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A Detailed Look At Goldman's Mortgage Trading Strategy In Late 2006 And 2007; The Goldman "Directive"

Tyler Durden's picture




 

One of the key topics over the next week will be just what was Goldman's exposure to the mortgage industry in 2006 and 2007, and was the firm actively short mortgage exposure or was it merely, as it claims, just a market maker without any active positions on its prop desk. Courtesy of Carl Levin's recently declassified Goldman emails and presentations we get an extensive glimpse into Goldman's net exposure, its DV01, its counterparties, as well as how the firm was planning on interfering with the market when it needed liquidity to offload legacy positions. We also get a rare glimpse into the contributions from Tourre's mentor, Jonathan Egol. Let's dig in.

The first question of whether the firm was short mortgages is answered clearly and definitely by the following table included in its September 17, 2007 presentation to the Goldman Sachs Board of Directors, updating the firm on its Residential Mortgage Business. The table is particularly useful because it provides a snapshot of the firm's risk exposure to mortgages on November 11, 2006, long before Abacus was conceived. It also shows the firm's bias on the mortgage crisis from a prop trading perspective.

The implications of the data in the table above are obvious, but first, here is the commentary associated with the DV01, with a focus on Goldman's VaR change between Q4 2006 and Q1 2007.

Daily Mortgage VaR increased from $13 mm to $85 mm between 11/24/06 and 2/23/08 largely driven by an increase in SPG [Structured Products Group] Trading desk. The risk increase in SPG Trading desk was primarily driven by a combination of increased volatility in ABX market and the desk increasing their net short in RMBS subprime sector.

Translation: the firm's SPG prop trading desk (no, not its client facing flow exposure, its prop operations) which likely held the bulk of prop capital around the end of 2006 and beginning of 2007, was already net short, and only got net shorter in the three months from November 2006 (before Abacus) into February 2007 (around the time Abacus was being marketed and the term sheet was being concluded).

As the first table indicates, Goldman Sachs' associated DV01 with mortgage exposure was net short by just over $1 million per basis point change, that number nearly tripled to a $2.8 million DV01 by the end of February 2007. So much for Goldman being confused about whether it is long or short the mortgage market.

Another way to visualize this is the firm's disclosed Daily VaR, which also exploded over the period in question. This can be seen on the table below:

Translation: Goldman went against the grain, and in a time when everyone was trying to at least superficially reduce their risk exposure by going with the flow, Goldman took a risky bet (and yes, they had already done so in November 2006 if not sooner), and increased their mortgage VaR from 13 to 85 in three short months.

And the way they did it was by going all in: whereas previously the firm had been hedging its exposure in mortgage by holding on to a long credit position in the BBB- tranche of the ABX index in November, soon thereafter, the firm rotated its exposure drastically by boosting both its single name mortgage exposure in lower rated tranches (A and below), while covering some of its senior and supersenior ABX tranches (AAA DV01 went down from short $816,000 to just $11,000).  However, the BBB- long credit position was whacked massively, and DV01 declined from $1.8 million to just $479,000. As Goldman itself describes it:

SPG Trading desk started the off the quarter with long ABX "BBB-" risk to the tune of $1.8 mm/bp, hedged with "AAA/A" rated ABX indices and single name CDS. Over the quarter, desk reduced its long ABX "BBB-" risk by $1.3 mm/bp and increased their single name CDS hedges.

Bottom line: Goldman was very much net short mortgages in November 2006 (it would make $1 million for every bp change lower in absolute terms), and went all in to over $2.8 million by the end of February 2007. This should end all discussions on how the firm was positioned around the time the Abacus was being constructed and marketed.

What happened next: in order to determine the firm's mortgage exposure between early 2007 (March) and late in the year (late August), we use the following table which points out that March 2007 was in fact the time the firm had the highest net short exposure in mortgage securities (cash, derivative and structured), and as everyone else was gradually becoming bearish on housing, Goldman in fact became much more bullish. An email from Richard Ruzika from March 14, 2007 captures the prevailing mood: "Four weeks ago you couldn't find a bear in the market period. Now it feels like its all doom and gloom as the longs get out." Indeed, everyone who was nimble, was scrambling to go short.

As the table below indicates, the bulk of Goldman's bet on mortgages can be seen in its "Residential Mortgages" and "Structured Products Trading" verticals. Needless to say again, these are pure prop exposures, and have nothing to do with market making: the firm was actively betting one way or another on its view of housing. As the table below shows, Goldman went from a net short ABX position of $5 billion in Res Mortgages, and $7.7 billion short in RMBS CDS ($3.5), CDO CDS ($2.0) (hello AIG), and $2.2 billion ABX, for total $12.7 billion net short (not apple to apples) in March 2007, to $1.8 billion short ABX and $0.3 billion short RMBS CDS in Res Mortgages, and $4.9 billion RMBS and $3.3 billion CDO CDS (at this point the firm was using AIG as the dumbest people in the room to buy protection on RMBS and CDOs, even as other banks were starting to finally derisk). Concurrently, the long side in Structured Products Trading was ballooning, going from $5.6 billion to $8 billion, with the bulk of the difference occurring due to a shift of ABX, moving from a short to a long position ($3.6 Bn). Also, the firm was consistently long Cash CDO and RMBS, hedging it by being short matched CDS. Oddly, in the 6 month interval, the firm had managed to accumulate an additional $1.5 billion in cash CDO exposure, presumably because it was unable to offload origination. As a result, it had to buy protection more and more from idiots like AIG and anyone else who would sell it protection (more on this later).

Was the strategy successful? Certainly, as we can see from the following annual and quarterly revenue breakdown of Goldman's mortgage business.

In summary, Goldman was making money from mortgages all along 2007: Lloyd's disingenuous defense of his profitability, as seen in an email from November 18, 2007, is hilarious. "Of course we didn't dodge the mortgage mess. We lost money, then made more than we lost because of shorts. Also, it's not over, so who knows how it will turn out ultimately." Lloyd's statement would be completely acceptable if he was, as he obviously thought, dealing with idiots: indeed the gross long book tumbled, however the net hedge book more than made up for the gross exposure. To say that the firm lost money because of one or two, we dumb this down for the benefit of Steve Liesman and Jim Cramer, long positions, even as it made more than double on the hedging shorts is an insult to the intellect of anyone who still listens to these people.

Yet Lloyd was more prophetic than even he could imagine with his last sentence. The problem was that even Goldman did not anticipate just how bad it was about to get. Recall, the firm was rerisking in Q3 and likely onward. The problem is that even Goldman did not anticipate that in 6 short months Bear Stearns was implode to be followed by Lehman. The collapse in the housing market would be untenable even for Goldman, whose traders had explicit orders from Winkelreid and Cohn to minimize their trading exposure. Had the government not stepped in, Goldman would have been toast - no question about it.

Another good perspective on Goldman's thinking from March 2007 is the following email from Dan Sparks, which in addition to everything else, provides a unique glimpse into how terrified of a blocked CDO pipeline Goldman was at the time (this is concurrent with Abacus):

Aside from counterparty risks [a topic all to its own: Goldman was actively shorting all firms it knew had mortgage exposure, we presume using CDS: AIG, Bear and Lehman most certainly at the fore - in fact we have discussed why we believe Goldman's profit on its AIG CDS position should be investigated for insider trading by the SEC], the large risks I worry about are listed below:

(1) CDO and Residential loan securitization stoppage - either via buyer strike or dramatic rating agency change.

On the CDO front, we have been locking people at various parts of the capital structure (with a primary focus on the super-seniors top 50% of the deal), and rushing to get deals rated. We have liquidated a few deals and could liquidate a couple more, and we are not adding risk (we had slowed down our business dramatically in the past 4 months). Our deals break down into 2 $1BB CDOs of A-CDOs (most risky, but good progress), 2 $1BB AA- diversified deals (less downside, less progress), and 4 other various smaller deals [Abacus is certainly one of these]. We have various risk sharing arrangements [hello John Paulson], but deal unwinds are very painful....

(3) Covering our shorts. We have longs against them, but we are still net short.

$4 BB single name subprime split evenly between A, BBB, BBB- and $1.3BB of A-rated CDOs.

ABX index - overall the department has significant shorts against loan books and the CDO warehouse. The bulk of these shorts ($9BB) are on the AAA index, so the downside is limited as the index trades at 99.

Our shorts in (3) above have provided significant protection so far, and should be helpful for (1) and (2) in very bad times. However, there is real risk that in medium moves we get hurt in all 3 areas.

Therefore, we are trying to close everything down, but stay on the short side. But it takes time as liquidity is tough. And we will likely do some other things like buying puts on companies with exposure to mortgages.

Ah yes, buying puts, or buying protection, on companies like AIG. No, shorting mortgages directly was not enough for Goldman, it took the derivative play as well, of shorting anyone else who was stupid enough to be long mortgages, using its impressive flow book as the basis of knowing who was trading what.

And here is how Goldman compared itself vis-a-vis other players in the business:

Goldman was fully aware its key financial competitors were axed massively the wrong way, even as it was gloating its net short exposure. This was certainly the case as of November 2, 2007. We are confident that it had been the case all along.

And while its competitors is one thing, for the first time we also get a unique glimpse of how Goldman was trading on the opposite side of its key clients: MS Prop, Peloton, BSAM, ACA and Harvard (where Larry Summers was teaching courses on the benefits of monopolies in communist societies). Enter Jonathan Egol.

