Miserable bankers

Note most of the research for the book from which this article originates took place during the post-credit crisis bust for financiers. Still the best risk-adjusted path to $5-10 M net worth.

See also Creators and Rulers and From physics to Goldman to Y-Combinator.

Atlantic: ... Jeremy, for instance, had arrived at Goldman thinking that his specific job—trading commodities derivatives—could make the world a teensy bit better by allowing large companies to hedge their costs, and pass savings along to customers. But one day, his boss pulled him aside and told him that, in effect, he’d been naïve.

“We’re not here to save the world,” the boss said. “We exist to make money.”

The British economist Roger Bootle has written about the difference between “creative” and “distributive” work. Creative work, Bootle says, is work that brings something new into the world that adds to the total available to everyone (a doctor treating patients, an artist making sculptures). Distributive work, on the other hand, only carries the possibility of beating out competitors and winning a bigger share of a fixed-size market. Bootle explains that although many jobs in modern society consist of distributive work, there is something intrinsically happier about a society that skews in favor of the creative.

“There are some people who may derive active delight from the knowledge that their working life is devoted to making sure that someone else loses, but most people do not function that way,” he writes. “They like to have a sense of worth, and that sense usually comes from the belief that they are contributing to society.”

During my interviews with young bankers, I heard a lot of them express this exact sentiment. They wanted to do something, make something, add something to the world, instead of simply serving as well-paid financial intermediaries at giant investment banks. It doesn’t hurt that creative jobs—including, but not limited to, jobs with Silicon Valley tech companies—are now considered sexier and more socially acceptable than Wall Street jobs, which still carry the stigma of the financial crisis. At one point, during the Occupy Wall Street protests, Jeremy told me that he had begun camouflaging his Goldman affiliation in public. ...

Goldman v. Aleynikov

Michael Lewis on the Aleynikov-Goldman HFT matter. The article mentions that Goldman trailed other players like Citadel when Aleynikov was hired. The head of HFT at Citadel was (I believe) a contemporary of mine in grad school at Berkeley, who did his dissertation in string theory. Malyshev, the guy who hired Aleynikov from Goldman, had his own legal problems when he left Citadel.

Vanity Fair: ... Serge knew nothing about Wall Street. The headhunter sent him a bunch of books about writing software on Wall Street, plus a primer on how to make it through a Wall Street job interview, and told him he could make a lot more than the $220,000 a year he was making at the telecom. Serge felt flattered, and liked the headhunter, but he read the books and decided Wall Street wasn’t for him. He enjoyed the technical challenges at the giant telecom and didn’t really feel the need to earn more money. A year later the headhunter called him again. By 2007, IDT was in financial trouble. His wife, Elina, was carrying their third child, and they would need to buy a bigger house. Serge agreed to interview with the Wall Street firm that especially wanted to meet him: Goldman Sachs.

... And then Wall Street called. Goldman Sachs put Serge through a series of telephone interviews, then brought him in for a long day of face-to-face interviews. These he found extremely tense, even a bit weird. “I was not used to seeing people put so much energy into evaluating other people,” he said. One after another, a dozen Goldman employees tried to stump him with brainteasers, computer puzzles, math problems, and even some light physics. It must have become clear to Goldman (as it was to Serge) that he knew more about most of the things he was being asked than did his interviewers. At the end of the first day, Goldman invited him back for a second day. He went home and thought it over: he wasn’t all that sure he wanted to work at Goldman Sachs. “But the next morning I had a competitive feeling,” he says. “I should conclude it and try to pass it because it’s a big challenge.”

... He returned for another round of Goldman’s grilling, which ended in the office of one of the high-frequency traders, another Russian, named Alexander Davidovich. A managing director, he had just two final questions for Serge, both designed to test his ability to solve problems.

The first: Is 3,599 a prime number?

Serge quickly saw there was something strange about 3,599: it was very close to 3,600. He jotted down the following equations: 3599 = (3600 – 1) = (602 – 12) = (60 – 1) (60 + 1) = 59 times 61. Not a prime number.

The problem wasn’t that difficult, but, as he put it, “it was harder to solve the problem when you are anticipated to solve it quickly.” It might have taken him as long as two minutes to finish. The second question the Goldman managing director asked him was more involved—and involving. He described for Serge a room, a rectangular box, and gave him its three dimensions. “He says there is a spider on the floor and gives me its coordinates. There is also a fly on the ceiling, and he gives me its coordinates as well. Then he asked the question: Calculate the shortest distance the spider can take to reach the fly.” The spider can’t fly or swing; it can only walk on surfaces. The shortest path between two points was a straight line, and so, Serge figured, it was a matter of unfolding the box, turning a three-dimensional object into a one-dimensional surface, then using the Pythagorean theorem to calculate the distances. It took him several minutes to work it all out; when he was done, Davidovich offered him a job at Goldman Sachs. His starting salary plus bonus came to $270,000.

... One small example of the kind of problems Serge found: Goldman’s trading on the NASDAQ exchange. Goldman owned the lone (unmarked) building directly across the street from NASDAQ in Carteret, New Jersey. The building housed Goldman’s dark pool. When Serge arrived, 40,000 messages per second were flying back and forth between computers inside the two buildings. Proximity, he assumed, must offer Goldman Sachs some advantage—after all, why else buy the only building anywhere near the exchange? But when he looked into it he found that, to cross the street from Goldman to NASDAQ, a signal took five milliseconds, or nearly as much time as it took a signal to travel on the fastest network from Chicago to New York. “The theoretical limit [of sending a signal] from Chicago to New York is something like seven milliseconds,” says Serge. “Everything more than that is the friction caused by man.” The friction could be caused by physical distance—say, if the signal moving across the street in Carteret, New Jersey, traveled in something less direct than a straight line. It could be caused by computer hardware. (The top high-frequency-trading firms chuck out their old gear and buy new stuff every few months.) But it could also be caused by slow, clunky software—and that was Goldman’s problem. Their high-frequency-trading platform was designed, in typical Goldman style, as a centralized hub-and-spoke system. Every signal sent was required to pass through the mother ship in Manhattan before it went back out into the marketplace. “But the latency [the five milliseconds] wasn’t mainly due to the physical distance,” says Serge. “It was because the traffic was going through layers and layers of corporate switching equipment.” ...

