Friday, January 29, 2010

Humiliatingly Ceremonial

In general, I'm not a fan of Goldman-bashing. But this, from Michael Lewis, is too funny:
That’s perhaps the most curious trait of these ordinary Americans: you don’t need to give them any money to lead them to hope that you might. Take Larry Summers, for instance. We both know that we would never actually employ even this surprisingly intelligent Mort in anything but the most humiliatingly ceremonial role. But he doesn’t know that -- and thus he has done so much for us.
It's funny because it's true.

Tuesday, January 26, 2010

A Plea to Journalists

Please don't get sucked into the NY Fed/AIG circus tomorrow. There is nothing there. The people who are hyping this as some sort of outrage(!) are charlatans, and they're hyping this purely for their own benefit. Either that, or they simply have no idea what they're talking about. Look, these are complicated issues of securities law, with many competing interests. Anyone who tries to tell you that this as a simplistic story about good vs. evil is trying to manipulate you. Please resist the urge to regurgitate these simplistic narratives.

Oh yeah, and please stop quoting Chris Whalen as some sort of expert on finance. The guy is a freaking lunatic.

Thank you.

In addition to being a jaw-droppingly superficial idea overall, here’s another reason why breaking up the banks and capping their size would be a titanic mistake. Everyone seems to agree that normal, non-TBTF banks can be resolved without causing a meltdown in financial markets. This is, in fact, the justification given for capping bank size — it would make all banks “small enough” to be resolved smoothly, which means that no single bank failure would pose systemic risks. Mission accomplished! Of course, this argument quickly breaks down when you think for more than 15 minutes about how the FDIC resolves failed banks.

The FDIC resolves the vast majority of failed banks through what’s known as “purchase and assumption” agreements, or P&As. P&As are transactions in which a healthy bank purchases some or all of the assets of a failed bank and assumes some or all of the liabilities, including all insured deposits. P&As are much less disruptive to both communities and financial markets than straight deposit-payoffs by the FDIC. The FDIC has used P&As to resolve 163 of the 187 failed banks since the beginning of 2008. The JPMorgan/Bear Stearns deal was also a form of P&A (which was entirely intentional), with the Fed playing the role of the FDIC.

Now imagine that we cap bank size at, say, $100bn in assets. What happens if a bank with $99bn in assets fails? The way the FDIC resolves failed banks smoothly is through P&As, but the only banks big enough to buy the $99bn failed bank would surely be over the $100bn cap if they agreed to the purchase. So the choice is effectively between (1) a disorderly liquidation by the FDIC, which would pose exactly the kind of systemic risks that proponents of capping bank size are trying to avoid; or (2) granting an acquiring bank (or banks) a waiver from the $100bn cap and proceeding with a P&A. (The FDIC could technically use a conservatorship, but these are extremely rare, and no regulator has the capacity to manage a $99bn conservatorship.)

But think about how potential acquiring banks would respond if the FDIC approached them and offered them a waiver on the $100bn cap in exchange for agreeing to a P&A. They would think:

“Well, the government begged JPMorgan to buy Bear and begged BofA to buy Merrill, but then the government turned around and forced JPM and BofA to break themselves up a few years later! So thanks but no thanks, Sheila, we’re not interested in buying a bank that you’re just going to force us to divest in a couple years.”
So with a cap on bank size, P&As would likely be off-the-table for the largest bank failures. But if the FDIC can’t use P&As, then it can’t ensure that the largest banks will be resolved smoothly—and thus pose no systemic risks—even with a cap on bank size in place! And if the FDIC can’t ensure that the failure of the largest banks won’t pose systemic risks, then what was the point of the cap on bank size in the first place?

See how easy it is to knock down this silly “break up the banks” idea?

Monday, January 25, 2010


Remember when the New York Times was casually referring to Paul Volcker as a "foot-dragger on bank deregulation"?

My how times have changed.

