“How Goldman secretly bet on the U.S. housing crash” (AIG as Bagholder Watch)

McClatchy, the only major US news organization to question the Iraq war until is was obvious to all that it was a misguided exercise in neocon hubris, has started a series on Goldman’s famed “short subprime” exercise. While the timing and overall outline are not new (as to when and allegedly why the investment bank went short), it delves into some details that have heretofore not been examined, as to how much subprime paper it dumped onto investors during this period, whether this duplicity was permissible, and what sort of damage was visited on foolhardy borrowers.

Unfortunately, for my taste, the series does not appear to be getting enough into the nitty gritty (and it indicates clearly that Goldman has successfully kept mum about the details of how it executed its short). I am keenly interested, because my understanding is that any simple subprime index short would have blown out spreads and thus been very costly to execute.

Goldman used another route….and the road, not surprisingly, was through AIG. From an e-mail over the summer:

This also points out a *VERY* good nugget re: banks who used CDOs/AIG offensively as opposed to as a hedge. This is likely what bothered me most about the AIG debacle. The trades GS had on with AIG were generally *not* super senior CDOs GS was long simply because they had
underwritten CDOs and were “stuck” with the AAA risk as a result. Rather, GS had a whole program of issuance — something they called “Abacus” — which were deals they put together with the sole purpose
of getting short subprime/CDO risk. Their sole purpose in doing the deals was to get long protection/short risk on the underlying collateral. AIG was simply the vehicle they chose to moneitze that PnL. Call me crazy, but I put the AIG counterparties in two different camps: guys like SocGen, who bought bonds in good faith and then hedged the credit risk by buying CDS from AIG, and guys like GS, who used AIG as their lottery ticket for offensively constructed trades to capitalize on mispriced subprime risk. The former, to me, seem much more deserving of a bailout than the latter…

DeutscheBank had a broadly similar program called Start.

This of course makes complete sense. There simply was not enough insurance capacity (the monolines plus the volume on the Markit indexes) to account for the big names that went short (Paulson, Goldman, one other large but secretive player we are aware of). That road had to go through AIG as well.

And bear in mind another fact: asset backed securities CDOs (and the subprime kind were that type) were managed rather than passive. That mean when the collateral paid down, the manager would go and find new collateral. Again from an e-mail:

AIG got out of subprime in 2005/2006 – whenever – but it didn’t matter.  Why??  Because the same crappy borrowers that made it into 2005/2006 subprime RMBS refinanced and ended up in the 2007 vintage.  Guess who had to buy the 2007 subprime RMBS paper when the 2005/2006 paper repaid?  You got it – the 2005/2006 CDOs.  CDOs have reinvestment periods (4 yrs for SF CDO) whereby they have to continue to be fully invested rather than letting their liabilities get repaid.  The liability buyers don’t want their valuable paper to be repaid early – or, do they????

Readers who know the terrain, and Abacus and Start in particularly, are very much encouraged to comment or ping me at yves@nakedcapitalism.com.

Now to McClatchy:

McClatchy’s inquiry found that Goldman Sachs:

Bought and converted into high-yield bonds tens of thousands of mortgages from subprime lenders that became the subjects of FBI investigations into whether they’d misled borrowers or exaggerated applicants’ incomes to justify making hefty loans.

Used offshore tax havens to shuffle its mortgage-backed securities to institutions worldwide, including European and Asian banks, often in secret deals run through the Cayman Islands, a British territory in the Caribbean that companies use to bypass U.S. disclosure requirements.

Has dispatched lawyers across the country to repossess homes from bankrupt or financially struggling individuals, many of whom lacked sufficient credit or income but got subprime mortgages anyway because Wall Street made it easy for them to qualify.

Was buoyed last fall by key federal bailout decisions, at least two of which involved then-Treasury Secretary Henry Paulson, a former Goldman chief executive whose staff at Treasury included several other Goldman alumni.

The article continues here.

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  1. ozajh

    I wonder how the crisis would have played out if AIG had split into AIG Financial Products and AIG Insurance-and everything-else in, say, mid-2006. At that time I believe the FP side would have been valued higher than the rest of the company, based on earnings.