In this last paragraph Aleynikov sounds more like Sakharov than a millionaire quant ;-)

“If the incarceration experience doesn’t break your spirit, it changes you in a way that you lose many fears. You begin to realize that your life is not ruled by your ego and ambition and that it can end any day at any time. So why worry? You learn that, just like on the street, there is life in prison, and random people get there based on the jeopardy of the system. The prisons are filled with people who crossed the law, as well as by those who were incidentally and circumstantially picked and crushed by somebody else’s agenda. On the other hand, as a vivid benefit, you become very much independent of material property and learn to appreciate very simple pleasures in life such as the sunlight and morning breeze.”

Inside the vampire squid

NYTimes Dealbook interview with the Goldman elevator tweeter (GSElevator).

Q. Why did you start this thing?
A. Again, I wanted to amuse myself during the summer lull and while market volatility keeps capital markets transactions to a minimum. I also thought that despite the disdain out there that exists for Wall Street professionals, people still really have no idea really how bad it is — and how shallow the industry really is, and frankly, how unimpressive 98 percent of the employees are.

Q. Are you really a Goldman employee?
A. Yes. However, I cannot really elaborate on this in terms of team or location, other than to say that I am a career banker. And to preemptively clarify, I am in a front-office, revenue-producing, client-facing role. Apologies for the aggressive clarification, but it is quite pathetic to see back/middle office employees telling people (women in bars) that they are “investment bankers.” If people are at all skeptical about my employment status, it doesn’t bother me. I am doing this for my own amusement.

Q. How many of the submissions are actually yours?
A. The first few were either conversations that I have overheard directly, or that have been told to me by colleagues. Having said that, I have avoided tweets that would be too closely connected to me or any of my friend/colleagues. Once it started to get some attention, I started to receive some good submissions.

Q. Overall, what are your thoughts on your Goldman colleagues?
A. They are obsessed with working for Goldman Sachs. They seem to define themselves by their jobs/firm, as opposed to who they are as people and what their interests are.

Sample tweets:

“You can’t spell genius without a G and a S” (not said in jest)

Work hard. Eat right. Exercise. Don't drink too much. And only buy what you can afford. It's not rocket science.

#1: The Cheesecake Factory looks like a restaurant poor people think rich people might eat at. #2: Same with anything Trump.

Starbucks needs a separate line for people who have their shit together.

From my experience, most people really should have lower self-esteem.

Advice for a daughter depends almost entirely on how attractive she is.

Kids should know that Chris Paul's twin brother, Cliff, only makes $32,000 a year

As a shareholder, I have to ask... Is having a book section really the best use of Walmart shelf space?

In 50 years, no one will watch baseball. It was invented when there was absolutely nothing else to do.

Being single at 40 is perfect. Divorcées chase me. Sweet spot for 30-somethings. Rich enough to get girls in their 20s.

I don't read fiction. Unless you count an Indonesian bond offering memorandum.

Revenge of the muppets?

No. This guy will probably regret writing a bitter resignation op-ed.

NYTimes: ... It makes me ill how callously people talk about ripping their clients off. Over the last 12 months I have seen five different managing directors refer to their own clients as “muppets,” sometimes over internal e-mail. Even after the S.E.C., Fabulous Fab, Abacus, God’s work, Carl Levin, Vampire Squids? No humility? I mean, come on. Integrity? It is eroding. I don’t know of any illegal behavior, but will people push the envelope and pitch lucrative and complicated products to clients even if they are not the simplest investments or the ones most directly aligned with the client’s goals? Absolutely. Every day, in fact.

It astounds me how little senior management gets a basic truth: If clients don’t trust you they will eventually stop doing business with you. It doesn’t matter how smart you are.

These days, the most common question I get from junior analysts about derivatives is, “How much money did we make off the client?” It bothers me every time I hear it, because it is a clear reflection of what they are observing from their leaders about the way they should behave. Now project 10 years into the future: You don’t have to be a rocket scientist to figure out that the junior analyst sitting quietly in the corner of the room hearing about “muppets,” “ripping eyeballs out” and “getting paid” doesn’t exactly turn into a model citizen.

Already, the vampire squid is on the counterattack:

WSJ: ... Mr. Smith described himself as an executive director and head of Goldman’s U.S. equity derivatives business in Europe, the Middle East and Africa.

A person familiar with the matter said Mr. Smith’s role is actually vice president, a relatively junior position held by thousands of Goldman employees around the world. And Mr. Smith is the only employee in the derivatives business that he heads, this person said.

More fun at the Times Dealbook blog:

Former Goldman trader, quit last year

This guy might as well have had a microphone in the room with me during my exit interview…took the words right out of my mouth. To add to one thing he said, I had never heard the term “rip someone’s face off” until I started working at Goldman Sachs. Unfortunately, that phrase was all too often used in the context of client transactions.

Matt Levine, former Goldman employee, now an editor at Dealbreaker:

Maybe if he’d gotten the Rhodes, or won a gold medal for regular tennis at the goyish Olympics, he’d have made MD and would still have a job.

Goldman and Google

Two excellent podcasts I recommend.

William Cohan on his new book How Goldman Sachs Came to Rule the World. Cohan, a former banker, seems more knowledgeable than most financial journalists.

Steven Levy on his book How Google Thinks, Works, and Shapes Our Lives. Based on my own experience, Levy knows what he is talking about.

Some New Year's reading

I learned about the site longform.org via Seth Roberts. It aggregates long magazine articles from numerous sources. Below are some recommendations.


Financial Times on Moscow's stray dogs.

“Genetically, wolves and dogs are almost identical,” says Poyarkov. “What has changed significantly [with domestication] is a range of hormonal and behavioural parameters, because of the brutal natural selection that eliminated many aggressive animals.” He recounts the work of Soviet biologist Dmitri Belyaev, exiled from Moscow in 1948 during the Stalin years for a commitment to classical genetics that ran counter to state scientific doctrine of the time.

