Goldman Sachs, the story of the survival of the fittess...

Its been a while since I last wrote an article about credit derivatives so here, this article is for all you quant nerds....lol... Well, let me begin with two random quotes from Goldman's management during 2007 right around the time when the ABX BBB index faced an initial decline in December 2006:

" Sell what could be sold as is, repackage and sell everything else " - Keven Gasvoda, MD, Goldman's Fixed income, Currency and Commodities.

"We have been thinking collectively as a group about how to help move some of the risk. While we have made great process moving the tail risks, we think it is critical to focus on the mezz risk that has been built up...the best target, would be to put them in other CDOs"- Stacy Bash Polley, Co Head of Fixed Income Sales.


Goldman had it all figured out before anyone else even had a clue what was going on. Goldman is smart, the team is damn smart. They are the king of repackaging, from MBS to a CDO, from a CDO to CDO squared, they are the best, thats it! In 2010, after getting nailed with a 550$ million settlement for the Abacus synthetic CDO deal involving Paulson (who actually just lost 750$ million today by dumping all his share of Sino Forest, its his turn to get screwed this time) we have here a post by William Cohan about the credit derivative business at Goldman Sachs:

"Goldman's business model is designed around the exploitation of secrecy. Secrecy is organizing principle that governs modern credit markets. Credit default swaps, privately placed structured securitizations (e.g. CDOs), and hedge funds have all flourished-- they dominate the debt markets--because they are all designed to exploit secrecy. They all create extraordinary profits by keeping the rest of us in the dark. So in late 2006, if you wanted to find out what was happening in this newly created synthetic RMBS market, you couldn't find out much of anything. You couldn't find out anything about who bought or sold any CDO, or what was in any CDO, or how any CDO performed, unless Goldman or some other CDO underwriter deemed you sufficiently worthy of their selective disclosures. You couldn't learn anything from the sales or trading activity of mortgage bonds, because the related trading in credit default swaps was kept hidden beneath the surface. You didn't know anything about the trading activity related to the ABX indices, since that, also, was kept secret. And since the privately-held company that owned the ABX, CDS IndexCo LLC, operated in total secrecy, and since the privately-held company that published the price of the ABX, Markit Group Limited , operated in total secrecy, you had no way of knowing the extent to which the price of the ABX was manipulated through round-tripping, side deals with synthetic CDOs, or anything else. The only thing you knew, your only link to the illusory "reality " of market sentiment, was the quoted price of the ABX. And you might happen to know that the Chairman of CDS IndexCo was Brad Levy, a managing director at Goldman, which, along with a handful of other banks, controlled CDS IndexCo and Markit Group. Both the FCIC and the Levin subcommittee disclosed a wealth of information that others with a more skeptical bent can scrutinize in depth. This information poses a direct challenge to Goldman's dissembling, and to the moral hazard of access journalism, which is no substitute for the full transparency of a free and open marketplace of ideas. "

Well here you go, so whoever that wants to argue with me in regards to why Goldman is the best in the business, give me a call.. I'll be more than glad to. And to sum up, here is a diagram of the famous Abacus AC1 Syntheic CDO deal, talk about confusing the hell out of everyone....

Morgan's call on a 7s-10s DV01 flattner by Jim Caron

Here is a very good article from Zero Hedge for those of you that follow and trade the interest rates markets. FYI, I think that this 7s 10s flattener is a good relative trade idea since its better than going direct short on the 10s , but Caron's reason of trade ( economic growth ) vs Bill Gross's claim ( lack of Fed buying at the end of QE2) is completly INSANEEEEE. Anyways, here is the article...

