Why Paulson Didn't Understand Mortgage Securities
This morning, Derek Thompson posted a piece about Newsweek's article where Hank Paulson admits he did not really understand the mortgage-backed securities ("MBS") market. He finds this suspicious and bewildering. I imagine he is not alone. But having worked as an investment banker specializing in asset-backed securities origination, I am completely unsurprised.
I don't know if Paulson is fibbing, or if mortgage-securities were such a specialized and esoteric money machine that basically nobody understood what was going on, but either way, this seems devastating.
MBS is not nearly as esoteric as most people believe. The main reason that people don't know what so many of those securities are worth is based on the fact that they don't know how bad the housing market will turn out to be. If you have a relatively predictable housing market, then you can perform relatively accurate MBS valuations.
Instead, I would argue that most bankers who were not involved in MBS did not really care about it. A nice analogy might be comparing a bank to the human body. MBS is kind of like your pancreas. You know it's there; you're glad it's there; and yet, you probably don't know (and don't really care) how it works. That is, of course, until it stops working. Then you have a problem.
Securitization (the mechanism through which you create things like MBS) is a highly specialized part of an investment bank. Not just anyone can do it. It involves much deeper financial modeling than what most bankers do, along with intense knowledge of the debt markets to conclude accurate assumptions. Obviously, those assumptions turned out to be an epic failure.
But as a result, I find it almost obvious that Paulson knew very little about MBS -- unless you have ever worked to structure such securities, chances are you have only a vague notion of how they work. Sadly, this is probably also the case for many of the traders who purchased them, as they relied too heavily on rating agencies to provide accurate ratings for the MBS, rather than do their own due diligence.
Finally, it should be noted that Goldman was never one of the larger players in mortgage-backed securities. That (now) dubious distinction went to banks like Citigroup and Bear Sterns. That's one of the reasons why Goldman is still doing relatively well compared to other banks.
If you attempt to dissect Goldman's financials for 2005 -- the height of the boom -- then this is pretty clear. In Goldman's 2005 Annual Report (page 38), you find the following for their investment banking revenues, in millions:
MBS would be a part of Debt Underwriting. But so would unsecured corporate, municipal and all kinds of other debt. For more insight, on page 78, one learns that Goldman's entire securitization volume was $92 billion. For every billion securitized, the investment bankers usually earn somewhere in the ballpark of $1.5 to $2.5 million, to split between several banks. That means it's unlikely that Goldman earned much more than $100 million in securitization revenues, which amounts to a measly 5% of all investment banking revenues.
The investment banking team was highly focused on financial advisory and equity underwriting. This characteristic of Goldman Sachs is well known in the investment banking community.
But then there's trading. Goldman's profit in 2005 from investment banking fees was actually dwarfed by its profit in trading. It's pretty hard to know how much of its profits came from trading MBS. But, as mentioned, traders understand less about the intricacies of these securities than the bankers do. They're just buying and selling, mostly based on market forces.
Given Goldman was never too focused on securitization compared to its other businesses, I think it seems even more likely that Paulson knew (or even cared) little about it.
Then there's the question of whether or not he should have. Feel free to weigh in on that one, but I would argue that it's pretty impossible for the CEO of a place as complex as an investment bank to have a deep understanding of everything the bank does. They structure dozens of kinds of securities though dozens of businesses units. It just seems like too tall an order for any person, even someone of Paulson's stature.