Under the guise of studying animal physiology, Belyaev set up a Russian silver fox research centre in Novosibirsk, setting out to test his theory that the most important selected characteristic for the domestication of dogs was a lack of aggression. He began to select foxes that showed the least fear of humans and bred them. After 10-15 years, the foxes he bred showed affection to their keepers, even licking them. They barked, had floppy ears and wagged their tails. They also developed spotted coats – a surprising development that was connected with a decrease in their levels of adrenaline, which shares a biochemical pathway with melanin and controls ­pigment production.

[See related post on Belyaev and fast Fox evolution here. I find it quite plausible that humans domesticated themselves over the last 10k years.]

“With stray dogs, we’re witnessing a move backwards,” explains Poyarkov. “That is, to a wilder and less domesticated state, to a more ‘natural’ state.” As if to prove his point, strays do not have spotted coats, they rarely wag their tails and are wary of humans, showing no signs of ­affection towards them.

GQ on social networking startups in Silicon Valley:

Sitting here pinioned between the photon-cannon brains and futurey salesmanship of Rahul and Jiggity, I realize there's something that makes me simultaneously excited and agitated. It is an unfamiliar sensation: optimism. Jiggity knows. Rahul knows. Everyone at YC knows. The world belongs to them. You can hardly be alive in 2010 and not know that. You can't know what Facebook is without knowing that. This—Silicon Valley in general and YC more specifically—might be the last place in America where people are this optimistic. The last place in America where people aren't longing for a vague past when we were the shit.

Vanity Fair on Goldman Sachs ("a giant hedge fund that front-runs its so-called clients"?):

What Goldman doesn’t get is that all the murk about the ways it has benefited from public money taps into a deep fear that has long existed among those who think they know Goldman all too well. It’s a fear that, as one person puts it, Goldman’s “skill set” is “walking between the raindrops over and over again and getting away with it.” It is a fear that Goldman has the game rigged, even if no one can ever prove how, not just because of its political connections but also because of its immense size and power. And it is a belief that despite all the happy talk about clients and culture (and, boy, is there a lot of that) the Goldman of today cares about one thing and one thing only: making money for itself. Says one high-level Wall Street executive, “Why do you have a business? Because you have a customer. You have to make an appropriate profit. But is it possible that Goldman has changed from a firm that had customers to a company that is just smart as shit and makes a shitload of money?”

Lapham's Quarterly on a precocious 12 year old novelist who later vanished from the world at age 26.

The House Without Windows appeared in February 1927 to overwhelming praise. “A Mirror of the Child Mind,” announced a New York Times headline: “the most authentic and unalloyed document of a transient and hitherto unrecorded phase in plastic intelligence…[a] truly remarkable little book.” They featured Barbara on the front page of that day’s Photogravure Picture Section, showing her correcting a set of galley proofs.

The Saturday Review of Literature found the book “almost unbearably beautiful.” It is not hard to see why. The opening lines evoke a fairy-tale isolation: “In a little brown shingled cottage on one of the foothills of Mt. Varcrobis, there lived with her father and mother, Mr. and Mrs. Eigleen, a little girl named Eepersip. She was rather lonely…” Eepersip emerges from the forest dressed in garlands to try to lure other children away, including her own younger sister ...

Then again, her work always was about escape. Her mysterious disappearance echoes with the final words of The House Without Windows, when the lonely Eepersip finally vanishes forever into the woods.

“She would be invisible forever to all mortals, save those few who have minds to believe, eyes to see,” Follett wrote. “To these she is ever present, the spirit of Nature—a sprite of the meadow, a naiad of lakes, a nymph of the woods.”

Buffet on Goldman

Great minds think alike ;-)

NYTimes: ... Mr. Buffett said that he feels little sympathy for the firms the S.E.C. says were hurt by Goldman’s purported lack of adequate disclosure. Of one firm, ABN Amro, Mr. Buffett said: “It’s hard for me to get terribly sympathetic when a bank makes a dumb credit bet.”

What Mr. Buffett thinks about Goldman is something the investment community has been buzzing over for days. Berkshire has invested $5 billion in Goldman preferred shares, and Mr. Buffett is notoriously skeptical of Wall Street mores. One of the low points of Mr. Buffett’s investing career is stepping in at Salomon Brothers when the firm was embroiled in a trading scandal: he had to temporarily assume Salomon’s chairmanship and apologize to Congress.

In the case of Goldman, however, Mr. Buffett and his chief lieutenant, Charles Munger, made it clear they’re on the firm’s side. Goldman and Berkshire have a long history, with Mr. Buffett relying on Goldman as his longtime investment bank. (He’s famously said that Byron D. Trott, a longtime Goldman banker who left to start his own shop, is one of the few Wall Street bankers he trusts.)

According to DealBook’s Andrew Ross Sorkin, who’s one of three panelists asking questions at the meeting, Mr. Buffett essentially took Goldman’s defense that everyone involved in the now-infamous Abacus deal was a sophisticated investor fully capable of evaluating the risks in the subprime mortgage investment. Instead of needing to be told that a hedge fund manager who suggested which bonds should form the underpinnings of the Abacus collateralized debt obligation was also short the bonds, the investors should have relied on their own due diligence, Mr. Buffett said.

“If I have to care who is on the other side of the trade, I shouldn’t be insuring bonds,” he said.

Mr. Buffett added an implicit rebuke of a line of questioning raised by several senators during this week’s Goldman hearings. An investment bank could very well be short the securities Berkshire is buying, and a buyer like Berkshire should be perfectly aware of that in any case.

Mr. Munger added that were he on the S.E.C., he would not have voted to press charges.

That isn’t to say that Mr. Buffett and Mr. Munger think Goldman is blameless here. Mr. Munger suggested that there’s a difference between breaking the law and behaving unethically — and that simply following the former shouldn’t be the basis of a business’ conduct.

See you in court

The best reporting on the SEC charges against Goldman that I've found so far is by Felix Salmon at Reuters. See the post I linked to and several more he's made in the past day or two.

