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Tuesday, May 04, 2010

Short stuff 


To be clear, the castigation of Goldman Sachs or any other investor for shorting "America," mortgage-backed securities, or apple pie is, well, ridiculous. All decisions to buy have to have a matching decision to sell. A decision to sell is a decision to sell, and whether it is made before or after the seller's decision to buy is immaterial. Sellers who are "short" and sellers who are "long" share the belief that the asset they are selling is going to go down in price in the future. The only differences between the two transactions are technical. Those differences may argue for some regulation of short-selling, but they have nothing to do with the belief of the seller in the direction of the price. People, even politicians, who sell short are not "betting against their own team" any more than people who sell long.

That said, if a politician is going to wax sanctimonious about short-selling, he or she should not have done it themselves. Just as, for example, a politician who prosecutes prostitutes ought to avoid patronizing them.


28 Comments:

By Anonymous Anonymous, at Tue May 04, 12:40:00 PM:

>> To be clear, the castigation of Goldman Sachs or any other investor for shorting "America," mortgage-backed securities, or apple pie is, well, ridiculous.

To be equally clear, nobody is criticizing Goldman simply for shorting mortgage-backed securities. Goldman is being castigated because their trading desk was shorting mortgage backed securities that Goldman was actively selling, and Goldman failed to disclose that their own trading desk held a short position. Again, the criticism is due to Goldman's failure to disclose material information associated with the sale of the security.

Again, I remain completely baffled by the knee-jerk reaction in defense of Goldman's actions, which to me appear to be indefensible. TH, if I understand correctly you are the CFO of a publicly traded company. The analogue here would be if you oversaw the issuance of securities for your company at a given price while you and your executive team were actively shorting the security, and without disclosing the short position of the executive team. Would you condone this activity?  

By Blogger TigerHawk, at Tue May 04, 12:59:00 PM:

The analogue here would be if you oversaw the issuance of securities for your company at a given price while you and your executive team were actively shorting the security, and without disclosing the short position of the executive team. Would you condone this activity?

I do not agree that is the correct analogy. No institutional investor dealing with Goldman did not understand it was also trading with shorts. You had yield chasers who loved the subprime paper, and skeptics who were shorting. Sure, Goldman got its vig on both sides, but I would be flabbergasted if both parties did not know that. That is a completely different relationship than the "analogy" you propose.

More to the point, my company finances itself with convertible bonds. The underwriters of those bonds, and (by the way) the ultimate purchasers of those bonds, short our stock to hedge their purchase of the bonds. Shorting is a normal part of underwriting.  

By Blogger Escort81, at Tue May 04, 01:49:00 PM:

Of course there is a fundamental difference between managing an operating company that manufactures medical devices (subject to all of the usual regulatory procedures) and managing a financial institution that is both an intermediary to the buy and sell side, and makes bets with house money, long and short.

That said, I would be reluctant to buy shares in an IPO when the majority of shares being offered were from selling shareholders and not "new" equity going into the firm for working capital.

Let's also be clear that, although I suppose it is obvious, that selling a security from an existing position is not the same as shorting it. If I am long (I own) 100 shares of IBM, and sell 100 shares, I have no position; if I then sell another 100 shares, I am then short IBM, and I'm on the hook for the dividends (a cost of carry) to the long side of that transaction, for as long as I am short.

Also, let's distinguish between the criticism of GS (disclosure) which specifically relates to ABACUS/SEC, and the more general criticism of the firm for shifting its stance on the MBS market with respect to its house money bets while still making money putting its clients into long MBS positions. I think those are separate concepts.  

By Anonymous Anonymous, at Tue May 04, 02:32:00 PM:

TH, I respect the hell out of you and love your blog, but your continued defense of Goldman's disclosure gap leaves me baffled.

Your response diverged in a couple different directions. I would respond as follows:

>> No institutional investor dealing with Goldman did not understand it was also trading with shorts. You had yield chasers who loved the subprime paper, and skeptics who were shorting. Sure, Goldman got its vig on both sides, but I would be flabbergasted if both parties did not know that.

Agree on all points as to the finance aspects. Nonetheless, I am genuinely unaware of an "I would be flabbergasted if they didn't know" defense to securities fraud. My recollection of securities law, rusty as it may be, is that if you want to sell securities covered by the '33 or the 34 acts then you must disclose all material information relevant to the pricing of the security. Again, shorting isn't the problem; the failure to disclose that they were simultaneously shorting the same securities they were selling is the problem.

