, I recall informing ACA that Paulson’s fund was expected to buy credit protection on some of the senior tranches of the AC-1 transaction. This necessarily meant that Paulson was expected to take some short exposure in the deal…
If ACA was confused about Paulson’s role in the transaction, it had every opportunity to clarify the issue. Representatives of Paulson’s fund participated directly in all of my meetings with ACA regarding the transaction. I do not ever recall ACA asking me or Paulson’s representatives if Paulson’s fund would be an equity investor. Indeed, ACA and Paulson had several discussions about the transaction and at least one meeting without any Goldman Sachs representatives present. Quite frankly, I am surprised that ACA could have believed that the Paulson fund was an equity or long investor in the deal.
As for the testimony of the rest of the Goldman executives, they’re all clearly singing from the same songbook: that although they might have been long at certain times and short at others, the main directive they were given was not directional, but was rather just to reduce the amount of risk on their books.
But in the actual hearings, the members of the Goldman mortgage desk are looking decidedly weak. They don’t answer questions, they keep on asking to double-check documents to run down the clock, they give narrow and unhelpful answers, and they generally act in a slippery and unsympathetic manner. Interestingly, Fabrice Tourre is the most straightforward and cogent of the lot.
I can see why it’s working out this way: the Goldman team has been briefed by their lawyers to be very careful about what they say, while the Senators are interested in grandstanding and scoring points.
Disappointingly, no one seems to have got any clarity on the biggest point of contention here. Goldman Sachs claims that it made less than $500 million on mortgages in 2007, while Senator Levin claims that it made $3.7 billion. That’s a big difference, and I’m not at all clear on how either of those numbers are calculated or which one is more reliable. Certainly a trade which made $3.7 billion wouldn’t come from an overarching strategy of trying to get “closer to home” at all times, as the Goldman executives are suggesting they did.
But whatever the truth of the matter is, these hearings are clearly bad for Goldman. Look over Fabrice Tourre’s right shoulder whenever he’s on camera: the other face in the frame is that of Goldman spokesman Michael DuVally. And it’s not a happy one.
I am awed by Carl Levin’s ability to orchestrate press coverage of Goldman Sachs of late. When he released some pretty benign emails from Goldman, they got splashed all over the front page of the NYT; and today’s batch of emails is causing a whole new set of headlines, even after today’s WSJ story along similar lines.
Levin isn’t accusing Goldman of doing anything illegal, per se, but he’s on the warpath when it comes to the fact that Goldman went short the mortgage market. His list of email quotes is all about shorting the market, and so are his conclusions:
The Subcommittee’s nearly 18-month investigation found evidence that Goldman Sachs, contrary to the repeated public statements of the firm’s executives, made and held significant bets against the mortgage market – “short positions” in Wall Street terms…
As high risk mortgage delinquencies increased, and RMBS and CDO securities began to lose value, Goldman Sachs took a net short position on the mortgage market, remaining net short throughout 2007, and cashed in very large short positions, generating billions of dollars in gain…
Goldman Sachs used credit default swaps (CDS) on assets it did not own to bet against the mortgage market through single name and index CDS transactions, generating substantial revenues in the process.
Well, yes. If you have a substantial position in mortgages — and pretty much all banks had a substantial long position in mortgages come 2007 — then prudent risk management dictates that you try to hedge that position by selling what you can and putting on shorts in order to hedge what you can’t sell. What’s more, if you’re Goldman Sachs and you see the market going down, you’re going to be aggressive when it comes to putting on those short positions. That’s Wall Street.
As for Goldman helping to securitize subprime mortgages, yes, they did, but so did everybody else with a mortgage desk, and Goldman wasn’t even close to being the biggest.
Levin is convinced that if Goldman thought that mortgages were going down in value, and it still sold those mortgages to its clients, then that creates “a conflict between the firm’s proprietary interests and the interests of its clients”. But it doesn’t. If Goldman wants to go short mortgages and its clients want to go long mortgages, then it makes perfect sense for Goldman to sell mortgages to its clients.
I daresay that Levin is right when he complains that Goldman didn’t disclose its proprietary position to its clients, although I also suspect that if they asked the right people they probably would have explained their worries. But the fact is that Goldman wasn’t really making a big macro bet on the mortgage market failing, it was just making a large change to its own risk book in order to get away from what looked like a very dangerous position. If the mortgage market hadn’t tanked, Goldman would almost certainly still have made money. And while Levin talks portentiously about the “substantial profit” that Goldman made from its mortgage shorts, he never quantifies it or explains how he’s doing his sums. If he’s just looking at the short positions without looking at the offsetting long positions, that’s just silly.