I still think the SEC will have a tough time with this case. In terms of public opinion (no nuance), this is definitely a black eye for Goldman. But a court of law is a different thing, one hopes.

Below are two comments from Felix's blog that sum up the issue nicely. ABN/IKB are the large European banks that were big buyers of the senior tranches of the Abacus deal in question (more correctly, ABN was an insurer of the Abacus risk). ACA is the Abacus CDO manager that collected millions of dollars in fees and put its reputation on the line. The records show that they rejected many of Paulson's suggestions for reference names to be placed in the structure.

The bottom line is that when a trade occurs the buyer and seller typically have different views on the likely future of the security. See my previous post for some color on what the world looked like when the Abacus deal was being done. If ABN/IKB had done well with their investment they might be chuckling today: "Yeah, we took a lot of money from those short chumps back in 2007. Can you believe we got 100 bps for free for AAA! Who is John Paulson?"

Somehow it's easier to blame this disaster on evil fraudsters than on plain stupidity.

Well, that’s all very nice, but what is it that ACA was supposed to have done for the fee it was paid? Just accept Paulson’s selections? Were they not supposed to be you know actually evaluating the structure and underlying assets?

When a firm gets millions of dollars to validate an investment, doesn’t it have some obligation to do some research?


*********************


I'm still at a loss to understand why sellers of credit protection would have changed their mind if they knew the buyer of the protection structured the transaction.

Do ABN/IKB assume all market participants are lazy and gullible as they are? Popeye the Sailor could have selected the collateral but it was incumbent on ABN and IKB to perform their own due diligence on the underlying assets.

Paulson/GS also had no inside or non-public information that these bonds would default. They structured the CDO based on their view that the bonds were likely to default. This information was also available to ACA, ABN, IKB.

Paulson/GS certainly didn’t force the homeowners to default on their payments or cause the bond trustee to declare the bonds in default.

If I sell you a share of Apple stock, chances are I am less optimistic than you are about the future price. However, it's also possible I'm selling it just for risk management or asset allocation reasons; maybe I have too much concentration in my portfolio so I'm selling it just to rebalance. But we usually don't require that the buyer has to know my reasons for selling the share. The SEC is more or less saying Goldman committed fraud by not letting the buyers know that Paulson really thought subprime was a bubble, and wasn't simply hedging his mortgage positions. Yes, Paulson suggested names for the structure, but ACA was there to vet all of them.

The WSJ has a nice analysis of ACA's role, and its centrality to the case, here.

This NYTimes article describes the internal dynamics at Goldman -- until very late there was no consensus that CDOs built from subprime assets would melt down.

How it looked to Paulson

Why did Paulson and Magnetar need to participate in the creation of new CDOs? Apparently Paulson had trouble finding counterparties at the time willing to take direct billion dollar bets on CDS indices. If I had had a decent way to short subprime in 2005 or 2006 I would have done it too -- see post1 and post2 from 2004!

Regarding the SEC charges against Goldman: the buyers of synthetic CDOs should have realized that there must have been short interest on the other side of the deal, and at the time Paulson wasn't a prominent figure. His short strategy was very contrarian and took enormous guts. I think this is going to be a very tricky case for the SEC.

Here's a revealing excerpt from WSJ reporter Gregory Zuckerman's book The Greatest Trade Ever. Read the whole excerpt!

WSJ: ... Mr. Paulson traveled to Boston to meet with Mark Taborsky, who helped pick hedge funds for Harvard's endowment. Mr. Taborsky was wary. Mr. Paulson's fund was willing to lose 8% a year to buy the mortgage insurance, which seemed like a lot. Mr. Taborsky also thought Mr. Paulson might be excessively gloomy about the housing market. Mr. Taborsky turned him down, too.

Even some investors who agreed with Mr. Paulson's view that housing prices would tumble doubted he would make much money because there was relatively little trading in the investments he was buying. He might have a hard time selling his investments without sending prices tumbling, shrinking any profits, they said.

"It looked like a dangerous game, taking one single bet that might be difficult to unwind," said Jack Doueck, a principal at Stillwater Capital, a New York firm that parcels out money to funds. He, too, said no to Mr. Paulson's fund.

Mr. Paulson's growing fixation on housing began to spark doubts about his business. One long-time client, big Swiss bank Union Bancaire Privée, received an urgent warning from a contact that Mr. Paulson was "straying" from his longtime focus, and that the bank should pull its money from Paulson & Co., fast. The bank stuck with Mr. Paulson but turned down his new fund.

... By the summer of 2006, Mr. Paulson had managed to raise $147 million, mostly from friends and family, to launch a fund. Soon, Josh Birnbaum, a top Goldman Sachs trader, began calling and asked to come by his office. Sitting across from Mr. Paulson, Mr. Pellegrini, and his top trader, Brad Rosenberg, Mr. Birnbaum got to the point.

Not only were Mr. Birnbaum's clients eager to buy some of the mortgages that Paulson & Co. was betting against, but Mr. Birnbaum was, too. Mr. Birnbaum and his clients expected the mortgages, packaged as securities, to hold their value. "We've done the work and we don't see them taking losses," Mr. Birnbaum said.

After Mr. Birnbaum left, Mr. Rosenberg walked into Mr. Paulson's office, a bit shaken. Mr. Paulson seemed unmoved. "Keep buying, Brad," Mr. Paulson told Mr. Rosenberg.

[Yes, in hindsight everyone knows that subprime loans were "toxic waste" -- but at the time lots of smart money didn't think so. Mr. Market needs a little help sometimes ... Steve]

Months into their new fund, Mr. Paulson and Mr. Pellegrini were eager to find more ways to bet against risky mortgages. Accumulating mortgage insurance in the market sometimes proved slow. They soon found a creative and controversial way to enlarge their trade.

They met with bankers at Bear Stearns, Deutsche Bank, Goldman Sachs, and other firms to ask if they would create securities—packages of mortgages called collateralized debt obligations, or CDOs—that Paulson & Co. could wager against.

The investment banks would sell the CDOs to clients who believed the value of the mortgages would hold up. Mr. Paulson would buy CDS insurance on the CDO mortgage investments—a bet that they would fall in value. This way, Mr. Paulson could wager against $1 billion or so of mortgage debt in one fell swoop.

