Agora Financial’s Rude Awakening

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London, England

• Goldman bucks the trend by shorting the sub-primers,
• Who needs action movies with markets like these?
• Merrill posts biggest quarterly loss in 93-year history and more……

Joel Bowman, reporting from Dubai, UAE…

Here’s a way to save your self a quick twenty-bucks. Rather than shelling out
for a ticket to an action movie – and the exorbitantly overpriced popcorn
they hawk along with it – try buying some microwave popcorn and tuning into
the financial news instead. It’s got all the thrills and spills of a
blockbuster hit and, provided you don’t have any money in the mortgage
sector, it’s a good deal cheaper.

In the last two days of trading alone, the Dow Jones Industrial Average has
swung more than 260-points. Tuesday it was up over a hundred points on the
back of stronger than expected earnings reports from American Express Co. and
Apple Inc. Then, just 24 hours later, it tumbled more than 150 points on word
that Merrill Lynch had posted their largest quarterly loss in the company’s
93 years.

What a difference a day can make.

Many investors viewed Tuesday’s strong earnings reports as indicative of the
resilience of the US consumer in the face of the housing debacle and the
global credit crunch. “Today’s earnings reports helped alleviate concern that
the worst housing slowdown in 16 years would cause profits to drop for the
first time since 2002,” reported Bloomberg on Tuesday afternoon.

Fast-forward to Wednesday’s closing bell and that pesky sub-prime conundrum
reared its ugly head again. Despite earnest delusion from the perma-bulls and
a chorus of dubious confessions and promises from banks that the worst was
over, the sub-prime mess hangs on with all the ferocity of a jilted bride-to-
be.

According to Bloomberg.com, “The writedowns on subprime mortgages, asset-
backed bonds and leveraged loans led to a third-quarter loss of $2.24
billion, or $2.82 a share, six times more than Merrill estimated on Oct. 5.”

In a company statement released yesterday, Merrill CEO, Stanley O’Neil, said,
“We expect market conditions for subprime mortgage-related assets to continue
to be uncertain and we are working to resolve the remaining impact from our
positions.”

News of Merrill’s mammoth losses sent the stock plummeting almost 6%,
dragging the broader market down along with it.

Still think we’re done with sub-prime? Read on below as Adrian Ash takes us
through Part II of his ongoing investigation the whole fiasco.

—– Subprime – So NOT Over! The Survival Report —–

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Thought you were “done” with the property bust?

Think again — then get ready as a deadly subprime lending time bomb ticking
under Wall Street sparks the worst property-led recession of the last 76
years!

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Sub-Prime? So Over! Part II
By Adrian Ash

Goldman Sachs bucked the trend this summer by making money – pots of money – selling subprime bonds short. Ironically, Goldman also issued what might
prove the most toxic of all subprime bonds back in 2006. In other words, the
savvy investment bank sold the same junk twice, and make a tidy profit both
times.

Bravo for the Goldman Gang…this time. But next time these guys ride into
town, you may not want to be buying the stuff they’re selling.

Only Goldman Sachs escaped the summertime carnage in the subprime market…or so they say. “Common sense tells me that a lot of their losses were real and
a lot of their gains were paper,” says Charles Peabody, head of research at
Portales Partners in New York. “The opaqueness of Goldman’s balance sheet
makes us immediately question how they made money in the [third] quarter.”

But on thing seems fairly clear: Goldman sold short the very same type of
securities it had sold to its clients just a few months earlier…and made
millions doing so. Trading revenues at Goldman rose 70% from the same period
in 2006 – a massive $8.2 billion all told – taking the group’s net earnings
to a new record for the year so far. Merrill Lynch and UBS, on the other
hand, reported their first quarterly losses in more than four and a half
years as the International Herald Tribune notes, adding that:

“Bear Stearns posted its biggest earnings drop in a decade.”

So how did Goldman – “increasingly perceived as the world’s biggest hedge
fund” according to the IHT – succeed where everyone else failed? The bank
made no secret of its success in its Q3 report of Sept. 20th:

“Net revenues in [trading] mortgages were…significantly higher, despite
continued deterioration in the market environment. Significant losses on non-
prime loans and securities were more than offset by gains on short mortgage
positions.”

Put another way, Goldman Sachs cleaned up during this summer’s collapse in
subprime mortgage bonds…by selling the subprime mortgage-backed market
short. And why not?

It’s not like Goldman is barred from shorting the investment markets that it
helps bring into being. Nor did it have any special insight; all of the big
investment banks were busy creating and selling subprime junk in 2005-2006.

