The Local Paper

We're trying to handle the truth, but it doesn't conform to our desire for a simple answer

An admittedly overly simple example. I’m sure that my trading desk friends and others that read this with greater knowledge than I on this topic will laugh at my “crayon-like” simplicity.

There’s obviously lots of attention, anger and frustration being directed at Goldman Sachs, who had their senior mortgage staff and CEO testify before Congress yesterday. There was frustration on all sides, since the lawmakers don’t understand the business and the attempts by Goldman to try to explain it struck many as evasive. The example I’ve concocted below does not speak directly to the conflicts Goldman had in selling “shitty” CDO bonds to investors because they had a bigger fish on the other end of the trade who wanted to short the deal. My purpose in providing this elementary example is to show that this is all not as simple as people would like.

Let’s look at a major bank. They have one of the largest originators of loans in their Home Finance unit. This unit reports up through their Retail division. They don’t sell of all of their loans (i.e., they don’t securitize them or sell them all to the GSEs—you can see them on their balance sheet), so they are naturally “long” housing risk. They’re making loans and retaining the risk.

The Investment Banking division includes the loan trading and derivatives trading desks. It’s here that bonds, swaps, foreign exchange, loans and other securities are sold to clients. The Desk buys and sells these instruments based on client demand. The Desk is constantly buying and selling assets—positioning them—so that they have access to the assets that their clients want to buy and sell.  In addition, the Desk is responsible for selling those assets that are underwritten by the Firm. For purposes of our example, let’s say that some of those underwritten assets are bonds backed by home mortgages.

Management, housed in the “Corporate” segment, looks at the risks in the portfolio and has a choice: a) they can either sell the loans outright and forego the interest income on the ones that are going to pay in full, b) they can wait for those that are going to go bad to default and charge them off dollar-for-dollar or c) they can buy insurance on the portion of the portfolio that they think might go bad. This insurance doesn’t cost them 100 cents on the loan dollar (in the same way your car insurance premium is less than the cost of your car). They get many benefits from choice (c): loss protection at a fraction of the cost (it reduces the earnings drag on the firm as a whole with respect to charge-offs; it’s providing the funds used for reserves instead of having them come out of other earnings) and increases the stability of earnings to name just two. This process protects their shareholders.

What form does this insurance take? It can come from shorting the ABX index. This index is in layman’s terms the mortgage-backed securities equivalent of the S&P 500. They sell the ABX to someone who, for their own portfolio reasons, wants exposure to the US housing market but can’t buy individual loans and wants the diversity of an index as opposed to a single MBS issue. Foreign banks, insurance companies, pension funds, etc. might represent some typical buyers.

Home Finance is long housing. One part of the Desk is selling mortgage-backed bonds to clients, while another part is executing short trades on behalf of the Corporate segment. But if you look solely at the Desk as the Senate Permanent Subcommittee on Investigations did yesterday, you see a firm that is “selling bonds to clients while betting against the very same bonds”.

My question is: What should they do? Only be long housing and selling bonds? If that’s the case, they will reach the point where they don’t want any more housing risk and will stop making mortgage loans. This will raise the “why can’t I get a mortgage?” complaint from consumers. We don’t want that.  If they don’t manage their portfolioexposure in some way–by shorting or in the vernacular, “flattening the book”–they’re exposing their shareholders (and it need be said, the FDIC and ultimately the taxpayers) to more risk than they want to take. This increased risk is almost the opposite of the moral hazard.

What Goldman and the other Wall Street firms do is much more intricate and complicated than this example and much more complicated that they can explain when confronted with loaded questions, but looking only at one part of the picture is both unfair and disingenuous. But then again, no one said that the purpose of these investigations was to get to what’s fair or ingenuous. None of this excuses what the SEC alleges Goldman did wrong in the Abacus trades. That part of the story—the “who should have told whom about who else was involved in the deal” stuff, will all be aired in court. I’m not capable of judging whether Goldman violated the law or ethical treatment of their multiple clients.

The point of all this is that these firms are all engaged in multiple activities across their different platforms, and looking at only one part of a firm’s business can lead to drawing the wrong conclusions and bad legislation to try to “fix” the problem.  It is likely that any legislation that comes out of this will likely activate my favorite law, the Law of Unintended Consequences.

To those who say that there was no incremental economic activity associated with the synthetic trades at the heart of the Goldman deals, I ask, “How is that different from the secondary trading on the stock exchange?” The companies that have issued the stock already have the money, it’s just a transfer of wealth from one party to another; one that thinks that the value will go down and one that thinks that the value will go up. The firms that make markets in equities—that trade them off of their own book to facilitate client transactions aren’t telling their client that “someone else thinks the value of the stock you’re buying is going to go down—that’s why they’re selling it while you buy it.” No one seems to complain about that.

I fear that people take advantage of the fact that these activities happen beyond their normal sight. They’d rather not consider on a regular basis with the messy details of what makes markets work, of who gets and who is denied credit and for what reason. They reap the benefits of a vibrant capital market (and yes, on balance we’ve reaped much greater benefit from these markets and these activities than the events of the last two years have cost us) but once these practices are out in the open people are shocked (shocked!) and dismayed that such things happen.* The Wall Street Journal on Monday provided an email of unknown authorship that mashed up Colonel Jessup’s famous “You want me on that wall,” testimony from “A Few Good Men” in with the concept of the allocation of capital that the banking industry provides. I won’t dwell on it here, because it’s an overdrawn example (pardon the pun). But this letter to the New York Times printed today is worth reading and considering. In essence, the author says that had there been more John Paulsons out there, more people who wanted to “sell” and not “buy” exposure to the US housing market, the end would have come sooner and the damage less dramatic.

I understand that people want a scapegoat. They want a villain. I hold no quarter for Goldman Sachs. But none of this is as simple to explain as people might like and all of it is critical to the future success of our economy. Getting this wrong will have long-lasting effects and we may pay a price for it in terms of economic growth for years to come. It may be a price worth paying, but I think that we’d be better off knowing that price ahead of time.

*  When you hear an entrepreneur lament that he can’t get a loan to start his business, ask them how much equity he’s putting into the venture versus how much he’s trying to borrow. Banks have never been good at venture capital—they’re good at lending to businesses with track records of performance. People that are trying to borrow money to start businesses are looking in the wrong place. They want to use the bank because the bank is cheaper than going to a venture capitalist who will likely demand a higher coupon and an equity interest in the deal, which the entrepreneur is loath to surrender. The fact that during the bubble banks made these loans is as much a testimony to the lack of lending standards that existed as all those poorly conceived mortgages. It’s not that “banks aren’t lending”. It’s that banks are trying to return to the underwriting standards that kept them safe  for so long without a giant spasm of failures. We shouldn’t want banks to do the same deals they did over 3 of the last 4 years. We should want something better. There’s money out there to be had, but it’s more expensive than it used to be.