Guest Post: Goldman's Disinformation Campaign: Drilling Down Into The Documents

Tyler Durden's picture

By David Fiderer

Goldman's Disinformation Campaign: Drilling Down Into The Documents

In his latest Bloomberg column on Goldman Sachs, William Cohan makes an important point:

"Goldman hasn't made its internal analysis public, nor does it intend to, but it has showed the documents around town (including to me)."

In other words, the answer shall remain secret. Only those deemed worthy by Goldman may see its data, which purportedly refutes the Levin report. The rest of us are kept in the dark. We cannot challenge Goldman's claims, because we cannot see what they see. They know what they are talking about; we do not. Instead, we must rely on Andrew Ross Sorkin, Holman Jenkins, Dick Bove, and others to reveal the truth.

Except you don't need to read these secret documents to figure out what's going on. You need simply read the publicly disclosed documents to see how Goldman's defense is built on sand.   Consider Goldman's accusation, dutifully reported by The Wall Street Journal, that Levin's subcommittee used "sloppy math and incomplete analysis" too determine Goldman's net short positions. That's not really true. Senate staffers used no math and performed no analysis. They simply copied Goldman's numbers.

Copying Goldman's Numbers

The Senate subcommittee referenced Goldman's own "top sheets," which were daily reports prepared for the benefit of Goldman's head of the mortgage unit, Dan Sparks, who wanted a single-page summary of the firm's most critical mortgage risk concentrations.   As the Levin report makes clear, these top sheets represented a comprehensive measure of "the Mortgage Department's net positions in various asset classes."   Contrary to the false insinuations made in the media, the subcommittee carefully avoided any suggestion that these top sheets captured all of Goldman's positions in all types of mortgages. Nor did the subcommittee state that the top sheets used the exact same categories of mortgage exposure over time.

During the investigation, Goldman made a critical point, which the subcommittee acknowledged in its report. Not all mortgages are created equal. A long position in prime mortgages does not offset a short position in subprime. A triple-A tranche does not offset a triple-B tranche. Therefore, no single dollar amount, long or short, adequately captures all that's going on in a mortgage portfolio. Goldman trader Josh Birnbaum suggested that the number should be "beta adjusted." While noting Goldman's important caveat, the subcommittee also noted that the top sheet totals were regularly referenced in contemporaneous correspondence, and that, at the time, Goldman had no other comparable calculation for companywide exposures. So the subcommittee determined that the internally generated top sheet totals represented the best available proxy for how Dan Sparks was evaluating his firm's overall long or short positions. Investigators conspicuously declined to apply any math or analysis to put everything on an apples-to-apples basis, which might have invited criticism about manipulating the evidence. Unlike Goldman, the subcommittee was upfront about what it did. It never held anything back.

Anyone reviewing the top sheets published by the subcommittee in April 2010 can see that, over time, Sparks wanted additional categories added to his one-page summaries. Some commercial real estate securitizations were added in June 2007, and by September 2007 prime mortgages were added as well. That made sense, because investor distaste for residential securitizations began to spill over into commercial deals. Sparks was very aware that CMBS CDOs are stuffed with subprime bonds and vice versa.   In addition, home prices decline throughout 2007 meant that problems in the subprime sector could migrate into prime markets.

So the Journal writes, " For June 25, 2007, Goldman officials believe Senate investigators didn't take into consideration more than $5 billion of prime, or high-quality, mortgage-backed bonds held by the firm at the time, another document shows." Andrew Ross Sorkin references the same document, and goes further to impugn the subcommittee:

"But in studying the document, the subcommittee may have mixed apples and oranges. It added in $4.1 billion worth of short positions for commercial real estate to residential real estate. And the subcommittee ignored the footnote on the bottom of the document that the 'top sheet' had not included long positions in other parts of the business that people close to the firm said were in excess of $5 billion."

As it happened, some staffer made one of those dumb typographical mistakes with regard to this particular top sheet. He accidentally doubled the top sheet total, which showed a net short of just over $6.9 billion, and presented it as $13.9 billion. Embarrassing, especially since the mistake had been hiding in plain sight since April 27, 2010.

Net Totals Are For Dummies

Birnbaum was right. No singular net number adequately captures all that what is going on. The suggestion that the inclusion or exclusion of prime loans somehow debunks the Levin report or vindicates Goldman is, to put it charitably, a red herring.  Suppose gas trader Brian Hunter said: "I have been unfairly maligned by the Levin report, which accuses me of destroying my employer, Amaranth Advisors. The report says I took enormously risky bets on the price of gas, I can point to evidence showing that the opposite was true.   Whenever I bought gas futures for January 2007, I simultaneously sold futures for November 2006.  In other words, I was fully hedged!"