Sunday, January 24, 2010

The Devil is in the Exemptions

We've been discussing financial regulatory reform for well over a year now, and unfortunately, the discussion is still taking place at a very high level of abstraction. Of course, the real battles in financial regulation aren't fought at the theoretical level, nor are they fought at the statutory level. The real battles are fought in comment letters on proposed and interim regulations, in SEC no-action letters, and in various (carefully selected) requests for exemptions. It's not enough to say, "We should limit Wall Street's risk-taking if they're going to have access to the federal safety net." At some point, people have to start getting specific about the wording of regulations they'd like to see, or about how specific existing regulations need to be changed.

Here, I'll kick it off. Here are two specific regulatory changes I'd like to see. They both involve Reg W, so you just know they're exciting. I don't have a lot of time to explain the background (which some of you don't need anyway), but this should give enterprising young financial reformers and legislative aides more than enough information to get them started. So without further ado:

1. Jesus H. Christ, can we please get someone to revise the derivatives exemption in Reg W so that derivatives are subject to the Section 23A limits? (And by "someone," I mean "the Fed.") The Section 23B limits — which generally require transactions between banks and their non-bank affiliates to be conducted on market terms — are clearly not enough. We need to swing the big bats when it comes to derivatives transactions between FDIC-insured banks and their non-bank affiliates, and that means the hard quantitative caps of Section 23A. If memory serves, the reason the Fed gave for exempting derivatives (other than credit derivatives, which weren't exempted) from Section 23A was that there wasn't enough evidence yet on the risks posed by derivatives transactions between banks and their non-bank affiliates. Still waiting for that evidence, are we?

2. Get rid of Reg W's "ready market exemption," and go back to the old "Wall Street Journal test." Yes, I know some people thought the Fed didn't go far enough with the ready market exemption, but they were wrong then and they're wrong now. Pretty much every security has an electronic service that provides real-time data on price anymore, and the SEC is way too liberal with its definition of a "ready market." The ready market exemption basically allowed some banks (I won't name any names) to use their insured deposits to, shall we say, "support" some pretty crappy paper, like ABS and ABCP. And it wouldn't take much for comparable securities to get back into that exemption. Let's just go back to the old "Wall Street Journal test." It was conservative and reasonably clear, which is exactly what we're looking for in regulations governing large, complex financial institutions.

This isn't the stuff op-eds are made of, but this is where all the action is. You can talk about moral hazard until you're blue in the face — and then Wall Street will take your lunch money anyway, and they'll do it in a comment letter on some proposed interim rules you weren't even aware of.

This new meme among journalists is truly baffling:

One widely used strategy by the financial industry has been to deploy representatives of smaller high-street banks to make the case to lawmakers. Organisations such as the Independent Community Bankers of America tend to get a sympathetic hearing because they can point to members in towns and cities in almost every Congressional district, rather than purely in lower Manhattan.
Saying that Wall Street "deployed" community banks to do their bidding on Capitol Hill is beyond absurd. Community banks detest Wall Street. They'd sooner set their own branches on fire than lobby on the Street's behalf. Seriously, this is the equivalent of saying that Walmart deployed the AFL-CIO to do its bidding on the Hill.

A lot of people, especially journalists, seem to have a very romantic view of community bankers — as if they're all modern-day George Baileys or something. So when community banks come out strongly against something journalists like a great deal, like the Consumer Financial Protection Agency, it's like it doesn't compute. How could community banks be against something as obviously noble as the CFPA? (For the record, I'm for the CFPA.) So the answer they come to (entirely in their head, of course) is that Wall Street must be behind it somehow. Wall Street — which, as every good journalist knows, is pure concentrated evil — must be using community banks as a front. Of course!

Is Wall Street opposed to the CFPA? Meh. They're not enthusiastic by any means, but it's way down on their list of priorities. The CFPA will mean a lot more regulatory compliance, but banks like BofA and Chase can handle regulatory compliance issues relatively easily. The Street will happily trade their support for the CFPA for one of their bigger issues, I guarantee you.

