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The “Vampire Squid” squeaks

After the long analysis of Jamie Dimon’s 36-page shareholder letter, we now have an 8-page shareholder letter from Goldman Sachs.

I cannot remember such letters being of such interest in the past, and wonder if the let’s tell-all letter writing from Bank CEOs is the new fashion for the teens (or 2010s if you prefer).

Alternatively, Goldmans just don’t like being called names, since this is their longest shareholder letter ever.  If anything, it appears to be a direct response to the accusation of being a Vampire Squid lobbed at them last year by Rolling Stone’s Matt Taibbi (who I’m sure will have something to say about this letter).

Mind you, if I had just dished out $16 billion in bonuses for last year, for an average pay of $500k per staffer, you could call me anything you want.

It’s noteworthy that the letter refers to ‘clients’ on at least 56 occasions. A good example being: “We are responding to our clients’ desire either to establish, or to increase or decrease, their exposure to a position on their own investment views. We are not ‘betting against’ them.”

Yea, right.

That’s why Goldman Sachs managed to generate over $100 million in pure profit every day for over 131 days of trading last year I guess, a new record.

It also defends the bank’s controversial employee bonuses, relationship with AIG and role in short-selling the mortgage market.

Here’s a summary of the really juicy bits (the last three pages):

“In July 2007, as the market deteriorated, we began to significantly mark down the value of our super-senior CDO positions.

The letter refers to Collateralized Debt Obligations – click here to find out background on this stuff.

July 2007 was a key point as Goldmans had just lost billions on their Alpha Fund, due to their algorithmic systems messing up.

Our rigorous commitment to fair value accounting, coupled with our daily transactions as a market maker in these securities, prompted us to reduce our valuations on a real-time basis which we believe we did earlier than other institutions. 

They would do this on a real-time basis because their systems are controlling  ahead of the markets.

This resulted in collateral disputes with AIG. We believe that subsequent events in the housing market proved our marks to be correct — they reflected the realistic values markets were placing on these securities. 

“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.

What this implies is that, acting as an intermediary in the markets and as a market maker, Goldman Sachs could see the ensuing implosion in the housing markets and specifically in Credit Default Swaps (CDS) and CDOs, in real-time.

These complex derivatives were integral to their trading strategies for hedging purposes, as well as being a prime broker of these risk instruments at the same time. Therefore, they were using these hedging strategies to cash-in their insurances with AIG to get out of any risk positions early.

This is why: “In mid-September 2008, prior to the government’s action to save AIG, a majority of Goldman Sachs’ exposure to AIG was collateralized and the rest was covered through various risk mitigants. Our total exposure on the securities on which we bought protection was roughly $10 billion. Against this, we held roughly $7.5 billion in collateral. The remainder was fully covered through hedges we purchased, primarily through CDS for which we received collateral from our market counterparties. Thus, if AIG had failed, we would have had the collateral from AIG and the proceeds from the CDS protection we purchased and, therefore, would not have incurred any material economic loss.”

So they aren’t saying they screwed AIG, but they legitimately ensured they weren’t screwed by insuring someone else was. All perfectly legal and above board. Only the fittest and strongest survive and all that.

The letter then goes on to talk more generally about their involvement in the mortgage securitisation market.

“The markets for residential mortgage-related products, and subprime mortgage securities in particular, were volatile and unpredictable in the first half of 2007 (which is why they unravelled their position with AIG). Investors in these markets held very different views of the future direction of the U.S. housing market based on their outlook on factors that were equally available to all market participants, including housing prices, interest rates and personal income and indebtedness data. Some investors developed aggressively negative views on the residential mortgage market. Others believed that any weakness in the residential housing markets would be relatively mild and temporary. Investors with both sets of views came to Goldman Sachs and other financial intermediaries to establish long and short exposures to the residential housing market through RMBS, CDOs, CDS and other types of instruments or transactions. 

“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). These investors had significant resources, relationships with multiple financial intermediaries and access to extensive information and research flow, performed their own analysis of the data, formed their own views about trends, and many actively negotiated at arm’s length the structure and terms of transactions. We certainly did not know the future of the residential housing market in the first half of 2007 any more than we can predict the future of markets today. We also did not know whether the value of the instruments we sold would increase or decrease. It was well known that housing prices were weakening in early 2007, but no one — including Goldman Sachs — knew whether they would continue to fall or to stabilize at levels where purchasers of residential mortgage related securities would have received their full interest and principal payments. 

“Although Goldman Sachs held various positions in residential mortgage-related products in 2007, our short positions were not a ‘bet against our clients’. Rather, they served to offset our long positions. Our goal was, and is, to be in a position to make markets for our clients while managing our risk within prescribed limits.”

In other words, Goldman Sachs puts everything down to prudent accounting and intelligent risk management.

Maybe … but the fact that both clients selling and buying mortgage products and complex instruments (which no-one understood except Goldmans traders and a few others, such as JPMorgan Chase, creators of Credit Default Swaps) came to Goldmans, meant that they could see very early on that more people were getting out of the housing and mortgage markets than getting in.

Why are they coming to Goldmans? 

Because Goldmans market manipulating systems for high frequency trading give them the best price. This resulted in Goldmans getting out of the mire before everyone else got into it, and is why they cashed in their positions with AIG before everyone else.

They were almost acting as a primary market in and of themselves and, as a market, therefore had much greater knowledge of what was being bought and sold.

Then, as not just the market but also an investor, they invested when everyone was getting out (buy low) and were selling when everyone was getting in (sell high).

The only difference with this market being that it just happened to be the whole US housing market, based upon leverage and funding fuelled by AIG's insurances and complex hedging instruments.

The result is that Goldmans is the nimblest firm at avoiding bubbles bursting and bandwagons rolling.

It’s not illegal of course. It just means they’re far more likely to be onto a sure thing than anyone else.

So, Matt Taibbi’s claim that Goldman Sachs is “a great vampire squid wrapped around the face of humanity” is obviously wrong, and their bonuses are fully justified. 

Download Goldman Sachs Shareholder Letter, April 2010


About Chris M Skinner

Chris M Skinner
Chris Skinner is best known as an independent commentator on the financial markets through his blog, the Finanser.com, as author of the bestselling book Digital Bank, and Chair of the European networking forum the Financial Services Club. He has been voted one of the most influential people in banking by The Financial Brand (as well as one of the best blogs), a FinTech Titan (Next Bank), one of the Fintech Leaders you need to follow (City AM, Deluxe and Jax Finance), as well as one of the Top 40 most influential people in financial technology by the Wall Street Journal’s Financial News. To learn more click here...

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