International Investing

W&G tells the tale in this interesting piece. Here is an excerpt:

Late in 2006, Goldman still had huge exposure to the subprime mortgage market, due to its holdings of CDOs and other securities. David Viniar, Goldman’s CFO, suggested to the group that it adopt an even more bearish look on the subprime market. Swenson and Birnbaum could not agree more and the pair quickly got to work.

Swenson and his group of traders began shorting slices of the ABX. The depression of subprime lending had yet to hit the market and these credit default swaps they were buying were still very cheap. Goldman had a lot of work to do if it wanted to sufficiently hedge its position in the subprime market. Goldman’s exposure was high, and it took a lot of time and even more money to build enough swaps to fully hedge the bets.

Swenson and Birnbaum had bets focused on indexes in the ABX that reflected the riskiest portion of the index. The subsequent weakening of the index was twofold. As predicted in the 2006 study, many subprime loans had begun the foreclosure process. Also working at the same time was an increase in hedging activity involving the ABX index.

As reported as early as September 2006 in the Financial Times, the activity of hedge funds in the U.S. housing market had grown substantially. As a result of the hedging activity, the ABX index began declining. Home prices were falling, and the early signs of a collapse were all presenting themselves. The time to get into this short market was running out.