A Detailed Look At Goldman's CDS Holdings And How CDS Trading Has Become The Squid's Multi-Billion Cash Cow
One of the more useful information items in Goldman's periodic filings is granular disclosure on the firm's CDS holdings, and specifically segregated data by maturity bucket and by spread as pertains to "maximum payout and notional amount of written credit derivatives." In essence, due to the firm's monopoly in CDS inventory and, therefore, trading, this is the squid's beating heart: between buying and selling (hopefully offsetting positions) CDS in billions of dollars worth of notional daily, and being able to capitalize on wide spreads, courtesy of the extinction of such traditional competitors as Bear and Lehman, the firm will continue to make hundreds of millions in profits every day, month and quarter, due to its newly found monopolist exposure when it comes to trading CDS, both as principal and as agent.
A little background on why CDS is the primary cash cow in Goldman's sales and trading repertoire.
A Goldman CDS flow trader will traditionally make markets, for example in company XYZ, where he will give the (5 year) market as 500/530 bps, meaning buyers will put on new CDS at a spread of 530, while sellers will offload and/or short positions at 500 bps. By running traditionally balanced books, Goldman's flow trader is able to extract a 30 bps spread on any block of matched buys and sells. On $1 billion of notional traded CDS (which is much less than the firm does daily), with a DV01 of about $400k, if Goldman can unwind its CDS book daily to natural buyers and sellers, it can make $12 million simply by taking advantage of the spread ($400k (DV01) x 30 bps). At an average CDS block trade size of $25 million, Goldman's hundreds of salespeople need to just call up 40 accounts to trade in size and make the firm a risk-free $12 million. In days of volatility, Goldman can easily trade over $10 billion in notional equivalent. Again assuming a 30 bps spread, which the 85 Broad firm has basically guaranteed itself for life, courtesy of monopolizing the CDS market with just itself, and JPMorgan providing any relevant CDS inventory, Goldman can easily make $120 million daily, merely from trading CDS on a risk free agency basis.
This analysis does not even include Goldman's prop operation, which as we have discussed prior, at least in the CDS world, has its traders/analysts sitting feet if not inches away from the flow guys who scream all day long what the Fidelitys and the Putnams of the world are about to trade (and we are talking size: $100MM blocks or more) as trader X tries to find trader Y who may have a matched natural opposite interest. As this screaming match continues, prop trader Z quietly puts on a $10-20MM or more million position, frontrunning whoever may be the large block trader about to execute, without actively moving the market. Once the elephant prints, Goldman's flow guys have locked in the spread, while the prop trader now has a heavy tape to serve as a tailwind. In such a way, combining prop and flow, Goldman is able to make millions and millions daily, without any notable risky exposure: it all is a function of Goldman having i) the largest CDS inventory, ii) the best and largest client accounts, iii) the most liberal seating chart on its trading floor, and iv) nobody who is willing to not take Goldman markets: after all where else would you go?
Sometimes there will be quirks: like when the firm has net notional exposure to a firm like AIG, which may or may not be able to fund tens of billions worth of margin calls, thereby skewering Goldman, which is forced to eat the loss. Of course, in those instances people like Tim Geithner step in and bail out the counterparty so that things at Goldman can continue running as smoothly as always, and the firm can go back to making hundreds of millions in virtually risk free trades daily (and that even excludes the perpetually Fed backstopped balance sheet: this aspect of its risk free business is merely a function of its near-monopolistic dominance of the CDS market: nothing more fancy).
Another time when things get problematic is when Goldman is running an unmatched book: in other words when it has sold more CDS than it has bought, a disbalance from a purely P&L point of view, or when it has sold less than it has bought, a risk from a counterparty perspective.
The last is precisely what happened to Goldman as it transitioned from last year and headed into 2009. As the charts below demonstrate the company materially tightened its overall sold CDS exposure, in other words the gross maximum payout it may have been on the hook for at any given moment.
What is obvious is that the firm has collapsed its total CDS exposure by 25% since Q4 2008 (is that November or December? We are not sure which month Goldman prefers: as readers will recall December is the orphan month in which the firm jettisoned all its credit ($1.5 billion) and currency ($2.3 billion) losses). The current CDS total exposure is roughly $2.8 trillion (max loss if all the companies that Goldman has written protection on file tomorrow). Of course this is netted by CDS purchases, which should net out. More on this in a second. Also curious is that the one segment where the firm has collapsed its risk exposure the most is in the 250-1000 bps sector, while it has actually grown its exposure in the 0-250 bps segment. This of course could also be due to the fact that names which were previously trading point up front are now back to double digits spreads, courtesy of the Fed's $23 trillion in excess liquidity propping up all risk assets.
Another view of the data indicates that Goldman, just like the US government, has considerably reduced its term exposure, with the 0-12 month tenor category having grown from $230 billion to $300 billion.
The inverse trend is evident in both the 1-5 year and 5+ tenor holdings, with reductions in exposure across the board.
Yet on a notional basis, things are not quite as bleak, and it appears that Goldman has learned its lesson: while at Q4 2008 the firm had a net liability arising from the carrying value of its written CDS of almost half a trillion, or $460 billion to be precise(that would mean its net exposure if all counterparties failed, would leave the company scrambling to get first row seats before Bernanke's printing press and praying it could print $460 billion worth of worthless dollars in one day), that number has since collapsed to a liability of merely $82 billion. Yet even that number is staggering, and begs the questions of what will happen to Goldman if we have another Lehman event at some point when the Fed's printing presses finally blow a fuse, and, more importantly, just what is the exposure of the other major CDS trading power houses which have likely not been as prudent in managing their credit derivative exposure. Zero Hedge will next analyze disclosed CDS exposures at JPM, DB and some of the other left over CDS trading desks. Luckily, with Lehman and Bear no longer out there (providing a happy Goldman with limitless Fixed Income monopoly powers), our task will be much easier.