CEO Lloyd Blankfein signed a letter to shareholders for the Goldman Sachs annual report to shareholders, explaining the company’s position on issues that have been giving it public relations heartburn. It says Goldman Sachs acted properly in its dealings with AIG. And it says that it wasn’t betting against its clients on securities related to residential mortgages. The explanations aren’t new, but….
There were a number of reports that Goldman Sachs was betting against its clients, including this one by Gretchen Morgenson in the New York Times last December. There is a brief explanation of one way to do this, used by the hedge fund Magnetar, in this post, and a longer discussion here. Magnetar denies that it did anything wrong, and specifically denies that it would make more money if the CDOs tanked.
Blankfein tells his investors that the market for residential mortgage related products and subprime securities was volatile in the first half of 2007. Its customers all had their own views of the future, positive and negative. Clients
… came to Goldman Sachs and other financial intermediaries to establish long and short exposures to the residential housing market through RMBS, CDOs CDS and other types of instruments or transactions.
Although Goldman Sachs held various positions in residential mortgage-related products in 2007, our short positions were not a “bet against our clients.” Rather, they served to offset our long positions. Our goal was, and is, to be in a position to make markets for our clients while managing our risk within prescribed limits.
The NYT article describes Goldman Sachs’ use of CDOs to bet against the housing market. Some of these CDOs were designed to hedge against losses in the company’s inventory of residential real estate backed mortgage securities. One of the CDOs, called Abacus, was a synthetic CDO. Morgenson explains:
Abacus allowed investors to bet for or against the mortgage securities that were linked to the deal. The C.D.O.’s didn’t contain actual mortgages. Instead, they consisted of credit-default swaps, a type of insurance that pays out when a borrower defaults. These swaps made it much easier to place large bets on mortgage failures.
Rather than persuading his customers to make negative bets on Abacus, Mr. Egol kept most of these wagers for his firm, said five former Goldman employees who spoke on the condition of anonymity. On occasion, he allowed some hedge funds to take some of the short trades.
There is nothing there that would be inconsistent with the Magnetar strategy. Among other things, the Magnetar strategy works best if the CDO fails, and the Abacus deals were flops.
The NYT article describes another important change in CDSs in 2005. The new rules required counterparties to post collateral if one or more triggers occurred, including a ratings downgrade or a decrease in the value of the CDO. That made it easier to collect on the CDS in the event of collapse of the CDO.
According to Bloomberg, AIG wrote protection CDSs for some of the Abacus deals. In the shareholders letter, Goldman Sachs says it demanded that AIG post more and more collateral for AIG’s prospective obligations on the CDSs. It claims it did so because the evidence it had from its market-making activities showed that the market was weakening. Of course, it knew what kind of assets were in the Abacus deals, which probably helped it have an opinion. AIG did not agree with the collateral calls, but eventually posted more collateral. Goldman Sachs claims that it bought other instruments to protect itself in case AIG didn’t pay in full. When AIG failed, Goldman Sachs got paid in full on its CDSs, effectively by taxpayers.
The Abacus transactions allow speculators place bets on the direction of the housing market. If AIG sold protection, does that mean it had a position on the housing market? Or was Goldman Sachs just taking advantage of a foolish player?
Here’s more from the letter:
Clients come to us as a market maker because of our willingness and ability to commit our capital and to assume market risk. We are responding to our clients’ desire either to establish, or to increase or decrease, their exposure to a position on their own investment views. We are not “betting against” them.
Goldman Sachs creates a new definition of “market maker”, someone who enables speculation. Blankfein thinks his company has no responsibility to share information it gathered in its position as “market maker” with the people it invites to the new casino. Evan Newmark, a columnist in the Wall Street Journal, nails the issue: are the investors customers or counterparties?
The definition of a business PR fail? The Wall Street Journal writes a humor column on your spin.
[video borrowed form Gregg Levine's post "Bet Against the American Dream!"]