>> More to the point, my company finances itself with convertible bonds. The underwriters of those bonds, and (by the way) the ultimate purchasers of those bonds, short our stock to hedge their purchase of the bonds. Shorting is a normal part of underwriting.

I view this as being completely inapposite. The purchasers have no obligations under the '33 or '34 act, so that's out. The underwriters are not shorting the same security they are underwriting. I'm not sure I follow your logic here.  

By Blogger Escort81, at Tue May 04, 03:38:00 PM:

Er, it's unclear whether Gov. Spitzer had a long or a short position.  

By Blogger JPMcT, at Tue May 04, 06:37:00 PM:

Some of these statements are confusing. Goldman lost 90 million on the deal by going long on the investment. Sure, the traders profited whether their clients were long or short, but the institutional position was long...and lost.

I suspect the SEC needed soomething to do in the lull between surfing porn sites.  

By Blogger Bomber Girl, at Tue May 04, 07:30:00 PM:

Although there is lots of info out about the SEC suit and the deal, there appears to be more misinformation. As Escort81 says, regarding Abacus, the issue was mainly about nondisclosure of (allegedly) material information. (in my view, Paulson's role was material, but that's one opinion). However, generally and during the hearings, the fact that I-banks are regularly long and short - and sometimes taking positions which are opposite their clients', gets back to the subject of earlier posts on the topic about the evolution of banks to trading houses - for their own account - and not mainly bankers, advisers and market makers.

(BTW, Escort81, I do hope we never find out any more about Spitzer's position. WayTMI - no disclosure warranted).  

By Blogger randian, at Tue May 04, 08:05:00 PM:

Again, shorting isn't the problem; the failure to disclose that they were simultaneously shorting the same securities they were selling is the problem.

No, it isn't a problem. That Goldman was shorting said securities is irrelevant, because Goldman's net position was long. Since what the buyers thought Goldman's position was (net long) matches Goldman's actual position (net long), what is there to disclose?  

By Blogger Bomber Girl, at Tue May 04, 08:20:00 PM:

randian, read the suit on the SEC website. Here is an excerpt:

"Undisclosed in the marketing materials and unbeknownst to investors, a large hedge fund, Paulson & Co. Inc. (“Paulson”), with economic interests directly adverse to investors in the ABACUS 2007-AC1 CDO, played a significant role in the portfolio selection process. After participating in the selection of the reference portfolio, Paulson effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (“CDS”) with GS&Co to buy protection on specific layers of the ABACUS 2007-AC1 capital structure. Given its financial short interest, Paulson had an economic incentive to choose RMBS that it expected to experience credit events in the near future. GS&Co did not disclose Paulson’s adverse economic interests or its role in the portfolio selection process in the term sheet, flip book, offering memorandum or other marketing materials provided to investors."

It's not about the GS position, it's about the disclosure. Material or not? for a jury to say. I'm guessing they settle.  

By Anonymous Anonymous, at Tue May 04, 09:06:00 PM:

How can I put this politely?

If I buy a stock or some such, within a few days the back office guys or the market specialist for that stock has to get the shares of whatever I bought credited to my account. This is a long on the account.

The guy who sold me the shares didn't short the shares.

If I agree to buy at some time in the future shares of something at a particular price, I'm making a bet that the price will be higher in the future.

On the other hand, if I agree to sell shares in the future at a given price that I do not currently possess, that's a short sale, since I'm betting that the price will decline.

The first two instances are investment decisions. The second two are bets on the red and black.

BTW: I didn't read most of the previous comments.

JLW III  

By Anonymous Anonymous, at Tue May 04, 09:11:00 PM:

A question to the securities experts commenting here - imagine the following statement from GS, or any other big institution, back in 2005/2006: "We think sub-prime paper is ultimately worthless because the loans were issued in order to avoid political harassment. They are a bomb that will go off, the market is simply making bets on how long the fuse is. Therefore, to protect our investors, we will not be playing in that particular sandbox."

What reaction would that have gotten?  

