Goldman Correlation Desk Profits from CIT CDS; Is Sallie Mae Up Next?

One of Wall Street's biggest whipping boys since the post-Lehman days, culminating with the insanity in credit markets in early March, have undoubtedly been correlation desks. These trading outfits, which hit their heyday in 2004-2005, when CDS spreads were nice and tight, and negative convexity would at most bring a 20-30bps widening, would repackage securitization tranches whereby usually they kept the senior and equity wrap around a mezzanine piece, which was in turn sold to investors. Buyers of mezz tranches, whose junior and senior layers would become impaired after a 15% and 30% cumulative losses, respecitvely, saw what the definition of a world of pain is first hand recently, and effectively shut down the correlation business at many major banks. But not all.

As Debtwire reports, several correlations desks made a killing over the recent CDS blow up: most notably Natixis (NTXFF.PK) and the omnipresent Goldman Sachs (GS). According to Debtwire's Nicoletta Kotsianas:

Correlation trading desks at a few firms, including Natixis and Goldman Sachs, have been buying up CIT protection on the cheap since January to hedge risk in the instruments they structure and trade...CIT stood out to some traders, both because of its exposure to the credit crunch and its ubiquitous placement in the bespokes, said two correlation traders. Just six months ago, jump to default exposure to the name averaged roughly €50MM for many correlation desks, estimated two of the trader sources... One correlation trader who runs a mid-sized bespoke book said that he bought $85MM in short dated protection at an average price of 12 pts up in January and throughout the spring. Five-year protection on the name was quoted at 34 on 9 July but ballooned to the high 50s by 20 July when it became clear the government would not bail out the asset-based lender. Much of that price movement originated from other correlation desks rushing to hedge their jump risk.

So whose CDS will Goldman's correlated tentacles blow up next? According to Debtwire, it is Sallie Mae's turn:

Sallie Mae is the next name in correlation traders' crosshairs, said two correlation traders, an analyst at a boutique brokerage and a sellside desk analyst. Five-year protection on Sallie Mae trades at 20 pts upfront, reflecting relatively low risk of default in post-credit crunch terms. Though not as widely held in bespokes as CIT, nor as distressed, Sallie Mae caught attention in recent weeks as correlation desks braced for the company to be downgraded to junk, all the sources said. Standard & Poor's last week placed the ratings on credit watch following a vote by the House Of Representatives Education and Labor Committee to pass a bill that would eliminate the origination of federal student loans by private lenders after July 2010... Offers to sell protection from dealers grew scarce this week and several dealers have faded offers, in a sign that not all desks are covered for Sallie Mae jump risk, aid three traders. Some bids did get picked up this week but the market is now 18/20 upfront on the contracts as opposed to 691 bps on July 19, according to a broker and data from Markit."

And who wants to bet which way Goldman's notoriously non-rumor spreading correlation desk is axed. Look to the student lender for some major fireworks over the next few weeks.

Comments

[Gtarras:]

this better stop. i will be watching Sallie for coming weeks now. for how long are we going to allow these sharks to destroy businesses out of their greed??? its been all too familiar tactic recently- find a wobbly business driven by short term funding (stupid, maybe, but it worked for so long), preferably big, ie Lehman, CIT, drive up their CDS, cause panic, stop creditors from extending credit lines to the victim, kill their business. SEC, you have to stop this madness!!!!!!

Aug 02 12:03 PM

[Pottermus:]

Now why would the SEC bite the hands that feed it?

Aug 02 01:33 PM

[Ishortyou:]

those CDS markets need to be regulated anyways, the problem is that nobody knows for sure how?...certainly many investors make bets on CDS that the company will go belly up or be in a dire situation at the same time that they short the stock, panic and fear will do the rest as their liability/equity ratio goes to the roof, this for banks or investment banks is a lethal blow but for lenders like Sallie Mae god knows how is gonna be...

Aug 02 08:15 PM

[Michael Clark:]

For too long now we've accepted anything the investment banks have been able to cook up, in the name of 'the free market system'. That has to end. It's time to get rational again, about our country's future. That's what regulation of business is all about, establishing limits. The Great Depression of 2006 has been brought on by having no limits in place.

Aug 02 09:28 PM

[Moon Kil Woong:]

The failure of the Mae's can't be laid at the feet of derivatives traders betting against them. They are failures of what happens when government gets involved in backing and providing credit through quasi-private business. 1. They ask them to do dumb things like loan to people they shouldn't, 2) They ask them to loan at too low of a rate, 3) They kill off the real loan market for those products consuming a vast swath of our economy which becomes unhealthy, 4) They spawn a cottage industry of companies taking advantage of their stupidity. It is essentially like blaming gamblers for betting against a sick and dying horse at the races.

The government must cut back the size and scale of the Mae's including Freddie Mac and Fannie Mae that are growing in marketshare not shrinking. If you want the biggest cause of the next big recession I guarantee they will once again play a leading role.

Aug 03 03:49 AM

[Bill S. Friend:]

I understand the free market economy argument all too well. My fear is that from this angle only a fraction of the market manipulation is apparent. There is so much more going on that we have no way of divining. The large traders call the tune and reap the rewards through ever increasing complexity and misdirection. Government tinkering has done us great harm I agree, because their reactions are contemplated far in advance, by think tanks who are currently planning the next fleecing.

Aug 03 05:30 AM

[Michael Clark:]

The failure stems from the regulators all being bought off and being in the pockets of Goldman Sachs, Fannie Mae and Freddie Mac....and of course Mister Madoff.

The police were being paid by the criminals.


On Aug 03 03:49 AM Moon Kil Woong wrote:

> The failure of the Mae's can't be laid at the feet of derivatives
> traders betting against them. They are failures of what happens when
> government gets involved in backing and providing credit through
> quasi-private business. 1. They ask them to do dumb things like loan
> to people they shouldn't, 2) They ask them to loan at too low of
> a rate, 3) They kill off the real loan market for those products
> consuming a vast swath of our economy which becomes unhealthy, 4)
> They spawn a cottage industry of companies taking advantage of their
> stupidity. It is essentially like blaming gamblers for betting against
> a sick and dying horse at the races.
>
> The government must cut back the size and scale of the Mae's including
> Freddie Mac and Fannie Mae that are growing in marketshare not shrinking.
> If you want the biggest cause of the next big recession I guarantee
> they will once again play a leading role.

Aug 03 11:12 AM

[msgtb:]

Its clear that CDS's need to be strictly regulated or outlawed. The pain these things have caused are not worth the reward. As the reward only goes to the banksters. Ban CDS and MBS and lets get on with rebuilding our country.

Good luck and good trading

Dave

Aug 03 01:03 PM

[jstratt:]

This guy got it write back in 2007 when he said

Lindzon writes that “Goldman is the world’s largest bookie that fixes games and legally sells you shit while they are dumping it out the back door.”

Aug 07 04:17 PM