Financial Firms, Adverse Selection, and Goldman’s Best Mistake (Ever)
How did Goldman make so much money on sub-prime? They were short. Easy! That was a short post…
Not so fast! First, let’s think about Investment Banks as a business. Essentially they are paid to bear the brunt of adverse selection in the capital markets. Who provide liquidity for bonds and stocks? Investment banks. When are investment banks most likely to be made to buy massively? When everyone is selling. What’s going on when everyone is selling? The price is going down! Still want to be a line trader at an bulge bracket investment bank?
Now that’s just supply and demand overlayed onto a bunch of job descriptions. What everyone in the business knows is that Goldman wasn’t a big player in either sub-prime nor CDOs according to all-important league tables (note, this isn’t year end 2007, and 2006 was a different picture as it relates to CDOs, but more on that in a second). The major investment banks being hurt most are, in general, the ones with residential mortgage conduits (operations, run by investment banks, that directly make loans to people looking to purchase a home or re-finance but that look to only securitize, not hold, those loans). UBS, Merrill, Morgan Stanley, BofA, and Bear Stearns–these firms all have conduits and directly lend. These firms also fall prey to adverse selection with Early Payment Defaults. When you originate the loan you don’t have the “put” back to the originator that you generally have with loan packages you purchase for the purpose of securitization.
So, what did Goldman have going for it? It didn’t have a conduit. It didn’t have a large inventory of sub-prime bonds because it wasn’t a large player in that business. Now, while it did do a nominally large volume in CDO issuance, there’s a trick to those numbers. First, the breakouts on collateral type likely show a very different mix for some banks versus other (more Corporate CDOs versus more Structured Finance CDOs). Also, Goldman did a huge number of synthetic CDOs where Goldman bought protection on multiple billions of dollars in notional and then sold the long side to investors (due to the arbitrage in these types of CDOs investors demanded less than what Goldman was paying and Goldman was able to monetize that difference immediately). Couple that with, as described by the WSJ, the fact that senior people were brought in to sell down what Goldman was already long, and you see the dynamic at work here: Goldman wasn’t naturally long sub-prime in the same way everyone else was. If you’re not long, it’s easier to be short. Do you think Merrill could have hedged their exposure by being short a mere few billion of ABX? No.
And that’s why Goldman, a firm which was trying to increase it’s CDO business as recently as early 2007, was lucky as well as smart.