By Anonymous The Truth is Out There, at Tue May 04, 09:33:00 PM:

"It's not about the GS position, it's about the disclosure. Material or not? for a jury to say. I'm guessing they settle."
I'd go further. GS had a conflict. At a minimum, the conflict should have been disclosed including details about Paulson's involvement.
Here's my pet theory: Since Paulson paid GS $15 million to work on the deal, there likely was a Paulson-GS engagement letter. There also had to have been a lawyer involved who drafted the offering memorandum and other marketing materials. If said lawyer knew about the engagement letter, said lawyer would have taken the fall. Ergo, said lawyer wasn't given the engagement letter -- said lawyer never knew from Paulson. Was this an oversight or done on purpose? The first is bad, the second is real bad. Either way, what happens when traders try to be bankers.

"The first two instances are investment decisions. The second two are bets on the red and black."

Agreed. Neither Paulson nor the Abacus buyers were doing anything that tied to investment in the real economy. Don't tell me it was hedging. Legitimate hedging transfers risk created in normal economic activity. Derivatives have created an enormous volume of risk for its own sake. The volume of derivatives dwarfs any legitimate hedging need.  

By Blogger Bomber Girl, at Tue May 04, 09:35:00 PM:

If I passed a Series 7, am I a securities expert? My reaction: to have shorted Fannie Mae. I would have considered this an investment, not a red/black bet.  

By Blogger Bomber Girl, at Tue May 04, 09:49:00 PM:

BTW, the payoff on an investment can be much harder to predict than the payoff on a red/black bet. The popular comparisons to casino gambling are as useless as the Wall Street vs. Main Street rhetoric if we are hoping for concrete ways to bring some sanity to the financial markets.  

By Blogger JPMcT, at Tue May 04, 10:04:00 PM:

The principals in the deal were WELL AWARE of Paulson's position. The flip book was specific about the quality of the paper (BBB..low as you can go), as well as specific mention about potential conflicts of interest amongst the principals in the deal.

Good Lord...NOBODY who lost the lion's share of money in this deal ever complained about it.


It was BUSINESS AS USUAL for an insider group of sophisticated financiers.

If you don't want to play with the big boys, for God's sake get off the playground...don't go running to the SEC!!!  

By Blogger Bomber Girl, at Tue May 04, 10:29:00 PM:

As to what all the investors knew, it is hard to tell - some of the emails available are fairly slimey to say the least and indicate that there may have been misleading information provided - and I don't think Paulson's name was in the flip book, although i did not read every page. That said, GS basically had a statement in the flip book saying they may know stuff that they weren't going to disclose (non public information) so they may be covered legally. However, if I was a salesperson on this deal, it would not pass the cringe test if investors didn't know pretty clearly the raison d'etre for the deal and could make their own judgements accordingly. I think it is like the "I know porn when I see it" concept. Of course, the SEC would be all over that, n'est-ce pas?  

By Blogger randian, at Wed May 05, 12:20:00 AM:

The volume of derivatives dwarfs any legitimate hedging need.

Right. Because you're so smart you know exactly how much hedging should happen in a trillion dollar stock market.  

By Blogger Bomber Girl, at Wed May 05, 06:14:00 AM:

WSJ on "sophisticated" investors and sophists...
http://online.wsj.com/article/SB10001424052748703866704575224511672855990.html?KEYWORDS=sophisticated+investors  

By Anonymous The Truth is Out There, at Wed May 05, 06:51:00 AM:

"you know exactly how much hedging should happen"

I don't. Not even ball park.

I can, however, sometimes see structural flaws in economic activities -- usually after-the-fact. Warren Buffet is good at seeing them beforehand, which is why he gets the big bucks.

Buffet was a big investor in Fannie and Freddie for the longest time, but sold out in 2000. Buffet usually doesn't sell his positions, but he didn't like the direction Fannie and Freddie were taking.

Buffet has been famously critical of derivatives. He spoke from his experience of winding down the legacy derivatives business he acquired from GenRe.

I don't know how big the derivatives market should be, let alone "exactly." I can say that it's a lot bigger than it should be because it's growth has been driven by structural flaws. It's a trader's wet dream.

Wanna argue the details? Here's Buffet in Fortune 2003: http://webcache.googleusercontent.com/search?q=cache:xa3oKfSIHnsJ:www.freerepublic.com/focus/news/855968/posts+buffet+warren+Fannie+mae&cd=8&hl=en&ct=clnk&gl=us

At root, they're often mispriced because counterparty risk is largely ignored. We're learning that "AAA" isn't always really "AAA" They're often not capitalized nor collateralized.