In February 21, 2007 email from Jonathan Egol who at that time was likely busy cultivating the Paulson relationship, we read the following. Incidentally, the subject of the email is: "Block size tranche protection for Paulson or others"

Summary of ABX-related tranches we could offer protection on if we want to close down shorts:

  • $2.4bn notional 40-100 super senior tranche off of ABX "Quadrant" trade (25% each of 06-1/06-2 BBB and BBB-), could potentially offer NC4 [non-call 4] (we did $1.8bn NC3 with MS Prop and $600mm NC4 with Peloton)
  • $200mm notional 20-30 tranche off of 06-1 BBB- (open risk vs ACA w/CIBC intermediation, NC5)
  • $500mm notional 40-100 super senior tranche off of 06-1/06-2 BBB- (open risk vs Harvard, non-callable)

We are currently managing ABX deltas against all of these tranches.

In other words, Egol, like every other fastidious banker, knew full well who the firm had bought protection from, in this case on ABX, but on virtually all other single name, and index products too. It would therefore know who to wring when the market ripped in either direction, and who to demand accelerated margin calls from. Too bad for the firms named above: Peloton, MS Prop, Harvard and, oops, ACA. These were counterparties that were facing Goldman on its short trades. That ACA had been selling protection on ABX 20-30 before February 2007 does not lead much credibility to the CNBC promoted thesis that ACA was fully aware of the troubles in the housing market.

Yet what is the essence of this email? Just prior to February 21 Goldman decided to cover their shorts en masse (they would subsequently reshort again. This was the profit taking trade). And here is where we get what in our opinion is the most incriminating email from Dan Sparks, which details just how Goldman mobilizes its troops when it is profit-taking time:

Thursday.

We need to buy back $1 billion single names and $2 billion of the stuff below - today. [referring to the Egol email] I know this sounds huge, but you can do it - spend bid/offer, pay through the market, whatever to get it done. It is a great time to do it - bad news on HPA, originators pulling out, recent upticks in unemployment, originator pain...I will not want us to trade property derivatives until we get much closer to home as it will be a significant distraction from our goal.

This is a time to just do it, show respect for risk, and show the ability to listen and execute firm directives.

You call the trade right, now monetize a lof of it.

You guys are doing really well.

The guys in question are Josh Birnbaum, Michael Swenson, and David Lehman. Birnbaum and Swenson are largely acknowledged as being the guys responsible for the firm's $4 billion in mortgage-related profits:

Mr. Swenson, known as Swenny on the trading desk, is a former
Williams College hockey player with four children and an acid wit. A
veteran trader of asset-backed securities, he joined Goldman in 2000.
In late 2005, he helped persuade Mr. Birnbaum, a Goldman veteran, to
join the group. Mr. Birnbaum had developed and traded a new security
tied to mortgage rates.

Mr. Swenson and Mr. Sparks, then No. 2 in the mortgage department,
wanted Mr. Birnbaum to try his hand at trading related to the first ABX
index, which was scheduled to launch in January 2006. Because
securities backed by subprime mortgages trade privately and
infrequently, their values are hard to determine. The ABX family of
indexes was designed to reflect their values based on instruments
called credit-default swaps. These swaps, in essence, are insurance
contracts that pay out if the securities backed by subprime mortgages
decline in value. Such swaps trade more actively, with their values
rising and falling based on market sentiments about subprime default
risk.

Messrs. Swenson and Sparks told Mr. Birnbaum the ABX was going to be
a hot product, according to people with knowledge of their pitch.

They were right. On the first day of trading, Goldman netted $1
million in trading profits, people familiar with the matter say. But
the index was tough to trade. In comparison to huge markets like
Treasury bonds, there wasn't much buying and selling. That meant that
Mr. Swenson's team nearly always had to use Goldman's capital to
complete trades for clients looking to buy or sell.

 

Ah yes, so much for the "market making" defense.

What is most notable is learning just how Goldman goes about scrambling when a "firm directive" is at stake: show no mercy when executing, regardless of how many clients get destroyed in the process. Another firm that suffered the wrath of Goldman's directive to fill trading axes as required by the executive team: Stanfield. Note the following exchange between Dan Sparks, Tom Montag and Lloyd Blankfein.

Ah yes, the Goldman trader "development" approach: kill, maim and extort. Good client, bad client - no matter. Money must be made when a "firm directive" is at stake.

There is much more, but here are the key observations:

  • Goldman was net short housing all the way back in November 2006, when it had a DV01 of ($1) million.
  • Goldman was already covering its shorts for the first time in February and March 2007, when the HSBC and New Century news were only just getting everyone else's attention.
  • Jonathan Egol and his traders were actively looking for dumb money on which to offload "Paulson" like open axes. Alternatively, if the firm needed to cover shorts, they knew who had sold protection and could be persuaded to covering losing positions.
  • "A firm directive" had emerged in February to cover short positions. Surely a directive had originated these short positions in the first place. For Lloyd to claim the firm was still long mortgages in early 2007 is disingenuous.
  • Goldman was shorting not just mortgages and subprime, but all entities who it knew had exposure. This includes Merrill, Citi and UBS.
  • Goldman would increase its net long housing exposure going into H2 2007. The firm thought the worst was over. It wasn't. Goldman had nearly $8 billion in RMBS and CDO CDS with firms like AIG who would get annihilated when the eye of the hurricane finally passed. While the firm had bet correctly, it was so far ahead of its time, all its negative counterparty bets would have been worthless had these same counterparties not been bailed out.
  • Goldman is a monopoly.
  • Goldman always wins.
 

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Sun, 04/25/2010 - 19:38 | 317302 kujiranoai
kujiranoai's picture

"Lloyd's disingenuous defense of his profitability, as seen in an email from November 18, 2007, is hilarious. "Of course we didn't dodge the mortgage mess. We lost money, then made more than we lost because of shorts. Also, it's not over, so who knows how it will turn out ultimately." Lloyd's statement would be completely acceptable if he was, as he obviously thought, dealing with idiots:...."

Blankfein would be aware that whenever he writes an e-mail there is a much greater chance of it coming into the public domain given his position in the firm.

This e-mail sounds like an e-mail written to be found by the SEC or GSs client's lawyers once they work out how much they have been ripped off.  To paraphrase "We were up a bit, we were down a bit, who knows where it is all going to end" - difficult to pin any case on that. However the reality is - as the var analysis, reports, firm directives and other e-mails show - is the Blankfein and others knew exactly how they had profited to date and what their exposures were.

Fabulous Fab on the other hand never expected his missives would fall into the public domain.  Being that much more junior he would be that much more revealing of the real views of the firm (as well as affording much of the financial world and in fact the rest of  world with great entertainment for the coming few months...)

Sun, 04/25/2010 - 19:52 | 317319 drwells
drwells's picture

If I ran one of these companies I'd budget for people - hundreds of them, if necessary - to sit around reading other employees' emails, deleting all trace of them and administering beatings as appropriate. It seems like such a huge and obvious vulnerability.

But then, these geniuses never think the bubble du jour is going to bust, either. God doesn't need caution.

 

Mon, 04/26/2010 - 03:03 | 317648 BorisTheBlade
BorisTheBlade's picture

If I ran one of these companies I'd budget for people - hundreds of them, if necessary - to sit around reading other employees' emails, deleting all trace of them and administering beatings as appropriate.

This may count as a destruction of the evidence if worse comes to worst, then again no one is guaranteed from one of those employees becoming a whistleblower and then suddenly: "OMG, GS (or anyone else for that matter) deleting their e-mails containing important information". One of the reasons why Arthur Andersen passed away:

On June 15, 2002, Andersen was convicted of obstruction of justice for shredding documents related to its audit of Enron, resulting in the Enron scandal. Nancy Temple (Andersen Legal Dept.) and David Duncan (Lead Partner for the Enron account) were cited as the responsible managers in this scandal as they had given the order to shred relevant documents. Since the U.S. Securities and Exchange Commission does not allow convicted felons to audit public companies, the firm agreed to surrender its CPA licenses and its right to practice before the SEC on August 31, 2002 - effectively putting the firm out of business in the U.S. Meanwhile, Andersen's non-U.S. practices ceased to be viable due to reputational collateral damage. Most of them were taken over by the local firms of the other major international accounting firms.

In addition to that, GS is subject to Sarbanes Oxley, so deleting e-mails could be in violation of it, should this happen: http://searchstorage.techtarget.com/expert/KnowledgebaseAnswer/0,289625,...

Mon, 04/26/2010 - 08:35 | 317750 aus_punter
aus_punter's picture

GS was prime broker to many large hedge funds (such at Peloton , mentioned above) They knew what was coming. GSAM was one of the largest investors in these hedge funds.

Sun, 04/25/2010 - 19:48 | 317309 Conrad Murray
Conrad Murray's picture

It's a shame ZH has to do the job of CNBC, the SEC, and Congress; but damn, I'm sure glad someone is.  Keep up the good fight!

Sun, 04/25/2010 - 22:41 | 317512 Cookie
Cookie's picture

Seconded

Sun, 04/25/2010 - 23:23 | 317547 sushi
sushi's picture

Thirded

Mon, 04/26/2010 - 02:49 | 317646 BorisTheBlade
BorisTheBlade's picture

Quadrupled

Mon, 04/26/2010 - 04:09 | 317669 Dr. Hannibal Lecter
Dr. Hannibal Lecter's picture

My Dear Friend,

Do you really think CNBC is interested in (honestly) discussing  anything that may remotely damage the markets and thus go against the wishes of ObaMao and his minions?  I think not.