    It might have been a bit harder politically to throw the requisite money at a relatively small Financial Products company to make their counterparties whole. Especially if AIGFP had domiciled in London . . .

  2. Mark

    And I wonder if I could make a peanut and jelly sandwich if I had some peanut butter

    and then bought some jelly

    and, oh, found some bread

    1. ozajh

      marc fleury’s comment makes my point better than I did.

      How much cover did the insurance side of AIG give the bailout? I think a lot.

  3. craazyman


    Sounds more and more like Goldman Soaks = Enron

    By the way, thank you Rob Johnson of New Deal 2.0 for your testimony to the House Financial Services Committee on OTC derivatives. I read every page and every word, including the Appendix.

    Even if the apparently bought-and-paid-for Committee treated you with inexcusable rudeness, you are “bearing witness” in the great religious tradition anyway. That grain of faith will grow like a mustard seed and it will take over the earth.

  4. i on the ball patriot

    Hmmmm …

    CIA? 9/11? Put options? Conspiracy? PROMIS? Pattern and practice? Pattern and practice? Global financial coup? Intelligence? Real time trade monitoring? Terrorists? Pattern and practice? GGG (Great Geopolitical Gains)? Conspiracy? Conspiracy of class? Pattern and practice? Aggregate generational corruption? Pattern and practice? Conspiracy of class?

    Ivy League grads,
    Work the revolving door,
    From government shill,
    To ruling elite whore.

    Deception is the strongest political force on the planet.

  5. marc fleury

    This was covered in a salon.com story a year ago: http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom/

    The vehicle was naked CDS on the senior tranches of CDOs. In the article you hear about how those that used the instruments wonder why it is even legal.

    To me the real shame of the bailout of AIG was that a lot of money was sent to cover naked bets by speculators. Naked CDS are truly weapons of mass destruction (covered CDS are kosher imho).

    Naked CDS should have been banned yesterday. I haven’t heard a single good argument in their favor.

    1. Siggy

      Thanks for article lead. Having worked in the industry when Salomon Brothers Hutzler was the name, I can relate very well to the piece and I must say that it is about time that how the industry has changed since it went corporate is a very important part of how we got to here.

  6. RueTheDay

    As much as I dislike GS, I really don’t see the issue with them going short subprime CDOs.

    The biggest problem I have is that they didn’t take into account counterparty risk when it came to the AIG CDS, and then when TSHTF, they expected the taxpayer to make their bets good. On that count alone, GS should not exist as an independent entity today.

    1. Yves Smith Post author

      Actually, there is once you understand the full implications and the mechanisms. My views were similar to yours until I dug into this further (hate to sound mysterious, but I am in the process of putting more together). This is a different category than naked shorting of stocks, which is overly maligned (yes, if folks are short stocks AND then engage in a bear raid, that is bad, but it is the manipulation that it the issue, not being short per se. Some traditional measures, like the uptick rule, had been sufficient to curb the majority of stock shorting abuses).

      1. Siggy

        I agree. GS appears to have had a major failure of their Chinese Wall. GS may well be spending an inordinate amount of time in the courthouse in the near future.

        1. i on the ball patriot

          Well now … according to Intractability Theory;

          “Trading in derivatives brought down Lehman Brothers, AIG, and many other buyers, based on mistaken assumptions about the independence of the underlying asset prices; they underestimated the danger that many mortgages would all default at the same time. But the new paper shows that in addition to that kind of danger, risks can arise because a seller can deliberately construct a derivative with a booby trap hiding in plain sight.

          It’s like encryption: it’s easy to construct an encrypted message (your browser does this all the time), but it’s hard to decrypt without knowing the key (we believe even the NSA doesn’t have the computational power to do it). Similarly, the new result shows that the seller can construct the CDO with a booby trap, but even Goldman Sachs won’t have enough computational power to analyze whether a trap is present.

          The paper shows the example of a high-volume seller who builds 1000 CDOs from 1000 asset-classes of home mortages. Suppose the seller knows that a few of those asset classes are “lemons” that won’t pay off. The seller is supposed to randomly distribute the asset classes into the CDOs; this minimizes the risk for the buyer, because there’s only a small chance that any one CDO has more than a few lemons. But the seller can “tamper” with the CDOs by putting most of the lemons in just a few of the CDOs. This has an enormous effect on the senior tranches of those tampered CDOs.