In reality, community banks are violently opposed to the CFPA, because they'll probably have to hire a couple additional people, at least, to handle the increased regulatory compliance work. (Stimulus!) For community banks, that's a very big cost. And the truth of the matter is that community banks have far more sway on Capitol Hill than the Street. Think about it — community banks are in every Congressman's district, and they tend to have a lot of influence at the district level. They're the ones who killed the mortgage cramdown legislation, even after big banks like Citi had acquiesced. Just remember, all politics is local.

Friday, January 22, 2010


Is it supposed to be news that Geithner talked to Goldman and JPMorgan on the day of the AIG bailout? First of all, we already knew that. Second of all, of course he did. Geithner had asked Goldman and JPMorgan to try to raise private capital for AIG, or, alternatively, to set up a $75bn syndicated lending facility for AIG. When they reported back to Geithner and told him neither could be done, Geithner decided the Fed had to step in. It would've been very strange if he'd asked Goldman and JPMorgan to try to raise private capital for AIG and then not talked to them before committing taxpayer resources.

Not surprisingly, one of the reporters on this story is Bloomberg's Chief Hyperbolist, Hugh Son. Someone really needs to stick an editor on that guy. It's getting embarrassing to watch.

Sen. Shelby on Bernanke:

"I asked Chairman Bernanke how much time his board of governors spent on regulatory affairs: Was it 1 percent, 2 percent, 10 percent? And he never gave us even an answer. It was 1 percent. So I’m not going to support the Fed chairman."
OK, I'll bite. If he never gave you an answer, how do you know it was 1 percent?

  • The single best thing we could do for financial reform: Triple the budgets of all financial regulatory agencies. Immediately. Regulators are woefully understaffed; this is fact.
  • Obama has proposed banning banks' prop trading desks and internal hedge funds. I'm fine with that, as long as it's done properly. From a P&L perspective, this is obviously bad for the Street. From a public policy perspective though, there's really no compelling reason why the banks need to have prop trading desks or internal hedge funds.

    But you can't simply prohibit banks from buying and selling securities for their own account, because that's precisely what market-makers do. Market-makers have to stand ready and willing to buy or sell securities for their own account, at firm bid and offer prices. If an investor is looking to sell a security, the market-maker will buy the security using its own capital, and hold it in inventory until an investor who's looking to buy the security surfaces. This is different from having a prop trading desk, which has no market-making obligations, and essentially acts as a hedge fund (except it has the not-insubstantial advantage of being inside the prime broker).

    Some people will claim that it's impossible to distinguish between market-making trades and propietary trades, but that argument is completely baseless. The banks themselves already distinguish between their market-making trades and their proprietary trades, as there's a whole different set of rules for proprietary versus market-making trades. So don't be fooled by that argument.

    In any event, I don't even know why I took the time to write about this, because there's zero chance the proposals Obama announced today will ever be law. This was a fairly transparent political stunt — the White House needed to do something to take the media's focus off of health care 24/7, so they flew in Volcker and announced some proposals that sound good to the media. The two Senate staffers I talk to regularly both said their offices were basically ignoring Obama's proposals, because even if the White House fights for them (which they won't), Chris Dodd has no intention of inserting them into his committee's bill. I like how some people think Obama's proposals represent a fundamental turning point on financial reform, because....well, clearly this is their first rodeo. (Hence the uber-quixotic language they use to describe financial reform.)