 

Regards,

H.

Sun, 04/25/2010 - 19:46 | 317317 Mark McGoldrick
Mark McGoldrick's picture

I started reading this at 4:35.

By 4:39, had I not ran to the kitchen and stuck my head in the freezer, my brain would have exploded. 

Fantastic research....

Sun, 04/25/2010 - 21:19 | 317398 girl money
girl money's picture

Brazenly offtopic, but thought I'd pop this into the sticky post:

For anyone keeping an eye on Katla volcano...

Icelandic Met Office

http://en.vedur.is/

Activity updates

http://en.vedur.is/earthquakes-and-volcanism/articles/nr/1884

Tremor Graphs

http://hraun.vedur.is/ja/englishweb/tremor.html

http://en.vedur.is/earthquakes-and-volcanism/earthquakes/myrdalsjokull/

Katla is under Myrdalsjökull glacier in Southern Iceland

Latitude: 63.63°N   Longitude: 19.05°W  

Blog keeping eye on Katla and Eyjafjallajökull

http://scienceblogs.com/eruptions/

Sun, 04/25/2010 - 20:02 | 317327 Double down
Double down's picture

This was awesome.  Carry on, please

Sun, 04/25/2010 - 20:48 | 317370 Inspector Asset
Inspector Asset's picture

I would like to nominate TD for the Nobel Peace Prize,

+1001

 

Sun, 04/25/2010 - 20:14 | 317330 Mercury
Mercury's picture

So did GS lose $1bil writing CDS for Paulson or did they lay that trade off on someone else and/or did their net short RMBS position more than make up for that bad bet?  Was the making or losing money part 'evil' or what?...I forget.

I'm doing my best to stay interested in how Goldman outsmarted everyone else three years ago but I...., I mean it's just that...

     rtyuio   ']

asdfghjkl;\\

....sorry my forehead hit the keyboard there...

....no,...this is great! ...really!...if I'm not awake give me a shake when we get to 2008...OK?

We're not missing anything that's happening now are we?

Mon, 04/26/2010 - 00:57 | 317592 sweet ebony diamond
sweet ebony diamond's picture

we like to study the biggest theft in the history of mankind.

and goldman still hasn't answered this question:

Why did blue-chip Goldman take a walk on subprime's wild side?

http://www.mcclatchydc.com/2009/11/04/77852/why-did-blue-chip-goldman-ta...

however, when I read this ZH post and some of the comments, I know the answer.

 

Sun, 04/25/2010 - 20:09 | 317331 geopol
geopol's picture

 

Short story,

The Obama administration has been posturing this week about the life and death issue of Wall Street reform. Obama’s predicament is that of a Wall Street puppet who has been put into the White House thanks among other things to almost $1 million of contributions from the infamous Goldman Sachs – but who now needs to make a show of fighting his own Wall Street patrons for political reasons. Of course, Obama’s health-care reform was largely a bailout of insurance companies, which are themselves a key part of Wall Street. But Obama is now pretending to quarrel with Wall Street to shore up his waning credibility, partly because many House Democrats are desperately seeking anti-banker, economic populist street creds in order to avoid defeat in November. So far, the results have been largely feckless and inadequate.

The urgent problem raised by all this is the $1.5 quadrillion derivatives bubble. The financial crisis which struck the United States and the world in September and October 2008 was in fact a world a derivatives panic. This panic marked the first phase of a world economic depression caused by derivatives speculation. The second phase of this depression, which is now beginning, can also be attributed in large part to derivatives, since derivatives are the main tool being used in the speculative attacks on Greece, Spain, Portugal, Italy, Ireland, and other nations, building up towards a chaotic collapse of the euro.

Derivatives are the Cause of the World Depression of Our Time

Far from being some arcane or marginal activity, financial derivatives have come to represent the principal business of the financier oligarchy in Wall Street, the City of London, Frankfurt, and other money centers. A concerted effort has been made by politicians and the news media to hide and camouflage the central role played by derivative speculation in the economic disasters of recent years. Journalists and public relations types have done everything possible to avoid even mentioning derivatives, coining phrases like “toxic assets,” “exotic instruments,” and – most notably – “troubled assets,” as in Troubled Assets Relief Program or TARP, aka the monstrous $800 billion bailout of Wall Street speculators which was enacted in October 2008 with the support of Bush, Henry Paulson, John McCain, Sarah Palin, and the Obama Democrats.

Asset-Backed Securities

Derivatives can be defined as any financial paper which is based on other financial paper. In other words, they are financial instruments whose value depends upon or is derived from the value of other financial instruments. Any kind of securitization results in the creation of derivatives. If individual mortgages are wrapped up and packaged together as a mortgage-backed security (MBS), that is a derivative. Any asset-backed security (ABS), be it based on car loans, credit card debt, or anything else, also qualifies as a derivative.

Beyond this, there are generally speaking two kinds of derivatives. The first type includes the derivatives which are traded more or less openly on exchanges like the Chicago Board Options Exchange, etc. These include options, futures, and indices, plus all the combinations of these. These are what expire in each quadruple witching hour in the markets. This type of derivative has generally amounted to about $600 trillion of speculation in recent years.

OTC Derivatives

Then there are the so-called over-the-counter (OTC) derivatives, otherwise known as structured notes, counterparty derivatives, or designer derivatives. These often take the form of contracts which are kept secret by the counterparties, and which are often not included on the balance sheets of banks and other institutions which enter into these contracts. This type of derivative is currently not reportable to any regulatory agency. This secrecy is a result of the successful effort by Robert Rubin, Larry Summers, and Alan Greenspan to block the modest proposal of Brooksley Born of the Commodity Futures Trading Commission to bring the OTC derivatives into the sunlight during the second Clinton administration. Since these derivatives are not reportable at the present time, we must guess at their amount, and the best guess is that OTC derivatives make up almost $1 quadrillion of ultra-toxic speculation.

CDOs, CDS, and SIVs

OTC derivatives include collateralized debt obligations (CDOs),which often represent the packaging together of large numbers of mortgage backed securities, along with other debt instruments. A CDO can also be concocted out of other CDOs, in which case it qualifies as a synthetic CDO or CDO squared (CDO²). Notice that a synthetic CDO is not really an investment, but rather a form of gambling, in which a speculator in effect places a bet on the performance of some other financial instruments. This fact exposes the big lie inherent in the widespread reactionary myth that the current depression was caused by poor people taking out subprime mortgages on slum properties and then defaulting on these loans, thus bringing down the US and British banking systems. This fantastic story ignores the fact that derivatives were only a wager placed by speculative bettors from afar on mortgage backed securities which included some subprime notes.

Credit default swaps represent bets on whether a given asset or company will go bankrupt or not. As such, they can be used as insurance against such an eventuality, or else they can be used to make money on the insolvency. CDS are therefore a form of insurance, but they are issued by counterparties who have not registered as insurance companies and who have not met the legal and capital requirements which are necessary to function as an insurance company. It ought therefore to be clear that CDS have been totally illegal all along, and have flourished only because of an outrageous failure by state insurance regulators to enforce applicable laws against the privileged class of financiers.

Structured investment vehicles (SIVs) are another type of derivative, commonly used to wrap up masses of CDOs and synthetic CDOs and then to park them off-balance sheet, where they can be hidden from regulatory and public scrutiny.

All Derivatives Illegal under the New Deal, 1936-1982

All kinds of derivatives, be they exchange traded or over-the-counter, were strictly banned and outlawed in the United States between 1936 and 1982 thanks to a wise measure enacted under the New Deal of President Franklin D. Roosevelt. In the wake of several attempts by predatory and sociopathic speculators to manipulate the prices of wheat and corn during the First Great Depression, the Commodities Exchange Act of 1936 outlawed the selling of options on agricultural products. This law had the effect of blocking most derivative speculation, until the counterattack of free-market fanatics gathered steam under the presidency of Ronald Reagan, an ideological zealot of the Austrian and Chicago schools. The very existence of derivatives today and their resulting ability to bring on a new world depression are thus directly attributable to the reckless and irresponsible dismantling of the New Deal regulatory regime. It should be added that derivatives were also banned in many states as a result of laws prohibiting gambling or forbidding bucket shops, which were betting parlors in which side bets could be placed on stock market fluctuations.

If Obama wants to pretend to have something in common with Franklin D. Roosevelt, he ought to be proposing measures to ban at least the most poisonous types of derivatives, and to discourage the others. Notice that he does nothing of the kind. Obama’s Cooper Union speech of April 22, 2010 approvingly cites Warren Buffett’s remark that derivatives represent financial weapons of mass destruction. But Obama then says that derivatives nevertheless have an important and legitimate role to play. So which is it? Some years back, French President Jacques Chirac rightly referred to derivatives as “financial AIDS.” What useful purpose can these toxic instruments possibly serve?

Again: in his 1936 re-election speech in Madison Square Garden in New York City, Franklin D. Roosevelt famously noted that the forces of organized money hated him, and that he welcomed their hatred. Obama, in sharp contrast, called on the Wall Street predators to join him in his efforts, compounding this with the monstrous thesis that Wall Street and Main Street are in the same boat. Nothing could be farther from the truth. The recent Goldman Sachs scandal has underlined once again that the Wall Street investment houses serve no useful social purpose whatsoever. They exist solely for the purpose of pursuing speculative profits through a process of looting and pillaging the rest of the economy. The Wall Street zombie banks are monopolizing US credit, while Main Street goes broke.

