The Econophysics Blog

This blog is dedicated to exploring the application of quantiative tools from mathematics, physics, and other natural sciences to issues in finance, economics, and the social sciences. The focus of this blog will be on tools, methodology, and logic. This blog will also occasionally delve into philosophical issues surrounding quantitative finance and quantitative social science.

Thursday, December 06, 2007

Goldie Gets The Porridge (Everyone Else Will Get Lawsuits)

Regulars to this blog will recognize that -- very early on in the current credit crises -- I diagnosed and laid out the problems and predicted how this crises would play out. Sadly, everything I foresaw happening has come to pass.

Anyone who doubts that credit derivatives (for the most part, mortgage backed securities) helped to inflate the bubble -- and are now magnifying the downturn to almost cataclysmic levels -- should read a recent New York Times article: Wary of Risk, Bankers Sold Shaky Mortgage Debt (Dec. 6, 2007). The part that I found most interesting -- but not surprising -- was that many prominent investment banks paid inflated prices to buy into mortgage deals that they could turn around and repackage into CDOs and sell to now embittered investors (which includes those banks themselves).

My next prediction: Lawsuits. It will be based on legal concepts like uberrima fides (utmost good-faith, in Latin) from insurance law. Banks relied on high-priced legal opinions from their favorite law firms -- not having case law and/or statutes to support their lucrative business of selling credit derivatives while washing their hands of being treated like insurers or guarantors of default risks -- to do what they did. Those legal opinions -- along with other practices of banks related to the credit derivatives business that can be challenged by lawyers -- will be challenged.

My advice to the I-banks: Don't believe your own bluffs. They shouldn't have loaded up on risk the way that they did. They should have hedged earlier and more earnestly. They shouldn't have bought at bloated prices mortgages that weren't worth the paper they were printed on while they were turning around and selling the same garbage. It's bad enough to sell rubbish, it's even worse to buy, basically, the same rubbish (at inflated prices no less)! Many banks suckered regulators, rating agencies, and investors, but they (also) wound up suckering themselves. Now, lawyers will come and sucker them all.

I suppose there is a bit of a bright spot in this atmosphere of gloom (at least, if you're fortunate to work for them). There was one bank who 'got it' and didn't sucker themselves: Goldman Sachs. According to the above cited article and an earlier article in The New York Times -- Goldman Sachs Rakes In Profit in Credit Crisis (Nov. 19, 2007) -- 'Goldie' is the one I-bank that, as the article puts it, "made more money in the boom and, at least so far, has managed to keep making money through the bust."

How did they do it? One reason is that Goldman Sachs -- unlike so many of their competitors as well as hedge funds -- takes risk seriously. As a Merril Lynch (which is facing turmoil because they didn't do what Goldman Sachs did) analyst admits, “The risk controllers are taken very seriously ... They have a level of authority and power that is, on balance, equivalent to the people running the cash registers. It’s not as clear that that happens everywhere.” In fact, unusually, risk managers are given legitimate opportunities to make the kind of money that traders and corporate bankers make. That shows how seriously Goldie takes risk!

As one Goldie alumn put it, Goldman Sachs has a 'culture of success.' It's hard for people who talk about risk during booms (when the bubble is being created and inflated) to be taken seriously -- i.e., actually given authority to affect change. Goldman Sachs is one of the few places that -- against the grain -- has enough 'humility' (at least when it comes to the possibility of losing money ... but I suppose not when it comes to making it) to take the 'fearmongers' seriously and give them backing from upper management to affect change.

That's what happened: When they saw warning signs -- as early as 2006 (last year) -- that 'mortgage risk' was on the rise, they cut their positions and hedged their risks. The results: While their competitors were trying to dump toxic waste (along with valuable holdings that they had to sell below value to raise liquidity), Goldie's hedges were profitable.

Goldman Sachs is an example of how one can profit from being cautious and wary of Black Swan type risks. We all have to take risks. Life is, in many ways, like poker. But we have to know when to fold 'em and know when we shouldn't bluff ... or, at least, to not believe the bluffs.

(NB: Both Lisa Endlich & Emanuel Derman are Goldman Sachs alumni.)

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