Goldman Accused of Naked Short Selling of Leveraged Loans

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).

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  1. doc holiday

    Goldman simply is trying to make an efficient market, in a time where the market is very, very thin, thus the only possible bets for them (which may pay off) are those that happen to be related to the inside info they have on stupid clients that are hoping that Goldman will reward them for taking part in this current volatility charade!

    I hope they all go under, or go to jail!

  2. baychev

    blame it on goldman, other short sellers, the russians, chinese and the cubans that no one wants to pay dollar for dollar for highly levered companies’ debt in a deleveraging environment. it is simply pathetic.

    from what i know, this market even in the best times has been quite illiquid: loans were carried at stale prices (some 3-6 months old) as a given. how come in the present stressed environment they can short sell things that may have not traded in more than a year? even if they screw clients, it is due to their supperior knowledge of the funding needs of the present loan holders. selling you something for 75 cents that could be bought for 60 ain’t short selling, just being more informed i would say.
    rather than complain, those ‘managers’ should reevaluate the accrued bonus pool (may be none) for their analysts.

  3. ReturnFreeRisk

    Remember the insanity that CNBC termed “Merger Mondays?” These loans were part of the mania that swept Wall St in late 2006-early 2007. Why was noone complaining against people buying junk at sky high prices? Give me a break. No one complains when prices are going up? Now if someone actually trades these things and price discovery happens – NOOOOOOO!!!! Stop!!!! Unethical, illegal and unpatriotic are the terms thrown around. Same in the housing mkt. Dont listen to this whining. They are all long. That is the real reason.

  4. michael

    Yves, I’m confused:
    Wasn’t short selling in general banned, not just naked short selling? Do you make the assumption even shorting the subprime market was done through naked short selling?

  5. ccm

    Over at Alphaville, Wolf observed that volatility in the stock market is likely to be due to market-makers who are less willing to make markets. If you think about it, this conclusion is probably close to a self-evident truth (i.e. market-makers exist to ensure smoothly functioning markets).

    Since Goldman itself admits: “Increased volatility in the secondary market has been broadly documented”, isn’t it fair to conclude that, if Goldman is profiting from volatility — then it is profiting from not doing its job? Explain what’s wrong with my logic here — or alternatively explain to me why we have market-makers at all if they’re just going to be allowed to profit off of inside information.

    Maybe my question is: why is it legal to both be a market-maker and to trade on one’s own account?

  6. Penn

    ‘Naked short selling on leveraged loans’? This sounds like pure, crystalline speculation.

    We’ve only seen the beginning of the collapse of leverage. There’s more leverage in the system than in 1929.

    The investment banks have just eked out a survival because of the government giveaways. Practically nobody takes notice of the Federal Reserve leveraging itself massively.

    The Federal Reserve’s leverage ratio is around 40:1. A real pyramid scheme.

    My understanding of leverage is that it’s totally phony. A bank borrows a million and puts that loan toward collateral on another loan, and so on multiplied by 30, 40, 50, 100. Anything goes.

    Anyway, The Federal Reserve will collapse in a few months under the weight of leverage.

  7. Penn

    I like to think of leverage in terms of the floors of the WTC. When the steel beams weakened because of the burning and the top of the building began to implode, the rest of the floors pancaked downward and landed in a pile of dust.

    Citigroup and Goldman will go this way. So will scores of banks and trusts and finally the Federal Reserve.

  8. doc holiday

    FYI Clue for valuation:

    Consolidated balance sheet

    Explanation and reconciliation of the Firm’s use of non-GAAP financial measures on pages 32–33 of this Annual Report. Managed results exclude the impact of credit card securitizations on Total net revenue, the Provision for credit losses, net charge-offs and loan receivables. Securitization does not change reported Net income; however, it does affect the classification of items on the Consolidated statements of income and Consolidated balance sheets.

    That is brought to you by, J P MORGAN CHASE & CO:: Profit in its credit-card business fell to $35 million from $202 million last year because of Target's lower investment in the portfolio, a decline in its overall performance because of higher bad-debt expenses and lower interest rates.

    The company sold 47 percent of its credit card receivables to JPMorgan Chase in May.

    >> Let's review:

    1. Securitization does not change reported Net income

    2. … however, it does affect the classification of items on the Consolidated statements of income

  9. esb

    Say what!!!!!

    When I was at GS in the 1980s the prop desks ALWAYS traded against the client order flows and the PM (perception management) teams worked very hard to generate the order flows to trade against.

    The entire operation (or set of interrelated operations) is far more perfected these days, I will wager.

    To watch a perception management operation gone awry (or perhaps just gone nuts) one need only follow the Paulson follies over the past few weeks.

    (I suspect that Paulson realizes that he and his too-clever-by-half plutocratic buddies have blown up the world and is attempting to reassemble it using only bullshit.)

    It is all quite amusing, actually, even if it will eventually cost me much of my net worth.

  10. Stuart

    Clients of Goldman Sachs are like cattle. To be herded, cultivated and then fed upon to meet the nutritional requirements of Goldman Sachs. Vampires they be. Goldman Sachs has alot of vampire like friends.

  11. Jesse

    “Maybe my question is: why is it legal to both be a market-maker and to trade on one’s own account?”

    this is precisely the point, aggravated to a much larger degree with the demise of Glass-Steagall and the access to cheap fed funds by the banks.

    Think of the way this market is set up in terms of a poker game, and the absurdity of it becomes obvious.

    As the financial sector grows more outsized relative to a shrinking GDP and real economy it will have to become more aggressive in its more parasitical activities, or diminish. Do you think it will do so voluntarily? More likely it will try to feed off other hosts. Look for foreign bank acquisitions in the developing world.

  12. Anonymous

    When Bear Stearns was forced out of business I wondered if it wasn’t payback for not participating in the LTCM rescue. What goes around comes around.

  13. doc holiday

    Special delivery for Yvesblog:

    Cash-Strapped Companies Grow to Record, Moody's Says (Update1)

    Companies are increasing capital reserves as banks tighten access to credit following more than $966 billion in writedowns and losses since the start of 2007. What began as a cash crunch for small companies with limited amounts of debt has spread to major U.S. companies, with “tens of billions'' of dollars in rated debt being downgraded, Moody's said.

    “This is a sign of how things are worsening in the second year of the credit crunch,'' wrote Puchalla, who is based in New York.

    As of October, 28 percent of the 72 issuers with an SGL-4 rating had more than $1 billion of rated debt on their balance sheets, totaling $128 billion. That compares with 18 percent of the 39 borrowers in that category at the end of 2007, representing $21 billion of debt, the report said.

  14. CPA

    price discovery and price manipulation two different things

    no opposition to free market and taking a negative position, but when you take a position and then manipulate price to the downside that is not free market

    rules not the same for everyone, dumbass analysts cannot win without cheating, no better than next guy

    glad to see GS is getting what it deserves, send them all to the unemployment line

  15. bobby99

    I agree with esb. This is a Chineese wall issue. As long as prop trading is insulated from origination (and client flow) they should take whatever positions they want.

    Even more interesting was how Goldman made money by shorting subprime MBS. Prop was long, like the rest of the street, but a special group under top management was short.

    Prop trading with clients to move prices in the right direction would be manipulation.

    I have no love lost for Goldman, but in this case I think the outrage is misplaced.

  16. Sandra

    The truth about Naked short selling comes out on DVD June 10 in Stock Shock: The Movie (

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