Goldman’s uneasy subprime short | FT Alphaville

Goldman’s uneasy subprime short

In early 2007 Wall Street was in the early stages of the subprime crisis.

Spreads on the ABX indices, which had become synonymous with the crisis, were falling. And Goldman Sachs was about to do something which would eventually lead it to a $4bn profit and make it one of the last banks standing on Wall Street.

It was going to short subprime.

Two traders in Goldman’s mortgage group — Michael Swenson and Josh Birnbaum — are now widely credited with the move. Their unit was charged with market-making for products tied to Mortgage-Backed Securities (MBS), but they were also allowed to trade for Goldman’s own accounts if they spotted a profit-making opportunity.

So when Birnbaum and Swenny, as the latter was known, took their subprime bets they came in the form of shorting certain bits of the ABX by buying relevant CDS.

In early 2007, with the ABX sliding, the bets were paying off.

But by spring, the index was experiencing that dead-cat bounce (probably on the back of last-gasp CDO issuance) and arguments over Goldman’s risk management in light of ABX volatility exploded with Swenny and Benson reportedly curbed.

Despite the rally, Goldman started taking a hard look at its CDO holdings that spring too. The conclusion soon made was that losses were coming. The firm began selling off its portfolio from April, and allowed Swenson and Birnbaum to start shorting the ABX again soon after. What happened next is well known — Goldman managed to offload much of its own subprime exposure, via those CDOs, and went on to cephalapodous infamy.

We bring up these spring ’07 events because they’ve just been re-unleashed by a US Senate Permanent Subcommittee hearing, in which chairman Carl Levin accused the bank of trading abuse. The centrepiece of the argument is the below email thread:

From: Swenson, Michael
Sent: Tuesday, May 29, 2007 11:06 AM
To: Salem, Doob
Subject: Re: they want to think about doing this again …

We should start killing the sn shorts in the street – let’s pick some high quality stuff that guys are hoping is wider today and offer protection tight – this will have people totally demoralized

—– Original message —-

From: Salem, Deeb
To: Swenson, Michael
Sent: Tue May 29 10:41:55 2007
Subject: RE: they want to think about doing this again …

the index won’t close where it is this morning in my opinion…

—–Original message —-
From: Swenson, Michael
Sent: Tuesday, Hay 29, 2007 10:21 AM
To: Salem Deeb
Subject: Re: they want to think about doing this again …

Then you need to be prepared to widen their marks we also need credit approval

—– Original Message —-

From: Salem, Deeb
To: Bhavsar, Avanish R; Swenson, Hichael Cc: Chin. Edwin; Birnbaum. Josh
Sent: Tue May 29 10:05:52 2007
Subject: RE: they want to think about doing this again …

indices -125bps wider since trades 1 week ago…

The implication being that Goldman was pursuing a short squeeze strategy to push out its short competitors — allowing the bank to buy CDS more cheaply and perhaps even shift its toxic assets into new CDOs which would fetch better prices.

Goldman itself says “this type of language sounds awful and is very disappointing, but it does not reflect the reality of what happened. There was no short squeeze” — though commenters like Yves Smith at Naked Capitalism certainly suggest otherwise.

But there’s a bit more detail in Deeb Salem’s 2007 self-evaluation:

We … remained as negative as ever on the fundamentals in sub-prime, the market was trading VERY SHORT, and was susceptible to a squeeze. We began to encourage this squeeze, with plans of getting very short again after the short-squeezed caused capitulation of these shorts. The strategy seemed do-able and brilliant, but once the negative fundamental news kept coming in at tremendous rates, we stopped waiting for the shorts to capitulate, and instead just initiated shorts ourselves immediately …

Anyway — the CDS market was then unregulated so “trade abuse” as senator Carl Levin suggests is pretty much impossible. What the latest Goldman scandal is not great for though, is PR for Goldman’s clients. Market-making seems to have pretty much fallen by the wayside for a while, in favour of Goldman’s own positions.

But then, many people suspected that already.

Related links:
Goldman CDS trading activities under fire – FT
How Goldman won big on mortgage meltdown – WSJ
Blankfein and Levin spar over Goldman Sachs’ market-making role – Daily Finance
When is a market maker not a market maker – FT Alphaville