It has not been Jim Caron's decade. The Morgan Stanley rates strategist, riding on the coattails of the always wrong Morgan Stanley economics team led by David Greenlaw, has been wrong in his annual rates call year after year after year. Which is unfortunate because while unable to see the forest for the trees, Caron does have a better grasp of rates than most other Wall Street penguins. That said, just like everyone else in the status quo, Caron has just come out with another short duration call (i.e. sell bonds), probably the 6th time in a row he has done that in the past 3 years. Perhaps 7th time will be the charm. Amusingly, Caron, terrified to be seen in the same camp as Bill Gross who is short bonds on fears that there will be nobody available to step in an buy the 80% of gross issuance that has been monetized by the Fed to date, make this very loud caveat on his short bond call: "To be sure, our shift toward short from neutral duration has nothing to do with the end of QE2 and related concerns that there will be a lack of demand to buy US Treasuries once the Fed stops buying them. As we have stated many times in the past, the outlook for the economy will be the main driver of yields, not the end of QE2." No, instead Caron believes that the sell off in bonds will be due to the same bullish economic growth call that he has been predicting over... and over... and over... and over... etc. More interesting is how he suggests the trade is implemented: in MS' view the best way to be bearish on rates is with a DV01 neutral 7s-10s flattener: "we continue to recommend being short 5s on the 2s5s10s fly. In line with the butterfly, and in order to express a more robust short duration position, we recommend a curve flattener on the UST 7s10s curve: · Sell $133.7mm OTR 7y Notes; · Buy $100mm OTR 10y Notes." Perhaps those who want to be short bonds, but for the right reason, that predicted by Zero Hedge and then Bill Gross, this may be one of the better ways to put the trade on.

And the best way to express a bearish stance in the rates complex according to Caron:

Since April, the belly of the curve has richened significantly as rates have marched lower (Exhibit 1). We continue to recommend being short the belly vs. the wings, as previously discussed short 5s on the 2s5s10s fly (see “Fade the Recent Outperformance of  the Belly,” US Interest Rate Strategist, June 9, 2011). In line with the butterfly, and in order to express a more robust short duration position, we recommend a curve flattener on the UST 7s10s curve:

· Sell $133.7mm OTR 7y Notes

· Buy $100mm OTR 10y Notes

Both the 7s10s curve flattener and the butterfly allow the investor to play for a reversion in the richness of the belly. Rather than going outright short we suggest initiating these relative value trades, which capture some duration exposure and some relative  value exposure between different points on the curve.

We argue that growth expectations have not been downgraded to the extent that rates in the 5-10y sector have fallen with survey consensus at 3.35% for 2H11. In our view, the rates market is pricing levels of US growth that are inconsistent with surveyed forecasts (see “Reducing Duration Exposure from Neutral to Underweight” in this publication).

This past week, price action in the market has reflected uncertainty as, for example, the 7y point increased 12bp on Tuesday only to decrease by 14bp on Wednesday returning to similar levels. We expect the market to remain range-bound in the near term; however, we see fair value of the 10y note at about 3.10% with a 25bp standard deviation (Exhibit 2). With the 10y dipping to the low 2.90’s, we see an opportunity to fade this extreme.

Fannie, Freddie, Ginnie and all about that government crap...

So, market crash in 2008, who is to blame? We've been though this one many times, some blame the shadow banking system, some blame deregulations, securitizations, other point their fingers at Greenspan while many are holding a knife at the doors of the credit rating agencies. Well, in my view, they all play a huge role but today, I want to write about the three government giants, Fannie, Freddie and Ginnie because many people don't seem to have a clue what they do and where they come from other than the fact that they deal with mortgages.

Fannie Mae was chartered by the reconstruction finance corporation during the great depression in 1938 to buy mortgages insured by the FHA. Back in the day, Fannie either held the mortgages they bought in its portfolio or they simply resold them to thrifts, banks, insurance companies or investors at a later time. The model worked fine but there was one major issue with this system. Fannie Mae, in order to buy these mortgages, they did it by borrowing the money. In 1968, the mortgage portfolio of Fannie had grown to 7.2$ billion USD and the government started to notice this issue. So in order  to get the debt off the government’s balance sheet, president Johnson’s administration reorganized Fannie as a publicly traded corporation and created Ginnie Mae to take over Fannie’s subsidized mortgage program and loan portfolio and this was how Ginnie Mae was created.

