All the Devils Are Here [175]
Other firms besides Goldman were also trying to dump their exposure onto buyers who hadn’t figured out that the ratings had become degraded. Other firms also sold synthetic CDOs while keeping a short position. But Goldman was unquestionably better at it than its competitors. What Goldman Sachs really did in 2007 was protect its own bottom line, at the expense of clients it deemed disposable, in a conflict-ridden business that maybe—just maybe—the old Goldman Sachs would have been wise enough to stay away from.
In all the subsequent frenzy over who did what to whom in the synthetic CDO market, a series of deeper, more troubling questions tended to get overlooked. One was this: What, exactly, was the point of a synthetic CDO? It didn’t fund a home. It didn’t make the mortgage market any better. It was a zero-sum game in which the dice were mortgages.
“Wall Street is friction,” said Mark Adelson, the former Moody’s analyst. “Every cent an investment bank earns is capital that doesn’t go to a business. With an initial public offering, you get it. But with derivatives, you can’t tie it back. You could argue that at least it’s not hurting things, and that was a compelling rationale for a long time.” He concluded, “We may have encouraged financial institutions to grow in ways that do not directly facilitate or enhance the reason for having a financial system in the first place.”
If only that were the worst of it. But it wasn’t. The invention of synthetics may well have both magnified the bubble and prolonged it. Take the former first. Synthetic CDOs made it possible to bet on the same bad mortgages five, ten, twenty times. Underwriters, wanting to please their short-selling clients, referenced a handful of tranches they favored over and over again. Merrill’s risk manager, John Breit, would later estimate that some tranches of mortgage-backed securities were referenced seventy-five times. Thus could a $15 million tranche do $1 billion of damage. In a case uncovered by the Wall Street Journal, a $38 million subprime mortgage bond created in June 2006 ended up in more than thirty debt pools and ultimately caused roughly $280 million in losses.
As for prolonging the bubble, synthetics likely did it in two ways. Firms were much more willing to buy and bundle subprime securities from some of the worst originators knowing they could use a synthetic CDO to hedge any exposure they might be stuck with. Would Goldman have sold over $1 billion of Fremont mortgages to investors in early 2007 if it hadn’t been able to enter into credit default swaps to hedge some of its own resulting exposure to Fremont? Without the means to off-load these exposures, investment firms would likely have been more cautious—and shut off the spigot sooner.
Secondly, selling the equity in the CDO, the riskiest piece, required finding buyers willing to take that risk. There weren’t that many to begin with, and once they had enough equity risk on their books and stopped buying, the market for mortgages would have naturally wound down.
But around 2005, some smart hedge funds began to realize that there was a compelling trade to be made by buying the equity in a CDO while shorting the triple-As. If the mortgages performed, the return offered by the equity pieces, which could be upwards of 20 percent, more than covered the cost of the short. And if the mortgages didn’t perform? Then the short position would make a fortune. It was a classic correlation trade. It was also practically