No gas trader would be stupid enough to believe that, and no mortgage trader would be stupid enough to believe, as Goldman now suggests, that a long position in prime mortgages represented any kind of hedge against a short position in subprime mortgages. As noted here earlier, the difference between prime mortgages and subprime mortgages is like night and day.

It's All About The Triple-Bs, Stupid

But there's a far more salient point, which Birnbaum noted and which Goldman's defenders now choose to overlook.   Even within the same subprime mortgage securitization, a long position on the triple-A tranche can never effectively hedge a short position on the triple-B tranche. A lot of these "correlation trades" are oxymoronic.   The triple-B tranches are heavily reliant on excess spread, which can be wiped out in a heartbeat. (Excess spread is the cash left over after: (a) the interest coupon for all the tranches is fully paid, and (b) all the principal for the 94% of all debt senior to the triple-Bs is fully paid.) Subprime deals were set up so that the size of the initial equity cushion below the triple-Bs was always smaller than the expected losses on the collateral. If the mortgage pools prepaid faster than expected, or if delinquencies spiked faster than expected, the excess spread got wiped out, so that the triple-Bs got wiped out.   Conversely, the triple-As, with at least six times the equity cushion of the triple-Bs, had almost no prepayment risk; early prepayments meant these investors got their cash back sooner rather than later.

All this media noise distracts away from the important evidence about Goldman's role in cornering the market for mortgage synthetics.   Remember, The Big Short--which paid off handsomely for Goldman, John Paulson, Greg Lippmann, Magnetar, Blue Mountain Capital, Steve Eisman, and others--was concentrated almost exclusively in those deeply subordinated--but still investment-grade--tranches of subprime mortgage bonds, the triple-Bs   (BBB+, BBB or BBB-). The way the math worked, to be discussed elsewhere, the payout became a sure thing as soon as the real estate bubble ended. It didn't matter if the housing bubble were followed by a crash or the gentlest of soft landings; the triple-B defaults were a virtual certainty. (Yes, it was an open secret that the credit ratings were bogus.)

During 2005 and 2006, there were about $900 billion in subprime mortgage securitizations, of which a tiny 3% sliver, maybe $30 billion, were tranches rated, either BBB+, BBB or BBB-. And about 90% of those triple-B tranches were unavailable to be traded; they were taken off the market and stuffed into CDOs. And that would have been the end of it. The economic damage from those toxic triple-B subprime investments, either as bonds or repackaged into CDOs, could never have been more than $30 billion, give or take a couple of billion, had it not been the schemes devised and spearheaded by Goldman.

As Goldman is quick to remind everyone, the firm was only a single player in the market. Though it frequently acted as a market maker, it wasn't the entire market. But consider the activity of this single player in the market for triple-Bs. Look at Goldman's top sheet for September 25, 2007, (Footnote exhibits page 3778), which drills down a bit further to show both the long and short positions within different categories.   In the category that lumps together subprime and 2nd lien mortgages, Goldman had insured $31.7 worth triple-Bs, and held swaps insuring $34.5 worth of triple-Bs, or trades totaling $66.2 billion. More than three-quarters of all credit default swaps in the subprime/2nd lien category were concentrated in the triple-Bs.

Or consider the schedule titled, "RMBS CDS Trade History 19-Han06 – 19Mar07," prepared for Birnbaum (Footnote Exhibits – Page 4147). Again, more than three-quarters of the trading volume, $34.5 billion out of $43.3 billion, was concentrated in that tiny sliver of the RMBS capital structure, the tranches triple-B and triple-B-minus. The triple-Bs were where the action was.

Or consider the dollar amounts compiled by ProPublica with regard to the mezzanine CDOs (i.e. triple-B portfolios) issued from May 2006, when it became obvious that real estate bubble had stopped expanding, through July 2007, when Moody's announced the first wave of downgrades and shut the subprime market down. That's $114 billion worth of toxic CDOs, which never would have been issued but for the schemes spearheaded by Goldman Sachs.

Goldman Invented and Cornered the Market in Housing Shorts

Contrary to the myth prevailing in some circles, the "market" for synthetic mortgage products was not something that predated the real estate bubble. Nor was it ever something that grew organically out the normal dynamics of supply and demand. Goldman invented this market and it cornered this market in order to short triple-B bonds on a massive scale.

As we learned from Michael Lewis's book, hedge fund manager Dr. Michael Burry was the pioneer who bought naked shorts on triple-B subprime bonds in early 2005. At that point, banks were unable to replicate that strategy on a larger scale, because mortgage securities are not like corporate bonds.

