Michael Lewis’ Theory of Why Goldman Got It Right

Michael Lewis, of Liar’s Poker fame, gives an elegant explanation of why Goldman got its subprime position right when everyone else on the Street was disastrously wrong. And I mean elegant in the mathematical sense: it fits known facts and has few moving parts.

As Lewis tells it, Goldman did not use the largely impotent risk management practices that other firms rely on to rein in trading positions. Richard Bookstaber, card carrying risk manager, illustrated in “Conversations with the Trading Desk” how discussions with traders about their large and growing subprime positions were likely to have gone. Lewis argues that a couple of traders who made a case that housing credit was probably going south were given sufficient rein so as to lay on a bigger short position than the trading inventories of the relevant businesses, unbeknownst to them.

Lewis compares this “higher intelligence” in the proprietary trading desk, approved by Blankfein and the CFO, David Viniar, as operating like a hedge fund. That is true, and is also a criticism frequently made against the firm, that it is really a hedge fund masquerading as a client business. Indeed, just as size was valuable in the bond trading business (the more trades you saw, the better your “market intelligence,” meaning your ability to manage and price risk), clients might worry that their business, while presumably profitable to the firm, is valued as much as a potential input into the firm’s trading decisions as it is for its own merits.

Goldman is fortunate that the traders in this case had better judgment than the fellows running its hedge fund Global Alpha.

From Bloomberg:

What’s odd about the subprime crash is Goldman Sachs Group Inc. A single firm took a position contrary to the rest of Wall Street. Giant Wall Street firms are designed for many things, but not, typically, to express highly idiosyncratic views in the market.

Even more surprising is how little Wall Street seems to have dwelled on how and why Goldman Sachs made its killing. There are insane conspiracy theories — for instance, that former Goldman chief executive officer and current U.S. Treasury Secretary Henry Paulson tipped his old pals, etc. (But then, how did HE know?)

There is also the widely held opinion that people who work at Goldman Sachs are just smarter than ordinary people — hence the lust to hire former Goldman employees to run other Wall Street firms, as Merrill Lynch & Co. did. (But why would any trader who could systematically beat the market waste his time at Goldman Sachs?)

So far as I can tell, there has been only one attempt to explain this strange event, and that was by a journalist, Kate Kelly of the Wall Street Journal.

Ms. Kelly’s very good piece offered up the sort of irrelevant details — this little piggy ate which sandwich for lunch as the market crashed, which trader went to the gym at which odd hour to relieve the incredible stress of gambling with billions of dollars of other people’s money — that leaves the reader, along with employees of Goldman Sachs, feeling as if someone inside Goldman must have spilled the beans.

But Goldman didn’t cooperate with the Journal…. the Journal story is probably true, as far as it goes. The only trouble is that it doesn’t go far enough.

Briefly, the Journal story runs as follows:

By the end of 2006, the people creating and selling subprime mortgages and other so-called CDOs (collateralized debt obligations), had put Goldman Sachs in exactly the same position as every other Wall Street firm. Left to their own devices, traders in subprime-mortgage bonds would have sunk Goldman just as they sank Merrill Lynch, Citigroup Inc., Bear Stearns Cos. and every other major Wall Street firm.

Enter two smart guys who trade Goldman’s proprietary books to argue to the CEO and chief financial officer that the subprime market feels soft and that Goldman should short it. This they do, in such massive quantities that they more than offset the long positions in subprime held throughout the rest of the firm, leaving Goldman short the subprime market and in a position to make billions when it crashes. End of story.

And it’s a good story. But consider what it implies. Their own traders and salespeople in subprime mortgages and related securities had put Goldman in exactly the same position as every other Wall Street firm: long subprime mortgages.

The only difference between Goldman and everyone else was that Goldman had, in effect, an entirely separate enterprise, sitting on top of the firm, with the power to reverse the judgment of its own supposed experts in various markets. They were able to do this, apparently, without ever saying a word about it to their own traders. Instead of telling the fools trading subprime mortgages that they are wrong, and that they should unwind their positions, they simply offset their trades.

All across Wall Street risk managers are being fired, reassigned or hovering under a cloud of contempt and suspicion. Heads must roll, and after the CEO, these guys are the most plausible to guillotine.

But at the same time it’s pretty clear that a lot of these so-called risk managers never really had the power to manage risk. They had to consider the feelings, for example, of the guys who ran subprime mortgages. Morgan Stanley conceded as much when it said recently it was considering changing things around so that the risk manager reported to the CFO, rather than the heads of individual businesses.

But at Goldman there were two intelligences at work: one, the ordinary Wall Street intelligence, which was allowed to get itself in trouble, just as at every other Wall Street firm; the other, more like an extremely smart hedge fund that made its living off the idiocy of big Wall Street firms, including its own people.

