Posted by: Ravi Saraogi | October 11, 2008

The “Golden Touch” of Goldman Sachs

Lloyd Blankfein, CEO, Goldman Sachs

Lloyd Blankfein, CEO, Goldman Sachs

One after the other they keep falling. Yet Goldman stands tall. Was it pure genius or luck. Or was it fraud? To understand why Goldman emerged unscathed (till now at least), we need to brush up on certain concepts and discuss it’s operations.

Lets start with the basics. An investment bank has two operations, the “buy side” and the “sell side”. For an excellent description of buy and sell side, make your way here. For the lazy, I will try and sum it up in a few lines.

The sell side would refer to any activity of the bank relating to market making (i.e. facilitating transaction of financial assets through activities such as research reports, buy/sell calls, acting as broker or agent, etc) or creation of financial assets (such as conducting an IPO, underwriting, engineering private placements of equity or debt, helping a company raise capital from the market, etc). So the two key words are “market making” and “creation of financial assets”. Both activities, sort of, take care of the supply side of financial securities. The research reports and buy/sell calls (which are made public), acting as a broker or agent, helps in the smooth circulation of the already available securities in the financial markets. Moreover, new securities are added to the existing pool by activities such as helping a company to raise capital by engineering an IPO, issue of corporate debt papers, underwriting, etc.

The buy side of an investment bank refers to activities it undertakes in managing other people’s money. These services are rendered to high net worth individuals, pension funds, etc. Basically, anybody who has loads of money and wants advise on how to invest it, can approach Goldman. These activities are of the nature of wealth, portfolio and risk management. The research undertaken by the buy side wing is private and is available only to the clients the investment bank services.

If you would notice, there is a problem here. Say Reliance Industries approaches Goldman and asks it to help it in raising additional capital. The sell side springs to action and helps Reliance issue some securities to raise capital. The job on hand is to ensure that all the issued securities are subscribed and Reliance is successful in raising the amount of capital it requires. Now, what better way to ensure that the securities are fully subscribed than simply directing the buy side to pour the client’s money on the Reliance securities. The sell side is salesmanship, where the primary job is to push the Reliance securities and ensure full subscription. What return these securities generate to the investors is secondary to their concern, whereas, the buy side has to ensure maximum return for it’s clients. Clearly then, the operations of the sell side and the buy side has to be kept separate to take care of the interests of the buy side clients.

So, the two activities of an investment bank is kept separate by a “chinese wall”.

The sell side wing of Goldman was a major player in issuing mortgage backed securities in the US financial markets. Mortgage lenders and banks had huge home loans that they had issued to borrowers with shaky backgrounds. To get rid of the junk on their balance sheets, they approached investment banks like Goldman, Lehman, Morgan, etc to package the loans on their balance sheets as mortgage backed securities and offload in the market. This way, the banks got their money back and investment banks earned a commission. If things stayed to this, it would not have hurt any investment bank as in the above process, the sell side activities earns the bank a huge commission and the bank themselves do not hold any toxic mortgage backed securities (these activities only makes people other than investment banks hold such securities!!!).

The issue was the buy side. Since, it was believed that housing prices never fall, independent research of the buy side suggested putting client’s money into mortgage backed securities. Even if it stayed at this, the investment banks would have escaped as they would have still earned a commission from the clients (for their advisory role that made the clients invest in mortgage backed securities!!!) while themselves not holding any exposure to the mortgage backed securities. The death knell was proprietary trading. Proprietary trading refers to a firm using its own money to invest and make profits. Investment banks started believing that investing in mortgage backed securities is such a good idea that they themselves started investing in such securities with their own money, i.e. profits of the firm. In fact, they were so gung ho about it that they borrowed also to invest in such securities. This is where they dug their own graves after digging graves for other people.

So Lehman got wiped out as a result. How did Goldman escape?

It seems that two smart traders at Goldman, Michael Swenson and Josh Birnbaum betted against the mortgage backed securities. When all the trading members in the proprietary desk were going long (i.e. buying) on mortgage backed securities, these two smart dudes convinced the top brass that the sub prime market would collapse and they should go short (take a bearish position) on mortgage backed securities. And the top brass listened. And they shorted mortgage backed securities, to such an extent that it was more than enough to compensate for the long positions that the firm held on mortgage backed securities.

Hmmmm… Really fascinating no? What on earth prompted the two smart dudes to take such a step I wonder? And they approached the top brass, since apparently, they were unable to convince their fellow traders. Hence, the short position was taken in knowledge of the two traders and the top brass, while the rest of the traders remained oblivious to it.

For a fascinating account of the above process, read here. Some excerpts for the lazy..

“The only difference between Goldman and everyone else was that Goldman had, in effect, an entirely separate enterprise, sitting on top of the firm, with the power to reverse the judgment of its own supposed experts in various markets. They were able to do this, apparently, without ever saying a word about it to their own traders. Instead of telling the fools trading subprime mortgages that they are wrong, and that they should unwind their positions, they simply offset their trades.”

The above enabled Goldman to make surprise profits of nearly $4 billion during the fiscal year ended Nov 2007, more than sufficient to overcome mortgage related losses arising out of long positions. Two issues emerge here. One, Goldman was shorting the same securities it’s supply side wing had dumped in the market. Second, while the buy side wing generously poured the money of the client on toxic mortgage backed securities, the proprietary desk was taking short positions on them on a massive scale.

So, the firm’s own money was used to short sell mortgage backed securities on the belief that their values will scoop down, while at the same time branding the securities it was short on as excellent investment opportunities to clients. The result, on it’s own investments, Goldman makes a cool 4 billion dollars while its flagship hedge fund for the clients, Global Alpha, tumbles over 35 % in the market meltdown.

But it remains unscathed and seems comfortably poised to navigate out of the sub prime mess. Genius? Luck? Fraud? You decide.

Published by Ravi Saraogi.

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Responses

  1. I recently came accross your blog and have been reading along. I thought I would leave my first comment. I dont know what to say except that I have enjoyed reading. Nice blog.

    Tim Ramsey

    • Thank you… 🙂

  2. Nice writing. You are on my RSS reader now so I can read more from you down the road.

    Allen Taylor

    • hey.. thanks for that…

  3. In Vegas, the house always wins, the punters may or may not. The Goldman brass has been smart and has taken the right position at the right time.

    No wonder Mr. Buffett has backed this horse and the rider too and has also ensured that the riders have a limit on the number of shares they can sell (10%) in their own horse.

  4. Very true Mahesh…. Goldman roping in Buffet to invest about 5 billion dollars in the firm is seen as a major victory of Goldman in trying to convince investors that it is not going down.

    The fascinating story of how Goldman escaped the subprime mess also throws up another irony. Henry Paulson, US Treasury Secretary, was the CEO of Goldman upto about mid 2006, in the period when Goldman was busy offloading mortgage backed securities by the truckloads in the US financial markets. And the same person is now in charge of coming out with a rescue package to save the financial markets from the junk his firm offloaded in the market !!!!

  5. Hey man..I tell you one thing..you are GOD SENT for guys like me…..:)
    The respect I have for you can only grow in stature from here..cool job!!!!:)

  6. oops..u can delete the previous one ravi..n ya..george I recognise your efforts too..m sure ur mastermind was working somewhere there too…lol!:)

    • thank u very much golu.. keep visitin for more updates.. 🙂


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