Goldman has just issued an eight page letter to shareholders, in which it tries to defend itself against its critics, particularly regarding its conduct vis-a-vis AIG, with how it got short the residential mortgage market, and its compensation.
To be more terse than usual: the AIG argument is generally plausible (and not inconsistent with what Tom Adams’ analysis has found), the other two are problematic. to put it politely.
Goldman has been charged with overly aggressive marks on its AIG related exposures, which have included allegations of nefarious intent. There have long been problems with this theory. The big one is that there was and still is a greaat deal of denial among banks as to how far mortgage-related paper needed to be marked down. Tom Adams looked at the marks that Goldman asked, based on news reports and other sources, and found their marks to be realistic. Moreover, the CDOs in question were not owned by Goldman (it has been clear for some time that at least some of the AIG-related CDOs were client position; the letter indicates they all were). That means that Goldman was a swap intermediary; it had sold CDS protection to clients, then turned around and laid that risk of on AIG.
There is one part of Goldman’s argument that is tripe, however:
Over the ensuing weeks and months, we continued to make collateral calls, which were based on market values, consistent with our agreements with AIG. While we collected collateral,
there still remained gaps between what we received and what we believed we were owed. These gaps were hedged in full by the purchase of CDS and other risk mitigants from third parties, such that we had no material residual risk if AIG defaulted on its obligations to us.
Yves here. Neil Barofsky of SIGTARP has dismissed this argument. If AIG had foundered, the CDS market would have suffered cascading counterparty failures. The idea that Goldman’s insurance of AIG risk was any good is an utter canard. The fact that they are still trying to sell that discredited line does call their candor on other issues into question.
On Goldman’s betting against its clients, the firm mentions only in passing that it used CDOs to lay off mortgage risk. The reason the use of a CDO is important is that, while the offering documents contemplated all sorts of outcomes, investors would assume that Goldman was acting as an intermediary and had devised its CDO merely to satisfy market demand and lay of mortgage pipeline exposure, acting as an intermediary. But in using a CDO to create a short positio, Goldman would have the incentive to dump the very worst dreck possible into the CDO. And had Goldman disclosed its role, investors would have looked at the deal much harder.
In addition, Goldman makes it sound as if it laid off its risks on professional counterparties:
The investors who transacted with Goldman Sachs in CDOs in 2007, as in prior years, were primarily large, global financial institutions, insurance companies and hedge funds (no pension funds invested in these products, with one exception: a corporate-related pension fund that had long been active in this area made a purchase of less than $5 million)
Yves here. This is wonderfully incomplete. Goldman started its synthetic CDO program in 2004, doing 25 deals in total. Who was on the other side of these trades prior to 2007? And who were these “global financial institutions”? Were they big Eurobanks, which could be correctly viewed as professional counterparties, or does that list include foreign financial chumps like the German bank IKB? Similarly, while insurance companies are nominally professional investors, monolines save ACA were not insuring purely synthetic deals (or do they simply mean the Abacus trades with AIG?). And even though the monolines blew themselves up on CDOs, it was not for want of technical knowledge of the product. By contrast, “insurers” covers a multitude of players, some of whom are not terribly savvy and would see themselves as clients rather than trading counterparties.
Goldman’s section defending its compensation is simply lame. It so clearly believes its pay is deserved that it doesn’t even try hard here. Consider:
…we announced that for 2009 the firm’s entire management committee would receive 100 percent of their discretionary compensation in the form of Shares at Risk which have a five-year period during which an enhanced recapture provision will permit the firm to recapture the shares in cases where an employee engaged in materially improper risk analysis or failed sufficiently to raise
concerns about risks.Enhancing our recapture provision is intended to ensure that our employees are accountable for the future impact of their decisions, to reinforce the importance of risk controls to the firm and to make clear that our compensation practices do not reward taking excessive risk.
The enhanced recapture rights build off an existing clawback mechanism that goes well beyond employee acts of fraud or malfeasance and includes conduct that is detrimental to the firm, including conduct resulting in a material restatement of the financial statements or material financial harm to the firm or one of its business units.
Yves here. This sounds good, right? Read it again. It includes ONLY the management committee. The ranks of producers (de facto profit centers) goes far deeper into the firm than the management committee. This mechanism is far too shallow, in terms of the number of employees covered, to be effective (ahem, how rich are management committee members already before they reach that lofty level?)
And this:
In addition, our shareholders will have an advisory vote on the firm’s compensation principles and the compensation of its named executive officers at the firm’s Annual Meeting of Shareholders in May 2010.
Yves again. Many of Goldman’s large investors met with the firm in 2009 to object to the bonuses that the firm appeared ready to offer. Their pleas were rebuffed. And I would be curious to know how Goldman shares are held (as in how many are in mutual funds which routinely support management).
So Goldman is unrepentant, not that that is any surprise.
I
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“These gaps were hedged in full by the purchase of CDS and other risk mitigants from third parties such that we had no material residual risk if AIG defaulted on its obligations to us”
..
“Neil Barofsky of SIGTARP has dismissed this argument. If AIG had foundered, the CDS market would have suffered cascading counterparty failures.”