    [Update: Just to clarify, when I said Obama's announcement was a "fairly transparent political stunt," I wasn't criticizing the Obama administration. We live in a political world, and political stunts are often useful. If I were Rahm Emanuel, I'd be a dick have done the same thing. I think it was probably a savvy move, and if health care reform ends up passing, then it was worth it.]
  • This, from John Taylor, is just sad:

    "[N]ot one counterparty, derivative counterparty to Lehman, filed for bankruptcy after the Lehman case. The major creditors who did not fail. So it's hard to find a direct knock on effects from that in the data."
    What?! First of all, Lehman's biggest derivatives counterparties — the other dealers — were virtually all bailed out by their governments. Second of all, there were lots of hedge funds that failed because of their open derivatives positions with Lehman, and especially with Lehman Brothers International (Europe). The fact that John Taylor didn't know about these hedge fund liquidations at the time doesn't mean they never occurred. They occurred. Oh believe me, they occurred.

Tuesday, January 19, 2010

OTC Derivatives Reform, Part 1

A few weeks ago, Mike Konczal wrote a couple of posts about OTC derivatives reform that I want to address. One was called, "An Argument for Exchanges and Swap Execution Facilities." If you haven't read Mike's post, then you should probably go read it first.

First of all, Mike claims:

I’m not saying everything needs to be forced onto an exchange proper. There are plenty of great innovations going on in the swap execution facility (SEF) world.
That's a change from the position he had taken quite publicly eight days before, when he proclaimed that a key goal of financial reform was "to get as many derivatives as possible to trade on exchanges," and told a scare story about how lobbyists (unnamed, of course) had "snuck another loophole into the OTC Derivatives bill." Mike based his story on a change in the definition of a "swap execution facility" in the final version of the House financial reform bill, which Mike claims "could, quite simply, be a telephone over which two people trade a derivative."

This is almost certainly untrue. First of all, all SEFs will have to be registered with the CFTC, which will undoubtedly prescribe conservative capital, risk management, and other requirements for SEFs, simply as a gatekeeping matter. You can't just go to the CFTC and say, "Hey, I technically meet the statutory definition of a SEF — now let me make a market in swaps!" That's not how it works. A registered SEF will have to comply not only with all CFTC regulations, but also with the 14 "core principles for swap execution facilities" detailed in the House bill. These include requirements for "timely publication of trading information" on "price, trading volume, and other trading data on swaps," as well as a requirement that the SEF maintain "complete audit trail[s]" for at least 5 years. The core principles also require the CFTC to "adopt data collection and reporting requirements for [SEFs] that are comparable to corresponding requirements for" exchanges. And the core principles are just a minimum — the CFTC can (and probably will) adopt regulations that go beyond the core principles.

So let's put an end to this meme: Under the House bill, the definition of a "swap execution facility" would not allow for a continuation of traditional unregulated OTC derivatives trading. Anyone who says otherwise doesn't know what he's talking about.

In any event, it appears that Mike is now all for SEFs, just so long as they look and act just like exchanges. Innovation! What he really wants — and what he seems to think is a magic cure-all with no negative consequences whatsoever — is pre-trade price transparency:
I want to see pre-trade price transparency. I want a facility where multiple parties can see and execute on offers from other parties. A facility that collects the prices at which multiple parties would be willing to trade a a moment in time, and update those prices as time passes.
Later, he talks up a virtuous cycle that he thinks would result from mandatory pre-trade price transparency:
The more actively traded the contracts become and the more transparent prices get, the narrower the spread. There are less economic rents, and markets becomes more efficient.
That's a nice theory, but things work much differently in reality. Pre-trade price transparency is more likely to reduce liquidity, not enhance it — especially in the much-thinner OTC derivatives markets. Let me give an example. Say a dealer makes a risk price to a client on a trade that requires the dealer to delta-hedge in size. As soon as that trade is shown on the exchange floor, everyone will know that the dealer needs to delta-hedge in size. Other traders will then front-run the dealer, moving the price away from him and benefiting from the price impact of a dealer putting on a large delta-hedge in thinner OTC derivatives markets. If the dealer knows that the mandatory pre-trade price transparency will raise the cost of his delta-hedge, then he'll simply charge the client a wider bid-ask spread. This is actually a pretty common situation, and if you think liquidity games like this don't go on all the time, then you're crazy. (This is all block trading desks did back when I was coming up.) Clients, of course, quickly realize that for even marginally complicated trades like these, they need a broker-dealer that can do the trade without moving the price much — which means doing the trade away from an exchange. (This is just one example; portfolio managers and traders can provide an endless list of comparable situations.) Once you realize that markets aren't complete, and that the majority of markets aren't nearly as deep as everyone likes to believe, the argument for mandatory pre-trade price transparency quickly breaks down.

