Speculation and Portfolio Diversification Strategies for Goldman Sachs - Term Paper Example

MBA DISSERTATION PROPOSAL PROFORMA Sheeraz Awan Number: 15012838 room MBA-DI- DT-071128-06-Awan Programme Manager: Alina Muller Contact details: 1 613 7617823 Embanet name and private email address: Sheeraz Awan sheeraz_awan@hotmail.com DISSERTATION ADVISOR: Alfonso Mendoza PROPOSED DISSERTATION TITLE: How financial speculation and portfolio diversification strategies helped Goldman Sachs avert the subprime mortgage crisis in the United States? DATE: July 25, 2008 (Tentative aiming date) Grades awarded for Seminar one …… Seminar two …… Seminar three …… Seminar four …… All references are to the recommended text White B. (2002), Writing Your MBA Dissertation, London, Continuum 1. Aims of the Dissertation Chapters 1, 2 A very recent risk management problem developed in the US subprime housing market led to billions of dollars in losses to the major banks and investment houses. This risk management issue highlighted the importance of timing in financing speculation and also that financial derivatives are a zero sum game. Huge losses by the banks and investment houses have led to a panic and fear in the US that recession is on the horizon. With the US being the biggest and most powerful economy of the world, the fear of a slowdown in the US economy has led to fears of global slowdown and worldwide recession. The aim of this dissertation is to look into how Goldman Sachs engaged in financial speculation as “its mortgage department made bets that securities backed by high-risk home loans would plunge in value. The well-timed move has generated nearly $4 billion in profits for the year ending on November 30”. (Spence, 2007). The financial investment strategies of Goldman Sachs will be explored in this dissertation whereby financial speculation, hedging and portfolio diversification policies will be examined. What this dissertation strives for is to prove that the timing and its impact on the financial strategies employed by the Goldman Sachs and that of Citibank and Morgan Stanley are critical in managing financial risks. Using financial derivatives in itself is not enough if they are not carefully and timely executed. The dissertation wishes to examine firms in the financial sector with emphasis on the following three: 1. Goldman Sachs 2. Morgan Stanley 3. Citigroup It is necessary to compare the speculation, hedging and diversification strategies employed by these three financial giants before, during and after the subprime crisis at the end of 2007. No such thorough review exists at this time that looks and compares these three US financial institutions in relation to the subprime. 2. Methods Chapters 3, 4, 5 I intend to examine risk and the diversification and explore the implications in the light of efficient markets and market timing theory. There are some risks that cannot be diversified away like the market risk. This dissertation will focus on the financial investment strategies – speculation, diversification and hedging - specifically looking at the use financial derivatives products. This dissertation will look into the company policies surrounding financial hedging and speculation and how it related to the timing of their investments in relation to the subprime crisis. Each firm will be researched by examining documents like the company’s annual reports for the past few years, press releases, government documents, and reports from international bodies like the BIS and the World Bank. Speculation, arbitrage and hedging investment strategies employed by Goldman Sachs, Morgan Stanley and Citibank will be compared. Timing and the use of specific instruments will also be recorded. In this regard, the theory and application of market timing is critical. Levy (2005, p. 890) stated that “market timing is an active investment strategy exploiting market inefficiency by moving into underpriced asset classes and out of overpriced asset classes”. I will be using secondary and third party documentation resources to look into the financial strategies employed by the three organizations and analyzing them within the context of market timing theory. This will help me understand the operational and organizational setups and how they played a part in the financial investment strategies of these firms. The hypothesis of this dissertation is that market-timed financial risk management strategies were necessary and some firms took advantage of the market inefficiencies to avert the subprime mortgage crisis. It is important to relate all of this to the Efficient Market Theory (EMT). Levy (2005, P. 377) defines it as following “a well-functioning financial market in which prices reflect all relevant information is said to be efficient market. Another way to state this is that the EMT claims that security prices reflect all relevant information; that is the current market price of a security incorporates all relevant information”. This is very critical since it supports the paradigm of making financial decisions in an uncertain environment and there is a psychology of combining the information available and making the decision. Companies such as Goldman Sachs have more or less the same set of information that is available to Morgan Stanley and Citibank in the same volatile securities market. The EMT and Market Timing theories therefore are critical in answering the investment strategies, hedging, speculation and arbitrage pursued by the financial firms under examination in this dissertation. Furthermore, I will use hedging and risk management academic resources from the Centre for International Securities and Derivatives Market, Hedge Fund Research Inc. and Lipper Tass (TASS) financial resources tools. 3. Feasibility I will be using extensively the research material provided to the public through corporate reports, financial statements, individual studies and international publications by the Bank of International Settlements (BIS). The topic is new and the information is abundant. I have access to local universities here in Ottawa. I can use their libraries, I can use the internet by going to the corporate websites and I can use the online library at Liverpool. I am in touch with some of the business analysts who have written articles and analysis on this topic and hopefully I can obtain some information from them. Generally it is difficult for financial institutions to release such confidential and private information and hence there will be a reliance on the public information that is available. 