Why Goldman Sachs was Short CDOs

Michael Lewis has a very peculiar column up at Bloomberg today, tied to Kate Kelly’s December 14 WSJ story about the subprime traders at Goldman Sachs. Lewis says that Goldman’s executives essentially overruled their own traders, thereby saving themselves from subprime losses:

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…

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.

But really that’s not what Kelly’s story says at all. It was the traders in subprime-mortgage bonds who were told to go short, and who indeed were prevented from going even shorter at a few key moments. The "supposed experts" in subprime mortgages were if anything even more bearish than the higher-ups; Lewis’s "fools trading subprime mortgages" are never once mentioned in the story, and I’m far from convinced that they exist. Here’s Kelly:

Last December, David Viniar, Goldman’s chief financial officer, gave the group a big push, suggesting that it adopt a more-bearish posture on the subprime market, according to people familiar with his instructions. During a discussion with Mr. Sparks and others, Mr. Viniar noted that Goldman had big exposure to the subprime mortgage market because of CDOs and other complex securities it was holding, these people say. Emerging signs of weakness in the market, meant that Goldman needed to hedge its bets, the group concluded, these people say.

Note that the bearish bets weren’t an attempt to offset trading positions entered into by prop traders on a mortgage desk: they were an attempt to offset structural long positions built up as a result of Goldman’s activities putting together CDOs. It’s wasn’t traders who built up that position, it was bankers, structuring products, selling them to buy-side clients, and retaining some piece of them for the firm’s own books. It was the traders who rescued the bankers from building up huge potential losses, not the executives parachuting in some crack team to rescue the traders.

Lewis makes a good point, and then undercuts it:

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…

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…

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?

Lewis is right about the risk officers. What Goldman did is what any decent risk officer should have done: look at the risks on the bank’s balance sheet, and then work to offset them. There’s a difference between that and "making the market calls". The guys at the top of the firm didn’t try to make money shorting mortgages, they just wanted to hedge their positions. In fact, they behaved much like the guys at Magnetar, who were structurally long CDOs, who therefore hedged their positions, and who wound up getting lucky when those short positions ended up returning much more than anybody could ever have anticipated.

One can argue about whether Goldman was lucky or whether it was smart. But I don’t think it’s fair to say that it was overruling its own traders.

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