More broadly, notice who the intended beneficiaries of all Mike's preferred requirements are: not average taxpayers, mind you, but the end-users who trade OTC derivatives. These end-users are predominantly large institutions — bond managers, institutional investors, hedge funds, large corporates, etc. If pre-trade price transparency would be so beneficial to them, then why haven't they already moved to exchanges? There's absolutely nothing stopping them — the exchanges have been offering OTC lookalikes for years, with little success. The problem is that no one wants their products. And it's not like there's no competition in this space. To the contrary, the competition among the different trade execution venues (ECNs, dark pools, etc.) is incredibly fierce.

Even the price competition in the traditional OTC market is fierce, despite what journalists think. For example, according to Risk's 2009 survey of corporate end-users, 65.3% of end-users listed price as the most important factor in choosing a derivatives dealer. Fully 73.5% of end-users negotiated with 2-3 derivatives dealers before agreeing on a trade, and an additional 14.3% of end-users negotiated with 4-5 dealers.

So what Mike is essentially saying to end-users is, "Trust me guys, even though you do this for a living, and I don't, and even though you've consistently rejected trade execution venues with pre-trade price transparency for years, I just know this is going to be better for you." Is that really how we want to legislate OTC derivatives? I didn't think so.

Much better OTC derivatives reform would require all standardized OTC derivatives to trade through regulated clearinghouses; would require the clearinghouses to publish timely and adequate trade information on price, volume, positions, etc.; and would give regulators unfettered access to clearinghouse data. Beyond that, why should we require that all trade execution venues conform to a particular model? To protect PIMCO and D.E. Shaw from the big bad dealer banks? Oh, please.

It's amzing to me that people are still referring to commercial banks and thrifts as "safe and boring operations," even though 140 commercial banks/thrifts failed in 2009, and the number of banks on the FDIC's "problem list" has risen to a whopping 552. Commercial banking is inherently risky — in all loans, there's a risk that the borrower won't pay you back. Just ask all the commercial banks and thrifts that lent most of their deposits out in the form of commercial real estate loans.

The financial regulatory reform debate is starting to kick into high gear, and I hope to bang out a post on financial reform this weekend. But in the meantime, here are a few general (and somewhat random) thoughts relating to financial reform:

  • My nomination for the Ten Worst Decisions in the Financial Crisis List (you know, if that list existed, which I think it should): Citi's decision to bail out its SIVs and bring over $100bn in toxic assets back onto its balance sheet. Really this was Vikram Pandit's decision — the day after he was appointed CEO, he decided to bail out the biggest Citi-managed SIVs and bring ~$50bn in toxic assets back onto Citi's balance sheet (reversing the bank's previous position, which had been that it wouldn't bail out investors in SIVs without liquidity puts). If you're wondering how Citi ended up with so many toxic assets, and how regulators missed such a massive build-up of risk on Citi's balance sheet, this is your answer. This is also why I'm somewhat sympathetic to the regulators (in this case, the NY Fed). For supervisory purposes, all these toxic assets were gone from Citi's balance sheet, because these were true-sale securitizations to bankruptcy-remote SIVs. Then, all of the sudden, the toxic assets were back on Citi's balance sheet. And it's understandable that regulators didn't foresee that Citi would voluntarily agree to buy back $100bn in assets that it had previously sold in true-sale securitizations.

