Does It Matter if Goldman Made Money Shorting Mortgages?

The firm is taking measures to show that it merely hedged the market, but that might not satisfy authorities

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Goldman Sach's public relations staff probably didn't have a very relaxing weekend. Late last week, we learned that the Manhattan district attorney and New York State had issued the firm a subpoena. Speculation immediately began mounting that the authorities were seeking information in response to a recent Senate report that alleges the bank acted improperly as the housing bubble began to burst. Reports today indicate that Goldman intends to mount a preemptive strike against a potential criminal case. Will it be enough to prevent a criminal investigation?

At the heart of a potential government case stands the assertion that Goldman Sachs engaged in a strategy to short the mortgage market in late 2006 and 2007. As a result, a court might decide that its failure to disclose this strategy to investors to whom it sold mortgage exposure constitutes a failure to provide all material information. But if the bank didn't, in fact, have a net short on the mortgage market but merely a hedge, then it thinks it should be able to escape unscathed.

Liz Rappaport from the Wall Street Journal reports:

Executives at Goldman haven't denied to lawmakers or in other public comments that the firm's overall bias was to be negative on the subprime-mortgage market, meaning the company would benefit as housing prices fell and borrowers stopped making payments on their loans.

But during the past few months, Goldman churned through its computers all the mortgage trades made by the company in 2007, ranging from high-quality bonds backed by mortgage loans to mortgage bonds created with derivatives and packaged into synthetic collateralized debt obligations, said people familiar with the matter. That process helped convince Goldman executives to become more aggressive in trying to fend off some of the Senate subcommittee's findings.

This raises an important question: what sort of strategies must a broker-dealer like Goldman Sachs reveal to investors to whom it sell securities?

A Hedge vs. A Short

For starters, there's a fine line between a hedge and a short. The difference is one of magnitude, not direction. Let's think about the mortgage market example. In both cases you are trying to buy securities from which you will profit if the mortgage market deteriorates. If the mortgage market falls apart and you have a net loss, but a smaller loss than you would have otherwise been forced to endure, then you merely had a hedge. If the mortgage market collapses and you have a net gain, then you had a net short.

So in either scenario, you would seek the same sorts of trades. The only difference is that you will attempt to engage in relatively more or larger trades if you hope to end up with a net short than you would with a mere hedge. In other words, the intent is the same -- you are trying to derive a benefit if mortgages decline in value. So if the intent is the same shouldn't either strategy be disclosed?

It would probably depend on whether or not this strategy is part of normal hedging activity or whether it is uniquely developed to address an abnormal expectation about the market. For example, if it's common for Goldman to hedge its bets in proportion to what it did with mortgages, then it didn't need to disclose anything more. But if a special strategy was created to acquire a position in opposition to the mortgage securities it sold, then you might be able to argue that if a net shorting strategy needed to be disclosed, so should an aggressive hedging strategy.

The Strategy's Limitations

Intent here might also matter more than the actual results. For example, perhaps Goldman would have liked very much to have held a net short position against mortgages, but it couldn't find enough investors willing to go long on the mortgage market to make that happen at the time the strategy was underway. Perhaps, then, the firm's shorting strategy only resulted in a mere hedge.

If that's the case, then it would seem that the hedge, again, was just as potentially material to investors as a net short would have been. What matters is the strategy that the firm was engaged in, not the actual results. It may have failed to accomplish what it set out to do, but investors would have been adversely affected either way.

What if the Short Hadn't Worked?

Finally, what if the short hadn't worked? What if the market hadn't collapsed and Goldman's hedging/shorting efforts led to pure losses, instead of huge gains? If that had been the case, then there's little question that we wouldn't be talking about Goldman's strategy right now. Instead, we'd all be enjoying 5% unemployment and reading about what President McCain has planned to commemorate D-day.

Of course, that's not the world we live in, and this episode has raised a question that needs to be answered. If it is material when a firm's strategy conflicts with the securities it sells, then that strategy should be disclosed -- whether it succeeds or fails. But is it material? This needs to be determined, either by regulators or by a court.

Image Credit: REUTERS/Brendan McDermid