None of the other big banks, however, had the chutzpah to short the very
market in junk they’d given birth to – not yet, at least. And few banks seem
to have created bonds quite as toxic as Goldman did.

Take last year’s vintage, for example. In 2006, Goldman Sachs’ mortgage-bond
division – Alternative Mortgage Products (known as GSAMP for short) – issued
83 home-loan-backed bonds, valued at $44.5 billion. In the subprime sector,
it grew its business by 59% from 2005, unloading some $12.9 billion on to
unsuspecting, stupid and/or greedy investment fund managers who thought a
bond under-pinned by home-buyers with no hope of repaying might be worth
having.

According to Inside Mortgage Finance, that made GSAMP the 15th biggest issuer of subprime-backed bonds in 2006. And come the start of the third quarter
this year, those securities were being downgraded by the credit ratings
agencies faster than anyone else’s.

Research from Citigroup, dated 22nd June, found that “portions of Goldman’s
GSAMP-issued bonds, which include subprime loans from a variety of lenders,
have been downgraded a combined 69 times by Standard & Poor’s and Moody’s
Investors Service in the year through June 15.”

“Sixty of the GSAMP downgrades refer to classes from 2006 bonds,” Citigroup
added, and one of Goldman’s 2006 crop – the GSAMP Trust 2006-S3 – may
actually be “the worst deal…floated by a top-tier firm,” reckons Allan
Sloane in the Washington Post.

In spring 2006, “Goldman assembled 8,274 second-mortgage loans originated by Fremont Investment & Loan, Long Beach Mortgage, and assorted other players,”
explains Sloane after studying the public record. “More than one-third of the
loans were in California, then a hot market. It was a run-of-the-mill deal
[face-value $494 million], one of the 916 residential-mortgage-backed issues
totaling $592 billion that were sold last year.

“The average equity [these] borrowers had in their homes was
0.71%…[meaning] the average loan-to-value of the issue’s borrowers was
99.29%.

“It gets even hinkier,” Sloane goes on. “Some 58% of the loans were no-
documentation or low-documentation. This means that though 98% of the
borrowers said they were occupying the homes they were borrowing on – ‘owner-occupied’ loans are considered less risky than loans to speculators – no one
knows if that was true. And no one knows whether borrowers’ incomes or assets
bore any serious relationship to what they told the mortgage lenders.”

Whatever the truth, one in every six of the 8,274 mortgages bundled together
in GSAMP Trust 2006-S3 was already in default 18 months later. Whoever bought the S3 bonds will have either taken a very hefty loss, or they’re now waiting
– and hoping against hope – for some other schmuck to turn up and take this
toxic waste off their hands at a very heavy discount.

Meantime at Goldman Sachs, the profits made by shorting the subprime market
flipped Q3 ‘07 from “significant losses” to “significantly higher” net
revenues. In other words, Goldman produced its dazzling earnings result by
selling ‘em twice – first as an asset…and then as a tasty short.

Yes, it’s legal. But the process feels a little odd, nevertheless. As a
Goldman shareholder, I’d be delighted by their deft double-dealing. But as a
client, I’d be somewhat less impressed.

It doesn’t really matter how Goldman went short the subprime market. It may
have sold derivatives against an asset-backed index such as the ABX (which
now looks close to winding down, by the way, because “securitizations have
fallen so low, there may not be enough bonds to fill the series” says Markit,
the index’s developer). Alternatively, Goldman might have borrowed a fistful
of mortgage-backed bonds and derivatives from poor, benighted investors…and
dumped them into the market as it plunged between June and Sept.

Goldman may even have borrowed the bonds that it shorted from its own 2006
customers, but I guess that’s unlikely. Can you imagine THAT phone call from
Goldman?

“Hey Mr. Client, Remember those mortgage bonds we sold you last year? Betchya can’t forget them! But we don’t think they’ve sunk far enough yet. So we
wanna borrow a bunch and sell ‘em short. Whadya say?”

Congrats to Goldman…I guess.

[Joel's Note: City correspondent for The Daily Reckoning in London and a
regular contributor to MoneyWeek magazine, Adrian Ash is the editor of Gold
News and head of research at BullionVault – where you can buy gold today
vaulted in Zurich on $3 spreads and 0.8% dealing fees.

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Rude Endnote: We’ve run a bit over length today, so we’ll wrap it up there.
For all the intraday action, don’t forget to check out your 5, heading your
way shortly.

Cheers,

Joel Bowman
Rude Awakening