Wednesday, April 21, 2010

Paulson and Goldman

Brad DeLong has a great post (by an anonymous commentator) about why Goldman might really be innocent.

Consider the view from Goldman Sachs. Paulson shows up, says he thinks the subprime market is going to crash and is going to crash hard and is going to crash soon and wants to start laying big bets to that effect. GS goes out, runs the numbers, tests the market, and decides that yes, they can create a great deal of AAA securities plus an equity tranche out of the long side.

The AAA securities will really be AAA securities: minimal risk. Thus they can be sold off at a healthy price to those who want AAA securities. This will burnish the reputation of the firm--look! we made some more AAA securities for you!--in a market that really likes AAA securities and is short of them. And the buyers will be happy because they will get Treasury+5 or Treasury+10 basis points on their cash without risk.

The equity tranche--well, there is a healthy carry trade associated with it in the short run. The short-term earnings from that carry trade will mount up over time, and will more than offset the losses even if the subprime market crashes. Only if the market crashes and not only crashes but crashes hard and crashes soon and moreover crashes freakishly hard and freakishly soon will the equity tranche be a loser.

The overwhelming probability, GS thought, is that Paulson will be the loser--but because his expectations are irrational he's willing to take the short side. So the important thing is to keep this big fish who promises to give us lots of money on the hook. Let him pick the underlying securities--it really doesn't matter, and it gives him the illusion of an edge. Don't bother telling Paulson's role to IBX and company--it really doesn't matter, and it might spook them off and then we might lose the real pigeon while we hunt for more counterparties to take the long side.

Clearly at the time most thought Paulson was out of his elements. This is quite clear in Zuckerman's The Greatest Trade Ever. Maybe Goldman thought that Paulson was the sucker. Somebody has to be wrong in these bets.