          In principle, an alert buyer can detect tampering even if he doesn’t know which asset classes are the lemons: he simply examines all 1000 CDOs and looks for a suspicious overrepresentation of some of the asset classes in some of the CDOs. What Arora et al. show is that is an NP-complete problem (“densest subgraph”). This problem is believed to be computationally intractable; thus, even the most alert buyer can’t have enough computational power to do the analysis.

          Arora et al. show it’s even worse than that: even after the buyer has lost a lot of money (because enough mortgages defaulted to devalue his “senior tranche”), he can’t prove that that tampering occurred: he can’t prove that the distribution of lemons wasn’t random. This makes it hard to get recourse in court; it also makes it hard to regulate CDOs.”

          More here …


          Deception is the strongest political force on the planet.

      2. john bougearel

        A full scale investigation into manipulation is warranted.

        It is no great leap to imagine that players like GS took a long position in the Credit Default Swaps of AIG, LEH and other firms and then executed a calculated and pre-meditated strategy that would lead to the demise of these companies.

        It is not hard to imagine that the financial crisis of Sept 2008 was pre-meditated. And if the facts and findings were to bear this suspicion out, for that, they should be hung.

      3. RueTheDay

        Interesting, and I’d love to hear the details on what differentiates the shorting described here.

        On another note, CIT is filing for BK, the taxpayers are set to lose their $2.3 billion in preferred stock from last year’s bailout, and an accord was reached with GS to preserve their $2.13 billion in loans to CIT through the BK process. Yet another naked transfer of wealth from the taxpayers to GS.

  7. Allen C

    I conclude that GS plan all along was to threaten global meltdown in the event of AIG default. The govi can effectively screw secured auto bond holders, but somehow are compelled to pay off AIG CDS at par.

    Investigation Please!

  8. DownSouth

    ► Goldman Sachs was “buoyed last fall by key federal bailout decisions, at least two of which involved then-Treasury Secretary Henry Paulson, a former Goldman chief executive whose staff at Treasury included several other Goldman alumni.”

    A fair contest this was never meant to be. The unlevel playing field is by design, not accident.

    One only has to dig a little deeper into the ideology that informs the Fed and Treasury decisions to ascertain this.

    In today’s NY Times is a book review of the latest Ayn Rand biography:


    While the review and the suject book are of great interest, I nevertheless found some of the links provided of even greater interest, such as a letter that Alan Greenspan wrote in 1957 in response to an unflattering NY Time’s review of Atlas Shrugged. Here’s the letter:


    “Atlas Shrugged” is a celebration of life and happiness. Justice is unrelenting. Creative individuals and undeviating purpose and rationality achieve joy and fulfillment. Parasites who persistently avoid either purpose or reason perish as they should. Mr. Hicks suspiciously wonders “about a person who sustains such a mood through the writing of 1,168 pages and some fourteen years of work.” This reader wonders about a person who finds unrelenting justice personally disturbing.

    New York

    Now compare Greenspan’s quote with the following two quotes:

    [I felt] the obligation in accordance with the Eternal Will that dominates this universe to promote the victory of the better and stronger, and to demand the submission of the worse and the weaker…
    –Adolph Hitler, Mein Kampf

    Dadaism, Futurism, Cubism, and other isms are the poisonous flower of a Jewish parasitical plant, grown on German soil… Examples of these are the strongest proof for the necessity of radical solution of the Jewish question.
    –Dr. Reinhold Krause, Rassische Erziehung als Unterrichtsgrundsatz der Fachgebiete, 1937

    What we have in both of the above are expressions of the doctrine of social Darwinism. Granted, “survival of the fittest” has shifted from the group to the individual. The Nazis touted a Master Race (a group), whereas Rand and Greenspan touted a Master individual, but other than that, their ideologies are hauntingly similar. In both cases we can observe how the authors have anointed themselves judge, jury and executioner. It is they who will determine who is the “master”—who is to live and who is to die.