  • It's true that the idea that "what's good for Wall Street is good for America" has been disproved, but that does NOT prove the opposite—that is, it doesn't prove that "what's bad for Wall Street is good for America." It's frightening how many commentators fail to grasp this distinction. Which brings me to...

  • Cutting into Wall Street's profit margins shouldn't be an explicit goal of financial reform. In other words, we shouldn't look for where the Street has the highest profit margins, and then say, "OK, now how can we cut into those profits?" In most instances, enacting sensible regulation based on an objective weighing of the evidence will lower Wall Street's profit margins anyway. But the fact that the Street is going to profit from a particular regulatory change doesn't necessarily make the regulatory change ineffective, or insufficiently "tough on Wall Street." One argument I hear a lot on OTC derivatives is that we need to push them onto exchanges rather than clearinghouses because Wall Street would still make fat profits if they just went through clearinghouses. That's not a coherent argument for why public policy should require exchange-trading for standardized OTC derivatives.
I'll address OTC derivatives reform more this weekend.

Felix Salmon appears to be deeply confused about what he calls the “moral hazard trade” (otherwise known as the TBTF subsidy). James Surowieki challenged Felix’s earlier posts about the moral hazard trade, asking, “If big banks have lower borrowing costs than small banks, he asks, why do we automatically attribute that to moral hazard (the idea that they’re much more likely to get bailed out in extremis) rather than the simple fact that they’re less likely to default?” In response, Felix cites a recent anomalous spike in the COFI (cost of funds index) which was attributable to a change in the index components, and which essentially showed that Wachovia has a much lower cost of funds than small banks:

This datapoint is telling, because Wachovia — largely because of the Golden West acquisition — was a very rocky bank indeed, and was sold as a highly-distressed asset to Wells Fargo. The fact that its cost of funds was so low clearly had nothing to do with its inherent safety, which means that we have to attribute it instead to the moral hazard trade.
Um, what? All this proves is that big banks tend to have a lower cost of funds than small banks. No one is disputing that. The dispute is over how much of that lower cost of funds is attributable to implicit government support, and how much is attributable to other factors, such as the relative credit risk in the portfolios of big banks vs. small banks. Felix simply asserts, without any evidence, that “clearly” the difference had nothing to do with any other factors, and therefore concludes that the entire difference must be attributable to the moral hazard trade.

Of course, it’s not at all “clear” that the entire difference is attributable to the moral hazard trade. For one thing, small banks’ balance sheets tend to be heavily concentrated in real estate loans — especially commercial real estate, which is in a free-fall right now. The big banks — which got badly burned by CRE in the early ‘90s — tend to be significantly less concentrated in CRE. So that’s one factor that undoubtedly accounts for some of the difference in small banks’ cost of funds.

How much of the difference is attributable to small banks’ exposure to CRE, and how much is attributable to the moral hazard trade? I don’t know. (And I’m not denying that the moral hazard trade accounts for some of the difference; it definitely does.) My point is simply that there are lots of factors at play here. You can’t just assert that there are obviously no other factors at play, and that the entire difference must be attributable to the moral hazard trade.

Thursday, January 7, 2010

Oh, the Irony

I just saw this story on the Huffington Post about California lawyer Ben Pavone, who is refusing to pay his credit card bill out of protest after BofA raised his interest rate. In a letter to BofA, Pavone wrote:

"I consider your action an anticipatory repudiation of the contract and am treating you as in breach," he wrote in a Dec. 31 letter to the bank. "I am therefore not paying the money that is currently due on January 3, 2010 out of protest."
"I have no doubt that you will mark my credit in light of this default, but if you do, I will sue you. I am eager to argue to a court that your interest rates are unfair within the meaning of various state and federal statutes, and anxious to point out that you 'had' to cut my credit limit from $32,000 down to $30,000 at the same time you were borrowing billions from the federal government and paid your executive bonuses in full."
Well, I tend to doubt that Pavone is "eager to argue [in] court," although I don't doubt that he's eager to say he's earger to argue in court.

