Goldman Sachs Soaks in Subprime Wins

The entire financial world is beginning to wake up to a cold reality: the subprime-mortgage crisis walloped Wall St.

The ships called Merrill Lynch, Citigroup, Bear Stearns, and almost every other major Wall Street firm sank, sucking the economic stability of many nations with it.

The investigation by the Securities and Exchange Commission into the repercussions of subprime lending has waves of evidence to wade through before we’ll have a conclusive understanding of what went wrong, but today one of the winning financiers of the debacle revealed a little more than it had been willing to just one month  ago.

Goldman Sachs’ Chief Accounting Officer Sarah Smith wrote in an Oct. 30 letter to the Securities and Exchange Commission made public today, and I quote,“During most of 2007 we maintained a net short subprime position with the use of derivatives and therefore stood to benefit from declining prices in the mortgage market.” An understatement.  Goldman Sachs made a killing. But they had been as entrenched in the subprime lending as any other Wall St firm before the system crashed.

How did they come out with the trophy when all the others lost the boat?

Goldman earned a record $11.6 billion in fiscal 2007 while competitors including Morgan Stanley and Bear Stearns posted quarterly losses and annual profit declines.

Until recently, all we heard from the New York-based company was that it was short the mortgage market in the third quarter. They had declined to comment on the matter when it released fourth-quarter earnings last month.  Investors and analysts in the prior quarter were told that it profited by betting the market would decline.

For those who are following the mystery of who did what to whom to win or lose in the process, the bread crumbs to the witches hut in the forest is a fascinating trail.

Kate Kelly’s December 14 Wall Street Journal story about the subprime traders at Goldman Sachs has sparked some restive musings. She reports that by the end of 2006, the people creating and selling subprime mortgages and other collateralized debt obligations had put Goldman Sachs in exactly the same position as every other Wall Street firm. Left to their own devices, traders in subprime-mortgage bonds would have sunk Goldman just as they sank every other major Wall Street firm. Here the trail gets muddied. Kelly reports that two guys who trade Goldman’s proprietary books argued to the chief financial officer that the subprime market felt soft and that Goldman should short it. So they did. In massive quantities. More than offsetting the long positions in subprime held throughout the rest of the firm. So Goldman was left short in the subprime market and in a position to make billions when it crashed.

Journalist Michael Lewis of Bloomberg concludes from Kelly’s investigative reporting that the top brass at Goldman reversed the judgment of its own experts in various markets, without teling their traders. They simply offset their trades.

But  Felix Salmon of Market Movers begs to differ with this interpretation. He maintains Kelly’s story says it was the traders in subprime-mortgage bonds who were told to go short, who were prevented from going even shorter at a few key moments. She tells us that Goldman’s chief financial officer David Viniar observed Goldman had big exposure to the subprime mortgage market because of collateralized debt obligations and other complex securities it was holding. Emerging signs of weakness in the market, meant that Goldman needed to hedge its bets.

The SEC’s Division of Corporation Finance wrote to Goldman on Sept. 20, the same day that Goldman reported higher-than-expected third-quarter earnings, requesting “supplemental information about your involvement in subprime loans.” No kidding.

The firm’s response? That mortgage-related activities represented less than 3 percent of total net revenue in fiscal 2005, 2006 and the first three quarters of 2007, of which roughly half was subprime-related. That balance sheet exposure to all subprime mortgage products represented less than 2 percent of total assets in those same periods.

We will watch the regatta with eager anticipation for the next clue and keep you posted.

 For judith cockman Financial Journalist 2008