Paulson & Co. wasn't doing anything new. A few other hedge funds also worked with banks to short CDOs the banks were creating. Hundreds of other CDOs were being created at the time. Other bankers, including those at Deutsche Bank and Goldman Sachs, didn't see anything wrong with Mr. Paulson's request and agreed to work with his team.

At Bear Stearns, however, Scott Eichel, a senior trader, and others met with Mr. Paulson and later turned him down. Mr. Eichel said he felt it would look improper for his firm. "On the one hand, we'd be selling the deals" to investors, without telling them that a bearish hedge fund was the impetus for the transaction, Mr. Eichel told a colleague; on the other hand, Bear Stearns would be helping Mr. Paulson wager against the deals.

Some investors later would argue that Mr. Paulson's actions indirectly led to the creation of additional dangerous CDO investments, resulting in billions of dollars of additional losses for those who owned the CDO slices.

At the time, though, Mr. Paulson still wasn't sure his trade would work. He simply was buying protection, he said. "We didn't create any securities, we never sold the securities to investors," Mr. Paulson said. "We always thought they were bad loans."

Enough Magnetar, now on to Paulson, Goldman and the SEC

See Felix Salmon for a discussion of the SEC complaint against Goldman. They allege that Goldman violated its fiducial responsibilities in marketing a synthetic CDO called ABACUS. The SEC allegations are very similar to the story told by ProPublica and This American Life, with John Paulson's fund playing the role of Magnetar.

This is being covered aggressively by the NY Times and WSJ as well.

The Magnetar trade part one, two, three.

Money talks

In an earlier post 100 cents on the dollar I discussed the controversial AIG bailout, summarizing a WSJ narrative as follows:

IF AIG (credit rating) Downgrade,
THEN collateral provisions trigger in derivatives (CDS) contracts,
THEN AIG bankruptcy,
THEN systemic meltdown.

So the AIG counterparties played chicken with the Fed and got 100 cents on the dollar for $60 billion in derivatives contracts. Paid for by you and me and our kids :-/

If I have any of this wrong, experts please correct me -- I'm just trying to understand how the world works.

A reader with considerable expertise weighs in with the following analysis of the events of late 2008. While this person has more expertise on this matter than anyone I know, he may not be completely unbiased, considering his employer ;-)

Steve - I do think you have it wrong. The plot line is false, but it is also imbued with plenty of facts - so explanation is difficult.

Quick summary: An AIG bankruptcy filing did not hinge on the resolution of these contracts, thus there could not have been a game of chicken.

Details (greatly simplied but still quite wordy): This story is set in November of 2008, but to understand it we have to go back two months earlier - to September. In September 2008 the clearing price of mortgage-backed securities implied a high rate of mortgage default with low recovery on foreclosed property - a decline in real estate values such as never seen before. Observers were still debating whether prices were correctly forecasting widespread defaults or whether prices were merely depressed due to illiquidity. For institutions levered to real estate the distinction was very important because it meant the difference between short-term liquidity problems and long run insolvency which would force bankruptcy.

To understand liquidity problems, we need to understand collateral. In order to minimize credit risk to each other, financial institutions ask for collateral from each other. As trades slowly move up or down in value, cash and securities flow between institutions so that everyone owes each other approximately nothing and the effects of a sudden bankruptcy are much smaller than they otherwise would be. Having collateral in hand means not having to worry about why your counterparty's trades are marking down so low - you are 100% insured by the collateral and if prices rebound you'll just give it back. And if your counterparty goes bankrupt you won't take a loss. Lehman was long real estate and, due to falling prices and having to post collateral, come September they ran out of cash. Regulators shopped them to other banks whose traders pored over Lehman's books and concluded "the company is insolvent, not just illiquid" so "goodnight Lehman Bros".

AIG was in the same boat as Lehman however AIG is an insurance company - this opened up three problems. (1) Banks are usually regulated by federal entities like the Fed and the SEC, so they all fit into similar frameworks nationwide. However insurance companies are only regulated by states. States are not particularly great at regulating because they are small and every state does things differently. (As a side note for fans of health care reform, regulating insurance companies at the federal level and creating national competition is the single most important reform needed. Lack of this in the so-called reform bills is proof that the legislation is all about creating health care entitlement without any real reform.) You can't just call in JP Morgan or Goldman Sachs to tell you what to do here because a bank can't really analyze an insurance company over a weekend. (2) Next, the ratings agencies had assigned AIG their highest rating, AAA, meaning that people who didn't want to do a lot of their own credit analysis, but didn't want to take any risk of default, were the sort of people who bought AIG bonds - that is to say, AIG bonds were largely being held in accounts that were presumed to be taking no risk by their owners. If you go back to news stories from September 2008 you will find many shrill voices invoking the spectre of systemic melt-down, but those voices tend to come from holders of AIG bonds, not random investors worried about "the system". (3) As an insurance company the general public was very broadly exposed to AIG in pensions, annuities, home insurance, etc... and these people aren't holding any collateral at all, but would account for a lot of votes at the polls come November. So, because of these three complications, the same politicians who let Lehman go under decided, at about the same time, to bail out AIG.

Now, there are lots of ways to do a bailout. This very same month, the largest financial entities in the world, Fannie and Freddie, were bailed out - and basically by the federal government saying "we simply guarantee all the debts and obligations of Fannie and Freddie". (Note that, in the end, the agency bailout is where the "taxpayer" will take almost all his lumps. But the politicians don't talk about this too much because Washington spent decades exempting Fannie and Freddie from any meaningful regulation and encouraging them, via various acts of congress, to facilitate mortgage loans to people who probably couldn't afford homes, but would make U.S. home ownership "more diverse".) In the case of AIG the bailout took the form of an $85 billion loan. It is important to remember at this point the debate over whether real estate securities were down because a bunch of mortage defaults were coming or just because nobody wanted to own the bonds. The politicians were still hoping for the latter and hoping that a loan would tide AIG through its illiquid period and into a time when the securities recovered. The TARP legislation was debated this same month, and the original intent of TARP was to buy these securities, thus creating a market for them, and a recovery in their prices. (In the end, however, TARP was not used in this way. It was used to invest in banks, for which no legislation was required anyway, and auto companies - which was probably illegal.) The TARP debate informs us that in September the politicians were not believing the market-implied rate of mortgage default. So, AIG used its bailout money to keep collateral flowing on its real estate positions. The thinking on this was that it stopped the counterparties from closing out the trades and thus "locking in the loss".

