[Wall Street Scandals]
I am a former options market maker at the American Stock Exchange.
I possess an MBA in Finance. So, I shall analyze Goldman Sachs’ enormous profits, $11.4 billion for fiscal year 2007- as a trader would examine these profits. I would like to explain in simple terms what Goldman Sachs has done with its marketing, packaging, slicing and dicing of Collateralized Mortgage Obligations (CMO’s), which are nothing more than home mortgages that are backed (collateralized) by your home in case of default.
Goldman has taken numerous mortgages and has packaged these mortgages for investors. It then subdivides these mortgages into various tranches (slices). The first tranche is for payments on principal. Other tranches shall be for the first year of interest payments; for the second year of interest payments; etc. By doing this Goldman performed the alchemist’s dream: The sum of the parts is greater, worth more, than the whole. That is why these mortgages were sliced, diced and chopped.
But Goldman ensured that it would lose no money on these CMO’s. And I shall provide an example of how this could be accomplished. But first one must remember this: When you insure an item (such as a house, a car or a painting), you cannot insure that item for more than it is worth.
You own a house. You purchased the house for $1,000,000. But the house is worth only $700,000. Let us say that you pay Standard and Poors or Moodys to fairly appraise your house and the fair value at which Standard and Poors and Moodys appraises your house is $2,000,000. You then insure the house for $2,000,000. Some natural calamity unfolds and you collect the $2,000,000 for your house. But you knew that the natural calamity would unfold. And you have earned a million dollars- just like Goldman Sachs earned billions.
This is a simplified but accurate, account of how Goldman earned record profits, while every other Wall Street firm was losing billions- a total industry loss of $100 billion for 2007. How could Goldman Sachs have earned record profits of $11.4 billion for fiscal year 2007 including $3.2 billion in the fourth quarter, in the midst of the CMO collapse, when Goldman Sachs was one of the prime sellers of CMO’s?
Goldman Sachs did not have many CMO’s in its inventory. Goldman sold these CMO’s to its willing customers. Goldman knew that these CMO’s were potentially valueless. So Goldman bought derivatives (credit-default swaps) that would be profitable when the CMO’s imploded- as Goldman knew the CMO’s would.
You might inquire: But these CMO’s were sliced, diced and marketed with a AAA rating, so how is it possible that there was this collapse? The rating agencies, such as Standard and Poors, are paid to rate these CMO’s- and this is an inherent conflict of interest. The collapse is simple to understand. Everything about these CMO’s was based on lies. These CMO’s were treated as if they were AAA-rated securities and were given the same credit rating as the debt of Exxon. In other words, Goldman passed off as AAA-rated CMO’s, junk bond CMO’s, which Goldman knew would collapse in value.
These were sub prime mortgages, which were granted to individuals with poor credit ratings or no credit ratings at all, and Alt-A mortgages, which were given to individuals without a complete credit history. But there is more. Mortgage defaults for individuals with a good credit history follow a bell curve (normal distribution). Thus, the provider of credit can estimate with confidence the percentage of mortgages that shall be delinquent and foreclosed- and the provider of credit holds a mortgage on the property and the mortgage is thus collateralized. The property, which has been mortgaged, insures that the creditor can collect most of his debt. Every pension fund, bank, investment fund, etc. bases its financial decisions concerning mortgages (CMO’s) on a normal distribution and on a fairly appraised property, which serves as a guarantee. And let us not forget that these standard mortgages require a 20% down-payment.
So, the originating firms, which sold these CMO’s, then fraudulently passed these loans off as AAA-rated CMO’s. Goldman was the only firm, which sold these junk-bond CMO’s to its customers and simultaneously purchased enormous amounts of credit-default swaps that guaranteed a profit when the value of these CMO’s collapsed.
Now let us examine Goldman Sachs’s alleged hedging. As a former equity options market maker, I find it easiest to discuss Goldman’s hedge tactics in terms of stocks- but the principle remains the same. A credit-default swap is an instrument that provides insurance should a particular financial instrument decline in value- a put, which provides the right to sell a stock or an asset at a particular price.
