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News : International Last Updated: Apr 24, 2009 - 5:31:05 PM


How Goldman Sachs made money from US subprime mortgages on the way up and down
By Michael Hennigan
Dec 3, 2007 - 5:19:00 AM

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Henry "Hank" Paulson responds to President George W. Bush Tuesday, May 30, 2006, after the President announced the nomination of the Chairman and Chief Executive Officer of the Goldman Sachs Group as US Treasury Secretary.

US Treasury Secretary Hank Paulson had thought that the subprime crisis would be contained last spring and since August, with the onset of the subprime-related credit crisis, he has been involved in various proposals to rescue the financial sector from a trauma of its own making and also some of the at-risk of foreclosure householders.

Meanwhile, the top US investment bank Goldman Sachs has been on a roll as rivals such as Merrill Lynch have been mired in the subprime fallout. The funny thing is that when Paulson headed Goldman Sachs, until the summer of 2006, the bank was as active in the packaging/securitization of subprime debt as its rivals.

According to the website ABAlert.com (asset-backed alert), Goldman Sachs was one of the top 10 sellers of CMO's (Collateralized Mortgage Obligation - a financial debt vehicle that was first created in 1983 by investment banks Salomon Brothers and First Boston. Legally, a CMO is termed a special purpose entity that is wholly separate from the institution(s) that create it) for the last two and a half years and it may have sold about $100 billion in CMO's in that period, according to ABAlert.

Goldman Sachs CEO Lloyd Blankfein said last June that low interest rates and narrow yield premiums on riskier debt fueled economic growth for the past four years by boosting investment in real estate, emerging markets and LBOs (Leveraged Buy-outs).

``The biggest risk we face, and there are a lot of things that contribute to this risk, would be a very big crisis in the credit markets,'' he said. ``Some of that is supply-demand fundamentals, but a lot of it is sentiment.''

Goldman Sachs recorded $1.48 billion in charges for the third quarter but its trading income was up a massive 70% on the year-earlier quarter. By contrast, Merrill Lynch & Co. disclosed a $7.9 billion write-down just three weeks after the bank estimated a $4.5 billion charge. Citigroup Inc. has recorded nearly $6 billion in credit losses and warned it may have to record as much as $11 billion in further losses. Investment bank Morgan Stanley is expected to take a charge of $4.9 billion in its third quarter, which ended last Friday.

Blankfein told a Merrill Lynch banking conference in November that his firm is no more prescient than anyone else. Rather, the bank's success is a function of an aspiration "to be the most nimble when the changes actually happen, and to see quicker and respond quicker because we did a certain amount of war-gaming."

"To be out of it the day before the credit cycle changes, that's not going to happen a lot," he said. "It's really not of this Earth to step into a place five minutes before it's the right place."

As the credit markets imploded and triggered ripples across the globe, Goldman Sachs had protected itself from the junk it had sold and was positioned to profit massively from a decline in those securities. 

In a report from northern Norway last week,  north of the Arctic Circle, the New York Times said that the sun does not rise at all this far but Karen Margrethe Kuvaas said she has not been able to sleep well for days.


What is keeping her awake are the far-reaching ripple effects of the troubled housing market in sunny Florida, California and other parts of the United States.

Kuvaas is the mayor of Narvik, a remote seaport where the season's perpetual gloom deepened even further in recent days after news that the town along with three other Norwegian municipalities had lost about $64 million, and potentially much more, in complex securities investments that went sour.

"I think about it every minute," Ms. Kuvaas, 60, said in an interview, her manner polite but harried, according to the report. "Because of this, we can't focus on things that matter, like schools or care for the elderly."

The New York Times said that Norway's unlucky towns are the latest victims and perhaps the least likely ones so far of the credit crisis that began last summer in the American subprime mortgage market and has spread to the farthest reaches of the world, causing untold losses and sowing fears about the global economy.

Where all the bad debt ended up remains something of a mystery, but to those hit by the collateral damage, it hardly matters.

 The Times said that tiny specks on the map, these Norwegian towns are links in a chain of misery that stretches from insolvent homeowners in California to the state treasury of Maine, and from regional banks in Germany to the mightiest names on Wall Street. Citigroup, among the hardest hit, created the investments bought by the towns through a Norwegian broker.

Dr. Jan Hatzius, Managing Director and Chief US Economist for Goldman Sachs
Also in the New York Times, columnist Ben Stein
wrote on Sunday  that "economists, like accountants, are artists. They have a tendency to paint what their patrons, who pay them, want to see."

