Annals of CDS manipulation, Goldman Sachs edition

By Felix Salmon
December 10, 2010
engineer a short squeeze in CDS:

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A politician whipping up a storm over artificial manipulation of the CDS market? So far so boring. But this time it’s different: the politician in question is Senator Carl Levin, and he has explicit emails from Goldman Sachs (oh yes) which show bond trader Michael Swenson trying to engineer a short squeeze in CDS:

Goldman Sachs’ trading activities in the credit insurance market in 2007 have come under attack from a US senator after e-mails revealed a senior trader urged colleagues to “kill” some investors’ positions.

Carl Levin, chairman of the Senate permanent subcommittee on investigations, told a hearing on Wednesday that the alleged activity “looks like a trading abuse to me”, although he added that at the time in question the credit insurance market was unregulated.

If you look a bit closer into this story, it turns out to be doubly ironic. For one thing, the squeeze was meant to drive down the price of credit protection. The WSJ misses this, saying that Goldman “wasn’t the only player in subprime mortgages to bet that the market would suffer”; in fact, the scheme was designed to bolster the market and make it look artificially healthy. If it had worked, Goldman would have made money on bond values going up.

Which raises the second irony: the scheme, in the end, despite being “do-able and brilliant”, in the words of Swenson, the strategy didn’t work. Which allows the bank to wheel out the rare Goldman Sachs Incompetence Defense:

Goldman said on Thursday: “This type of language sounds awful and is very disappointing, but it does not reflect the reality of what happened. There was no short squeeze.”

Which is true, but not for lack of trying.

One question raised by all this, though: was the trade put on by Goldman’s prop desk, or was it the kind of thing which Goldman could still attempt with its present, post-Volcker rule, setup? It’s clearly proprietary trading in fact. But so long as Goldman was giving great prices to clients looking to short the market, it could colorably claim to have been working on behalf of clients all along.


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I’m confused. How can you create a “short squeeze” in a derivative whose potential supply is unlimited? It’s not like they’re going to run out of copies of the ISDA contract.

Posted by FosterBoondog | Report as abusive

@FosterBoondog, I think “short squeeze” is a figure of speech here. Obviously you cannot squeeze an asset that does not need to be delivered. BUT … these deals would be under CSA and you can “squeeze” them for collateral. If you can sell enough protection to move the market, the protection buyers have to post more collateral. Few funds have heaps of collateral sitting around doing nothing, so they would have to sell something. Eventually they might have nothing to sell but the CDS position itself. Once that point is reached, the process is self-reinforcing, as the process of closing out the positions narrows spreads further.

Posted by Greycap | Report as abusive

Look at how the trader is renumerated. If he is renumerated solely on the P&L of the positions then he is probably a prop trader – as opposed to say a govie market maker who may lose a bit of money but does enough volume to drive the business to the sales guys underwriting government debt. Look at his position on the trading floor, if he is off in some glass office to the side or not on the floor at all then he is probably a prop trader. If he is sitting next to the sales traders he is probably market making not prop trading. Look at the tools on his desk, look at the people he trades with.

Banks usually have zero difficulty deciding who is a prop trader vs servicing a client. By the way it has nothing to do with whether the client makes or loses money on the trade.

Posted by Danny_Black | Report as abusive

From the WSJ: ml

“Many mornings before Bernard Madoff’s arrest, Mark Madoff would arrive at his trading desk before 7 a.m. On the Friday before he died, he was still following Wall Street news, sending to friends and ex-colleagues around 5 p.m. a Reuters blog item about Goldman Sachs and Sen. Carl Levin.”

Posted by JohnCoogan | Report as abusive