Buffet was especially prescient in 2003. Here he is in early 2009:

"Derivatives are dangerous. They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks. They allowed Fannie Mae and Freddie Mac to engage in massive misstatements of earnings for years.

"Improved “transparency” – a favorite remedy of politicians, commentators and financial regulators for averting future train wrecks – won’t cure the problems that derivatives pose. I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives. Auditors can’t audit these contracts, and regulators can’t regulate them.

"Additionally, a frightening web of mutual dependence develops among huge financial institutions. Receivables and payables by the billions become concentrated in the hands of a few large dealers who are apt to be highly-leveraged in other ways as well. Participants seeking to dodge troubles face the same problem as someone seeking to avoid venereal disease: It’s not just whom you sleep with, but also whom they are sleeping with."  

By Anonymous The Truth is Out There, at Wed May 05, 07:20:00 AM:

"you know exactly how much hedging should happen"

I don't. Not even ball park.

I can, however, sometimes see structural flaws in economic activities -- usually after-the-fact. Warren Buffet is good at seeing them beforehand, which is why he gets the big bucks.

Buffet was a big investor in Fannie and Freddie for the longest time, but sold out in 2000. Buffet usually doesn't sell his positions, but he didn't like the direction Fannie and Freddie were taking.

Buffet has been famously critical of derivatives. He spoke from his experience of winding down the legacy derivatives business he acquired from GenRe.

I don't know how big the derivatives market should be, let alone "exactly." I can say that it's a lot bigger than it should be because it's growth has been driven by structural flaws. It's a trader's wet dream.

Wanna argue the details? Here's Buffet in Fortune 2003 Fortune 2003

Buffet was especially prescient in 2003. Here he is again in early 2009:

"Derivatives are dangerous. They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks. They allowed Fannie Mae and Freddie Mac to engage in massive misstatements of earnings for years.

"Improved “transparency” – a favorite remedy of politicians, commentators and financial regulators for averting future train wrecks – won’t cure the problems that derivatives pose. I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives. Auditors can’t audit these contracts, and regulators can’t regulate them.

"Additionally, a frightening web of mutual dependence develops among huge financial institutions. Receivables and payables by the billions become concentrated in the hands of a few large dealers who are apt to be highly-leveraged in other ways as well. Participants seeking to dodge troubles face the same problem as someone seeking to avoid venereal disease: It’s not just whom you sleep with, but also whom they are sleeping with."  

By Anonymous The Truth is Out There, at Wed May 05, 08:15:00 AM:

Sorry for the double post.

Here's a better link to Buffet in 2003: Fortune 2003 This is worth reading, including because it was such an insightful, early call.

Goldman shouldn't get to massively trade in derivatives based on a business model that says "heads we win", "tails the feds will bail us out." It's crony capitalism. The optics aren't good when the Treasury Secretary and Goldman's CEO have each other on speed dial. What hasn't been asked of Lloyd is why he didn't go public as a critic of subprime in 2007 - 2008. (1) Pirate traders take advantage and rape and plunder -- they don't expect a government pension. (2) Plugged-in bank CEOs have bigger responsibilities -- they need to be part statesman.

I'm not anti-Goldman -- just trying to call them as I see them. Some here just knee-jerk defend Goldman. I wonder why?

We had a financial system that systematically magnified risks, with players that tried to take advantage of those risks. We still do. We came close to going over a cliff in 2008, there's still a risk of our going over a cliff.  

By Blogger randian, at Wed May 05, 02:22:00 PM:

Buffet has been famously critical of derivatives.

Buffet sells insurance. Derivatives are mostly used in hedging transactions, which are a form of insurance. Do the math.

Buffet is far too self-interested for me to listen to him regarding policy. He loves estate taxes, for example. Why? Because it would kill his life insurance business if they went away. He was also lying or terribly ignorant when he said his tax rate was less than his personal assistant's.

Buffet is indeed correct that derivatives make analyzing a balance sheet difficult. So what? That fact is already priced into the market value of the firm, which is lower than it would be in their absence. Even if you could prove it isn't, again so what? It's not my, yours, or the SEC's job to save investors from their own imprudence.

I don't know how big the derivatives market should be, let alone "exactly."

