naked capitalism

In the stone ages, when I worked for a short while at Goldman, it would have been unthinkable to trade openly against clients. But those proprieties were abandoned long ago.

In 2007, the firm was unapologetic about its decision to short the subprime market (a big, perhaps the big reason for its departure from industry profit declines) even though it was also still trading and selling those products from its institutional desks. The consternation I heard from Main Street types and old-school investors was not shared in the media.

This year, the SEC took up the demonization of naked short sellers of stocks, even though the period of its ban on naked short selling of financial shares was a period of a particularly dramatic decline, putting to rest the theory that evil naked shorts were why financial stocks were taking (um, had anyone at the SEC bothered reading the shareholder reports?).

Now we have an interesting confluence of events: Goldman again accused of trading against its customers and counterparties, this time in the leveraged loan market (recall that Goldman, like many other firms, was heavily long these instruments when the credit market started going south in 2007 and was seeking aggressively to reduce inventory). However, although unseemly, this practice is permissible. And predictably the investors making complaints are accusing Goldman’s moves of driving down prices.

From Bloomberg:

Investors in the $591 billion high- yield, high-risk loan market are accusing Goldman Sachs Group Inc. of naked short selling to profit from record price declines.

At least two fund managers complained verbally to officials of the Loan Syndications and Trading Association, saying they believe Goldman helped drive down prices by using the technique, according to people with knowledge of the objections. New York- based Goldman is acting against its clients by trying to profit at their expense, the investors said.

A $171 billion drop in the value of the loans in the past year is pitting banks against investing clients on assets once considered so safe they typically traded at par. The drop exposed flaws in an unregulated market where trades can take from several days to months to settle and banks may have information unavailable to investors. In a naked-short transaction, a firm would sell debt it didn’t already own, betting the price will fall before it purchases the loan and delivers it to the buyer…..

“Increased volatility in the secondary market has been broadly documented and loan portfolio managers have suffered negative returns since July 2007,” Michael DuVally, a spokesman for Goldman, said in a statement.

“Investors are understandably focused on the many different causes of this volatility, but Goldman Sachs’ trading positions should not be one of them,” he said, declining to comment on whether the firm was short-selling loans.

Goldman rose to the fourth-largest U.S. originator of leveraged loans last year from eighth in 2005, according to data compiled by Bloomberg. The firm helped arrange financing for First Data’s purchase by Kohlberg Kravis Roberts & Co. as well as the $32 billion acquisition of First Energy Holdings Corp., formerly known as TXU Corp. by KKR and TPG Inc.

The bank was seen as the most aggressive in recent months in selling loans at prices below other dealers’ offers and taking longer than the LSTA’s recommended seven days to settle the deals, according to the investors complaining to the trade group.

There’s no rule preventing naked short selling of loans….

The slump in loan prices during the global seizure in credit markets is causing particular disruption in the loan market because the debt typically trades close to 100 cents on the dollar. Prices never were below 90 cents until February this year. By October they had fallen to a record low of 71 cents, according to data compiled by Standard & Poor’s. The decline, which S&P said equated to losses of about $171 billion, helped drive the complaints from fund managers.

“Investors are shell-shocked” by the decline, said Christopher Garman, chief executive officer of debt-research firm Garman Research LLC in Orinda, California. “In many ways they’re all but wiped out.”

Because prices were so stable, short sales of loans were unheard of until now, Elliot Ganz, general counsel of the LSTA, said at the group’s annual conference in New York last month.

“No one ever shorted loans,” Ganz said. “Prices never went down.”.

Ahem, as much as I have little sympathy for Goldman, one also has to take their accusers’ charges with a handful of salt. There have been rumors that the prices of loans prior to the dramatic fall (they traded in the low 90s and upper 80s for a while) was due to price manipulation, dealers trading unusually small lots among themselves so they could continue to report reasonably favorable prices on their inventories for financial reporting purposes (and of course to help with valuation for any customer sales).