Clearly Levin’s theatrics haven’t done much to impress Senate Republicans — or even Ben Nelson (D-Buffett): they blocked the financial regulation bill today, happy to be seen as obstructionist on financial reform even with Goldman dominating the headlines. Levin has, on the other hand, managed to muddy the waters surrounding Goldman a great deal, with the serious allegations about lack of adequate disclosure now being mixed up with all manner of vaguely-choate ideas about shorting and profiting off other people’s misery. It’s as though Goldman’s real sin here was not to lose as much money as everybody else when the housing market collapsed. If it had done, Levin would have much less to complain about.
Where does this leave Goldman? In a pretty tough spot, I’d say. The SEC case has severely damaged its reputation among its clients, while Levin and the press are doing their bit to undermine Goldman’s public image more generally. Right now, no accusation is too outlandish to throw against Goldman: if Ben Stein were to start accusing Jan Hatzius of deliberately talking down the US economy in order that Goldman could make money from bearish bets, as he’s been known to do in the past, the chorus of disapproval — against Stein, not against Goldman — would be much quieter than it was back then.
To Blankfein, I’m sure all of this seems horribly unfair. But the FT’s 2009 Man of the Year can’t whine about persecution. Instead, he should take the apology he’s already proferred, and make it more explicit: explain exactly which “things” Goldman participated in which were “were clearly wrong” and which Goldman has “reason to regret”. I’ve never got a very straight answer out of Goldman’s PR team on that front, although CDOs were certainly mentioned. Blankfein should be more forthright about that, and try as best he can to put a line under this whole episode.
I just found this, buried in a Landon Thomas story on Abacus at the end of last week:
Some inside ABN Amro were leery of Abacus early on. Indeed, several traders there immediately bought credit default swaps — insurance-like instruments — from Goldman Sachs to hedge their exposure to ACA.
Now it’s worth noting that the headline on the story is “A Routine Deal Became an $840 Million Mistake”, and Thomas repeats many times in the story that the deal ended up costing Royal Bank of Scotland, which bought ABN Amro, $840.1 million.
But the bit about the CDS hedge is intriguing — especially the detail that the hedge was bought directly from Goldman Sachs, which was the company hedging its own exposure in the first place. If Goldman was happy to write credit protection on ACA, and presumably buy offsetting ACA protection elsewhere in the market, then why didn’t it just use ACA to insure the Abacus deal directly, and then turn around and hedge its ACA counterparty risk?
The answer, I think, might have something to do with collateral posting: Goldman only wanted CDS hedges where it could ask for collateral in the event of a downgrade or a fall in market prices, while ACA only wanted to insure the deal if it didn’t risk needing to post hundreds of millions of dollars with Goldman. So Goldman went through ABN Amro instead, which was happy to agree to Goldman’s collateral requirements.
I’m not clear how the $840.1 million was calculated — was that net of the hedges, or was that before Goldman paid out on them? And if ABN was hedging its ACA exposure with Goldman, why did it make any sense to do the deal in the first place? I’m sure that Goldman charged ABN Amro more than 17bp for ACA protection, so it’s hard to see how a hedged ABN could make any money on the deal at all.
Maybe if and when the UK government sues Goldman Sachs for RBS’s losses, we’ll learn more. But right now it’s all very vague where those super-senior losses really did ultimately end up.
I just had a very interesting conversation poolside at the Beverly Hilton with a couple of high-profile delegates at the Milken Global Conference. The pool, one level down from where all the panels take place: is clearly the place to be: Arnold Schwarzenegger was just a couple of tables away. But I doubt he was talking in great depth about the Greek debt situation and what’s likely to happen there.
I walked away from the conversation decidedly bearish on Greece. Why?
- It’s not in the interest of Germany’s politicians to bail out Greece. Angela Merkel is taking a hard line on the subject, and you can see why she would — the German electorate has no particular desire to spend billions of euros bailing out the Greeks.
- It’s not even narrowly in the interest of Germany to bail out Greece. If Germany cares only about itself, rather than the full European Union, then in many ways the best-case scenario for Germany is to see Greece and Portugal default, leave the euro, and then re-enter a few years later at a more competitive exchange rate. That’s better than using German funds to try to sustain the national debt of those countries at their present elevated levels.