Then you can hardly say that it's "too big". "I know it when I see it" is no basis for regulating anything.

Goldman shouldn't get to massively trade in derivatives based on a business model that says "heads we win", "tails the feds will bail us out."

I agree, but that's a flaw of bailouts, not derivatives.  

By Anonymous The Truth is Out There, at Wed May 05, 03:29:00 PM:

To Randian:

"They have dramatically increased the leverage and risks in our financial system."

" ... a frightening web of mutual dependence develops among huge financial institutions"

Do you disagree with the Sage of Omaha on these points?

I have no dog in this fight other than I don't want the world to melt down. I've got no insight other than a sense that there's been more speculation going on than hedging -- given the growth in volume. There may even have been a lot of manipulation going on.

It's a small thing -- but the use of derivatives to flirt 13D filings bothers me. Why even have the rule then? The SEC doesn't care -- it's like a cop on the beat who doesn't say anything to the bum pissing on the lamppost in broad daylight in front of the kiddie park.

My day job has got me looking at litigation over derivatives. I don't know if this is a growth industry or not. If anyone has insight, please chime in.

I suspect it may be. One facet of counter-party risk is litigation risk. If a derivative requires a party to make a big payment years after the deal was struck, I can see the temptation for said party to call a lawyer before writing a check.  

By Anonymous Anonymous, at Wed May 05, 03:31:00 PM:

Continuing with my thesis about the political stupidity of the Republican party on this issue, here's Harry Reid's snippet for the day:

"Republicans are having difficulty determining how they can continue making love to Wall Street," Reid said at a press conference this morning. "It's obvious that they do not want to put any decent restrictions on what Wall Street has done or [is] doing."

http://tpmdc.talkingpointsmemo.com/2010/05/reid-republicans-want-to-continue-making-love-to-wall-street.php

This message will resonate with voters. Obama's numbers have stopped dropping, and are rising in some polls. Most Americans still blame the recession on Bush. And now Democrats can correctly paint Republicans as being the party in bed with Wall Street bankers. This will be THE issue that sinks the Republican plan to retake Congress in 2010.  

By Blogger randian, at Wed May 05, 09:35:00 PM:

Do you disagree with the Sage of Omaha on these points?

Yes. Those issues are not exclusive to derivatives. Any contract obligating A to B can cause it, like borrowing money. There is no way to eliminate interlocking contracts, even contracts that were not intended to be interlocking, without outlawing entirely these firms doing business with each other. Mark to market accounting exacerbates the problem because it causes instant market collapse.

"Republicans are having difficulty determining how they can continue making love to Wall Street"

That's rich, seeing as how the Democrats are raping Wall Street and demanding tribute (campaign contributions).  

By Anonymous The Truth is Out There, at Wed May 05, 10:10:00 PM:

To Randian,

(1) "Any contract obligating A to B can cause it, like borrowing money."

(2) "Mark to market accounting exacerbates the problem"

What are you, channeling Ron Paul?

We live in a world with fractional reserve banking and leverage. etc. etc. I didn't invent it. I'm dealing with it. Which is why I'm a little "l" libertarian.

If you're a serious Wall Street "player" type, then you're thinking has already brought us to the edge of financial apocalypse. We may go over that edge yet (my over/under is 10%).

If you're not a serious player, then "ditto." What's the difference these days.  

By Blogger randian, at Wed May 05, 11:39:00 PM:

What are you, channeling Ron Paul?

Even if I were, which I'm not, so what? "Channeling Ron Paul" is not an argument.

you're thinking has already brought us to the edge of financial apocalypse

No, bailing out Wall Street did. "Do nothing" is always the right thing to do when the private sector faces bankruptcy. Spending public money in this way invites corruption and moral hazard. The cure (public borrowing) is worse than the disease. Remember that assets do not disappear because their owner goes bankrupt. Had we just let these bozos crash and burn, somebody would have stepped in and bought their assets for a song.  

By Blogger Gary Rosen, at Thu May 06, 03:05:00 AM:

We could sit around all day arguing whether Goldman broke the law ... hell, we *are* sitting around all day arguing whether Goldman broke the law. But isn't that the point of this?

Who is more responsible for the financial meltdown, Goldman or the GSEs? Are the GSEs getting called on the carpet - or are they just getting unlimited funding?

Unlimited funds to Fannie & Freddie  

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