At that time, Goldman didn’t know that AIG was going to fail causing mayhem. So when AIG doesn’t pay all the collateral, the sensible thing was to buy CDS from other counter parties to hedge that risk, right?
What would you have done? At that time when you didn’t know AIG was going to fail, possibly causing the world to collapse and you didn’t know AIG was going to be bailed out. Was there an alternative?
GS is directly aware of $30Bn+ of AIG CDO exposure that is subject to collateral calls, knows the actual total is bigger, knows the monolines are going bust, buys CDS on AIG…and somehow *doesn’t* know AIG’s going to fail??
It seems more likely that they did know.
Me, I’d 1) kick my risk manager hard, 2) buy the CDS from whatever well-capitalized sucker I can find, 3) cross my fingers, and 4) tip off Hank P. and Tim Geithner, because they are going to need some thinking time and I am a good citizen.
I can’t find any hint that Lloyd did 4). Not in his job description I suppose.
no of course Goldman never trades against its clients….
It appears to me that the GS letter is propaganda.
One should look at the CDO – CDS trades as being of a piece. The CDO position demands a CDS while the CDO position makes the CDS position reflective on an insurable interest and thereby of standing in court. Beginning in 2004 thru 2005, it was clear that a short on house prices would be a very good trade. Now how do you short house prices from a trading desk position. You need an instrument that is a fair proxy for those prices and their impending decline. Hence the CDO. It’s very clever indeed.
As you’ve noted, it appears that GS was an agent in certain transactions and what may appear to have been trading against its clients may well have been trading on their behalf.
I do believe that what all this means is that GS has a need to dissemble and direct attention away from are real vulnerabilites. Just what the vulnerabilites are is not the least bit clear. One might gain an insight by a close examination of the evaporation of December in the GS conversion from fiscal to calendar accounting periods. That strikes as having a great deal of similarity with repo105.
Thanks, Yves! Superb spotting of B.S. esp. re the cascading counterparty defaults that would have resulted from a failure of AIG. The thought that being hedged against AIG meant they had no exposure is silly, as you so rightly point out.
So, as a non-industry person, let me ask for clarification of the jargon.
As far as we know, Goldman did not sell mortgage debt and then bet against that debt for it’s own account, i.e. buy CDS that they, not their clients, would profit from if the bottom fell out?
Or are we to understand that they did so, but not with “nefarious intent?”
Parsing Goldman’s PR is always good sport, so here goes:
“These gaps were hedged in full by the purchase of CDS and other risk mitigants from third parties, such that we had no material residual risk if AIG defaulted on its obligations to us.”
They’ve stuck to this line from the beginning, but what’s notable, I think, is that “fully hedged” does not necessarily mean they were long single name CDS on AIG.
Their net short position via CDS from GS CDOs may have been used to cover the gap, and would have been fully cash collateralized by the time AIG went down, In that case, their claim they had no material residual risk, and that cascading counterparty risk exposure was not a concern is plausible. What some might call ‘betting against their clients’ GS seems to be calling ‘hedging their gap’.
“The investors who TRANSACTED with Goldman Sachs in CDOs in 2007, as in prior years, were primarily large, global financial institutions, insurance companies and hedge funds”
Of course those who transacted in the CDOS were as described. The ‘investors who transacted’ in the CDOs were the investors in the CDO vehicle, not the investors who
bought the resulting CDOs, (i.e chump German banks)
GS is not addressing the ultimate CDO investors in this statement. One might easily conflate the two but that would be the listeners error, not the speakers since GS is merely talking about the ‘transactors’.
Pension funds and Euro Banks may have bought the CDOs, and other GS customers may have purchased protection from GS resulting from the CDO, but these were separate transactions.
I think the gist of the new PR campaign is to point out that GS exists solely to service its clients. If anyone’s to blame here it’s those clients who prey on GS good nature, exceptional intelligence and connections to exploit every possible loophole in every market on the globe. They can’t help themselves, and make no apolgies for what they are. If you want to fix the system, fix the loopholes GS discovers (and helps create, perhaps) and points out to its customers. No point attacking GS, if nothing’s done to reduce the incentives of their devious clients.
Think of it as the “But prostitution’s legal in this state, officer” defense.
Spot on, Yves. And also check out this excellent parsing of Greedy Sachs’ statement by John Gapper in the FT:
http://blogs.ft.com/gapperblog/2010/04/the-indispensable-help-received-by-goldman/
Studying the claims made by Goldman Sachs about whether it would have collapsed if the US government had not bailed out the financial system, and invested $10bn in Goldman itself, is like Kremlinology in the days of the Soviet Union – every word counts.
See Table 8-1 in Milne’s ” The Fall of The House of Cards”.According to Milne a yardstick to test banks wellness is “credit related losses to annual pre-tax profit. Out of the list of 25 major banks GS was the healthiest with a ratio of 0.7.
I think that the hatred for GS at this site really obscures why there was a bailout. Foremost as Geithner says they were terribly concerned with the Insurance sector going belly up and thus ruining the public’s retirement holdings. Having said that I still think we have to get rid of this to big to fail situation.