    And likewise, Rand’s literary endeavors find their artistic precedent in the monumental sculptures of the National Socialists. As Peter Adam in Art of the Third Reich explains:

    They were supposed to represent the spontaneity and joyfulness of physical activity. Yet the many runners, discus throwers, rowers, and jumpers do not transmit any feeling of physical freedom. Each muscle, each tendon, had to express strength and force. In their disciplined, steel-like bodies they were representatives of a disciplined, steely nation. The next step, the presentation of the warrior, was only a small one. It was always the same basic principle: the celebration of conquest and victory.

    “Force has replaced sensitivity, hardness the fluidity shimmering in the light… I am the concentrated strength of man! I am anger against cowardice! I hate the enemy of my people. You should be like me!” a Nazi propaganda film intones.

    And as Adam goes on to explain:

    The forced and tortured poses of Brecker’s and Thorak’s figures look even more artificial if one compares them with nudes by Auguste Rodin. Rodin’s aim was to visualize feelings which came from within. Everything about them is full of infinite possibility and of yearning; they are human and warm. Brecker’s statues are cold and self-contained. In short, they radiate a superbly tailored lifeless perfection. These statues are merely the messengers of a program imposed on life.

    So Goldman Sachs has been crowned “Master Individual” by the disciples of Ayn Rand. Its role as survivor has been divined. It was divined many years ago. But as Jonathan Haidt so aptly points out, this is not real life. It’s “like watching professional wrestling or the Harlem Globetrotters,” he muses. “It’s great fun, with lots of acrobatics, but it must not be mistaken for an actual contest.”

    David Sloan Wilson calls Rand’s ideology and her Alice-in-Wonderland world a “stealth religion.” “[O]nce we take the concept of stealth religion seriously then we can entertain the prospect that there are belief systems which have nothing to do with God, not that particular departure from reality, but depart from reality in other ways.”


    1. Siggy

      A very long time ago I course I took had Atlas Shrugged as required reading and it was discussed at length in class. I thought the book was/is a mediocre novel. I never saw it as a basis for a philosophy. I have always marveled and never understood how it is that the book and its writer have had such celebrity and inane following.

      This thread began by noting that it appears that GS sold paper that it felt was worthless. What I’d like to know is did the traders who were shorting the paper know that the firm had quite recently been aggressively selling to clients, the very paper they were shorting?

      Whatever the resolve, the event is very much at the core of the problem of a monumental fraud and the failure of the agency position. Recall junk bonds, Citron and Merrill Lynch, a very similar event here and it would appear that there is enough tort action to support two or three gradutating law classess.

      1. i on the ball patriot

        DownSouth good post. There is some good illuminating information here (link below) on the historical use and justification of intentional deception (‘the noble lie’) that is melded with the survival of the fittest rationalization of this elite scum ideology. This intentional global coup is really the same old shit in a new suit but on a much grander scale (GS is only one of many interwoven tools) with the now added pressure of diminishing global resources;


        “Danny Postel: You’ve argued that there is an important connection between the teachings of Leo Strauss and the Bush administration’s selling of the Iraq war. What is that connection?

        Shadia Drury: Leo Strauss was a great believer in the efficacy and usefulness of lies in politics. Public support for the Iraq war rested on lies about Iraq posing an imminent threat to the United States – the business about weapons of mass destruction and a fictitious alliance between al-Qaida and the Iraqi regime. Now that the lies have been exposed, Paul Wolfowitz and others in the war party are denying that these were the real reasons for the war.

        So what were the real reasons? Reorganising the balance of power in the Middle East in favour of Israel? Expanding American hegemony in the Arab world? Possibly. But these reasons would not have been sufficient in themselves to mobilise American support for the war. And the Straussian cabal in the administration realised that.”

        More here …


        Deception is the strongest political force on the planet.

    2. Skippy

      DownSouth nice comments as always with melt in your mouth choc chip goodness re, references.

      Mystics and their devotes sure know how to screw up the planet with promises of the superior individual+group, man before all things eh.

      Wasn’t there a 33hr meth fueled stint by Rand in the creation of one of here works[?], and on that note how many leaders political and social fuel them selves with stimulants and suffer the chemical effects to ones brain over time ie sex drive, self import, delusions of grandeur, increasing myopic view of self and the world in the final stages of the addiction/usage etc.

      i on the ball patriot

      GWB Junior what a sorry excuse for a man, so easily lead, so willing a tool for his mystic masters. You can put 40 years of presidents and PMs globally in that category too.