Now let's move forward to November 2008, the subject of this post. By November those debating that real estate securities were down due to illiquidity rather than coming defaults had given up their argument. A wave of defaults was coming and everyone finally realized that a lot of people who took out sub-prime mortgages always had the intention of defaulting because they didn't want to own a home so much as speculate on real estate going up. Back at AIG, their positions had continued to go against them and it became pretty obvious that AIG was insolvent, not just illiquid, and a more aggressive bailout was going to be needed if they were not to declare bankruptcy. But now if AIG goes bankrupt the government is in for a loss too since it has made all these loans. So "in for a penny in for a pound" the feds decide to up the bailout. Among many issues to be sorted out in the fresh bailout is that AIG still has all these real estate positions which keep bleeding money and, since AIG made the wrong calls on this all along, the feds decide to close out all of these positions.

At this point, the "unlimited bailout" decision has been made, and the discussion over mopping up these positions is a sidebar, not super important at the time (but it will become very politically sensitive a year later). The feds would like to save a few bucks by negotiating the close-out on these trades with the banks. However, because all the banks are holding lots of collateral, and some of them are even insured against AIG defaulting, they expect to be paid in full just like everyone else exposed to AIG. The feds aren't calling PIMCO and asking them to take 80 cents for their AIG bonds, they are calling retirees and asking them to take 80 cents for their pension annuities, and the aren't calling up auto insurance holders and asking them to take 80 cents for fender-bender repairs. Further, the insured banks wouldn't take a loss even if AIG went bankrupt unless you buy the end-of-the-world systemic melt-down scenario. But, even if you believe that, why aren't all of AIG's creditors being asked to contribute? Indeed, why not everyone in the world, since all benefit from there being no global melt-down. The banks are not the primary beneficiaries of the bailout, the bondholders are - bondholders have no collateral. In essence, there is nothing for the fed to negotiate, so they abandon the effort.

So, back to Steve's question. AIG was going to go bankrupt without a bailout, and negotiating 80 cents on the dollar for its real estate positions would not have changed that either way - so no game of chicken. For political reasons, the decision was made to bail them out. The banks were not asked to pay a disproportionate amount towards that bailout, and intelligent minds can debate whether or not they should have, but the case is far from clear. Lastly, I will add that I am unconvinced that letting AIG go bankrupt would have created a systemic meltdown, but it is clear why those involved in the bailout would say that. It is human nature that when you make a convenient but unpopular choice, your first defense is likely to be that you didn't really have a choice. The choice to bailout AIG was convenient and unpopular, but I don't agree that it would have led to systemic meltdown, and the historical arguments on my side are quite strong. Panics happen every 10 to 20 years and it is never the end of the world.

100 cents on the dollar

IF AIG (credit rating) Downgrade,
THEN collateral provisions trigger in derivatives (CDS) contracts,
THEN AIG bankruptcy,
THEN systemic meltdown.

So the AIG counterparties played chicken with the Fed and got 100 cents on the dollar for $60 billion in derivatives contracts. Paid for by you and me and our kids :-/

If I have any of this wrong, experts please correct me -- I'm just trying to understand how the world works.

WSJ: ... The implicit deadline looming was Nov. 10, 2008, the day AIG was scheduled to report its third-quarter financial results. Fed officials knew the company's anticipated $25 billion quarterly loss wasn't going to be greeted favorably by major credit-rating firms, according to a person familiar with the matter.

Another downgrade would force AIG to pay out billions more to its counterparties and could give banks the right to terminate contracts and keep the collateral—moves that would likely send the insurer spiraling toward bankruptcy.

On Nov. 5, the New York Fed received a presentation, a 44-page analysis put together by a unit of BlackRock Inc., saying that the banks had significant bargaining power with AIG and had little incentive to cancel the contracts unless they received par, or 100 cents, on the dollar.

The next two days, Fed officials negotiated with executives at AIG's trading partners. [Goldman, foreign banks, ...]

"The concession negotiations did not go favorably…we've given up," Mr. Bergin wrote in an email to New York Fed colleagues at 7:11 p.m. on Nov 7.

The Fed decided to pay off the banks in full, viewing that as the quickest way to get them to agree to tear up the contracts.

See earlier post Les Grandes Ecoles: AIG and Goldman edition.

Vive les Grandes Ecoles (AIG-Goldman edition)

Did negotiators from French banks save Goldman from a haircut on its AIG CDS contracts? Or did Goldman save the French banks with its, um, connections to Paulson and other high places?

WSJ: The Federal Reserve's decision to pay billions of dollars to Goldman Sachs Group Inc. and other big banks as part of its bailout of American International Group Inc. has spawned criticism and conspiracy theories. Treasury Secretary Timothy Geithner, who presided over the New York Fed at the time, was summoned to Congress to explain why AIG paid off the $62.1 billion in soured derivatives in full, far more than they were worth in the market.

One element of the decision hasn't been well explored—how the Fed agreed to the full-payment demands of France's bank regulator and two of AIG's largest creditors, Société Générale SA and Calyon Securities, a unit of Crédit Agricole SA. The French banks and their regulator, it now appears, masterfully outmaneuvered the Americans to avoid discounts, or "haircuts," on their securities.

The French won the day by using a legal argument that some leading French scholars and corporate attorneys variously described in interviews as highly dubious and lacking real legal ground.

The banks and the regulator, known as the Commission Bancaire, said bank executives could be criminally liable for accepting a discount on their contracts, according to a November report of the inspector general of the Troubled Asset Relief Program.