Thanks no doubt to the efforts of certain House Democrats, the reform bill is likely to contain two points which can qualify as positive half measures.

Force Derivatives Out in the Open

The first is the effort to end the secrecy of OTC derivatives by forcing these instruments to be traded on public exchanges or through clearing houses. This is a step in the right direction. But this provision needs to be strengthened by making all derivatives of any type whatsoever reportable to a central regulatory authority. This would include, for example, the derivatives held by hedge funds. In 1998, the Connecticut-based hedge fund Long-Term Capital Management went bankrupt with more than $1 trillion worth of derivatives, blowing a huge hole in the international banking system, and causing Greenspan to rush in with a crony bailout. Nobody has any idea of the amount of derivatives held by hedge funds today. Highly leveraged hedge funds are perfectly capable of causing a worldwide systemic crisis with derivatives, so they must emphatically be made to report their holdings.

This reporting requirement should also include the derivatives held by non-financial corporations, whose shareholders deserve to know if and when management is dabbling in these toxic instruments. Some years back, the Gibson Greeting Card Company took a huge loss on derivatives, so this is no theoretical danger.

In addition, all derivatives must henceforth be clearly listed ON the balance sheets of banks and all other financial institutions. The intolerable practice of hiding derivatives off-balance-sheet must be immediately brought to an end.

The other positive half measure which might survive Obama’s usual quest for a “bipartisan” sellout is the so-called Volcker Rule, which specifies that commercial banks with insured deposits are not allowed to engage in proprietary speculation with their own money. Depending on how this is worded, this may include a long overdue ban on derivatives speculation by commercial banks. Senator Blanche Lincoln of Arkansas, the chair of the Senate Agriculture committee—who is fighting for her political life against a primary challenge this spring—has been backing a provision that would explicitly prohibit commercial banks from engaging in derivatives speculation. These ideas go in the right direction. But we need to do much more. We need to go back to the full New Deal regulations embodied in the Glass-Steagall Act. This law stated that a financial institution could be either or a commercial bank, or an investment house, or an insurance company, but never more than one of these. In other words, the suicidal folly of the Gramm-Leach-Bliley Act of 1999, which repealed Glass-Steagall, must be rolled back.

Outlaw Credit Default Swaps

Beyond this, we must urgently address the catastrophic effects and obvious illegality of credit default swaps. More than a year ago, Senator Warner of Virginia asked Fed boss Bernanke about the advisability of creating a “bright line prohibition” against these CDS. Remember that CDS are already illegal, because they always involve an investor masquerading as an insurance company without having fulfilled the legal and capital requirements that would be demanded from a real insurance company. Credit default swaps have cost the US taxpayer almost $200 billion in the case of AIG alone, because of the bankruptcy of the AIG London-based hedge fund which had issued more than $3 trillion of derivatives – a total greater than the gross domestic product of France.

Credit default swaps are also a clear and present danger today, since they are the principal tool being used by wolf packs of banks and hedge funds against Greece and other nations, accelerating the arrival of the dreaded second wave of the world economic depression. Unless credit default swaps are banned now, they will be increasingly used for speculative attacks against the bonded debt of American states like California, New York, Illinois, and all the others. Before long, credit default swaps will be used by international speculators to attack the value and integrity of United States Treasury securities, threatening our country with the calamity of national bankruptcy. If the United States fails to shut down credit default swaps with timely legislation now, credit default swaps will be used to help destroy the United States and human civilization in general.

Ban Synthetic CDOs

The synthetic CDO or CDO² must also be outlawed. These are the toxic instruments which brought down Bear Stearns, Merrill Lynch, and Lehman Brothers in the great derivatives panic of 2008. What are we waiting for to ban this kind of highly destructive derivative? Such a ban is easy to formulate: “Any collateralized debt obligation which contains other collateralized debt obligations is hereby prohibited.” End of story. This language recalls the approach of the very successful Public Utility Holding Company Act of the New Deal. One layer of CDO is more than enough risk, and it must not be further compounded.

Another ban which is long overdue and which should be included in the current legislation is the outlawing of the Adjustable Rate Mortgage (ARM). The ARM is another catastrophic innovation of recent decades which inherently carries with it an intolerable risk for any homeowner. No American family should be deprived of a roof over their heads because of the unpredictable and volatile fluctuations of interest rates over the life of a mortgage. These ARMs shift an unacceptable risk to the mortgage buyer. Fixed-rate mortgages should be the only legal kind, and any reset or change in interest rates on a residential mortgage should be strictly outlawed. While we are at it, we also need to outlaw the high-interest payday loan, a type of devastating usury to which the poorest and most defenseless parts of our population are now exposed. The outlawing of payday loans should take the form of a de facto federal usury law establishing an upper limit of no more than 10% on any promissory note or credit card. This was the limit traditionally set by state usury laws before the coming of the Volcker 22% prime rate three decades ago, and it should be restored. This simple prohibition of adjustable rate mortgages and payday loans will be far more effective than the proposed creation of an inefficient and unwieldy consumer protection bureaucracy, especially one that is located inside the Federal Reserve. The Federal Reserve has repeatedly struck out when it comes to recognizing systemic risk, when it comes to preventing financial bubbles, and when it comes to protecting ordinary Americans. The Federal Reserve failed in the run-up to the crash of 1929, in the run-up to the banking crisis of 1933, in the run-up to the stock market crash of 1987, in preventing the dot com bubble of 1999-2000, and in regard to the financial derivatives which caused the banking panic of 2008. Locating any consumer protection bureaucracy inside the privately owned Federal Reserve is simply to guarantee that such a bureaucracy will be subject to regulatory capture by Wall Street at the earliest possible moment.

Wall Street Sales Tax of 1% on All Financial Transactions

Derivatives which escape prohibition under these blanket bans on credit default swaps and synthetic CDOs must then be subjected to their fair share of the tax burden. In a time when haircuts, bowling alleys, and restaurants are threatened with new taxation, it is simply inconceivable that the financial turnover of US financial markets should remain immune to all taxation, rather like the French aristocrats of the pre-1789 old regime. Rather than crush the US economy under an ill-advised and oppressive Value Added Tax (VAT) or national sales tax, we must institute a Wall Street sales tax of 1% on all financial transactions and turnover, including derivatives. This is the levy known as the Tobin tax, the Wall Street sales tax, the financial transactions tax, the trading tax, the securities transfer tax, or the Robin Hood tax. A low-ball conservative estimate of US financial turnover (including derivatives) in any given year might be about one quadrillion dollars. In that case, a 1% Wall Street sales tax would yield $10 trillion, $5 trillion of which could be used to confront the federal budget deficit, the costs of entitlements, and the various unfunded liabilities of the federal government. The other $5 trillion would be available for revenue sharing with the states, who could use these funds to deal with their own budget crises, which currently threaten police, firemen, health services, and other indispensable parts of the fabric of civilization itself. One of the main causes for budget deficits of all levels of government in the United States is the glaringly obvious exemption of financial turnover from all taxation, while financial speculators use various tricks to escape paying the corporate income tax. The proceeds from such a Wall Street sales tax would almost certainly decline as speculation became less attractive, but in the meantime they would provide much-needed relief for the public treasury. Needless to say, any idea of paying the proceeds of such a tax to the International Monetary Fund is out of the question. Many other countries are in the process of instituting a Tobin tax on financial turnover, so the inevitable objection that a Wall Street sales tax would represent a crippling competitive disadvantage for US financial markets is increasingly untenable.

Additional Safeguards: Bankruptcy Triage, Reserve Requirement, Hedge Fund Ban

Further safeguards against the derivatives plague are also in order. Current bankruptcy law gives special privileged treatment to derivatives. These poisonous instruments continue to exact their claims even when protection against other creditors has been provided by the federal courts. This abusive and unwarranted favoring of derivatives must be reversed. Derivatives must be made to wait their turn in bankruptcy court, and sent to the end of the line after all other creditors and claims have been satisfied. If bankruptcy triage becomes necessary, it should be at the expense of derivatives.

Another needed measure is the establishment of a reserve requirement for anyone issuing derivatives. We have seen how Goldman Sachs is accused of designing their notorious ABACUS 2007-AC1 CDO, colluding with hedge fund speculator John Paulson to load this CDO with all kinds of super-toxic paper with the intent of designing an instrument which would have the best possible chances of going bankrupt in the short run. A reserve requirement for those issuing derivatives would mean that they would have to buy and hold on their own books for the life of the investment at least 20% of any derivatives they issued. This would represent an additional deterrent against the deliberate concocting of toxic derivatives with the intention of then allowing a speculator to short them with the help of credit default swaps.

A final necessary change involves the grave risk inherent in the existence of hedge funds. Despite their name, the main business of hedge funds is pure predatory speculation. Hedge funds are currently allowed to fly below the radar of the Securities and Exchange Commission, escaping regulation because they have only a limited number of super-rich investors. It is high time that this loophole came to an end. Once a hedge fund is regulated, it is no longer a hedge fund, so the call to regulate hedge funds is for all practical purposes a call for their abolition. Hedge funds should have been subject to regulation no later than the immediate aftermath of the Long-Term Capital Management debacle of 1998. The hedge fund loophole in the SEC rules must be closed now.