But first we must understand that a hedge does not increase profits. The purpose of a hedge is to reduce losses- and therefore profits are reduced by a hedge. This hedge has a cost and this cost reduces your profits. Thus if you purchase a stock (CMO) at $100, you might seek to limit your losses by purchasing one put with a strike price of $100 for approximately $10. (A put gives you the right to sell a stock or a CMO at a specific price- in this instance $100.)
But Goldman earned billions on its alleged hedges. These were not true hedges. Rather Goldman was directly betting that the CMO’s, which Goldman was selling to its customers, would collapse. Thus, Goldman knew that the CMO’s, which Goldman had sold to its clients, were a financial disaster waiting to occur. Goldman breached its fiduciary duty when Goldman sold these toxic waste CMO’s to its customers and simultaneously purchased credit default swaps- not to hedge its position- but because Goldman knew that the CMO market would collapse. Goldman’s credit-default swaps, would become valuable only when the CMO’s had imploded.
Furthermore, senior executives at Goldman Sachs were intimately involved in getting rid of CMO’s and the purchase of credit-default swaps. David Viniar, Chief Financial Officer of Goldman Sachs, was responsible for recommending the allocation of Goldman’s capital to purchase credit-default swaps- while simultaneously ordering that Goldman Sachs sell the CMO’s, which Goldman held in its inventory, to its customers- as was reported in various media outlets. Goldman Sachs had not only earned a profit of $3.2 billion in the fourth quarter of 2007 because of its purchase of credit-default swaps, but Goldman had also reduced its inventory of CMO’s to less than $400 million and its inventory of CDO’s (Collateralized Debt Obligations) to less than $1.2 billion. We shall now explain how Goldman earned its enormous profit.
Thus Goldman might have purchased AAA-rated CMO’s for the equivalent price of $100. But Goldman then bet on the decline by purchasing three puts, credit-default swaps, with a strike price of $100. Thus if the stock were to decline to $90 Goldman’s CMO income statement would look like this:
Current Value of CMO: $90
Purchase Price of CMO: -$100
Profit (Loss):-$10
The puts have a value of the strike price minus the stock price. The puts have a strike price of 100 and the stock is currently trading at 90. This gives each put a value of $100-$90=$10. We have three puts so the value of the 3 puts is $30.
Purchase Price of 3 puts: (3 times $10) $30
Value of Put at 90: (3 times $10) -$30
Profit: $ 0
We now determine Goldman’s CMO Income Statement (Profit or Loss Statement) for both the puts and the CMO:
Loss on CMO: -$10
Profit on puts: $ 0
Profit (Loss): -$10
With the CMO valued at $90, we now have a loss of $10 on the stock and a profit of $0 on the puts for a net loss of $10.
Now if the CMO were to decline to $70, a decrease in value of 30%, the income statement would look like this:
Current Price of CMO: $70
Purchase price of CMO: -$100
Profit (Loss) on CMO: -$30
The puts have increased in value because the price of the CMO has collapsed- and Goldman has hit a grand slam home run.
Strike price of put: $100
Value of CMO: - $70
Value of put: $30
We must now calculate the value of the three puts with the CMO at $70.
Value of 3 puts: $90
Purchase Price of 3 puts: -$30
Profit on purchase of puts: $60
Total profit with CMO at $70.
Loss on CMO: -$30
Profit on puts: $60
Profit: $30
Thus, Goldman would have needed a drastic collapse in the price of the AAA-rated CMO’s for Goldman to have a profit on its credit-default swaps. But there is something even more damning. If Goldman’s AAA-rated CMO’s had maintained a value of 100, Goldman’s puts, or credit-default swaps, would have expired worthless- thus producing a substantial loss.
