Goldman Sachs Was Wrong & 2 Million Families May Lose Their Homes

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What’s going wrong in the financial sector is not so unusual after all.

One of the funniest moments in the great credit crunch of 2007 came in the summer.

“We are seeing things that were 25-standard deviation events, several days in a row,” said David Viniar, CFO of the smartest financial firm in the world, Goldman Sachs (NYSE: GS).

That Viniar. What a comic.

According to the Goldman Sachs mathematical models… August, Year of Our Lord 2007, was a very special month. Things were happening then that were only supposed to happen about once in every 100,000 years.

Either that… or the Goldman Sachs models were wrong…

We recall looking out our window. Outside, we saw a summer day much like any other. And inside, what we saw in the news was also rather typical – a credit crunch. No, credit crunches don’t come along every day… but nor do 100,000 years separate one from another. In the United States, recently, we have had the crash of the dotcoms, the crash of Long Term Capital in ’98 and the crash of ’87; outside of the United States, there have been a number of credit crunches, in Japan, Russia, Mexico and various Asian countries.

When you make loans to people who can’t pay the money back, trouble is only a couple standard deviations away. So far, during the first eight months of 2007, some 1.7 million houses have been caught up in foreclosure proceedings in the United States. That is just the beginning. According to Congressional estimates, up to 2 million families are expected to lose their homes over the next two years.

The individual amounts of money weren’t very large, not by Wall Street standards. But when the money didn’t show up, it had an alarming effect. Last week’s press brought estimates of total losses of over $13 billion at Citigroup (NYSE: C). Morgan Stanley is said to be facing $8 billion in losses. Merrill Lynch (NYSE: MER)set records with estimated losses of $18 billion. The cat still has Goldman Sachs’ tongue. But when the losses are toted up, they will probably be spectacular. Altogether, there is more than $1 trillion in subprime debt outstanding; much of it will go bad.

Already heads have begun to roll. First, Warren Spector of Bear Stearns got axed. Then, it was Peter Wuffli at UBS. He was followed by Stan O’Neal of Merrill Lynch. O’Neal made the headlines when he was pushed out of the corporate jet with a ‘golden parachute’ valued at $160 million. After O’Neal hit the ground, along came Chuck Prince of Citigroup – America’s largest bank. The firm is expected to write down $5 billion this quarter alone. Chuck was chucked out.

What went wrong with the Goldman Sachs models? The business model seemed so pure and simple. You simply bought up subprime loans from the knaves who made them… then, you cut them up, slicing and dicing them into a kind of mortgage spam. You got the rating agencies to bless them… and then you sold them off to naïve investors. The idea was to earn huge fees upfront… while laying the risk onto the fools who bought the stuff.

When the going was good, it looked as though no business could be better. You were providing a valuable public service, helping people buy houses by redistributing the risk from the people who incurred it to people who had no idea it was there. And in the process, you earned such large fees you would get your picture in the paper, build a huge mansion in Greenwich and acquire some abominable paintings to put on the walls.

But wrong it did go. The Financial Times provides more detail on what happened at Citigroup:

“The bank reported that, at the end of September, it had around $2.7bn of unsold collateralized debt obligations – pools of debt securities that are repackaged and distributed to other investors.

“But it also had $4.2bn of subprime loans it had bought in the past six months, and about $4.8bn of loans to customers which were secured by subprime collateral. In addition, the bank had $43bn of exposure to the most highly rated tranches of CDOs based on subprime mortgage assets.”

It turns out Citi was fool and knave at the same time. It sold dubious subprime debt to its customers. But it bought it too… and took it as collateral.

Gary Crittenden, Citi’s chief financial officer, claimed Monday that the firm was simply a victim of unforeseen events. The losses were, “driven by some events that have happened during the month of October,” he said, referring to downgrades by rating agencies. No mention was made of the previous five years, when Citi was busily consolidating mortgage debt from people who weren’t going to repay… pronouncing it ‘investment grade’… mongering it to its clients… and stuffing it into its own portfolio… while paying itself billions in fees and bonuses. No, according to the masters of the universe, downgrades by Moody’s and Fitch’s were completely unexpected… like the eruption of Vesuvius; even the gods were caught off guard. Apparently, as of September 30th, Citigroup’s subprime portfolio was worth every penny of the $55 billion Citi’s models said it was worth. Then, whoa, in came one of those 25- sigma events. Citi was whacked by a once-in-a-blue moon fat tail.