      Skippy…Deception is the strongest political force on the planet, only to those that hand over their minds willing I might add.

  9. LeeAnne

    You bet. This is like taking out multi million dollar policies written by an insurance company with no capital and no regulatory standing as an insurance company on poor 90-year-olds with your man in charge of the government purse. The 90-year-olds die, insurance company can’t pay, defaults, man in charge of government purse rescues insurer, insurer pays off Goldman Sachs’ policies. Bingo! Genuises all!

    Goldman Sachs has guarantees in place for their own risk taking, the rest of you can sit on a tack.

    Interesting perspective in yesterday’s NY Times on the AIG regulatory quagmire.


    Injunction Sought to Keep A.I.G. Assets in State

    ‘”After the Federal Reserve rescued A.I.G. in September 2008, the thrift office withdrew as the holding company’s regulator. But the Fed did not replace it. The Fed describes itself as a creditor, not a regulator.

    Mr. Aguirre said the holding company was left to operate in “a regulatory vacuum.” ‘

  10. michael

    the nitty gritty of CDOs being “actively managed” is another eye opener, as big as the mortgage recourse/non-recourse was 18 months ago! So did some parties corner and squeeze entities like AIG that got themselves stuck in these maybe without even realizing it?

    This is another piece that makes the whole subprime debacle timeline look increasingly predictable, consequential, and inevitable once it had been set in motion.

    Won’t Option ARMs inescapably blow sky high next?
    [paranoid] Is that why we have no financial reform ongoing, because the people in charge know the next disaster is already baked in, unavoidable? We’re freaking doomed! [/paranoid]

    1. Yves Smith Post author

      The “managed” isn’t that active, but it means for a certain period, if the collateral in the deal falls (in the first years due to refis, there was no principal repayment) the manager substituted collateral, which would be NEW deals. So a 2004 vintage deal, which by the standards of what was to come, was not that bad, would have drecky 2005-6-7 collateral enter as 2004 deals refied or were otherwise paid off (sale of house, say).

      1. michael

        Yes, and when AIG got out of subprime in 2005/2006, they effectively didn’t get out until 2009/2010. Nice catch!

  11. Dave Raithel

    Hey all, remember this “blast from the past”?


    I know that Yves Smith did a take down:


    And Felix Solomon regularly used Ben as a punching bag. And sure, there is a whole lot there that Ben got just wrong (like the future) and even I quit listening to him about anything after he went after Darwin…

    But still, it amuses me to see that despite his being off the mark on details and the future (then) he was the guy who first tipped me off that something and somebodies at GS were just crooked ….

    1. Yves Smith Post author

      I am aware of that. The question is who bought them, meaning who were the de facto protection writers. That is hard to establish for any of these trades. Do you have any idea for this deal and/or START?

  12. Ginger Yellow

    “Call me crazy, but I put the AIG counterparties in two different camps: guys like SocGen, who bought bonds in good faith and then hedged the credit risk by buying CDS from AIG, and guys like GS, who used AIG as their lottery ticket for offensively constructed trades to capitalize on mispriced subprime risk. The former, to me, seem much more deserving of a bailout than the latter…”

    This seems completely backwards to me. I’m not saying GS are “deserving of a bailout”, and continuing to sell subprime deals while shorting the sector is very shady, but they did correctly call the market and put their money where their mouth was, albeit failing to recognise the risk in AIG. Conversely, SG (and others) either completely failed to call the market, or thought they could make free money on a negative basis trade. Or both. Why is recklessly going long more virtuous than (somewhat) prudently going short?

    In Europe it was well known that GS was shorting Northern Rock’s RMBS aggressively during the summer of 2007, something they could get away with as they didn’t really underwrite much RMBS in the region, focusing on infrastructure/corporate securitisation. If only SG had followed their example, they wouldn’t have been in such a mess.

  13. bobf

    One reason the Columbia University professor cited in the McClatchy article might not think that what Goldman Sachs did was illegal might be because 4 members of Columbia University’s board of trustees have been executives at Goldman Sachs in recent years.

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