In our example, Goldman purchased CMO’s with a value of $100 and then spent another $30 by purchasing puts (credit-default swaps). This lowered the rate on the CMO’s to less than the rate of Treasury Notes- which makes the investment a bet that the market in CMO’s would collapse.
Both Goldman Sachs and Spear Leeds and Kellogg, a firm which Goldman purchased in October 2000, have a history of trading against customer orders. It has been known to the federal government for at least 5 years that Goldman Sachs has been trading against customer orders- just as Goldman did when it purchased derivative products, which would guarantee a profit only if and when the CMO’s Goldman had sold to its clients declined precipitously. On June 18, 2002 and on July 10, 2002 I sent letters to Judge Lawrence McKenna, the federal judge who was presiding over a price fixing class action lawsuit in equity options at the American Stock Exchange.
The primary defendant in this case was Spear Leeds and Kellogg (a Goldman Sachs subsidiary). Copies of these letters were sent to Sullivan & Cromwell, Goldman’s defense attorney in the class action. Thus the information contained in these letters is public information. At the time Henry Paulson, currently Secretary of the Treasury was Chairman of Goldman Sachs.
In these two missives, which are public information, I stated that I had been informed by an employee of Goldman Sachs that Goldman Sachs was trading against its customers’ orders in various Exchange Traded Funds at the American Stock Exchange. I also quoted a Goldman Sachs employee, a specialist, as having stated that Goldman Sachs wished to cross its trades on various ECN’s (Electronic Computer Networks) so that Goldman could trade against its customers’ orders more effectively.
There is proof that Goldman Sachs breached its fiduciary duty when Goldman sold to its customers, CMO’s, which Goldman knew would collapse. A meeting was held on December 14, 2006. This meeting was chaired by David Viniar, Chief Financial Officer of Goldman Sachs, and was attended by senior members of the trading desk, the risk department, the controller’s office and other senior employees of Goldman Sachs. The purpose of this meeting was to discuss the risks of CMO’s and to discuss the increasing losses, which Goldman was showing on its books from Goldman’s positions in CMO’s. It was decided that an inordinate amount of Goldman’s capital should be placed at risk to purchase credit-default swaps and that Goldman must dump its toxic CMO’s.
Lloyd Blankfein, Chairman of Goldman Sachs; Gary Cohn, Co-President of Goldman; and John Winkelried, Co-President of Goldman, approved the decision to dump these toxic CMO’s and to purchase credit-default swaps, thus gambling an enormous amount of Goldman’s capital on the precipitous decline of the CMO’s that Goldman was simultaneously selling to its clients. Some of the credit-default swaps were liquidated as soon as they earned a profit, because Blankfein, Cohn, and Winkelried had risked so much of Goldman’s capital on these credit-default swaps that a loss on these credit-default swaps would have resulted in a loss for the fourth quarter and possibly the third quarter.
It cannot be stated too forcibly that Goldman’s management committee knew that the CMO’s, which Goldman was bundling together, were being sold short by its proprietary trading desk by purchasing credit-default swaps that bet on a precipitous decline in the price of these CMO’s. Simultaneously, Goldman was dumping these toxic waste CMO’s on its customers, publicly owned entities such as banks and insurance funds.
Lloyd Blankfein earned $69 million in 2007- because Goldman dumped its CMO’s on its customers. That is why Goldman purchased credit-default swaps for Goldman’s proprietary account and not for Goldman’s Alpha Fund- to which Goldman had a fiduciary responsibility. Blankfein and his cohorts care about their pay first and foremost.
America needs a prosecutor, who will not be swayed by Goldman’s influence and power, to investigate this pattern of abusive trading by Goldman Sachs.
Goldman did not return phone calls seeking comment.
To comment or to subscribe to or advertise in New York’s leading Pan African weekly investigative newspaper, or to send us a news tip, please call (212) 481-7745 or send a note to Milton@blackstarnews.com
Also visit out sister publications Harlem Business News www.harlembusinessnews.com and The Groove music magazine at www.thegroovemag.com
"Speaking Truth To Empower."
