What Was Goldman Sachs Doing With Libya's Options Bets?
If you more or less believe in the fundamental efficiency -- that is, randomness -- of markets, a lot of things get a lot easier. For instance you take losses more philosophically. If you lose money on an investment, that is not a sign that you should double down to make it back, nor is it a sign that you should stop investing altogether. It is a sign that a weighted random number generator has produced some random numbers and now one of those numbers lives in your bank account. Later more numbers will be produced, but you cannot make them bigger numbers just by wishing for it to be so, or by yelling about it, or by filling your days with stress and lawsuits.
I don't really know what's going on in this lawsuit that the Libyan Investment Authority filed against Goldman Sachs, and there is obviously a lot going on.1 One thing that is going on is that, depending on exactly which reports you read, the fund "lost about $1.75 billion betting on structured products in 2007 and 2008, about $900 million of which was with Goldman Sachs," or else "lost 98% of a $1.3 billion bet on currency movements and other complex trades done with Goldman in 2008." Apparently that $1.3 billion bet consisted of premium for "options on a basket of currencies and on six stocks: Citigroup Inc., Italian bank UniCredit SpA, Spanish bank Banco Santander, German insurance giant Allianz, French energy company Électricité de France and Italian energy company Eni SpA." And it lost 98 percent of its value by early 2010.
So that seems a bit harsh? At the same time, though, if a dicey oil-fueled sovereign wealth fund can't make nutty leveraged currency and equity bets that lose them all their money, who can? Someone should be able to take silly risks -- someone has to be the sink for the risk that the rest of the financial system wants to offload -- and I guess the Qaddafi-era LIA was reasonably high up the list of who it should be.2 Better them than AIG.
But another thing that is going on is this:
Goldman and Libyan fund officials went back and forth for months over several plans to make Libya whole on its investment, the Journal reported. Many of the ideas Goldman presented involved structured-finance instruments or investment funds that would have required the fund to invest even more money through Goldman.
So okay. You're the Goldman sovereign-nonsense guy, and Sovereign Wealth Fund X comes to you and says "hi, we have $60 billion to invest, what trades should we do?" And you give them a list of trades. And Sovereign Wealth Fund Y comes to you and says "hi, we have $59 billion to invest, what trades should we do?" And you give them, I will guess, a quite similar list of trades.
And then the Libyan Investment Authority comes to you and says "hi, we have $60 billion to invest,"3 and you presumably give them the Fund X list of options. And then they decide -- and I don't know if this was on the list of options or if it was their idea; remember they were doing money-losing structured products with other banks too -- but they decide to put a billion dollars into terrible nonsense. And you say "done," because you are after all the sovereign-nonsense guy and who are you to judge. And the LIA promptly loses its billion dollars, and comes back to you with its $59 billion, hopping mad. And you say, "wait wait wait, I have an idea for how you can make it back." And then you propose a complicated new trade that is designed to make LIA its money back.
So ... what trade is that? Like, we already sort of know what trades made sense for a $59 billion sovereign wealth fund, because they're pretty much the same trades that made sense for a $60 billion sovereign wealth fund, and presumably you already pitched those to LIA. So what are the new trades? And why?
You get the sneaking suspicion that there's a terrible story here, that there's a gambler's-fallacy sense that, since you lost a lot of money on risky bets, the only thing to do is to put even more money on even riskier bets. There were suitable positive-expectancy trades for Libya when it had $60 billion (maybe, whatever), and roughly speaking those trades remained suitable and positive-expectancy when it had $59 billion, but those trades were no longer on the table. "Produce $1.3 billion out of thin air" was the order of the day. But if that was going to work, wouldn't it have worked before? Why do those options trades in the first place if you just had a magic $1.3-billion generator? It almost makes one think that Goldman didn't have a magic $1.3-billion generator.
As it happens, the Wall Street Journal has some sense of what the magic generator looked like:
In May 2009, Goldman proposed that Libya get $5 billion in preferred Goldman shares in return for pumping $3.7 billion into the company, according to fund and Goldman documents. Goldman offered to pay the Libyan Investment Authority between 4% and 9.25% on the shares annually for more than 40 years, which would amount to billions of dollars more.
You see what's going on there? Libya pays Goldman $3.7 billion and in return gets securities with "THESE SECURITIES ARE WORTH $5 BILLION" on the front of them. Guess how much those securities are worth? If you guessed $3.7 billion ... there's a decent chance that you're too high? I dunno.4 If you guessed $5 billion you should be kept well away from money.
