Monday, June 14, 2010

Have You Been Goldman'd - Part 2

The US Government's pursuit of Goldman Sachs for allegedly mis-selling Collateralised Debt Obligations (or perhaps for taking both sides of a trade to the advantage of itself and just one of its clients). I wrote a little about the background to this a month ago. Goldman Sachs were certainly not first in to the Global Financial Crisis (shouldn't that be written all in caps?) but they were almost certainly first out - via a little Federal money and a rejigging of their banking status, some money from Warren Buffet and the benefit of money on loan at a rate of virtually zero that could be invested at leverage ratios that, whilst not as high as in the go go years, were certainly greater than one.

Goldman were but one player in a long list as I said in the first post on this topic:

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

I thought i'd explore what was going on in the market in the years leading up to the crisis. I combed several sources and found many US federal sources and some private sector ones that had copious amounts of data. Here is some of what I found.

Here are two graphs showing, first, how vast the mortgage market has become over the last 50 years and, second, how dramatic growth in the volume of refinancing appears to be a leading indicator in increasing foreclosure rates some 3 years later, just as interest rate adjustments kicked in and increased borrowing costs:

US Mortgage debt outstanding, 1952-2008, Home Mortgages only

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Data sourced from the Board of Governors of the Federal Reserve System. Figures in actual US$, not discounted for inflation.

Mortgage Originations (Purchase and Refinance) versus Foreclosure (Entering and Already In Foreclosure)

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Source: Mortgage Bankers Association of America, Washington, DC

Those home loans were turned into asset backed securities - and the growth in this graph inevitably maps closely with the growth in origination and refinancing in the previous graph. The fall off maps, in the same way, with the huge growth in loans either in or entering foreclosure.

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Source: Thomson Financial, Bloomberg, SIFMA

If the previous graph showed issuance, this graphs shows outstanding securities (the big section in the middle is credit card debt)

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Source: Thomson Financial, Bloomberg, SIFMA

The graphs above paint a picture of an economy growing at a huge speed fuelled by debt pulled down from the equity within a house (with that equity often put into another house, so reducing the available supply and pushing up prices) and also by credit card debt (which spiked highest in the period when home loans were reducing - that is, when house prices were already falling and taking equity from the house wasn't an option, but credit cards were).

Looking at the instruments that Goldman is alleged to have used inappropriately, here are two graphs showing the same dataset for CDOs, split by currency and by purpose. There are two obvious conclusions:

1) The vast bulk of CDOs were issued in US dollars (covering US originated loans) with Europe lagging US growth by at least a year

2) If the second graph is right, then the purpose of CDOs is to arbitrage. Or perhaps speculate?

CDOs by Currency (2000-2010)


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Source: SIFMA

CDOs by Purpose


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Source: SIFMA

The cliff all of the issuance graphs fall off in 2006/7 coincides with the sudden leap in foreclosure rates.

The big question for those chasing down Goldman is:

If you were sitting inside a bank, a financial institution, a pension provider or a hedge fund in February 2007, would you have known that that was the time to get out? The TIME TO SELL?

Here's another graph showing asset backed security issuance in 2007, quarter by quarter

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Source: SIFMA

Would that have been enough? In February 2007? To my eye, it looks like it would have been tough to see until sometime after the Q2 figures were in. Some smart people saw it earlier than that of course - they saw those foreclosure rates start to climb in 2006 and made their bets.

Did Goldman mislead? I have no idea. Doubtless they - and other Financial Institutions - will be negotiating settlements now where no fault or liability is admitted.

But every market ever traded is asymmetric. Someone always has more information than someone else - or they think they do. For every seller there has to be a buyer. For every buyer, a seller. Often there is both a buyer and a seller, sitting in the middle making the trade.

Part 3 of this blog will be on this very asymmetry.

This is the second part (of three). The first part was published here a month ago.

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