I spent most of the day yesterday listening to the Goldman Sachs testimony. Since I missed a few hours, I decided to revisit those parts I missed earlier today at the C-Span archives. I found it quite interesting how the Goldman Sachs traders spun their tales to deceive the Subcommittee. In particular, they often mentioned that their goal throughout 2006 and 2007 was to reduce risk. Yeah, fair enough. I’ve got to imagine with all the volatility in the market at the time, the middle and back office would have pushed pretty hard to reduce the risk.
One interesting thing I thought I’d dig into deeper is the difference between selling a long position and covering a short position. The witnesses often repeated the mantra that not only did they reduce their risk by selling their long position but they often also reduced their risk by covering their short position.
Well, yes. But not all risk is created equal, now, is it?
Between 2006 and 2008, to cover your short positions in the market basically meant you were “locking in” your profits. That’s because the mortgage backed security market was basically in freefall. By locking in your profits, you may indeed be reducing risk; risk that your counterparty (cough… Bear Stearns… cough) will not be around to pay you tomorrow. Either way, when you cover your shorts, you realize some amount of profit and reduce the company’s overall counterparty risk.
Selling your long positions between 2006 and 2008, however, was a whole different ballgame. In fact, I’d venture to guess that Goldman Sachs did very little of that because by the time they wanted to sell, there were probably no more buyers and therefore no market liquidity. They had no easy way to sell their longs since the buyer might have only been willing to pay pennies on the dollar. Instead, Goldman Sachs most probably offset these losses by taking opposite short positions. If they indeed made such spectacular profits in 2007, they must have indeed done the Big Short by several orders of magnitude more than their long positions. In any case, your aim in selling your longs is to minimize your market risk.
It’s interesting that the Goldman Sachs witnesses would combine market risk and counterparty risk and just call it risk in order to say their aim was to “minimize” risk and not go directional. Nice rhetoric guys.
