How Much Did Goldman Rip Libya Off?
The Libyan Investment Authority recently sued Goldman over some 2008-vintage derivatives trades gone wrong. I wrote about it last week but didn't yet have Libya's complaint. That came out today -- here is the complaint, or in British the "Particulars of Claim" -- and it's fun reading.
So ... how'd we do? I dunno, I am the worst person to ask except all the other people, in that I have biases up the wazoo (I used to sell equity derivatives for Goldman! I did this sort of thing! 1 ) and yet have no inside information and am relying on Bloomberg options calculators to figure out the answer. Still here we are on the internet. Let's do it.
The LIA accuses Goldman of ripping it off on nine options trades on six different stocks (Citi, Electricite de France, Santander, Allianz, ENI and UniCredit) in the first half of 2008. Those trades were dumb! I had previously read, and assumed, that they were complicated trades, but they actually weren't at all. Basically Libya bought a bunch of three-year at-the-money call options on stocks: If the stocks went up, Libya would make a (highly levered) profit; if they went down, Libya would lose its entire investment. The stocks went down. Libya lost its entire investment. That investment was about $1.2 billion. The end.
The LIA has two main claims:
- They should never have done those trades in the first place, and
- Goldman ripped them off on the price.
It is hard to argue with point 1! My general investing advice is that, if a trade loses 100 percent of its value, you should never have done it in the first place. You can take that to the bank, if your bank is in the past.
On point 2, here is some super duper rough math:
And here is a footnote that you might also find super duper rough. 2
Libya thinks that Goldman made $350 million on these trades. I think it made about $128 million -- not, mind you, of realized profit over the life of the trades, but rather first-day mark against "market" values. (I can't tell you much about realized profit, and neither can Libya, nor is it that relevant to their lawsuit.)
Both are big numbers! But not that big compared to the fact that these were three-year trades on more than $5 billion worth of stock. And they were risky trades! Yes, Goldman hedged, but for the most part these were outright call options on pretty volatile stocks. Those are not trades that Goldman would want to do! 3 Goldman was selling a whole lot of volatility here. In January through April 2008. A scary time to be had by all. 4
If -- incorrectly, but useful for our purposes -- you assume that Goldman locked up $5.2 billion of cash for three years to keep these trades on, then its profits work out to 0.8 percent (my math) to 2.2 percent (Libya's math) a year. On risky trades! That's not, like, an amazing return. Remember, banks tend to get a return on assets of around 1 percent. Meh. All in all that pricing looks sharpish.
I don't know what lessons you can draw here other than that I miss selling equity derivatives. If you're inclined to stick up for Goldman here -- and, remember, I have my biases -- you might say, look, Libya wanted equity upside exposure, so it bought some calls. Those calls were fairly priced, and would have made Libya money if stocks had gone up. Stocks -- especially European bank stocks and Citi! -- went down. You buy at-the-money calls, the stock goes down, you get nothing. You spend $1.2 billion to get nothing, you're sad and mad and want restructuring and sue and so forth. But none of that is Goldman's fault. They're a dealer, someone came to them for a trade, they gave them the trade, they can't guarantee success. 5
I guess that's not the point of the lawsuit though. The point is that the trades were super dumb. (Yep!) And that, while the LIA couldn't have known better, Goldman should have. Maybe?
The complaint is largely the story of how Goldman North Africa salesman Youssef Kabbaj did his job buttering up Libya. Kabbaj -- a vice president, 6 by the way, so good on him printing trades with nine digits of profits -- did his job. He was good at it! He entertained the LIA team in his native Morocco (on Goldman's dime), and
Mr Kabbaj addressed the LIA employees as his "friends" and his "team", and made them feel that he was part of their "team" (frequently bringing them small gifts, such as aftershaves and chocolates, when he visited Tripoli).
It's always the aftershaves. 7 This campaign worked so well that "by March 2008, when some of the LIA employees had not heard from Mr Kabbaj for a few days, they contacted Mr Kabbaj to check that everything was alright, and that Mr. Kabbaj was not upset with them. Mr Kabbaj reassured them that he was not."
Then he pushed these trades -- according to the complaint anyway -- and they ended up upset with him. First though they passed through the stage of "confused":
Within the LIA there was confusion as to the true nature of the Disputed Trades, both prior to and following their execution. In particular ... up until July 2008 ... both the LIA board of directors and employees did not properly understand whether the Disputed Trades involved direct equity investments, or a species of quasi-share ownership, or constituted an entirely synthetic financial instrument; and/or misunderstood the true position.
So, erm? In early July 2008, an Australian lawyer arrived at LIA, and told them what they had:
She explained that, rather than being cautious investments in shares or "quasi-shares" (as the LIA had previously thought), the Disputed Trades were actually complex derivatives and synthetic instruments which represented highly speculative gambles.