- Even if Germany cares about what might be called “narrow Europe” — Germany, France, Benelux — it still might well rather see Greece and Portugal exiled from the euro, thus making it a more credible currency in the eyes of many.
- If Germany can’t be sure that Greece will avoid default, it would be much better off simply letting Greece go its own way, and then bailing out its domestic banks if Greek did end up defaulting. The cost of the bank bailout would be lower than the cost of a Greece bailout, and the money would remain within Germany.
- If Greek did default, though, make no mistake that massive bank bailouts would be necessary — if not in Germany then certainly in places like Italy. Hedge funds and distressed investors aren’t going to start buying Greek debt pre-default: they’re going to wait for the default and the inevitable overshoot in prices, and then buy.
- Where would Greek debt trade in the event of a default? This is the scariest thing: my highly plugged-in companions both agreed that it wouldn’t just fall to 70 or even 60 cents on the dollar: they saw fair value closer to 40, and said that it would probably fall to 30 before people started buying.
- Needless to say, if Greek debt was trading at 30 cents on the dollar, it wouldn’t take long for the Portuguese domino to topple. After that, Spain — and then, it’s easy to imagine, Italy, Ireland, UK. And so the stakes are very high: it’s certainly cheaper to bail out Greece with virtually unlimited funds than it is to risk a fully-blown PIIGS default. But there does seem to be the hope or expectation that a line could get drawn in the Iberian sand, and that Italy and Ireland would not be allowed to default even if Portugal and/or Spain imploded.
- A couple of high-profile sovereign defaults in Europe would actually be welcomed by the fiscally-responsible wing of the Republican party — the people who want to raise taxes rather than lower them. The idea here is that there would be a come-to-Jesus moment and lawmakers would suddenly realize how dangerous large sustained deficits can be, and change their wicked ways.
I buy nearly all of this, with the exception of #6 and #8. My feeling is that a Greek default, while it could in theory be a disorderly and chaotic simple failure to pay, would more likely take the form of a public exchange offer, which would help to put a floor on the price of Greek debt.
And I very much doubt that defaults in southern Europe would improve the fiscal status of the US. To the contrary, the flight-to-quality trade would just make it even cheaper for the US to borrow money, and the lesson we’ve all learned many times is that so long as a country has lots of access to cheap money, it’ll go on borrowing.
But I do think that there’s a pretty low limit to how much money Germany is going to spend bailing out Greece. It’s already bailed out one basket-case European country, when it absorbed East Germany. It’s got no appetite to bail out another.
John Carney and Teri Buhl have a tantalizing story up at the Atlantic today:
Traders at Deutsche Bank sold similar collateralized debt obligations (CDOs) — built from credit protection on a portfolio of mortgage-backed securities selected in consultation with hedge fund manager John Paulson — to the German bank. And like Goldman, Deutsche Bank didn’t reveal Paulson’s role in the construction of the CDOs.
Two questions I think are key here. First, was there a Magnetar-style disclosure that the sponsor of the deal might have a net short position in the deal? And second, was there a nominally-independent CDO manager, like ACA, which claimed to have chosen the entire portfolio with an eye to making it high quality, but who in fact was severely constrained by the input of Paulson?
The key problem with the Abacus deal was not so much that Goldman didn’t disclose Paulson’s name. It’s that Goldman didn’t disclose the role of the sponsor to the nominally-independent CDO manager. And given that the manager was also an investor in the deal, that’s a significant omission when it comes to disclosure.
Larry Summers Defends Megabanks, Says Too Many Small Banks Make U.S. ‘Less Stable’ — HuffPo
Do those derivatives end-users just want to avoid taxes? — Time
Waldman helpfully takes Abacus apart. I simply don’t believe that ACA Capital really knew what it was insuring — Interfluidity
Why Goldman’s ‘Big Boy’ defense won’t work — WSJ
One hundred trillion dollars — Guan
The Worst Physics Article Ever — Science Blogs
I’ve been saying for years that most people are better off buying a Mac than AAPL stock. Seems I was wrong — Kyle Conroy
iPad not bad for your eyes, but is it bad for your sleep? — LAT
The covered bond industry is miffed about Basel — Alphaville
NYT blogger complains about being quoted and linked to — NYT
Rajat Gupta, GS board member and insider trader? This is the last thing Goldman needs right now — WSJ
Dambisa Moyo appointed to Barclays Board — Barclays