Seize and Liquidate the Zombie Banks

Obama’s $50 billion resolution fund for bankrupt banks is unnecessary. What we need most of all is to have the Federal Deposit Insurance Corporation, the Comptroller of the Currency, and other regulators enforce the applicable laws. Every Friday, Sheila Bair of the FDIC shuts down a number of small town banks because of insolvency. In her interview yesterday on CNBC, Ms. Bair blatantly admitted that she has no intention of enforcing these same public laws against the large Wall Street and other money center banks. She covers this malfeasance and nonfeasance with her opinion that bankruptcy does not work for the big banks. But there is little doubt that, if their massive derivatives holdings were priced according to mark to market rules, J.P. Morgan Chase, Citibank, and Bank of America would all be thoroughly insolvent candidates for Chapter 7 liquidation. Unless and until this is done, these zombie banks will continue to block any real economic recovery in the United States. Ms. Bair’s policies showed the destructive folly of the current administration’s illegal policies, which are all based in the final analysis on the discredited doctrine of Too Big to Fail.

Any Wall Street reform bill should also deal with the public scandal of the ratings agencies – Standard & Poor’s, Fitch, and Moody’s. These agencies enjoy a quasi-governmental status when it comes to certifying the quality of certain investments. But the failure of these agencies to provide timely warnings during the onset of the derivatives panic was nothing short of spectacular. During that crisis, the ratings agencies were certifying investments as AAA investment-grade until mere hours before they collapsed. Senator Carl Levin’s investigation of the ratings agencies has now unearthed horror stories of corruption and incompetence. The ratings agencies need to be stripped of any special role in relation to the United States government. Senator Levin’s findings merit criminal referrals to the Justice Department for prosecution of these agencies and their executives. In short, the United States government should take this opportunity to shut down these rating agencies, before these corrupt entities join in the looming speculative assault on the US Treasury, which is being prepared by George Soros and the other hedge funds.

Wall Street speculators will certainly howl that the measures outlined here represent a vindictive policy of discrimination against derivatives, which they will attempt to portray as a beneficial innovation serving the public interest. But no serious analysis of the banking panic of 2008 can ignore the obvious role of financial derivatives as one of the principal causes of this disaster. As for the charge of discrimination, it should be clear that the proposals made here generally represent nothing more than ending the privileged special treatment which has been granted to derivatives so far. Derivatives have been exempted from the gambling laws. Derivatives have been given special status in bankruptcy proceedings. Derivatives have been made non-reportable, and carrying them off balance sheet has been allowed. Derivatives have been exempted from the usual laws governing the operations of insurance companies. Hedge funds have been exempted from the scrutiny of the Securities and Exchange Commission. Wall Street derivatives banks have been exempted from the usual bankruptcy laws and probably from the antitrust laws as well. Finally, derivatives, like all financial instruments, have been exempted from state sales taxes. This distorted treatment amounts to a systematic pattern of facilitating and fostering derivatives speculation under US laws and regulations. This pattern might be defensible if derivatives represented a public good. But all experience shows that derivatives are just the opposite – they are a public menace which now threatens to destroy our civilization and way of life.

Sun, 04/25/2010 - 20:58 | 317380 Inspector Asset
Inspector Asset's picture

Satan has been unleashed unto the world.  I see him in 2 forms.

1.Derivatives

2.Drugs

Is there really much difference between a ganster and a bankster?

 

Sun, 04/25/2010 - 21:22 | 317408 Yossarian
Yossarian's picture

What specific change with respect to derivatives and the regulation and accounting thereof occurred in 1982?  

Sun, 04/25/2010 - 22:25 | 317498 Yossarian
Yossarian's picture

I skimmed the 80 pages in that link and I have read Frank Partnoy's Infectious Greed years ago; perhaps I missed something in the footnotes but I do not see an answer to my question regarding specific regulatory changes made in 1982.  Please specify- thx.

Sun, 04/25/2010 - 22:59 | 317521 geopol
geopol's picture

Don't skim,,

Forward,,do your own research....

Last response was a hint!! Good luck

 

 

Derivatives were illegal in the United States between 1936 and 1983. In 1933, an attempt was made to corner the wheat futures market using options, and the resulting outcry led to a 1936 federal law banning such options on farm commodity markets. This ban was repealed by the Futures Trading Act of 1982, signed by President Reagan in January 1983. During the G.H.W. Bush administration, Wendy Gramm of the Commodity Future Trading Commission went further, promising a “safe harbor” for derivatives. Despite the key role of derivatives in the Orange County disaster during the Clinton years, a valiant attempt by Brooksley Born of the CFTC to make derivatives reportable and subject to regulation was defeated by a united front of Robert Rubin, Larry Summers (today running US economic policy), and Greenspan.  Despite the central role of $1 trillion of derivatives in the Long Term Capital Management debacle of 1998, Phil Gramm’s Commodity Futures Modernization Act of 2000 guaranteed that derivatives, notably credit default swaps, would remain totally unregulated. These pro-derivatives forces must bear responsibility for the current depression, and those still in power must be ousted

Mon, 04/26/2010 - 00:30 | 317593 Yossarian
Yossarian's picture

http://en.wikipedia.org/wiki/Commodity_Exchange_Act

http://en.wikipedia.org/wiki/Commodity_Futures_Modernization_Act_of_2000

I still don't see what happened in 1982- the CFTC was created in 1974 and, as far as I can tell, the 1982 update further clarified the regulatory authority between the SEC and the CFTC.  As far as I can tell the build up of leverage in the system is less a result of a regulatory change and more the result of a long period of declining interest rates post-Bretton Woods.  

 

 

 

 

Sun, 04/25/2010 - 21:38 | 317441 Implicit simplicit
Implicit simplicit's picture

Great post Geopol. Love a post with solutions.

The only other two important chages that could be made would be some type of controls over the lobbyists'  contributions, and front running with high volume trades.

None of these great changes will ever be implemented if the the financial lobbyists are able to continue bribing the politicians in the present manner.

With 73% of trading done with computers using algos to front run with high volume trades, the markets can continue to be manipulated every day.

Sun, 04/25/2010 - 22:38 | 317511 Hulk
Hulk's picture

Excellent, excellent, excellent!

I don't expect your solutions will ever see the light of day, with fraud and corruption being rampant , wallstreet running DC, and the american public incapable of understanding derivatives and synthetics..

Would be surprised to see a Tobin tax, but VAT is baked in the cake.

Well done. getting ready for my second read..

Sun, 04/25/2010 - 23:40 | 317555 Crab Cake
Crab Cake's picture

Geo, first off, I would like to apologize for the people that junked you.  I love your posts, please don't stop.  I not only read them, but re-read them.  Sincerely thank you for contributing.

You have a much more knowledgeable, and researched, point of view but for me it is as easy as crying to the heavens, "Re-enact Glass Steagall!" 

Hulk posits that your solutions will not see the light of day, but I disagree.  Our so called representatives will do the right thing when there is no other possible option, and only then.  Which is to say that we will test the waters of oblivion, suredly.  If, if, we manage to avoid total catastrophe, and a new dark age, which is a debateable point; then your solutions will indeed see the light of day because there will be no other alternative. 

Mon, 04/26/2010 - 01:26 | 317621 Hulk
Hulk's picture

I hope you are correct CC, but I have to tell you, I work for the feds and see the corruption first hand, its in my face. Thats why I am so pessimistic. My guess is the system fails before these corrupt and evil bastards change their tune..Pay close attention to the writings of the poster colonial, that person knows first hand what is going on inside of DC and does nice reporting

Mon, 04/26/2010 - 00:40 | 317596 Jefferson
Jefferson's picture

While you accurately characterize the toxic nature of the derivatives industry, you fail to identify the causal role that fractional reserve banking, the Federal Reserve System and GSEs played in creating the necessary groundwork for said "monstrousities" to come to life in the first instance. You lamely ascribe to the "free market" financial outcomes that are nothing more than the inevitable result of an unconstitutional, state granted private monopoly over the issuance of money. Therefore, your proferred solutions are simply excuses for further government control and interference in the workings of the free market that had it been left to function properly would never have allowed the creation of financial Frankensteins. Just more pathetic myopic statist rationalizations.

 

Audit then end the Fed. Enough said.

Mon, 04/26/2010 - 04:49 | 317680 Pondmaster
Pondmaster's picture

Ok , now that my entire morning coffee market propaganda time has been taken up reading this . Good ideas . Where the heck did you come up with this . Do you have a URL  to it , or is it your own writing. If yours , you don't belong here and are wasting talent .

Sun, 04/25/2010 - 20:25 | 317345 parallaxview
parallaxview's picture

i read every bit ofthis. there should be 200 comments here, all of them by main stream media asking questions

Sun, 04/25/2010 - 20:32 | 317352 rawsienna
rawsienna's picture

The media is too stupid to ask the correct questions. So are most members of congress.

Sun, 04/25/2010 - 21:09 | 317386 SRV - ES339
SRV - ES339's picture

On the contrary... I think we should be asking the MSM a few questions (or maybe Lloyd just forgot a few things in his cover up memo to "Lies Man")!

Great post Tyler... can't wait for the followups!

BTW I sent a link of this post to Senator Carl Levin... Chair of the sub-committee questioning Goldman this week... hope you all can take the few minutes to join me! 