What's ironic about this is that Ben Pavone is evidently a sole practitioner in San Diego, and his website says that one of the four areas of law he practices is . . . wait for it . . . collections:
Using cutting edge software, the firm is able to find people, serve them with process and compel payment on debts, or compel liquidation of assets, especially in cases for which a judgment has been obtained. Counsel will also pursue debtors into bankruptcy court and has obtained substantial recoveries for clients by being skilled and persistent as a bankruptcy practitioner.
Classic. I wonder how a judge will view a collections lawyer refusing to pay his credit card debt based on a theory of unconscionability (which he apparently alleges in his demand letter). My guess is: not favorably.

Wednesday, January 6, 2010

Krugman on Land Use Regs

Paul Krugman rightly notes that one of the key differences between the metropolitan areas that experienced housing bubbles and those that didn't is that the bubble cities tend to have much more restrictive land use regulations. Land use is actually an area of policy/law which, for some odd reason, I've always enjoyed a great deal (and which I'm looking forward to getting back to, once we make it to the other side of this financial crisis). Land use is the only area of law that can rival finance in terms of complexity (which I thrive on), as well as real world policy relevance.

In any event, Krugman cites the Brookings survey of land use regulations in his post. The Brookings survey is fine, but for a variety of methodological reasons, the Wharton land use database is vastly superior, and much preferred in the urban economics literature. I've uploaded the Wharton database here, in case you're interested (which you should be).

Friday, January 1, 2010

On Goldman and Synthetic CDOs

The topic du jour is apparently Goldman's synthetic CDOs. Gretchen Morgenson wrote a typically ill-informed and absurd front-page article on this subject last week (can the NYT please stick a fact-checker on her?), which got a considerable amount of attention. Yves Smith also wrote a long post denouncing Goldman's "deceptive synthetic CDO practices." Most of Yves' arguments are frankly baseless, but after an exchange with Yves in the comments section, I think I've identified the nub of the issue.

Yves' argument is that Goldman should have disclosed to investors that it was planning to retain the short position in the synthetic CDO, and not simply act as an intermediary. Arranging banks necessarily take the initial short position in a synthetic CDO, but most would then sell off the short position, pocketing just the arranging fee. Goldman, however, arranged some synthetic CDOs (emphasis on some) where it kept the short position for itself — and when the housing and structured finance markets collapsed, it was Ferraris for everyone! Yves thinks Goldman should have disclosed to investors that it would be in a position to profit if the synthetic CDO declined in value. I disagree.

First of all, investors don't have a right to know what Goldman's internal positions are, and they never have. Every single investor understood that Goldman also invested for its own account, and no one would have expected them to disclose their proprietary positions.

More importantly, what you have to realize — and where I think Yves goes wrong — is that Goldman wasn't necessarily placing an independent bet against the synthetic CDO market; rather, it was using synthetic CDOs to bet against the housing market. There's a big difference. Goldman was betting that the housing bubble would burst, and that the resulting decline in the housing market would be reflected in synthetic CDOs referencing mortgage-backed CDOs. (The mechanism was this: declining housing prices → higher default rates → reduced cash flows to mortgage-backed securities → lower RMBS/CDO prices → higher value of CDS protection on RMBS/CDOs → ca-ching!)

Goldman wasn't betting that liquidity would vanish and the CDO market would completely collapse — that was an unexpected windfall. In that sense, they got lucky (more on that later). Think about it like this: Goldman was betting that RMBS/CDO prices would fall from 100 to 75 because of weak fundamentals in the housing market, so they put themselves in a position to benefit from a decline in RMBS/CDO prices; in reality, the first hints of weakness in housing caused liquidity to completely dry up and RMBS/CDO prices to collapse from 100 to 50. They definitely weren't expecting that.