Who could have seen that coming?

Bill Bonner
The Daily Reckoning Australia

Bill Bonner

Bill Bonner

Best-selling investment author Bill Bonner is the founder and president of Agora Publishing, one of the world's most successful consumer newsletter companies. Owner of both Fleet Street Publications and MoneyWeek magazine in the UK, he is also author of the free daily e-mail The Daily Reckoning.
Bill Bonner

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Comments

  1. Bill Bonner, whadda kidder. ;-) Who could have seen it coming indeed?

    The miracle is that these financial wizards needed models at all, AND the the models couldn’t demonstrate, that lending money only works out if the debtor CAN PAY YOU BACK. I think an event of default happens every day of every year, and not every 100,000 years at all – when one lends money to deadbeats.

    These bankster-corporates are even less “victims” than the idiots who signed up for loans too large to pay back in the first place…and are now about to “lose” houses they never owned anyway.

    These financial giants signed the papers too. Nobody put guns to their heads either. Now they too have to abide by the penalties they agreed to in every one of these broken contracts.

    If there are any victims here, it would be those taxpayers who DIDN’T sign suicide loans but will be affected by the resulting contraction. Including those who saved their rapidly-devalued dollars. And the soon-to-be unemployed.

    Taxpayers of all countries affected should keep a sharp eye on any proposed legislation, the effect of which might transfer losses away from those who so richly deserve them.

    Reply
  2. There seem to be 5 layers of culprits in this mass theft. First, and foremost, the big 3 bond ratings agencies in the US: Fitch, S&P and Moodys. These companies took the money, and told the world that they were all getting AAA paper in these CDO’s. They knew the models were based on the absurd assumption that U.S. real estate would increase in value indefinitely, i.e. there would never be a significant event. They also were based on the even more absurd assumption that defaults would never increase more than a few tenths of a percent. And the final absurdity: that all loans were properly qualified.

    The second group of criminals, that will never see life behind bars, built ridiculously complex derivatives, i.e. CDO’s, and the flawed pricing models. They worked hand in hand with the ratings agencies to perpetrate the crime.

    Third, the mortgage originators, the mortgage brokers, who had no stake in the mortgages they sold, since most states in the USA have stricter laws for massage therapists and barbers than for mortgage brokers. Millions of “liars loans” were sold that never should have been. The bulk were adjustable rate loans that would reset in 2-3 years. Many of these brokers showed their clients a graph of the current real estate price boom, and argued that the buyers of these loans could sell out, make a big profit, before the loans reset to higher rates (since, of course, real estate prices will never fall, or even flatten out!). In California, for example, if the loan survived 90 days (90 days!!), the mortgage broker got his money, and was out of the picture.

    The fourth group were the stupid consumers that looked they other way when the loan verification process was bypassed, believed the arguments that “you can just sell out for a nice profit” before the reset takes place. An appreciable percentage were probably well in the know about what would happen when the loans reset, but, what the hell, its great to live in a million dollar house, even if it doesn’t last!

    The last group, most people, even very educated and experienced folks, don’t pickup on. The folks that thought it was just fine to: deregulate banking laws, for example repealing Glass-Steagall, which allowed companies like Bear and Merryl to be on too many sides of the mortgage process, and write these hideous derivatives in the first place; and also pass even more laws protecting secrecy of what the central banks do. Where the hell did all of this dirty credit come from? So, Mr Greenspan wasn’t so brilliant afterall. His tenure was behind many of the changes in law, and absurd increase in the money supply that allowed these events to happen in the first place. Doesn’t the world believe that borrowers should be properly researched and their ability to pay sufficiently verified? Its quite naive to think that the central banks were blind to the whole thing from the beginning.

    That the big 3 bond rating agencies put their “It’s all AAA” stamp on these awful CDO’s has caused bond insurers to become the latest set of casualties, which will spill over to even fewer safe places to invest in the future, when Muni’s may be issued with no insurance.

    Shame on you Mr Greenspan. You knew a hell of a lot more than you’ll ever be blamed for. Shame on you,CEO’s of Fitch, S&P and Moody’s. You all are suitable for reinstatement of public stonings.

    Mike London
    February 3, 2008
    Reply

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