Michael Lewis’ Theory of Why Goldman Got It Right

Michael Lewis, of Liar’s Poker fame, gives an elegant explanation of why Goldman got its subprime position right when everyone else on the Street was disastrously wrong. And I mean elegant in the mathematical sense: it fits known facts and has few moving parts.

As Lewis tells it, Goldman did not use the largely impotent risk management practices that other firms rely on to rein in trading positions. Richard Bookstaber, card carrying risk manager, illustrated in “Conversations with the Trading Desk” how discussions with traders about their large and growing subprime positions were likely to have gone. Lewis argues that a couple of traders who made a case that housing credit was probably going south were given sufficient rein so as to lay on a bigger short position than the trading inventories of the relevant businesses, unbeknownst to them.

Lewis compares this “higher intelligence” in the proprietary trading desk, approved by Blankfein and the CFO, David Viniar, as operating like a hedge fund. That is true, and is also a criticism frequently made against the firm, that it is really a hedge fund masquerading as a client business. Indeed, just as size was valuable in the bond trading business (the more trades you saw, the better your “market intelligence,” meaning your ability to manage and price risk), clients might worry that their business, while presumably profitable to the firm, is valued as much as a potential input into the firm’s trading decisions as it is for its own merits.

Goldman is fortunate that the traders in this case had better judgment than the fellows running its hedge fund Global Alpha.

From Bloomberg:

What’s odd about the subprime crash is Goldman Sachs Group Inc. A single firm took a position contrary to the rest of Wall Street. Giant Wall Street firms are designed for many things, but not, typically, to express highly idiosyncratic views in the market.

Even more surprising is how little Wall Street seems to have dwelled on how and why Goldman Sachs made its killing. There are insane conspiracy theories — for instance, that former Goldman chief executive officer and current U.S. Treasury Secretary Henry Paulson tipped his old pals, etc. (But then, how did HE know?)

There is also the widely held opinion that people who work at Goldman Sachs are just smarter than ordinary people — hence the lust to hire former Goldman employees to run other Wall Street firms, as Merrill Lynch & Co. did. (But why would any trader who could systematically beat the market waste his time at Goldman Sachs?)

So far as I can tell, there has been only one attempt to explain this strange event, and that was by a journalist, Kate Kelly of the Wall Street Journal.

Ms. Kelly’s very good piece offered up the sort of irrelevant details — this little piggy ate which sandwich for lunch as the market crashed, which trader went to the gym at which odd hour to relieve the incredible stress of gambling with billions of dollars of other people’s money — that leaves the reader, along with employees of Goldman Sachs, feeling as if someone inside Goldman must have spilled the beans.

But Goldman didn’t cooperate with the Journal…. the Journal story is probably true, as far as it goes. The only trouble is that it doesn’t go far enough.

Briefly, the Journal story runs as follows:

By the end of 2006, the people creating and selling subprime mortgages and other so-called CDOs (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 Merrill Lynch, Citigroup Inc., Bear Stearns Cos. and every other major Wall Street firm.

Enter two smart guys who trade Goldman’s proprietary books to argue to the CEO and chief financial officer that the subprime market feels soft and that Goldman should short it. This they do, in such massive quantities that they more than offset the long positions in subprime held throughout the rest of the firm, leaving Goldman short the subprime market and in a position to make billions when it crashes. End of story.

And it’s a good story. But consider what it implies. Their own traders and salespeople in subprime mortgages and related securities had put Goldman in exactly the same position as every other Wall Street firm: long subprime mortgages.

The only difference between Goldman and everyone else was that Goldman had, in effect, an entirely separate enterprise, sitting on top of the firm, with the power to reverse the judgment of its own supposed experts in various markets. They were able to do this, apparently, without ever saying a word about it to their own traders. Instead of telling the fools trading subprime mortgages that they are wrong, and that they should unwind their positions, they simply offset their trades.

All across Wall Street risk managers are being fired, reassigned or hovering under a cloud of contempt and suspicion. Heads must roll, and after the CEO, these guys are the most plausible to guillotine.

But at the same time it’s pretty clear that a lot of these so-called risk managers never really had the power to manage risk. They had to consider the feelings, for example, of the guys who ran subprime mortgages. Morgan Stanley conceded as much when it said recently it was considering changing things around so that the risk manager reported to the CFO, rather than the heads of individual businesses.

But at Goldman there were two intelligences at work: one, the ordinary Wall Street intelligence, which was allowed to get itself in trouble, just as at every other Wall Street firm; the other, more like an extremely smart hedge fund that made its living off the idiocy of big Wall Street firms, including its own people.

And this second, higher intelligence was allowed to make a mockery of the labors of the first. I can’t think of another example of a big Wall Street firm saying so clearly through its trading positions as Goldman Sachs did over the past year that it thinks the rest of its industry, including its own people, is a bunch of idiots. They have obviously designed their firm to take into account their idiocy — without ever having to put too fine a point on it.

From now on, the ordinary traders and salesmen at Goldman Sachs can beaver away knowing that their opinions and judgments about the markets in which they operate are basically irrelevant. The guys at the top of the firm are making the market calls, and if the guys at the top disagree with them, well, they’ll just take the other side of their trades. But then, why do you need the traders? And what happens when the guys at the top of the firm are wrong?