Goldman Net Short Subprime Risk for Most of 2007

Bloomberg has come across some correspondence with the SEC that sheds light on Goldman’s much commented upon “net short” subprime position.

Note, despite the fulminations of certain members of the media, it is not at all clear that being short creates any liability whatsoever, regardless of whether customers may feel “had” or not. On secondary trades, it would seem to be a slam-dunk that Goldman is in the clear. Goldman is making a market, the investor is seeking to get a good price, traders are understood to be out for their own account, and it should therefore be understood for any trade that your friendly investment bank could be taking a point of view contrary to yours. Indeed, they’d be more likely to be shaving their prices if they were unloading inventory.

Where it looks less tidy is on underwritings, but again, the rule here is disclosure. If Goldman made adequate disclosures about the nature and risk of the securities and its own activities (that it was a market maker and could hold long or short positions), again, my dim recollection of SEC rules says they should be free and clear. But that might not protect some Goldman partner from getting hauled before Congress and called bad names for ten minutes.

From Bloomberg:

Goldman Sachs Group Inc., the world’s largest securities firm, said it bet on declines in the subprime mortgage market for most of 2007, as many of its competitors suffered record losses from the market’s collapse.

“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,” Chief Accounting Officer Sarah Smith wrote in an Oct. 30 letter to the Securities and Exchange Commission made public today. The New York-based firm has previously only disclosed that it was short the mortgage market in the third quarter.

Goldman declined to comment on the matter when it released fourth-quarter earnings last month, after telling investors and analysts in the prior quarter that it profited by betting the market would decline. Goldman earned a record $11.6 billion in fiscal 2007 while competitors including Morgan Stanley and Bear Stearns Cos. posted quarterly losses and annual profit declines.

The SEC’s division of corporate 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.”

The firm responded 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. It added that balance sheet exposure to all subprime mortgage products represented less than 2 percent of total assets in those same periods.

Disclosing balance-sheet exposure is “potentially misleading” because the firm’s traders “may choose to take a directional view of the market,” Goldman told the SEC. As a result, the firm’s “net risk position was either short or long depending on our then-existing view of the market,” Smith said in the Oct. 30 letter.

Smith’s letters to the SEC also disclose that the firm used the ABX Index and credit default swaps on single securities to hedge its holdings in the subprime market, establishing its short position.

The firm also told the SEC it bought Senderra Funding, a South Carolina-based subprime mortgage originator, for $14 million in March 2007.