Thursday, May 13, 2010

Have You Been Goldman'd?

201004251100.jpgSmart money, dumb money: Buy housing, sell housing. Buy bonds, Sell bonds. Buy banks, Sell banks.

Smart money, dumb money: Sell housing, buy housing. Sell bonds, buy bonds. Sell banks, buy banks.

What was smart is dumb. What was dumb is smart. The trouble is, at the time, everyone thinks they're smart. People forget there's always a fool at a poker table, and if you can't see who it is, it's you.

With the most recent market gyrations, initially caused by subprime mortgages, I'm reminded of M.C. Escher's famous picture, from 1961, titled, simply, "Waterfall" - what goes down, must go up. Until it goes down again.

Now the famously smart money, Goldman Sachs, is being pursued what many had previously labelled the dumb money (Madoff, Stanford, Moody's), the Securities and Exchange Commission. Did the smarts just get dumb, or are the dumbs smart again?

Doing God's work indeed.

Subprime bonds were packaged in tranches (a more positive way of saying layers which would imply some kind of hierarchy where if you're at the bottom, you don't want to be). Tranches were weighted in letters essentially from A to Z, but rather than say it that bluntly, special codes were created where AAA was exactly what you'd imagine it was (originally the lowest risk, where risk was relative rather than absolute) and BBB or BBB- was a much higher risk (how much higher is again a relative term - in this case it was much like sticking your feet in concrete as it was setting and just as the steamroller was firing up the engine. You could tell bad things were going to happen, but it wasn't going to be quick).   

The real art in the subprime market was packaging tranches that were originally BBB or worse into new tranches that magically - David Blaine kind of magic - were suddenly AAA. Classic three card monte. Find the lady, watch her fly, where'd she go? Oh I see, she ran off with your money.

The dumb money, thinking they were making a bet in a one way market, thought they were buying AAA yet they were buying BBB. In many cases, they weren't even buying the bonds themselves, but selling insurance that those same bonds wouldn't default. For a few million for every hundred million you wanted insured, they'd sell you a policy - a binary bet: if the bonds defaulted, they'd pay you face value, if they didn't, you'd keep paying your insurance premium.

The insurance premiums payable were calculated on two simple things

1) The risk weighting of the bonds. Given the diversity of the US property market, and keeping it simple, the risk models assumed that if you owned the mortgage on a house in Florida and one in San Diego, the odds of them each defaulting were independent, that is, there was no correlation. Multiplying that across all states of the USA (where nearly all of these mortgages originated), the correlation was assumed to be even lower. You soon learn that whenever someone brings algebra and applied mathematics into investing, you need to keep your wallet closed.

2) The one way moves in house prices over the prior years meant that market volatility was low (that is to say that prices hadn't bounced up and down but had only moved up in the previous 10 years) and so the risk premium was further lowered.

The oddest thing about the insurance market for such bonds was that you didn't actually have to own anything to buy insurance.

- You didn't have to be the house owner taking a bit of insurance in case your freshly bought house suffered a loss in value.

- You didn't have to be the banker who had sold the mortgage taking additional insurance in case your client couldn't pay.

- And you didn't have to be the eventual buyer of the securitised loan tranches that had been painstakingly assembled

This is much the same as me being able to buy a fire insurance policy on an allotment shed and then being able to throw a can of petrol and a match into it - without anyone knowing that you were going to be the beneficiary of the insurance policy.

Actually, the people buying these insurance policies didn't need any petrol. They had studied the market and decided that the unvarying ascent of house prices couldn't go on and so they'd decided to bet against it - that is, to go short.

In stock markets, if you want to go short you have to find someone to lend you the stock (you then sell it for them, promising to buy it back and deliver it back to whoever you borrowed it from). This has the neat effect of meaning that you can only go short what is out there - you can't find twice as much stock as exists to go short. It is also self-regulating - the more stock that is borrowed, the more risk there is that a sudden spike in the price driven by a news event can financially cripple those going short.

Those shorting the subprime market didn't need to own any of the bonds, didn't need to borrow them from anyone, they didn't even need to know how many were out there. Entirely synthetic (i.e. made up) transactions could be created that mimicked the behaviour of the real bonds. And they could be made up in huge volumes - far higher volumes than existed of those bonds. $1 of bonds could be insured once, ten times or a hundred times. Worse still, the lack of a central clearing house and a liquid market meant that everything was priced individually - there was no easy way to get a price for what you were buying (or selling) other than from whoever had their hands on it at the time. This was Michael Milken and Drexel's junk bonds all over again.

With the housing market moving up, those buying insurance were widely thought of as the dumb money. Insurers were happy to collect a couple of million on a $100 million portfolio every year. After all, housing was strong, the economy was strong, house prices hadn't gone down in 10 years and it was easy money. All money in such instances is easy. Until it isn't. We've been here before - the South Sea bubble, the LTCM crash, the dotcom bubble and so on.

And as everyone surveys the global wreckage and now that the money has been spent to prop up the banks, the regulators are going after the perpetrators. They have, though, started in an interesting place. Goldman Sachs, the poster child for banking profitability (and one of the few banks left standing largely on its own two feet after the crisis). Others will follow - it looks like Morgan Stanley is already next in line. This feels a bit like the Martha Stewart prosecution - go for the highest profile victim, hope to get a quick settlement and sizeable fine and then use that to scare everyone else into paying up without a fight. Martha resisted for a long time and went to jail for her trouble. It seems likely that Goldman will resist too.

The chain of people involved in this crisis is long and distinguished - involving everyone from individual home owners, to local banks, to big syndicating banks, to international buyers, global insurance sellers, regulators in each and every country, rating agencies, the media and others, including you and me. It's important, I think, to look at the role each of those played in creating this monster of a market, but concluding on the guilt and innocence of the chosen target, Goldman Sachs/

As Escher himself said:

"So let us then try to climb the mountain, not by stepping on what is below us, but to pull us up at what is above us, for my part at the stars; amen"

This is Part 1 of 3.

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