Financial service economists are usually the optimists supporting their firms' sales strategies but Stein charges Jan Hatzius, Chief Economist for Goldman Sachs in the US, with producing a report on the US housing market last month that was "mostly about selling fear," because it dovetailed with his firm's bearish strategy.

Goldman Sachs in September reported a blowout third quarter reporting a 79 percent increase in net income and had chalked up its huge gains in part due to its bets against mortgage-backed securities.

Fortune Magazine said in October that a large proportion of its third quarter profits were 'unrealized' - i.e. paper gains, and not hard cash payments from fully closed out trades - and came from financial instruments that Goldman values largely according to its own estimates.

The magazine said that much of the focus was on Goldman's trading revenue, which totaled a spectacular $8.23 billion, up 70% on the year-earlier quarter. Part of that increase was due to a bold bet that made money if mortgage-backed bonds and financial instruments tied to mortgage values fell in price. Because of the credit crunch, they did plunge in value, netting gains for Goldman that the banks said "more than offset" the losses it saw on the mortgages it was holding.

Allan Sloan, Fortune Senior Editor-at-Large wrote in October that it's getting hard to wrap your brain around subprime mortgages, Wall Street's fancy name for junk home loans. There's so much subprime stuff floating around - more than $1.5 trillion of loans, maybe $200 billion of losses (Goldman's Jan Hatzius, wrote in a client report in November that losses related to record US home foreclosures using a ``back-of-the-envelope'' calculation may be as high as $400 billion for financial firms), "thousands of families facing foreclosure, umpteen politicians yapping - that it's like the federal budget: It's just too big to be understandable."

Sloan wrote that in the spring of 2006, Goldman assembled 8,274 second-mortgage loans originated by home loan firms Fremont Investment & Loan, Long Beach Mortgage Co., and assorted other players. More than a third of the loans were in California, then a hot market. It was a run-of-the-mill deal, one of the 916 residential mortgage-backed issues totaling $592 billion that were sold last year.

The average equity that the second-mortgage borrowers "had in their homes was 0.71%. (No, that's not a misprint - the average loan-to-value of the issue's borrowers was 99.29%.)"

"It gets even hinkier. Some 58% of the loans were no-documentation or low-documentation. This means that although 98% of the borrowers said they were occupying the homes they were borrowing on - "owner-occupied" loans are considered less risky than loans to speculators - no one knows if that was true. And no one knows whether borrowers' incomes or assets bore any serious relationship to what they told the mortgage lenders.

You can see why borrowers lined up for the loans, even though they carried high interest rates. If you took out one of these second mortgages and a typical 80% first mortgage, you got to buy a house with essentially none of your own money at risk. If house prices rose, you'd have a profit. If house prices fell and you couldn't make your mortgage payments, you'd get to walk away with nothing (or almost nothing) out of pocket. It was go-go finance, very 21st century," Sloan wrote.

How does toxic waste get distilled into spring water, Sloan asked?  

The mortgages were packaged into various classes of securities with the level of interest payable to the purchaser related to a level of risk tied to the maturity periods, but suckers in Arctic Circle and elsewhere didn't appreciate the risk that they were buying into and the shambolic standards, if they could be termed that, that applied to the underlying loans. Besides, the likes of Goldman Sachs, a top Wall Street name, would hardly be expected to be peddling junk and while caveat emptor(Latin for "Let the buyer beware") should have applied, the modern economy would grind to a halt without some level of trust. Big established firms get lots of business e.g Mergers & Acquisitions work; IT projects, because the risk is assumed to be lower and the staff are expected to be among the best in the market compared with dealing with smaller firms. There is also the level of resources available and the assumed inclination to protect a reputation if something goes wrong. 

By the end of September, 18% of the underlying home loans had defaulted and will inevitably get worse as borrowers are hit with higher interest payments after the expiration period of the initial "teaser"/discounted mortgage rates expire.

Goldman made money because it hedged it bets and said in a Securities & Exchange Commission filing:  "Although we recognized significant losses on our non-prime mortgage loans and securities, those losses were more than offset by gains on short mortgage positions."

Allan Sloan wrote that Goldman made more on its hedges than it lost on its inventory because junk mortgages fell even more sharply than Goldman thought they would.

It's indeed an ill wind that doesn't blow somebody good and Goldman reported profits on both the bull and bear housing markets.

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