If a corporation becomes insolvent, it is forced to declare bankruptcy, at which point all bonds immediately become due and payable, meaning they are in default.  But mortgage securitizations do not file for bankruptcy. When it becomes obvious that the mortgage pool will run out of cash before all the investors are repaid, nothing happens. Or at least, nothing happens for a long time. All of these private label deals were set up so that no principal becomes due and payable for at least 30 years. The way their cash waterfalls work, it can take years and years, long past the point when everyone knows that the subordinate tranches will lose every dime of principal, before a subordinate tranche formally defaults on an amount that is due and payable. 

Generally, if you buy a naked short on a bond, you don't want to wait years and years to collect on your payout. So Goldman invented a new type of "credit default" swap, one that provided a payout before the mortgage bond actually defaulted. It came to be known as the "pay as you go" or PAUG credit default swap, and the standardized ISDA template was first published on June 21, 2005.

Goldman didn't invent the PAUG all by itself. Thanks to the pioneering reporting of the late great Mark Pittman, we know that in February 2005 Rajiv Kamilla of Goldman Sachs sat down over Chinese food with Greg Lippmann of Deutsche Bank and Todd Kushman of Bear Stearns, along with bankers from Citigroup and JPMorgan, to hammer out the form and structure of the PAUG CDS. Without the PAUG, Goldman's massive trading operation in mortgage synthetics--credit default swaps on individual bonds, plus CDOs comprised of PAUG swaps, plus swaps referencing market indices-- would not have been possible.

Soon after the PAUG template went live, Goldman went into action, selling billions of dollars of PAUG CDS to AIG. The swaps were embedded within synthetic CDOs that insured subprime mortgage bonds and subordinate tranches of CDOs. The first of these deals, Abacus 2004-1, closed on August 8, 2005.

Simultaneously, Greg Lippmann was putting the finishing touches on his famous flipbook presentation, "Shorting Home Equity Mezzanine Tranches," which he proceeded to hand out to a couple of hundred hedge fund managers. And, wouldn't you know, it turns out that the secret schemes designed to enrich hedge funds like Paulson & Co. and Magnetar became the norm in the CDO market. The majority of CDOs issued immediately after the end of the real estate bubble, during the last half of 2006, were arranged so that the hedge fund investing in the tiny equity tranche would also, secretly, take a much larger short on the rated tranches.

The Organizing Principle of Modern Credit Markets Is Secrecy

So let's circle back to William Cohan's column, which makes a passing reference to Goldman's attempt to trash the Levin report by relying on secrecy.   This is more than a metaphor. Goldman's business model is designed around the exploitation of secrecy.   Secrecy is organizing principle that governs modern credit markets. Credit default swaps, privately placed structured securitizations (e.g. CDOs), and hedge funds have all flourished-- they dominate the debt markets--because they are all designed to exploit secrecy.   They all create extraordinary profits by keeping the rest of us in the dark.

So in late 2006, if you wanted to find out what was happening in this newly created synthetic RMBS market, you couldn't find out much of anything.   You couldn't find out anything about who bought or sold any CDO, or what was in any CDO, or how any CDO performed, unless Goldman or some other CDO underwriter deemed you sufficiently worthy of their selective disclosures. You couldn't learn anything from the sales or trading activity of mortgage bonds, because the related trading in credit default swaps was kept hidden beneath the surface. You didn't know anything about the trading activity related to the ABX indices, since that, also, was kept secret. And since the privately-held company that owned the ABX, CDS IndexCo LLC, operated in total secrecy, and since the privately-held company that published the price of the ABX, Markit Group Limited , operated in total secrecy, you had no way of knowing the extent to which the price of the ABX was manipulated through round-tripping, side deals with synthetic CDOs, or anything else. The only thing you knew, your only link to the illusory "reality " of market sentiment, was the quoted price of the ABX.   And you might happen to know that the Chairman of CDS IndexCo was Brad Levy, a managing director at Goldman, which, along with a handful of other banks, controlled CDS IndexCo and Markit Group.

Both the FCIC and the Levin subcommittee disclosed a wealth of information that others with a more skeptical bent can scrutinize in depth. This information poses a direct challenge to Goldman's dissembling, and to the moral hazard of access journalism, which is no substitute for the full transparency of a free and open marketplace of ideas.   

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SheepDog-One's picture

Wall St criminal cabal Rule #1- Make everything so complicated and tangled that a team of MIT mathematicians would be baffled.

Nothing To See Here's picture

But isnt that the whole point of a sound free market that mathematicians should be baffled?

Mathematicians and modellers are part of the problem. If firms and investors wouldnt rely on mathematics so much to try to predict the market, they wouldnt have buy those MBS in the first place back in 2004-2007. But models told them to buy, so they bought.

The quants always fail because they cannot compute the "human factor". All this risk management scam is the biggest threat around. It corrupts minds and destroys entrepreneurship (which sould be about taking risks).

