I don’t have an opinion about the charges levied against Goldman by the SEC, but some of the bantering between the seven Goldman employees (past employees) and the Senate Subcommittee caught my eye. 

Let’s do a short review of what I believe the traders were thinking in 2006 and 2007 and what they did to address increasing risk to the firm.

They were essentially hedging the firm against financial losses as a result of a growing concern over the performance of subprime loans and counter party risk of mortgage bankers.  Maybe this is no different than a mortgage banker hedging against interest rate risk, especially if one believes rates are rising.

But first, let me tell a quick story before we discuss Goldman in greater detail.

I did an audit on a large subprime wholesaler in late 2005, and noticed what were the first signs of a crack in the subprime market. The mortgage banker was starting to see early payment defaults in late 2005 and could not repurchase the loans in question or enter into a settlement because they didn’t have enough net worth or cash.  My partner and I used to call these companies the “Walking Dead”.

The mortgage company had a large forward commitment with a major Wall Street firm to sell them subprime loans.  The street firm was aggressively buying subprime loans from mortgage bankers, packaging them into securities and selling pieces off to many investors. They were going to fail, but secondary market investors and Wall Street firms didn’t know it yet.  This mortgage company shut down 6 months later and left the Wall Street firm hanging high and dry. 

Let’s get back to Goldman Sachs now. 

As more and more mortgage bankers started to fail, file bankrupt or clandestinely wind down their operation, more and more lock desks couldn’t stand behind the agreements they entered into with Wall Street. 

Goldman’s risk management team soon started to re-assess its counter party risk with mortgage banker clients. In order to mitigate growing risk in the subprime market, traders purchased insurance against credit defaults through AIG.  These Credit Default Swaps (CDS) hedge the firm against mortgage defaults.  AIG was paid large premiums from Goldman to issue the insurance.

What is interesting about CDS’s is that investors can buy and sell protection without owning any debt of the reference entity.  It’s likely AIG didn’t know mortgage bankers couldn’t perform repurchase request or that there was growing signs of problems in subprime loans.Goldman probably didn’t purchase insurance on its entire subprime position, but added insurance as the subprime market continued to collapse.   In fact, traders probably bought more than their risk models stipulated in anticipation of an increase in risk of subprime mortgage defaults. They were short against their risk model.

What is interesting is RMBS investors didn’t realize this was the beginning of the end for the subprime mortgage market.  Overseas investors didn’t review financial statements of mortgage bankers and weren’t involved in managing loan level issues.  Yields were good and they kept buying pieces of these securities through 2006 and even 2007. 

I have no inside information into the risk management models or the past trading strategies of Goldman Sachs.  However, the strategy is no different than a mortgage banker anticipating interest rates may rise over the next week and loading up on investor commitments without having the loans to fill the commitments.  This is going short.  If rates rise, the mortgage banker can originate loans at a higher yield and make extra profits, or they can pair out of the position and generate profits from the trade. 

Is a mortgage banker criminal or unethical for engaging in this type of trade?

Maybe Goldman owed it to investors and AIG to let them know that mortgage bankers were failing because they couldn’t stand behind the agreement to repurchase defected loans and there was a growing number of defaults in subprime loans.