The link below gets you to a contact form...

http://levin.senate.gov/contact/

Sun, 04/25/2010 - 20:30 | 317347 rawsienna
rawsienna's picture

If the prop desk at Goldman knew what was going on with the Paulson trade, insider trading charges could be a possibility.  Knowing AIG's position and shorting the stock via the prop group is another issue.  Also, one needs to question all 1st and 2nd quarter earnings reports from ML/Bear and LEh given that the problems were already known in first quarter 07.  If memory serves me right, MER reported record 2nd quarter 2007. THey owned 40bb in cdo at the time - If I were a shareholder at the time I would be pissed. 

Last but not least.  Cant ignore the rating agency along with the role that Basel II played in creating the mess. Basel II allowed AAA rated structured products to get capital treatment similar to govt bonds. Banks went crazy to buy a "spread" product with minimal risk weightings.  Without the demand from banks, these CDO's would have been much more difficult to sell to "sophisticated" real money investors. At the very least, the spreads or yield premium of the AAA's would have been much greater (most real money guys knew the rating were bullshit .. how come no hedge funds or real money managers held CDO's?) THe rating agency arb would have been much less and fewer subprime loans would have been made. Oh, the biggest support of the reduction in teh capital requirements for banks holding AAA structured prodcuct - Rob Rubin, Greenspan and Little Timmy

 

Sun, 04/25/2010 - 21:26 | 317413 Augustus
Augustus's picture

MER, LEH, C, IKB, BS were all feasting on the carry trade.  It was intentional.  They did it on purpose and with a plan.  Can you recall the SPV and SIV arrangements that they created to enhance the ability to feed?  No one took advantage of them.

Goldman was way down the list of the creators of the junk.  They were just better at managing the risk. 

Sun, 04/25/2010 - 20:33 | 317353 dcb
dcb's picture

and all this time bernanake was saying there wouldn't be a problem

Sun, 04/25/2010 - 20:34 | 317354 Inspector Asset
Inspector Asset's picture

Quoting from "the Partnership" the making of Goldman Sachs with a few of my comments.  My view is Goldman, confesses to much of this current fraud in their own auto biography: 

 

page 672
Risk is complex and deceptive. There are known riskd and unknown risks. And risk is not entirely quantitative. At the margin, managing risk is closer to an art than to a science and depends on experience and judgement. That's why the original J.P. Morgan so wisely emphasized character
as the basis for extending credit.
Modern finance is based on one great simplifying assumption-- that markets are efficient and that market prices reflect almost all that is known or knowable. So, if diversified to absorb market imperfections , the aggregate portfolio will be "market efficent." Of course foe every rule there will be exceptions--exceptions that prove the rule--so when dealing with new or unusual securities, investors should diversify even more widely, adding a margin of saftey so their portfolios will be protected against risks---except for the unusual unexpected anomalies calles black swans.
Those with substantail experience knew that analytical models like (Var), however widely celebrated as the latest thing in risk controls, would catch all the normal risks, but not the killer risks-----the toxic black swans that reside in the six-sigma "fat tails" of a normal bell -curve distribtion of propbable events.
(Ah, but Goldmam was able to spot these "black swans?" I thought the book about black swans came out just recently, yet this author is throwing it around like its been around awhile. Hmm, I wonder why? Oh, because in the next paragraph he describes how Goldman made billions shorting sub prime. The "Black Swan" sounds like a great story, but the real reason is Goldman shorted the ABX index.)
Almost every element of risk ----toxic or rewarding was on display in the mortgage crisis that rocked the United States and the world in 2007. At Goldman Sachs, the structured-products group of sixteen traders is responsible for making a market for clients trading a variety of securities based on residential mortagages. Simultaneously but quite separtely, members of this group trade or invest the firms own capital or take the other side of a client's transaction, either because they a good opportunity or to fulfill their role as a market maker. Because those businesses are separate, (but they aren't really separate in you have the CFO giving a command to sell 10% ) it's well understood by all parties that Goldman Sachs has no obligation to tell trading clients what it is doing in its propreitary activities----even when it is handling buy orders for client's accounts and selling for its own account, as was the situation in 2007.

A year eariler, in yet another line of business, Goldman Sachs had been a major underwriter of securities backed by sub prime mortgages. Because subprime mortgage-backed bonds traded only occasionally and only privately, a new family of indexes, called ABX, was created to reflect these bonds' values based on instruments called credit-default-swaps. These are derivatives that pay the buyer if borrower default on their mortagages and the mortgage backed securties fall in price. The derivatives actually trade more often than the bonds themselves, with their prices rising and falling as investors' views of the risk of subprime defaults rise and fall. As expected, withen the firm's mortgage department, the introduction of the ABX was great for traders. The firm made $1 million on the first day, but volume was thin and the firm had to use its own capital on most trades.

In December 2006, David Viniar, the firm's highly respected, long serving, and unflappable CFO, pressed for a more negative posture (nice way of putting it) on subprime mortgages. (Yet Paulson is at the Tresasury saying everything is fine in real estate!) He wanted the firm to offset its long position in collateralized debt obligations (CDO's) and other arcane securities that it had underwritten and was holding in inventory to trade for customers, and to do so by shorting parts of the ABX or buying credit-default swaps. When traders complained they did not know how to price their portfolios, Blankfein (above they say it was Viniar) it ordered them to sell 10 percent of every position. (That should get the avalanch started in the stock market).
page 675

Sun, 04/25/2010 - 21:43 | 317449 dcb
dcb's picture

you need the link here to the quotes.

Mon, 04/26/2010 - 06:29 | 317700 Mercury
Mercury's picture

Those with substantail experience knew that analytical models like (Var), however widely celebrated as the latest thing in risk controls, would catch all the normal risks, but not the killer risks-----the toxic black swans that reside in the six-sigma "fat tails" of a normal bell -curve distribution of probable events.

'Fat tails' don't exist in normal distributions they are a characteristic of distributions with high kurtosis or 'peakedness' (as they appear when graphed).

Otherwise the jist is essentially correct here. VAR doesn't do well with extreme, outlier events and neither does anything else really that tries to cram messy reality into a normal distribution.  Taleb wasn't the first with this insight but he did tie it all together nicely (The Black Swan) and show how our world of complex, interconnected finance and information networks make us especially susceptible to being disrupted by rare but high impact events.

That, said, you didn't need a math Phd to come to the conclusion that the subprime mortgage market was a house of cards waiting to blow apart. 

Sun, 04/25/2010 - 20:45 | 317359 FEDbuster
FEDbuster's picture

"Pay no attention to that man behind the curtain." (Wizard of Oz 1939)

"We are doing God's work".  (Lloyd Blankfein 11/8/2009)

Thanks ZH for taking a peak behind the curtain and exposing the lies and fraud.

Sun, 04/25/2010 - 20:46 | 317365 fxrxexexdxoxmx
fxrxexexdxoxmx's picture

 of Bush, Henry Paulson, John McCain, Sarah Palin, and the Obama Democrats.

 

Why did you leave out the globalist Hillary and her DNC money from wall street? Hillary got calls from turbo tim.... why would you not have both Bill and Hill in this sentence. Bill Clinton got elected twice as a direct result of money from the Banks who are Wall Street.

Sarah Palin are you kidding? She is a hillbilly from Alaska who does not understand big time money stuff.

Sun, 04/25/2010 - 20:48 | 317369 jory
jory's picture

All this Goldman bashing is absurd.  They fleeced their clients.  So what?  If their clients are dumb enough to get fleeced, they deserve the loss.  What I can't understand is how Goldman still has clients willing to do business with them.  If they are dumb enough to continue doing business with Goldman, they deserve to get fleeced again.

 

Sun, 04/25/2010 - 20:58 | 317381 jomama
jomama's picture

'The implications of the data in the table above are obvious,' - how i wish this applied to the other 97% of the population.

Sun, 04/25/2010 - 23:18 | 317543 Miles Kendig
Miles Kendig's picture

Without question.

Sun, 04/25/2010 - 20:59 | 317383 Fritz
Fritz's picture

The squid must die!

Sun, 04/25/2010 - 21:01 | 317387 JR
JR's picture

The dominance of Goldman Sachs in financial markets and in politics is considerably more extensive than the Standard Oil and other trusts of Teddy Roosevelt’s era.  But Roosevelt set a tone for the damage these oligarchs cause to the American system.  Here for example, is the description of his “campaign against privilege” recorded in Edmund Morris’ best seller, “Theodore Rex.” 

“His targets were stock gamblers ‘making large sales of what men do not possess,’ writers who ‘act as the representatives of predatory wealth’ (among them, probably, the entire editorial staff of the New York Sun), and ‘men of wealth, who find in the purchased politician the most efficient instrument of corruption.’ He reserved his strongest language for these multimillionaires, not identifying them directly but taking care to repeat, with incantatory frequency, the names of John D. Rockefeller’s Standard Oil Company and E.H. Harriman’s Santa Fe Railroad.  Such men were ‘the most dangerous members of the criminal class—the criminals of great wealth.’”

It’s interesting to imagine what Teddy Roosevelt would feel faced with the far more dangerous developments to come in the Wilson Administration--the banker assisted world war, the banker division of the spoils of the Treaty of Versailles, and the signing of Paul Warburg’s Federal Reserve Act in 1913.  This is heritage of the Goldman Sachs dominance.

