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