Libya said no; they "prodded Goldman to recoup their losses faster" and "also worried about whether it was wise to invest in Goldman given the collapse of Lehman." Other things were proposed:
That August, Goldman proposed some other options to Libya, including investing in other U.S. financial firms and in a "special-purpose vehicle" tied to credit-default swaps, a form of insurance against losses on loans and bonds.
The Libyan Investment Authority decided that those options were too risky. Fund officials said they wanted to put the $3.7 billion into high-quality bonds. So Goldman devised another special-purpose vehicle in the Cayman Islands that would own $5 billion of corporate debt, according to a Goldman document prepared for the fund.
I understand this less but the basic theory seems to be the same: Put $3.7 billion into a thing that says "$5 billion" on the cover, and fiddle with risk and discount rates and market prices until the thing is worth $3.7 or $3.6 or, I don't know, conceivably even $3.8 billion, there's some value to Goldman in avoiding negative publicity.
But that doesn't really get you back your $1.3 billion, right? Goldman is not there to give you free money. The fact that you lost a lot of money does not change the fact that Goldman is not there to give you free money.5 No trade that you can do will generate free money. It can generate large numbers on pieces of paper, and when you hold those numbers up next to the large negative numbers that were put on previous pieces of paper, perhaps you will be soothed in your heart, but that is not an economic reality. That is just numbers.
I guess Libya knew that. They never actually did any of these make-up trades, and then events overtook them and they let this matter sort of slide for a bit. And now they (well, their successors) are suing, mostly over the original trades that worked out poorly for them. Do they have a case? I have no idea. But my guess is that both they and Goldman are relieved that they never ended up doubling down. Feels like that could only have made things worse.
2 That 2011 Journal article might give you some sense of LIA's sophistication, or lack thereof, at the time; it mentions "a cadre of inexperienced employees who hoped to make the fund one of the largest of its kind in the world."
By the way, that 98 percent number boggles me -- was that $1.3 billion basically just premium for options that expired worthless? Really? $1.3 billion of option premium as like your first trade out of the gate? -- but, to be fair, those were weird times. Santander and Unicredit and Citi were off by around 70 percent peak-to-trough in 2008-2010 (though the first two got better by the end), Allianz by 65 percent, Eni by 50-odd percent, etc. So just a straight stock position with 50 percent margin would more or less get you to that total loss, if you rode it all the way down, suggesting that Libya's trade wasn't necessarily all that exotic/stupid.
3 Says Bloomberg News, "Libya’s sovereign wealth fund built up assets of about $60 billion under Muammar Qaddafi," so that number is plausible. When it launched in June 2007 it had about $40 billion, but the numbers don't really matter.
4 Data points: Goldman's 6.20 percent Series B preferred, a smallish retail product, was trading at around a 7.3 percent yield in May 2009. Warren Buffett bought $5 billion of Goldman preferred in September 2008 at a yield of 10 percent (when those Series Bs were trading at around 9 percent), and he got at-the-money warrants to buy Goldman common stock as part of the deal. Based on similar deals, I will guess that those warrants were worth over a billion dollars, so Buffett effectively paid under $4 billion for $5 billion face amount of 10 percent pref. Suggesting that the "fair" rate for $5 billion of Goldman institutional preferred stock in September 2008 was around 13 percent (10/13 equals about 77 percent, and 77 percent of $5 billion is about $3.8 billion, or probably about what Buffett paid for the preferred stripping out the warrants).
Now May 2009 was not September 2008; if you figure the Buffett-ish preferred should have tightened by as much as the retail preferred (that is, by a little under 2 percent) you get about an 11 percent fair rate for Libya's proposed investment. A $5 billion investment in preferred that "should" pay 11 percent but pays 9.25 percent is worth about $4.2 billion. If it pays 4 percent, it's worth about $1.8 billion. I don't know what the structure of that "between 4% and 9.25%" was, but if you just assume the midpoint (6.625 percent) then you get a value of about $3 billion for the $5 billion preferred. That is not science of any sort but it gives you vague floaty orders of magnitude to ponder in your heart.
5 To be fair, and this point is so obvious that it hardly warrants a footnote: Goldman didn't make $1.3 billion on Libya's $1.3 billion losses. It's a straight bet for Libya but not Goldman, who presumably hedged. I'm sure they did okay, but not $1.3 billion worth of okay.