Sun, 04/25/2010 - 21:17 | 317401 Augustus
Augustus's picture

That Rockefeller just ripped the consumer a new one when he brought down the price of fuel by about 75%.  Why should he have been allowed to make a profit doing that?  That's just crazy talk.

Sun, 04/25/2010 - 22:50 | 317519 JR
JR's picture

And the benefits just keep coming.

“John D. Rockefeller made his initial fortune in oil but soon gravitated into banking and finance.  His entry into the field was not welcomed by Morgan, and they became fierce competitors.  Eventually, they decided to minimize their competition by entering into joint ventures.  In the end, they worked together to create a national banking cartel called the Federal Reserve System.”  ~ G. Edward Griffin

At that time, of course, the biggest investment houses such as Morgan & Company and Kuhn, Loeb & Company already had ceased doing serious battle against each other. Already, the concept of trusts and cartels had dawned in America.

John Moody wrote in the year 1919 from an inside view of the high number of interlocks on Wall Street of how John D. had used his enormous profits from Standard Oil to take control of the Chase National Bank…and his brother, William, bought the National City Bank of New York. 

Says Moody: “This remarkable welding together of great corporate interests could not, of course, have been accomplished if the ‘masters of capital’ in Wall Street had not themselves during the same period become more closely allied.  The rivalry of interests, which was so characteristic during the reorganization period a few years before, had very largely disappeared.  Although the two great groups of financiers, represented on the one hand by Morgan and his allies and on the other by the Standard Oil forces, were still distinguishable, they were now working in practical harmony on the basis of a sort of mutual ‘community of interest’ of their own.  Thus the control of capital and credit through banking resources tended to become concentrated in the hands of fewer and fewer men…  before long it could be said, indeed, that two rival banking groups no longer existed, but that one vast and harmonious banking power had taken their place.”

Mon, 04/26/2010 - 00:13 | 317578 Augustus
Augustus's picture

Repeating conspiracy theories does nothing to make them true.  However, it is observeable that the price of the oil was reduced by abut 75% to the consumer.  Was that good or bad for Mr. Regular Joseph?  And if there was still a profit, that was an evil?

A dew weeks ago there was an article about a hedge fund that had bought 10 yr. CDS on Greece a few years earlier at about 20 bp.  They just thought they were too cheap.  Now that they might be at 800 - 40X gain - are they to be prosecuted?  Supoena their email trail.

Neither Paulson, Citi, Goldman, JPM, MER, BAC or anyone else would have ever forecast that so many people posting at ZH would consider it ethical to simply walk away from their obligations and abandon their homes.

Sun, 04/25/2010 - 21:35 | 317433 buzzsaw99
buzzsaw99's picture

Michael You have to answer for AIG, Goldman, and you fingered Lehman for the Barclay's people.

Carlo Rizzi: Mike, you got it all wrong.

Michael: Ah, that little farce you played with the Paulsons. You think that would fool a Corleone?

Carlo Rizzi: Mike, I'm innocent. I swear on the kids.

Michael: Sit down.

Carlo Rizzi: Please don't do this to me, Mike. Please don't.

Michael: Moody's is dead. So is Bear Stearns. Countrywide. WaMu. FNM, FRE, AIG, delisted. Today I settled all family business so don't tell me that you're innocent. Admit what you did.

[GS starts sobbing]

 

Sun, 04/25/2010 - 23:42 | 317560 Crab Cake
Crab Cake's picture

+100

Love it.

Sun, 04/25/2010 - 21:54 | 317462 dcb
dcb's picture

does the post say that in effect they get aig to insure crap, then knowing that they insured crap then short aig. remember they were also the ones who forced aig to put up more capitial. Which many pundits have said that brought them to their knees 

 

Sun, 04/25/2010 - 21:56 | 317466 FranSix
FranSix's picture

Wall St. Journal posted an article via Yahoo, which is also featuring Maria Bartiromo (I always say Fart aroma) poo pooing fraud charges against Goldman.  She is on a doorstop tour.  You would also have to dig up every last tape of CNBC talking heads ridiculing the notion of a housing bust to realize that the job is not over until they say it is.

http://finance.yahoo.com/loans/article/109380/the-busted-homes-behind-a-...

I find it fascinating they are co-opting Tech Ticker at Yahoo as their online captive media.

 

Sun, 04/25/2010 - 22:21 | 317495 mister_x
mister_x's picture

And the media focusses on Tourre's love letters...

The people who should be reading these e-mails closely are their clients (the ones who survived the ransacking anyway). Market makers, my ass. There is just wanton disregard for their (sucker) clients. The only way The Squid goes down is if their big clients start leaving in droves disgusted by their behavior. No one else can harm GS.

Good work on digging through their emails.

 

 

 

 

 

Sun, 04/25/2010 - 22:52 | 317522 SilverIsKing
SilverIsKing's picture

As Goldman Sachs Turns, Part Deux

Sergey Aleynikov - What does he know?  Who did he tell?

Sun, 04/25/2010 - 23:15 | 317540 cbaba
cbaba's picture

Thank you Tyler Durden ,thank you  ZH team, its excellent work.

Sun, 04/25/2010 - 23:26 | 317548 Miles Kendig
Miles Kendig's picture

I wonder how the order & fee flow broke down over the same period in the other segments of its organization... and from that the real conversion rates.

Sun, 04/25/2010 - 23:53 | 317566 LeBalance
LeBalance's picture

What if GS is not about the bonuses?

What if GS is Project Mayhem?

Mon, 04/26/2010 - 05:32 | 317691 Alexandra Hamilton
Alexandra Hamilton's picture

Yes, what if?

Sun, 04/25/2010 - 23:59 | 317570 JR
JR's picture

Lloyd's disingenuous defense of his profitability, as seen in an email from November 18, 2007, is hilarious. "Of course we didn't dodge the mortgage mess. We lost money, then made more than we lost because of shorts."

Yes, of course Goldman Sachs did profit by going "short" on housing - by betting that mortgage-backed securities would fall.  And all this posturing brings to mind this excerpt from The Long and Short of It at Goldman Sachs written by Ben Stein on December 2, 2007 in the NY Times:

http://www.nytimes.com/2007/12/02/business/02every.html?pagewanted=all

…More thoughts came to me as I read a recent piece in Fortune by my colleague Allan Sloan, a veteran financial writer. Mr. Sloan traces the life and death throes of a Goldman Sachs-arranged collateralized mortgage obligation. He shows how truly toxic waste was sold to overly eager investors who now have major charge-offs, and he also points out that some parts of the C.M.O. were indeed safe and were either current or had been paid off.

But what leaps out at me from this story is that Goldman Sachs was injecting dangerous financial products into the world's commercial bloodstream for years.

My pal, colleague and alter ego, the financial manager Phil DeMuth, culled data from a financial Web site, ABAlert.com (for "asset-backed alert"), that Goldman Sachs was one of the top 10 sellers of C.M.O.'s for the last two and a half years. From the evidence I see, Goldman was doing this for years. It might have sold very roughly $100 billion of the stuff in that period, according to ABAlert. Goldman was doing it on a scale of billions even when Henry M. Paulson Jr., the current Treasury secretary, led the firm.

The Goldman spokesman would not comment on this except to note that other firms sold C.M.O.'s too.

The point to bear in mind, as Mr. Sloan brilliantly makes clear, is that as Goldman was peddling C.M.O.'s, it was also shorting the junk on a titanic scale through index sales -- showing, at least to me, how horrible a product it believed it was selling.

The Goldman Sachs spokesman said that the company routinely shorts the securities it underwrites and said that this is disclosed. He noted candidly that Goldman is much more short in this sector than usual.

From what I have observed over the years, Goldman has a fascinating culture. It is sort of like what I imagine the culture of the K.G.B. to be. You always put the firm first. The long-ago scandal of the Goldman Sachs Trading Corp., which raised hundreds of millions just before the crash of 1929 to create a mutual fund, then used the fund's money to prop up the stocks it owned and underwrote, was a particularly sad example. The fund, of course, went bust… (emphasis mine)

Here is a query, as we used to say in law school: ... Should there not be some inquiry into what the invisible government of Goldman (and the rest of Wall Street) did to create this disaster, which has caught up with some Wall Street firms but not the nimble Goldman?

Mon, 04/26/2010 - 00:25 | 317587 RockyRacoon
RockyRacoon's picture

Some years ago I read a biography of Amarillo Slim.  All through the book was the undertone, far from stated, that he would rip out your lungs for a buck.  He co-authored a book called Play Poker to Win.  Just like GS, Amarillo Slim never bet on anything that he didn't know the outcome of.  One of his ploys was to pre-count the number of watermelons on a farmer's truck.  When the truck rolled into town, Amarillo Slim would bet a bystander (the shill) that he could "guess" the number of melons on the truck.  GS knew that their "bets" were sure things.  I see no difference between the two characters.

Mon, 04/26/2010 - 01:21 | 317616 primefool
primefool's picture

This circus is deeply disappointing. It diverts attention from the real issue which is - Why was Lehman taken down? Was the financial panic purposely triggered - to facilitate the bailout of AIG counterparties by the US taxpayer? The motives are there - and the financial and economic damage caused to the country is very large. If a small group of interested players have the ability to trigger such crises at will for their own purposes this is a real problem that needs to be fixed.

