More Squiddery: Goldman Sachs and The Mortgage Crash

When discussing the Great Casino that is Wall Street, we
all have to admire the ability of The Great Vampire Squid,
Goldman Sachs.

As we have covered here previously, the ability of this wily
financial cephalopod to outwit, outrun, and profit from every
twist and turn of the market is nothing short of amazing.

Was it because of their High-Speed Trading algorithms?
Partly. Being able to front-run your own clients legally
is a huge advantage in any market.

Or was it because of their extraordinary political influence?
Partly. Having all the right spots in all the right places
filled by your alumni or seconded employees sure helps.

In late 2008, when the markets collapsed and Squid competitors
Lehman Bros. and Merrill Lynch disappeared, it didn't hurt
to have the immediate past CEO of Goldman Sachs, Henry Paulson,
as Treasury Secretary.

If you're Chief Squid Lloyd Blankfein, you knew your
call to Treasury would always be returned. And Treasury
would be calling to ask you for your instructions and orders.

But there's always one more explanation.

How about good old-fashioned Fraud?

In a series of articles beginning today, McClatchy Newspapers
(The Sacramento Bee), details how from 2001 to 2007 ,
Goldman hawked $135 billion of of high-risk mortgage-backed
securities filed with loans from "subprime" lenders to
institutional investors, almost all backed with "AAA" ratings
from the ratings agencies.

But did Goldman believe its own propaganda? Don't bet on it.

In fact, it believed the exact opposite. Beginning in mid-2006,
Goldman had come to the conclusion that the subprime
mortgage boom had just about run its course.

Underwriting standards were non-existent. If you could walk
and chew gum at the same time, you could get a subprime
or even an "Alt-A" mortgage - one step above toxic waste.

And The Squid was starting to see what it hates most -
competition from other securities operators.

So, it then began to do what any smart operator would do.

It started to play the downside.

First, it quietly liquidated much of its remaining MBS
inventory, while continuing to hawk the product as a safe,
high-yielding investment to unsuspecting institutional
investors.

Then, it began to go short. But not too obviously.
That could wreck bid/ask spreads and tip people off.
So, working through "dark pools" and off-shore vehicles,
it began to short the broader MBS (Mortgage-Backed Securities)
market.

Next, it went short directly against its remaining inventory,
a move known as "collapsing the box", while insuring what
it couldn't otherwise eliminate with a collateralized debt swap
from AIG.

That meant no matter what happened in the MBS market,
The Squid came up a winner.

Finally, to cap it all off, it started buying "naked swaps" -
credit default insurance against MBS positions it didn't own.
That's like my buying fire insurance on your house
without your knowledge, hoping that "Marvin The
Torch" will soon strike.

In all, a perfectly executed "Pump and Dump" against
the MBS market, with all of the risk pushed off on
unsuspecting other parties and all of the gain
firmly wrapped up in the Squid's tentacles.

Oh, to be sure, there was an anxious moment - when AIG
went under, it appeared that some of the Squid's bets
might not pay off. But, thanks to the link with Treasury,
AIG paid off those bets at 100 cents on the dollar - some
$13 billion worth.

But here's the key - as much as half of that amount
was on "naked swaps" - bets on positions it didn't own.
That's like Wynn's paying off on my side bets against
the other players on the craps table.

Now to be sure, there are some repercussions.
The State of Mississippi lost 5/6ths of its six million
dollar investment in "AAA rated" Goldman Sachs
MBS bonds. They are suing. So is CALPERS -
The California Public Employee Retirement System -
which lost $50 million of a $64 million investment.
And the Squid settled with the state of Massachusetts
on a similar deal, to avoid criminal prosecution under
state law.

Meanwhile, both California and Mississippi are seeking
class-action certification for their suits - and the attorneys
general of two dozen other states are watching things very closely.

But, if you're The Squid, all this is just par for the course -
after all, you have all the right friends in all the right places.
Nothing could go wrong.

Or could it? Now that Main Street's media is on the case,
as well as hundreds of anti-Squid bloggers, hey,Squid,
know what? All bets are off.

If I were you, I'd be watching very closely.

With my bags packed and passport at the ready.