And this second, higher intelligence was allowed to make a mockery of the labors of the first. I can’t think of another example of a big Wall Street firm saying so clearly through its trading positions as Goldman Sachs did over the past year that it thinks the rest of its industry, including its own people, is a bunch of idiots. They have obviously designed their firm to take into account their idiocy — without ever having to put too fine a point on it.

From now on, the ordinary traders and salesmen at Goldman Sachs can beaver away knowing that their opinions and judgments about the markets in which they operate are basically irrelevant. The guys at the top of the firm are making the market calls, and if the guys at the top disagree with them, well, they’ll just take the other side of their trades. But then, why do you need the traders? And what happens when the guys at the top of the firm are wrong?

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  1. jo jo

    If Lewis’ hypothesis is correct, Goldman’s bet against the credit market wasn’t much different than Morgan Stanley’s bet against the equities market before the 1987 crash. At least 1 trader at Morgan requested and received authorization to make major purchases of index puts (for the firm, his clients, himself, and his mother) at $0.06 a piece. His clients sold while the price of the puts climbed, but the trader and his mother rode the puts all the way to $53 a peice. The financial writer John Rothchild interviewed the trader about this trade. That’s a $848 return on each dollar, and the trader used it to retire. Maybe someone at Goldman did as well.

    Presumably, before the 1987 crash, Morgan was selling portfolio insurance and other products that contributed to excessive risk taking, and then the crash in equities.

    There’s a hell of a lot of luck involved in trades like this. Morgan was lucky in 1987, and Goldman was lucky in 2007. It is nuts to think Goldman is special just because it was lucky this time around.

  2. insurance guy

    I bet the downside wasn’t even that steep. Like in the Morgan ’87 example, insurance in the form of puts or CDS was CHEAP.

    When insurance is cheap, its a good idea to buy it.

  3. bob

    I’m not convinced that this is elegant in the sense of few moving parts. There were in facts 2 sets of moving parts – the “hedge fund” side and the securitization/toxic-portfolio side.

    Rather it is a slick way to be profoundly dishonest. It allows GS to tell customers “see, we’re still into this mortgage stuff, you can trust us” while simultaneously shorting those positions.

    This should be illegal. If it isn’t already.

  4. Lune

    I agree with bob. If Mr. Lewis is correct and the higher-ups really thought sub-prime was going to go south, the smart thing would have been to unwind the long positions and then go short. Why tolerate unnecessary complexity by being both long and short and take the risk that your positions will interact with each other in unpredictable ways?

    The crucial difference is that the long positions were held by Goldman’s external hedge funds, i.e. funds filled with other people’s money like Global Alpha, while their shorts were held by their own proprietary trading desk.

    In other words, they were using other people’s money to load up on stuff they knew was heading south, and used their own money to bet against that. That’s not intelligence. That’s breach of fiduciary duty.

  5. Yves Smith


    While I agree that Goldman’s actions are morally dubious, anyone who expects morality from the securities industry will be taken.

    It isn’t likely that Goldman held long subprime positions in its hedge funds, and even if it did, it would not show up on their financial statements. The hedge funds are separate legal entities. Goldman might own some or all of the management company, which is merely some employees, desks, computers, office space, and contracts with the the hedge fund investors to pay fees to the management co.

    Similarly, I have to differ with your view that slapping on a huge hedge was the wrong way to go about things. Yes, you have what is called basis risk, that the hedge won’t move in exact (or even close) correspondence with the underlying.

    Goldman’s long positions would be primarily in relationship to trading inventory. The firm is too smart to have done the stupid things Merrill did (hold on to unsold portions of underwritings, at least beyond one turkey deal) or Citi (enter into agreements in which you might have to fund CP of supposedly off balance sheet entities).

    While trading inventory goes up and down, as a dealer, it is pretty hard not to be net long (indeed, until recently, it was impossible to do what Goldman did, be net short). They’d have to abandon the business entirely not to be holding positions.

    And even if Goldman tried to skinny up on its trading positions as much as possible, where it would have been able to cut them the most would be in its most liquid, highest quality instruments.

    As someone who runs a modest stock portfolio for some family members, it is very difficult to decide what positions to cut and in what proportion when you want to reduce your long exposure. It is MUCH easier to throw on an index short that it reasonably comparable to the stocks held. And stocks are vastly more liquid than debt securities.

  6. bob

    But this maneuver avoided GS having to get out of the bad stuff. So they didn’t have to be seen selling off the stuff, thereby panicking the marks.

    This was a con game, pure and simple. An honest person or organization does not do business this way.

    I still think this should be illegal.

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