While true in the abstract, "their argument was very overstated," said Pierre-Henri Conac, a University of Luxembourg law professor and a director of France's oldest corporate-law review. "Banks give haircuts every day."

French banks aren't always the best negotiators, Mr. Conac added, but this time "the French were very good."

...

The Fed and AIG finally seized on a plan, according to the inspector general's report. Step one: Let the banks keep $35 billion of collateral already posted by AIG. Two: Purchase the banks' underlying securities, which were derivatives tied to low-grade mortgages. Three: Cancel the contracts. Over one frenzied weekend in early November, Fed and AIG officials struggled with the final step: What should they pay for those securities? By contract, the banks were guaranteed full payment.

There were some factors to suggest a lower, negotiated price was in order. The securities' market value had fallen significantly. And absent the extraordinary U.S. bailout, AIG would have been in bankruptcy, potentially leaving counterparties with zero.

...

"To say that these people would have gone to jail if they cut a deal and signed the same agreement as Goldman Sachs is really pushing beyond what goes on in France," said Christopher Mesnooh, a partner at Paris's Fields Fisher Waterhouse who has authored a book on French corporate law.

"There is no clear-cut provision that would have prevented SocGen or Calyon" from negotiating a discount, said one of Paris' top lawyers, who asked not to be named because he works for the banks.

More information may shake loose as Congress continues its study of AIG. At the upcoming hearings, one can only hope the French role is carefully examined. There may well have been compelling reasons for making good on the $20.8 billion owed the French banks. But —as is now clear—not for the legal reason that the Fed and the French banks claim.

Related links: AIG bailout , Societe Generale , Les Moines-Soldats , Les Grandes Ecoles

Fear and loathing of the plutocracy 2

Strangely we haven't heard much recently about impending gigantic Goldman bonuses. Once the issue hits the news radar again, I hope to see some detailed analyses of how, exactly, Goldman made its recent record profits.

At the link below you will find an analysis of Goldman's prop trading numbers for 2008 (not a good year), using the public records of its charitable Goldman Sachs Foundation. Thanks to a reader for sending this. I don't know how reliable this method is -- it all depends on whether GSF's records reflect the firm's overall trading pattern.

Zerohedge: ... Sometimes no capital is allocated to excluded strategies, but usually, and especially for product agnostic funds such as Goldman, each entity will be allowed its pro rata share based on the "fungible" capital that makes up the firm's entire Assets Under Management. Therefore, the GS Foundation ("GSF"), with its $270 million of capital at the beginning of 2008, would likely get its pro rata allocation as a percentage of the total capital backing the Goldman hedge fund (which can come from such places as Goldman Sachs Asset Management, and Goldman Sachs & Co., which in turn gets it funding via such taxpayer conduits as the Fed's repo operations and the Discount Window). So if Goldman for example had access to total capital of $50 billion last year (roughly), each trade, when allocated to GSF, would account for about half a percent (0.5%), absent special treatment, of the total capital invested or disposed. As an example, if Goldman were to trade $100 million notional in 10 year Index Swaps, GSF would thus be allocated about $500,000 of the trade.

Why is all this relevant?

Were one to comb through GSF's tax filings, one would uncover in 2007 over 500 pages worth of single-spaced trades, and over 200 in 2008, across absolutely every single asset class: equities, indices, futures, fixed income, currencies, credit swaps, IR swaps, FX, private equity, hedge fund investment, you name it (oddly absent are CDS trades). And this is in 2007 alone. These are a one-for-one proxy of absolutely every single trade that Goldman executed in its capacity as a prop trader in the last two years. The only question is what is the proration multiple to determine what the appropriate P&L for the entire firm would have been based on any one single trade allocated to GSF, and subsequently, disclosed in the foundation's tax forms.

... Yet what is obvious no matter how the data set is sliced and diced, is that the firm was bleeding money across virtually all prop-traded groups in 2008. Is it any wonder that the firm's only source of revenue is courtesy of i) the near-vertical treasury curve (thank you taxpayers) and ii) the ability to demand usurious margins on Fixed Income and other products from clients trading in bulk who have no other middleman choices.

Goldman apologia

The following appeared as a comment on my previous post discussing Paul Krugman's anti-Goldman and anti-finance column of last week. The commenter is a (very) senior quant with a PhD in physics. His knowledge of these matters is, I would guess, superior to Krugman's and certainly superior to that of any journalist.

Is Goldman entitled to keep its recently announced gigantic profits, given that they were (perhaps) saved by the government's bailout of AIG? Hear it from the horse's mouth :-)

For more background, click the AIG tag below. [If you are going to comment on this post, please read the earlier one first. Your thoughts might be addressed in the comments there!]

...on AIG - you might wanna check out this developing story.

When large derivative dealers trade with each other they typically agree to exchange margin so that on any given day neither owes anything to the other. Sometimes dealers will disagree on the value of their trades. GS has said that AIG owed them $10bio pre-bailout (in GS's opinion), and had given GS $7.5bio (AIG's opinion of the value) against this exposure. GS had purchased insurance from other large dealers for the $2.5bio balance.

AIG deals with the public too, of course, but the public pays premiums to AIG and holds no collateral. This is all "business as usual".

Now, let's look at what would happened if AIG had defaulted. For GS, the $7.5bio of collateral is "bankruptcy remote" and GS keeps it penny for penny. The insurance contracts pay off $2.5bio to GS and the right to pursue the claim against AIG passes to the counterparties. Mom and Pop who have purchased retail insurance from AIG are left with only a bankruptcy claim. So this is all very ugly, but absent further defaults, GS is left whole - no loss. But have no doubt, someone out there will be eating a big loss.

At this point in the discourse, most people have trouble understanding collateral and that it is bankruptcy remote (is this a skill? I guess so!), but let's say we have this one down. The next point people make is that letting AIG go under would have created a financial system meltdown that would have harmed GS such that GS could not collect all its $2.5bio insurance claim. Well, this is possible, but it is equivalent to saying that a large subset of JP Morgan, DeutscheBank, BNP, SocGen, Citibank, etc... all go bankrupt. However, we probably don't believe that even a full $2.5bio hit to GS would be lethal for it, so it is hard to say that a failure by AIG would have directly taken GS down.