Two years later, the thrifts and banks persuaded congress to charter a second GSE and Freddie Mac was created to help the thrifts sell their mortgages once again. Like we mentioned in the beginning, before 1968, Fannie Mae held the mortgages it purchased, profiting from the spread between its cost of funding and the interest paid on the mortgages. The new laws in 1970 gave Ginnie, Fannie and Freddie the option of securitization. So yes, in my point of view, the most early build up of the 2008 crisis can even start from as early as here. Therefore in 1971, Freddie got into the business of buying mortgages, pooling them and then selling MBS to investors. They did not originate mortgages, they bought them from banks and mortgage companies; either held them in the portfolio or securitized them and guaranteed them. The entire business model was changed.

The new laws in 1970 not only gave Freddie the option of securitization, but it also set the government sponsored enterprises’ minimum capital requirement at 2.5% of asset plus 0.45% of the MBS they guaranteed. Do you even know what kind of leverage this is?  They could borrow more than 200$ for each dollar of capital that was used to guarantee the MBS. If they owned the securities, they could borrow 40$ for each dollar of capital. Combined, they owned or guaranteed 5.3$ Trillion USD of mortgage related assets at the end of 2007 with only 70$ Billion USD in capital! This is a leverage ratio of 75:1! Talk about risk! The Basel accord is also to blame for this! The leverage ratio of the five major investment banks in 2007 were as high as 40 to 1, and you have the government leveraging at 75 to1. Ridiculous! So now you get why these guys didn't work out! A private business with a goal to maximize shareholder equity with the backing of the government, I don't think Johnson thought this one out too well back in the 60's!

Update with the birds at the FED: SocGen

Below is a summary of recent Fedspeak:

Bernanke – QE2 will be completed, but very little chance of QE3 as the trade-offs are unfavorable. Inflation expectations are still in comfort zone, but continue to watch very closely.

Pianalto – Labor market remains a long way from healthy. Looking at just above 3% GDP growth over next few years. Will take about 5 to 6 years for unemployment rate to reach NAIRU (5.5 to 6%).

Kocherlakota – Fed should raise the Fed funds rate by 50bps in 2011. Rate hikes hinge on his forecast for core inflation averaging 1.5% for rest of year. Rate hikes should be first move in exit strategy. Extended language means 2 to 4 meetings.

Lockhart – Extended period change hinges on Unemployment. Job progress slow and inflation transitory. QE3 probably unnecessary. Inflation will move to about 2% in two years.

Lacker – Inflation expectations at the upper end of the Fed’s comfort zone. Recent surge in commodity prices likely temporary. After QE2 focus shifts to timing and speed of stimulus withdrawal.

Bullard – Fed may put policy on hold to ensure economic recovery is gaining ground. Does not give judgment whether he agrees with this. US can weather recent oil price shock.

Dudley – Time to act is now. Current levels of inflation and unemployment and timeframe to return to mandate unacceptable. Showed support for price level targeting.

Evans – Believes that Fed needs to buy at a large scale several times. This would support a price level target to make up for the shortfall in Inflation. Strong support for price level targeting.

And as a bonus, here is SocGen's current set of assumptions for the chronology of Fed exit steps:

1. End of QE2 The April FOMC statement confirmed that QE2 will end on schedule, after reaching the $600bn target. This will mark the official end of the Fed’s easing cycle. When? June 2011

2. Halting MBS reinvestments Bernanke noted in its April FOMC press conference that halting MBS reinvestments will most likely occur early in the exit process. Fed will probably wait a few months following the end of QE2 to assess the impact before taking this next step. When? September 2011

3. Liquidity draining operations We believe this has to be done ahead of rate hikes, or else the effective fed funds rate will trade away from the target. The Fed could use a combination of reverse repos, term deposits and possibly restore the Supplemental Financing Program  (subject to Congress increasing debt ceiling). When? November 2011

4. End of “extended” language The Fed has previously suggested that the extended language means about 6-9 months. Given the timing of our rate call, the phrase should be dropped around the turn of the year. When? December 2011

5. Rate hikes Our call is for mid-2012, with a bias toward the third quarter. When? Q3’2012

6. Asset sales We believe that outright asset sales will begin around the time of the first rate hike. Fed has indicated a goal of returning the size and composition of its securities portfolio to pre-crisis trend over 5 years. We believe they will start by selling about $10bn per month. When? Q3’2012