Unfortunately this issue inconveniently puts the focus on high level govt officials. So lets distract and amuse the sheeple with emails from 27 yr olds to their girlfriends and scold a trading firm for umm - trading. Oh so its suddenly "salacious" to have internal messages rejoicing in trading gains and bemoaning trading losses? Its suddenly a moral problem when a trading operation correctly foresees a decline in a particular asset class and trades accordingly? I actually fail to see what exactly is so exciting about these GS emails. Just entertainment for the unwashed masses (including congress).

Mon, 04/26/2010 - 02:01 | 317634 Jefferson
Jefferson's picture

You correctly identified the smoke and mirrors nature of the current engineered financial crisis.

The financial crisis is simply another excuse to justify the globalists promulgating a new set of regulations to consolidate power and control over the financial system. These regulations are then sold to the deluded public as a solution to stabilize the "asymmetrical" tendencies of the so-called free market. But in reality financial reform is nothing more than a mechanism to further the globalists' ill fated social engineering project.

Mon, 04/26/2010 - 03:59 | 317665 FranSix
FranSix's picture

The financial crisis was not engineered in any sense.  Its real. Its as real a calamity as you would ever see.  The inflationary tactics in use since the peak of the discount rate in yr. 2000 are all manufactured, papering over what is an historic credit collapse.  The greatest slow motion train wreck in history.

You will never see as pervasive a financial crisis without a chart like this:

http://stockcharts.com/h-sc/ui?s=$IRX&p=M&b=5&g=0&id=p45163948136&a=191116053&listNum=2&listNum=2

 

Now as for derivatives, the salient detail over why these things may be fraudulent seems to have gone missing.  If you had signed to a CDO with one of these banks, and they hold the CDS or the risk, and they pooled the risk as they had been doing, forming a risk cartel, this is clearly a crime.  In some countries, its not, apparently to nakedly trade somebody's risk when they hadn't signed any sort of deal with you.  

Now, if they also had adjusted the underlying algorithms on which a CDO deal was struck after the fact, then that would be quite a whitecollar crime indeed.

Bankers are always pointing to the fact that the laws are antiquated when it comes to CDO's and CDS' and they should not be regulated.  Well, is it because they have found an avenue to preptuate a money making scam with no clear legal definition?

-F6

 

Mon, 04/26/2010 - 05:22 | 317689 Jefferson
Jefferson's picture

Engineered does not mean the crisis didn't really happen but rather it happened by design rather than by accident. Only a sucker would actually believe the fairy tale that the Fed was bamboozled and honestly believed exponential house price increases were driven by fundamentals. Or the other blatant lie that the Fed and its staff did not understand the destructive nature of a quadrillion dollars worth of derivatives because they were too complicated. Anybody who believes the Treserve propaganda is clueless.

 

 

 

Mon, 04/26/2010 - 07:01 | 317710 aheady
aheady's picture

Right on.

Mon, 04/26/2010 - 07:24 | 317717 FranSix
FranSix's picture

"Engineered does not mean the crisis didn't really happen but rather it happened by design rather than by accident."

To say the financial crisis was engineered is preposterous, because it would have taken 20 years of planning in the 1970's and 80's so that it could be carried out along with the Nasdaq crash. Absolutely preposterous nonsense.

If you only look at the banking crisis from a U.S. perspective, then you are likely to believe the whole thing was manufactured, because GS is such a large player in the whole affair.  The crisis is a worldwide phenomenon.  There were only a tiny number of economists and financial analysts pointing out the collapse of the U.S. housing bubble.

As they say, a sucker is born every minute.  The Fed (along with other central bankers) would have us believe that the financial crisis is over. This is widely accepted as fact right now.

Looking at this inflation-adjusted chart, we still have a very long way to go:

http://dshort.com/charts/N225-SP500-deflation-series.html?N225-SP500-ove...

Its just a replay of previous statements and claims that "the crisis is over" or "the crisis has been managed by The Fed."

Mon, 04/26/2010 - 08:27 | 317733 Jefferson
Jefferson's picture

Nobody at the Treserve truly believes the financial crisis is over. They know the next stage of the GFC consists of serial sovereign debt defaults because they planned it that way. Do some research into the numerous G-20 initiatives establishing an international monetary regime utilizing a single global reserve currency adminstered by the BIS/IMF/FSB crew. It is magical thinking to actually believe these initiatives including the $500 billion SDR denominated NAB, FAT and Green Fund just spontaneously descended from the monetary ether. The current GFC, along with a myriad of related "global governance" programs, has been decades in the planning.

The biggest proponent of a single global currency has been Volcker who just happens to be the designated adult in the Obama adminstration. Volcker was the prime mover at the Treasury in establishing Bretton Woods II. Not to mention the role Volcker played in moving the USD off the gold standard. Volcker, founder of the G30, and his buddies (e.g. see G-30 manual on derivatives published in 1993) have not only known about but have methodically planned the global monetary regime that is now being instituted in response to the GFC caused by the derivatives time bomb.

Mon, 04/26/2010 - 03:05 | 317649 KAckermann
KAckermann's picture

Thank you for posting this.

Mon, 04/26/2010 - 04:26 | 317675 ambrosiac
ambrosiac's picture

 

Excellent.

 

A summary and a link to this ZH post ought to be e-mailed around Washington, D.C. ASAP.   Which means now.

Mon, 04/26/2010 - 05:53 | 317695 if
if's picture

Wow, top notch analysis!!!

"We have various risk sharing arrangements, but deal unwinds are very painful...." 

In a previous ZH article it was noted that Goldman reduced its exposure to AIG by selling it to some european bank (Deutche Bank as I recall).  If they did so using the techniques described in the quote from Dan Sparks email it would confirm their massive exposure to AIG was partially hidden for the sake of appearances.  Pretty much what Lehman was doing.

Mon, 04/26/2010 - 07:29 | 317718 primefool
primefool's picture

I honestly dont understand all the hand-wringing going around the internets(hick) about the GS prop desk being short this or long that. I mean a prop desk exists to trade short and long in order to make profits - lots if possible. ( yes its a "profits scam" - from "The Jerk"). They exist only to make trading profits. The traders are under enormous pressure to make profits. This is most definitely NOT the issue.

The issue is why is uncle Ben stealing crumbs from Grandma and giving it to these masters of the universe. Is it fair that Gran is going without her favorite herbal tea ( cost $4.99) because her savings account pays Zero - so that JP Morgan can borrow at Zero to fund their BSD Masters Of The Universe? Do you know anyone that can borrow at 0% interest- any small businesses borrow at 0%? No sir - only the Masters Of The Universe. Zero is abou 2-3% below the manipulated inflation rate.

There is about $10 Trillion of retail deposits etc that should be earning , say, 3%. So about $300 Billion a Year is being tranferred from the grannies of the US to the Masters Of The Universe so they can buy Chinese stocks, short Greek Bonds etc etc.

This is an Outrage.

Mon, 04/26/2010 - 07:45 | 317727 Ambah Sabine
Ambah Sabine's picture

You reading this, Cramer, Erin? Good stuff, eh!

Mon, 04/26/2010 - 07:45 | 317728 primefool
primefool's picture

I am cynical enough at this stage that I think all that will come of these stupid congress hearings is a bunch of congress critters giggling about the 27 year old associate's love letters to his girl friend. That they can understand. That they enjoy.

Mon, 04/26/2010 - 08:02 | 317734 primefool
primefool's picture

Back on why Lehman failed. Uncle Ben clains he had no power to save them - no resolution authority. BS. You really believe that the Chmn Of TheFed Reserve could not have arranged a $20bil liquidity bridge for a large important WS firm that had met all their requirements a few days earlier and had $28 Billion in equity. One day after Lehman is shot down , the Fed enables unlimited acces to liquidity for Wall Street firms. I mean come on - really? You believe this story? So Lehman is executed and thus triggers massive panic - that then enables TARP to be passed - that then enable AIG counterparties to be made whole. Anyone feeling satisfied with the LAME answers from Ben and Tim?

Mon, 04/26/2010 - 08:09 | 317736 primefool
primefool's picture

After they are done giggling about the girlie letters, no doubt the congress critters will the turn to the serious business of scolding the GS guys about making too much money. To which the GS guys will say , no no we did'nt make that much actually we lost some money etc etc blah blah blah. All completely beside the point and purely for public entertainment. These congress critters have no real desire to actually get to the bottom of real issues. Just make a show of it.

Mon, 04/26/2010 - 08:21 | 317742 primefool
primefool's picture

Ok OK  I have a solution that congress can pass, and not hurt Wall Street profits in the least or reduce Wall Street contributions to congress Here goes:

Require the TBTF entities to send a postcrd tpo every owner of a savings /money market account in the country saying:

" We at JPM/GS/MS/BAC thank you for financing our trading operations. It has allowed our hardworking traders to once again enjoy their summers in the Hamptons like in days of old. But for your support , in these difficult time, it would be difficult for us to be the Best and Brightest this country has to offer the world. So once again , we thank you for accepting a Zero interest rate on your deposits/our borrowings."

Thats all I ask.

Mon, 04/26/2010 - 09:56 | 317878 Ned Zeppelin
Ned Zeppelin's picture

If you are unsure, allow me to offer some clarity. Here is the right way to look at this GS case.  A good, solid, zinger, slam-dunk, no-brainer case, by the way.  But remember, it's not criminal, it's civil.  Big difference.

http://www.ritholtz.com/blog/2010/04/10-things-you-dont-know-gs-case/

Do NOT follow this link or you will be banned from the site!