The next point you might make is that if all these other banks went under it might have created a large enough set of other problems for GS so as to take it out. However this final claim, which is frequently made, is specific to GS in no way at all. But if you wanna say "maybe the U.S. bailed out AIG so that the entire world banking system didn't collapse", then yes, GS benefits from that just as does anyone in the economy with any exposure at all - like anyone who purchased Auto Insurance underwritten by AIG. So maybe a smart bailout avoids a situation like the depression which followed the Panic of 1837, but the beneficiaries of the bailout are likely not dominantly the banks. This is why administrations as diverse as G.W. Bush and Barry Obama have reached for identical bailout buckets.

The Kruggy regulation question should be "would compensation reforms stop the sort of loss-making trading that went on at AIG?" - and that may be, I don't know. And might it accidentally stop economically productive trading as well? Krugs sure doesn't think so.

More algorithm wars

Some time ago I posted about two MIT-trained former physicists who were sued by Renaissance for theft of trade secrets related to algorithmic trading and market making. Reportedly, Belopolsky and Volfbeyn won their court case and are now printing money at a well-known hedge fund. The Bloomberg article below is about a former Goldman employee who may have made off with code used in prop trading and market making.

The story is also covered in the WSJ (whose reporters and editors don't know the difference between "code" and "codes" -- as in software vs cryptographic keys), where it is revealed that Aleynikov was paid $400k per year at Goldman and left to join a fund in Chicago which offered him three times as much.

Goldman Trading-Code Investment Put at Risk by Theft
2009-07-06 23:18:39.529 GMT

July 6 (Bloomberg) -- Goldman Sachs Group Inc. may lose its investment in a proprietary trading code and millions of dollars from increased competition if software allegedly stolen by an ex-employee gets into the wrong hands, a prosecutor said.

Sergey Aleynikov, an ex-Goldman Sachs computer programmer, was arrested July 3 after arriving at Liberty International Airport in Newark, New Jersey, U.S. officials said. Aleynikov, 39, who has dual American and Russian citizenship, is charged in a criminal complaint with stealing the trading software. At a court appearance July 4 in Manhattan, Assistant U.S. Attorney Joseph Facciponti told a federal judge that Aleynikov’s alleged theft poses a risk to U.S. markets. Aleynikov transferred the code, which is worth millions of dollars, to a computer server in Germany, and others may have had access to it, Facciponti said, adding that New York-based Goldman Sachs may be harmed if the software is disseminated. ...

The prosecutor added, “Once it is out there, anybody will be able to use this, and their market share will be adversely affected.” The proprietary code lets the firm do “sophisticated, high-speed and high-volume trades on various stock and commodities markets,” prosecutors said in court papers. The trades generate “many millions of dollars” each year.

... “Someone stealing that code is basically stealing the way that Goldman Sachs makes money in the equity marketplace,” said Larry Tabb, founder of TABB Group, a financial-market research and advisory firm. “The more sophisticated market makers -- and Goldman is one of them -- spend significant amounts of money developing software that’s extremely fast and can analyze different execution strategies so they can be the first one to make a decision.”

Aleynikov studied applied mathematics at the Moscow Institute of Transportation Engineering before transferring to Rutgers University, where he received a bachelor’s degree in computer science in 1993 and a master’s of science degree, specializing in medical image processing and neural networks, in 1996, according to his profile on the social-networking site LinkedIn.

The subprime primer

In case you haven't seen this, it's pretty funny (strong language warning).

Special bonus: The Making of Goldman Sachs. Leonard Lopate interviews Charles Ellis, the author of The Partnership.

Double plus good: the Times goes after Greenspan and those weapons of mass destruction, derivatives.

A higher intelligence at Goldman

Michael Lewis (Bloomberg) has some interesting comments on Goldman Sachs' vastly superior performance during the subprime meltdown. In an earlier post we discussed the $4 billion they made by shorting the major CDO indices. (See here for another close reading of the WSJ story that uniquely sheds some partial light on what happened.) It really boils down, as I mentioned earlier, to the huge proprietary trading component at Goldman. They apparently don't hesitate to take positions against other business units at the firm.

What Does Goldman Know That We Don't?
2008-01-17 09:00 (New York)

Commentary by Michael Lewis

Jan. 17 (Bloomberg) -- In retrospect, the most intriguing subplot in the collapse of the subprime mortgage market has been not the size of the losses but their distribution.

Wall Street firms have a talent for getting themselves into trouble together. They all were long Internet stocks when Internet stocks collapsed and they'll all be long North Korean credit-default swaps whenever North Korea gets hot and then crashes.

What's odd about the subprime crash is Goldman Sachs Group Inc. A single firm took a position contrary to the rest of Wall Street. Giant Wall Street firms are designed for many things, but not, typically, to express highly idiosyncratic views in the market.

Even more surprising is how little Wall Street seems to have dwelled on how and why Goldman Sachs made its killing. There are insane conspiracy theories -- for instance, that former Goldman chief executive officer and current U.S. Treasury Secretary Henry Paulson tipped his old pals, etc. (But then, how did HE know?)

There is also the widely held opinion that people who work at Goldman Sachs are just smarter than ordinary people -- hence the lust to hire former Goldman employees to run other Wall Street firms, as Merrill Lynch & Co. did. (But why would any trader who could systematically beat the market waste his time at Goldman Sachs?)

So far as I can tell, there has been only one attempt to explain this strange event, and that was by a journalist, Kate Kelly of the Wall Street Journal.

[... skip recap of WSJ article ...]


Rolling Heads

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. Morgan Stanley conceded as much when it said recently it was considering changing things around so that the risk manager reported to the CFO, rather than the heads of individual businesses.

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.

A Higher Intelligence

And this second, higher intelligence was allowed to make a mockery of the labors of the first. I can't think of another example of a big Wall Street firm saying so clearly through its trading positions as Goldman Sachs did over the past year that it thinks the rest of its industry, including its own people, is a bunch of idiots. They have obviously designed their firm to take into account their idiocy -- without ever having to put too fine a point on it.

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?