[PassedOut]

The NYT has a revealing piece about how Goldman Sachs made a bundle from the collapse of the US housing bubble: Banks Bundled Bad Debt, Bet Against It and Won

Quote

Goldman and other firms eventually used the C.D.O.’s to place unusually large negative bets that were not mainly for hedging purposes, and investors and industry experts say that put the firms at odds with their own clients’ interests.

“The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen,” said Sylvain R. Raynes, an expert in structured finance at R & R Consulting in New York. “When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson.”

Investment banks were not alone in reaping rich rewards by placing trades against synthetic C.D.O.’s. Some hedge funds also benefited, including Paulson & Company, according to former Goldman workers and people at other banks familiar with that firm’s trading.

In my opinion, making profits in that manner shows a lack of ethics. And I would like to see strong steps taken to regulate such activity. Not sure about the death penatly, but maybe.

[Winstonm]

Now take that idea and realize that virtually all of the high federal positions in Treasury come from GS....

[hrothgar]

Even after reading the article, its difficult to understand precisely what Goldman was involved in. To what extent was the company taking large positions as opposed to simply hedging to protect previous longs in the housing market? Moreover, with any company as large as Goldman Sachs, its entirely possible that the left hand didn't know what the right hand was doing.

I have seen a number of discussions that John Paulson prompted brokerage firms to issue addition CDOs so he could be against them. However, I don't see anything wrong with this. In theory, if people are playing in the market, they need to have some clue what they're doing.

From my perspective, the main problems are related to transparency, leverage, and scale.

On the transparency front: A number of professional argue that CDOs need to be traded on public exchanges to make these information public. If potential customers were in a position to understand Goldman Sach's behavior, they'd be in a much better position to decided whether to assume the countervailing risk.

On the leverage front: As we all know, there weren't any real leverage requirements for many different types of derivatives. Simply put, this is a bad idea.

On the scale front: You don't want a situation in which the failure of any one firm would impact the economy. "To Big to Fail" creates all sorts of perverse incentives. The government should stop firms from getting this large.

I'll note the following in passing: I consider myself a quite well informed investor. (Most of the large financial services firms use MathWorks software that I help design to implement their trading strategies). I spend lots of time working on this stuff.

I NEVER play around with complex instruments like derivatives. (And I never take short positions). For the most part, I tend to follow any extremely boring trading profile. The basic idea is to generate a balanced portfolio while keeping management fees and transaction fees to a minimum.

1. Start by creating a basket of Exchange Traded Funds (ETFs). I use a combination of the nine sector specific SPDRs as the baseline. I also include some additional ETFs that track industrial commodities (I use copper, fertilizer, and light sweet crude). Up until recently, I never owned property, so I also included a real estate component. If you're a home owner, this is probably redundant... I top things off with some foreign currency funds so I'm not overly exposed to the US dollar.

2. Run this basket of ETFs through some portfolio optimization software. The software will recommend what percentage of your funds should be invested in each of the ETFs.

3. Every six months or so, re-run the numbers and rebalance your assets. Ideally you'll be able to rebalance by shifting your new purchases rather than selling assets and incurring short term capital gains.

In theory, this type of investment strategy will do much better than investing in mutual funds. (In my experience, the management fees on ETFs are about 1.5% less than those for a reasonable mutual fund. Over time time, this can add up to an pretty significant amount of money)

You could - potentially - do even better if you are willing to use vanilla stocks rather than putting your money into "ETFS Copper" you could try to mirror the ETF with a portfolio of mining companies and the like. The only time that I do this is with fertilizer, because I never found an ETF that I liked...

[mike777]

I have long called for more transparency in the financial markets in these pages.


Rebalancing your portfolio is an excellent idea, but something almost no one does in real life.

In addition to all of the above posts, it is a good idea to sit down and decide what your goals are and how much risk you can accept.

Another problem with things like credit swaps is the lack of standardized contracts. This make each swap very unique and difficult to price.


What John Paulson was doing was very well known by numerous wall street insiders. They just thought he was nuts. Housing prices never fall across the country at the same time, they said.


btw ETF's are great, it is just that in real life people love to trade them rather than buy and hold them thus increasing costs, not reducing them.


btw2, owning stocks of commodities often magnifies your leverage about 50-75% to the underlying price of owning the commodity itself. For example this is very true with Gold stocks. If the price of Gold moves 25% it is not unusual for the "gold stock' to move 50%. That is 50% in either direction.

[mike777]

PassedOut, on Dec 24 2009, 03:38 PM, said:

The NYT has a revealing piece about how Goldman Sachs made a bundle from the collapse of the US housing bubble: Banks Bundled Bad Debt, Bet Against It and Won

Quote

Goldman and other firms eventually used the C.D.O.’s to place unusually large negative bets that were not mainly for hedging purposes, and investors and industry experts say that put the firms at odds with their own clients’ interests.

“The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen,” said Sylvain R. Raynes, an expert in structured finance at R & R Consulting in New York. “When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson.”

Investment banks were not alone in reaping rich rewards by placing trades against synthetic C.D.O.’s. Some hedge funds also benefited, including Paulson & Company, according to former Goldman workers and people at other banks familiar with that firm’s trading.

In my opinion, making profits in that manner shows a lack of ethics. And I would like to see strong steps taken to regulate such activity. Not sure about the death penatly, but maybe.

P.O.


John Paulson wanted to short the mortgage market. The problem is it was almost impossible to short this market. It was almost impossible to short CDO's in any great size.


What he was finally able to do was in simple basic terms, buy insurance.

He found banks, insurance companies and investment banks among others willing to sell him insurance. He would pay a yearly premimum and the counter parties would have to pay off if the mortgages defaulted. The insurance was very cheap, say 300,000 per year to get 10 million or more in insurance coverage.

Now say you pay 500Million in insurance premimums per year for 2 or 3 years and you get alot of coverage. This was called negative carry and everyone hates negative carry so they thought he was an idiot and that is was free money for them.


Later on he realized that these counterparties may go bankrupt and be unable to pay off so now he entered in credit default swaps. This was basically a third party bet that if say AIG went bankrupt the third party would pay off to him.

In real life the swap increased in value at it looked likeAIG may go under and he was just able to resell it in the open market.