If Goldman's plan all along was for the synthetic CDO market to collapse, then why were they consistently the biggest liquidity provider (by far) in structured products and structured finance CDS (i.e., ABX tranches)? The point is that Goldman didn't need to artificially drive down the synthetic CDO market. They set themselves up to profit from the decline in synthetic CDOs that would follow naturally from weakening fundamentals in the housing market. By the same token, Goldman didn't need to manipulate the structure of the synthetic CDOs they arranged; any run-of-the-mill synthetic CDO referencing subprime-backed cash CDOs (to the extent there was such a thing) would've suffered steep price declines once housing prices started plummeting. What's more, later investors sometimes made the deal conditional on Goldman retaining the equity tranche, or required that the senior or super-senior tranches contain put options, so it's not like investors were defenseless — they had tools they could use to protect themselves, and they sometimes did.

It's also important to examine the timeline. Goldman's Abacus shelf was started in 2004, and Goldman didn't start going short the housing market as a firm until December 2006. When they did decide to start shorting the housing market in December 2006, they were initially just hedging the long exposure to CDOs they had built up, and they primarily executed this hedge by shorting the lower-rated ABX tranches (an index CDS referencing 20 subprime-backed CDOs) rather than retaining the short position in synthetic CDOs. This makes sense: their long CDO exposure in early 2007 would have been concentrated in 2005-2006 vintages, and the ABX was the only product that would have allowed them to hedge earlier-vintage CDOs (by, for example, buying protection on the ABX BBB- 06-2 tranche, which references 2006-vintage CDOs).

It wasn't until late April 2007 that Goldman started unloading its CDO inventory and took a real directional short position on housing, and when they did, they again primarily used the ABX rather than retaining the short position in synthetics they arranged. From Charles Ellis' The Partnership:

In late April, Dan Sparks, head of mortgages, and two traders, Josh Birnbaum and Michael Swenson, met with a small group of senior executives and warned of a major problem with the firm’s inventory of $10 billion in CDOs: It was heading south. Sparks wanted the firm to cancel underwriting any pending CDO issues, sell all the inventory it could, and make major bets against the ABX index. Sparks’s recommendation was accepted and implemented. (emphasis added)
I know Goldman underwrote a few more CDOs after April 2007 — it was probably too late to cancel the May issues — but to my knowledge, not many of them were residential mortgage-related (they were mostly backed by CMBS and bank loans).

So let's sum up: Goldman arranged synthetic CDOs off its Abacus shelf from 2004 to 2007; they started betting against housing via synthetics and the ABX in December 2006, and began to take a directional short position on housing in late April 2007; they arranged — at most — only a handful of cash and synthetic CDOs backed by RMBS after they decided to actively short the housing market; in those deals, they fully disclosed that they would be taking the initial short position in the synthetic deals, and that they might choose to retain the short position; every investor understood that Goldman actively invested for its own account, and none of the investors had any reason to expect Goldman to disclose its proprietary positions; and Goldman had publicly stated on numerous occasions that it was bearish on housing. Yeah, it's safe to say that critics of Goldman are grasping at straws.

If you ask me, Goldman was almost as much lucky as they were good. Like I said earlier, they were expecting serious declines in the CDO market, but the utter implosion of the CDO market was an unexpected windfall. Also, the only reason they started to take a closer look at housing — as Lloyd Blankfein has stated on several occasions — was because they took mark-to-market losses on their MBS holdings for a few days in a row in late 2006. That prompted them to dig deeper, and they subsequently realized that the housing market was in serious trouble. That's all well and good, but Goldman got lucky: what if the MBS market had collapsed over a weekend, without any prior warning? Why did Goldman need mark-to-market losses to tip them off about the horrid state of the subprime market? Shouldn't they have learned how bad things were when their RMBS and CDO underwriting teams did their due diligence? They definitely deserve credit for investigating further after the mark-to-market losses, but that's not how it should have happened.