So, erm, again? What does a cautious investment in Citi shares look like in January 2008? I think the answer is "a trade that's lost 40 percent of its value by early July"? Of course that's better than losing 100 percent, but still. Losing money is always a great incentive to discover that your trade wasn't what you thought it was.
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Also here is your periodic reminder that I own a little Goldman stock subject to transfer restrictions. One tranche of restrictions expired last week, so I'm about 50 percent less biased towards Goldman than I was previously.
So! What I did here was to value these trades, based on the LIA's filing, using Bloomberg's OV tool with the date set to the relevant execution date. I adjusted as little as possible, so I used the default Bloomberg volatility surface and rates curves and so forth. Some adjustments were necessary: Bloomberg has a different spot price for Unicredit in April 2008 than, um, Unicredit does. (Also for Citi, but that's a straightforward reverse-share-split issue.)
One weird trick is that some of these trades were struck at the lower of (1) the stock price at the time of the trade or (2) the average over some subsequent period, floored at 90 percent of initial price. I just roughed that out by saying, "that's 90 percent like a regular at-the-money call option and 10 percent like a 90-strike call option." That math sure ain't right! But it's probably conservative.
Another trick is some trades were tranched into three expiries a week apart, for liquidity reasons. I took the midpoint expiry, which is close enough.
Bloomberg screenshots: Allianz, Citi trade 1 (as an at-the-money call), Citi 1 (as an in-the-money call), Citi 2, EdF trade 1, EdF 2, EdF 3, ENI, Santander, and Unicredit. One day maybe I'll tell you about the arithmetic to get from those screenshots to that table, but it's not that interesting.
In general if you're a dealer and someone wants to do billions of dollars worth of options trades with you, one thing you'll want to do is make those options trades less option-y (less volatility risk) and more stock-y. Stock is easy to hedge, you just buy or sell stock. Volatility, in a single name in giant size, is harder to hedge. So a couple of these trades (two of the three EdF trades) are capped calls (or call spreads), where Libya buys a call struck at $100 and sells back a call struck at $140, limiting its upside and Goldman's risk. Most were outright calls though.
What does this tell you? One possibility is that Libya proposed the trades: If Goldman was actually trying to rip Libya off, they'd propose more simpatico trades (trades with less risk to Goldman). Clients sometimes say, "hey sell me two and a half billion dollars of outright call options on Italian banks," but bankers say that much less frequently.
That possibility ... sure seems right? I don't know, but a person with some familiarity with what went on says that Libya concocted these trades and asked Goldman to do them. Libya's Particulars of Claim says the opposite:
In early 2008, Goldman (and Mr Kabbaj in particular) began heavily to encourage the LIA Equity Team and Mr Zarti to obtain exposure to stocks on a leveraged basis by entering into a number of large long-dated complex financial derivative transactions.
Umm? Maybe Goldman said, "hey do some levered stock trades," and LIA said, "ooh what about outright call options," and talked Goldman into it?
Another possibility is that Goldman was long a lot of three-year Italian bank volatility and decided to find a sucker to hedge with, and that sucker was the LIA. This seems weird but not impossible. Unlikely though?
Another possibility is that Goldman said to itself, "what trade can we propose that will never get price-checked because it is so risky, so we can charge whatever we want?" And then they settled on selling five billion dollars of global bank volatility in early 2008. But I don't think the pricing is that outrageous? I don't know.
Would you like to see what volatility did over the relevant three and change years? Here's S&P 500 index vol:
[imgviz image_id:iZiqz4Y2ADZQ type:image]
I think it is safe to say things got worse before they got better. Remember, Goldman was selling call options, meaning it was short volatility. Volatility goes up = Goldman loses money. In late 2008 these trades may have caused some concern at Goldman. (No inside information, just looking at graphs here.)
If you're inclined to fault Goldman you might notice the $200+ million profitability difference between my numbers and the LIA's (which are based on statements Goldman sent the LIA). Some of that is just bid/ask, but some of it may be that my math is wrong. Perhaps because I made a mistake, or because Bloomberg's data from 2008 does not correspond to what market participants in 2008 would have used. (Both are likely true.) Some of it may be that there are bells and whistles and doodads -- averaging periods and tranching and lookbacks and dividend treatments and whatever else -- that eke out a little bit of profit beyond what you can see in a vanilla options model. Not ... you know, not impossible.
"Executive director," but that's Euro-Goldman for VP. That's according to the Particulars of Claim, paragraph 17(2).
The aftershaves and the internships: Of course: "In early 2008, Goldman also made arrangements for Mr Zarti's brother, Mr Haitem Zarti, to be employed by Goldman as an intern." (Zarti, was the deputy executive director of the LIA, and he in turn "was appointed at the suggestion of Colonel Gaddafi's son, Saif Al Islam Gaddafi.")
(Matt Levine writes about Wall Street and the financial world for Bloomberg
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