Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Levin-Coburn Report and Goldman Risk Management

The Levin-Coburn report (prepared by the staff of the US Senate Permanent Subcommittee on Investigations) came out while I was on vacation and I finished reading it (nearly 650 pages) only now. In the meantime, the findings of the report have been discussed and analyzed extensively in the press and in the blogs. I will therefore focus on what the report tells us about risk management in a large well run investment bank.

Even as the crisis unfolded, we knew that Goldman was among the few firms that sold and hedged their mortgage portfolio and limited their losses. The Levin-Coburn report gives us a ringside view of how this process actually works. Of course, it is ugly, but it is also fascinating. Three examples stand out:

  • Even before one starts selling off problematic assets or hedging them, the first step would obviously be to shut down the purchase of more such assets. In reality, this is very difficult to do. When Goldman is half way through putting together a pool of assets to be put into a CDO, it has two choices – (a) it can abort the process and try and sell the underlying mortgages or securities, or (b) it can complete the pool and sell the CDO (securities). Which works better for Goldman depends on how quickly the situation is expected to deteriorate as well as the comparative liquidity and depth of the two markets. The report (pages 535-36) describes a decision taken late night on a Saturday to choose alternative (a) for the Anderson CDO, but this is reversed and alternative (b) is finally chosen. There is also an interesting discussion about the mark to market/model accounting under the two alternatives.
  • A tail risk hedge has very little VaR (value at risk) until the tail risk materializes; at this point when it becomes profitable, it also becomes highly risky. For example, the report (page 419-24) describes Goldman’s $9 billion short position in AAA rated tranche of an ABX index. When the short was put on, the index was trading close to par and the volatility was negligible. The tail risk if the index were to rise even further was also small – $80 million if the tranche traded at zero spread to Treasuries. The VaR was so small that nobody bothered too much about it even while monitoring the VaR of the mortgage portfolio very closely. But in mid 2007 as the index started falling, the highly profitable short position also became increasingly risky and began contributing a large VaR. Goldman had to unwind this profitable trade to bring down the VaR. This illustrates the power of the mark to market framework – since past profits are already embedded in the carrying value of the assets, any reversal in market direction shows up as a loss for the day and not as a reduction of past profits.
  • When you analyze a portfolio of short and long positions in closely related assets some of which (say on the long side) are highly illiquid while some others (say on the short side) are reasonably liquid, it is awfully difficult to measure the risk of the position. It is even more difficult to decide the optimal amount of the short position (hedge). Reading the report, one finds that Goldman did a tolerable job of this in a very turbulent environment only by cutting across organizational boundaries (vertically and horizontally) and involving top management in what would under normal conditions be regarded as operational decisions.

In short, implementing a risk mitigation strategy was extremely hard even though (a) Goldman had the right view on the market, and (b) it was willing to place its self interest far above that of its “customers” in executing its desired trades.

Finally, anybody who thinks that investment banks like Goldman would give them a fair deal should read the gory details of how Goldman dumped toxic securities (Hudson, Anderson and Timberwolf) on investors around the world to protect/further its own interests. There have been many press reports about these shady deals, but the wealth of detail in the report (page 517-560) is much more than what I have seen elsewhere. The Abacus deal which led to the record $550 million settlement with the SEC appears much less sinister in comparison.

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