Clampit's picture

Real mathematicians like Kurt Gödel would be quick to point out that any model of aggregate market dynamics, especially in the modern communications enabled world, is impossible. No closed system can fully describe itself. That modeling has worked so well in the past only serves to highlight how few were exploiting the data for profit.

Variance Doc's picture

No dumbshit, models are just *idealizations* of the world.  That is all they are.  Should people just rely on the models?  No, they should be used in conjunction with things like experience, new data, etc.  Do people often ignore proper models about the world?  Yes, to their peril.  Just look at the P&L distribution and capital requirments on a bank with and without fraud.  Is that the models fault there is a difference? NO!  Can we add a fraud factor to the model?  Yes.

The reason why we (mathematicians, statisticians, physicists and engineers) apply mathematics to the world is to sharpen the questions and think about the answers.  This is what pushes the boundaries of human knowledge.

If we followed your thoughts and abilities on the subject, we would still be living under trees in animal skins and shit, out on the prairie, howling at the moon.  Next time you see a silver bird like thing in the sky, remember it's not a sign the gods are angry, but just a result of science. It’s called an airplane.

Take you shity 5th grade education and mentality over to the flat earth society.  You'll find much company there.

Nothing To See Here's picture

You obviously dont know shit about what you talk about. Try reading books, you might like it. You could start with Nassim Taleb's Black Swann.

Be prepared to be that deer in the headlights.

XRAYD's picture

Only in America. Land of the free and the home of the brave!

qussl3's picture

I believe you meant, Land of the indebted and home of the slaves!

Smokey1's picture

Goldman Sachs eats shit.

Zero Govt's picture

+++++  very interesting article Mr Fiderer


i watched the CNBC documentary on Goldman Sucks where we had their PR people holding to their hearts one of Sucks founding 'Corporate Principles' to always do what's best for their clients... the documentary came out 3 days after news broke they'd lost over 95% of the Libyan Sovereign Wealth Fund ....nothing but a bunch of (bankrupt) fraudsters expert only in fleecing and smarm (Sucks should have been dead and fuking buried/jailed in 2008)

AbandonShip's picture

"Sucks should have been dead and fuking buried/jailed in 2008"

+2008, the whole thing's rigged man. TBTF are the puppet masters.  Oh, American Idol's on?  I'll be right back....

gwar5's picture

"Goldman's business model is designed around the exploitation of secrecy."

Ain't that the truth. GS gets too much credit for intellect and not enough for just being crooked. I wouldn't be surprised if they had a direct pipeline to CIA/NSA intel with theri seeming lock on the Treas. Sec. position.   

longontents's picture

I think Goldman's business model is actually based on shoving your face down a clogged toilet at a gas station in Miami, FL during a massive heatwave.  A clerical error will result in your death being labelled a suicide.  But then again, who am I to judge God's work?

disabledvet's picture

i like where you're going with this.  For me I simply take Bernie Madoff and imagine him "writ large."  It certainly is how he imagined himself--even today i have no doubt the toadies that still visit him in his prison cell are attracted to this vision.  The irony that "you came to Bernie" should be lost on no one.  No less than Franklin Delano Roosevelt himself coined the term "caveat emptor."  Any questions?

tradewithdave's picture

Technically speaking access journalism does not apply to dumpster diving for fully functional laptops. Dumpsters are private property with the full rights of corporate personhood. It violates the fairness doctrine to dive in uninvited.

Dave Harrison

Insiderman's picture

Actually, once the paper is in the trash it no longer belongs to the originator.  It's what you do with the information in the dumpster that determines whether you have committed a crime.

6_7_42's picture

The first rule of g-saks klub is you don't talk about g-saks klub.

The 2nd rule of g-saks klub is you don't talk about g-saks klub.

The last rule of g-saks klub is fuck clients, fuck society, fuck the world, kash the khekz.

Insiderman's picture

Well written guest post but no big surprises here.  Economic returns, by definition, are impossible in an efficient market.  Therefore, the way to earn alpha is through asymmetric information.

It's no secret why so many fortunes have been made in real estate; that is, the assets are not fungible or interchangeable, and each participant to the trade may have information that the other does not.

Goldman creates an inefficient market through deception.  It's not brain surgery to understand why there are no CFA charterholders in positions of power at that company.  They worked too hard to earn the charter to lose it for the kind of crap that makes money at the giant blood-sucking squid.

Drashta's picture

The "who" is not important in terms of transparency in the markets, the "what" and "when" are.

Careless Whisper's picture

That was an interesting post. Thanks.

But ya know what would be more fun? If Mr. Fiderer could give an analysis of what happened and how it may relate to New York's Martin Act. oooohhh la la

JEHR's picture

Thank you, David Fiderer, for the leg work you have done in bringing to light the secrets of Goldman Sachs.  We don't revile them enough!