4. How Your Work Fits Existing Published Work Chapters 6, 7 Market timing and the resulting investment strategies of Goldman Sachs was important to avert the subprime crisis. One of the key financial strategies employed was hedging. Chen and Liang (2007) explained that “a hedge fund can change its market exposure based on perceptions of both market return and market volatility. Even if the fund manager foresees a high level of market return, he may not take heavy positions in the market without considering market volatility and vice versa. An expected high volatility makes the manager behave conservatively in adjusting portfolio holdings”. The authors of this article have taken a sample of hedge funds between 1994 and 2005 and performed statistical analysis with qualitative explanations to relate market volatility with market timing. This article helps explain that market inefficiencies and the market timing with carefully timed bets can result in huge payoffs. Yet predicting and timing the market is horribly difficult and is purely a gamble which can result in either huge payoffs or huge losses. Inaccurate prediction and timing can result in more damage as it can potentially lead to a panic in the markets. Teach (2008, p.29) states that “a fund manager or a number of managers, worried by conditions in the markets, voluntarily decided deleverage at the beginning of August. The second possibility, which Khandani and Lofavor said is a multi strategy fund or proprietary trading desk, was forced to meet a margin call or reduce risk because of its exposure on the credit side to the subprime mortgage market”. Teach (2008, p.29) examines potential problems that arouse during subprime crisis when the market conditions were misjudged by some firms which exacerbated the financial crisis. This relates to the market timing because timing is crucial and a misinterpretation of information from the market leads to big problems and the crisis grows even bigger from its initial stage. BBC News (2007) through its business desk reported that “Goldman Sachs correctly betted that the value of Mortgage bonds would go down. Goldman was helped by the diversity of its investment portfolio and product range”. Even though it is a short article, it provides concise financial analysis for me. The diversity of investment portfolio by Goldman is one of its key derivatives that helped it hedge risk from the subprime. This financial strategy is further reinforced by a recent article in the Euromoney (2007) which looked at the diversification and liquidity as the main tools that helped Goldman. The article stated that, “Goldman will look to continue its winning strategy, extending its market making and derivatives business into South Africa and the Middle East”. The role of liquidity was also examined but that is not the main source of discussion here. This research was carried out by polling the fund managers from around the world. Financial derivatives have been the key for Goldman Sachs to avert these crises as has been proven so far from the above four sources. From the research and my own understanding is that proper diversification, a conservative financial attitude and equally important long term competitive attitude of the management helped Goldman turned a crisis into an opportunity. Spence (2007, 1) examines both Goldman Sachs and Citigroup with an emphasis on their financial strategies. Starting with Goldman Sachs, Spence (2007, 1) reports that, “Goldman Sachs group is set to reap a windfall as a result of bets made by its mortgage department that securities backed by high risk home loans would plunge in value, the Wall Street Journal reported on Friday. The well-timed move has generated nearly $4billion of profit for the year ended Nov. 30. Citigroup said it will take $49 billion worth of assets from several investment entities known as structured investment vehicles or SIVs that have been damaged by the credit crisis and add them to its own balance sheet. The move could place further pressure on the Wall Street giant’s capital base”. Spence take his studies from other sources like the Wall Street Journal and from his fellow writers at Market Watch. Nonetheless his conclusion is that well timed speculations helped Goldman Sachs reaped profits but at the same time he examines some of the ethical issues that go along with it. Although there are always ethical concerns involved in financial speculation as derivatives are a zero sum game. Someone’s profit is someone else’s loss. Therefore in such situation speed and internal maneuvering are crucial. Hennigan (2007, P.1) in his article exmained the investment strategies of Goldman Sachs, Morgan Stanley and Merrill Lynch and how these organizations responded to the subprime crisis. Hennigan (2007, P.1) states that, “as the credit markets imploded and triggered ripples across the globe, Goldman Sachs had protected itself from the junk it had sold and was positioned to profit massively from a decline in those securities. Hennigan includes the following submission from Goldman Sachs which was made in a filing to the Securities and Exchange Commission: Although we recognized significant losses on our non-prime mortgage loans and securities, those losses were more than offset by gains on short mortgage positions”. Hennigan investigates this topic by gathering bits and pieces from different sources like the New York Times and the Fortune Magazine. Hence we found from this article that a combination of hedging strategies and speculation by Goldman Sachs in a careful position helped it protect from the onslaught of the credit crunch. Goldman Sachs was able to move more quickly than other organizations. Getting information from the source itself is important. Goldman Sachs (2008) states on its website that, “we seek to structure our liability conservatively to reduce refinancing risk and the risk that we may redeem or repurchase certain of our borrowings prior to their contractual maturity”. As mentioned earlier and confirmed by the Goldman Sachs website, the conservative and conventional attitude of the organization is part of the financial investment strategies of the firm. It takes carefully planned risks and takes proper steps to protect itself from the market volatility. Carol Loomis (2007, P.1) looks into an interesting comparison between the hedging strategies of Goldman Sachs and Citigroup from the perspective of the new chairman of Citigroup who happened to be the former executive at Goldman Sachs. Loomis (2007, P.1) points out that, “Goldman appears also to have scored by hedging long positions early this year. At a Citi analyst call on Nov 5th, just after the impending write-downs had been announced, Citi CFO Gary Crittenden said the company did some hedging in the first part of the year too. But by July and August, when the need for protection was terrifyingly apparent, the ability to hedge, especially in the large amounts that Citi needed was virtually nonexistent”. Robert Rubin an ex Goldman Sachs executive has been the newly minted Chairman of Citi after the departure of Chuck Prince. Rubin explains as to why Citi was not able to systematically hedge the collateralized debt obligations (CDOs). The conclusion we draw from Loomis’s article is that timing played a key role. Rosenbush (2007, p. 9) in his article talks about the financial position of Goldman Sachs in the lead up to the subprime crisis. For instance he mentions, “Goldman said its mortgage business was strategically important, but relatively small. To the extent that it invests in mortgages, it tends to focus on prime mortgages and commercial mortgages”. This highlights the conservative financial strategy that has been mentioned before. In order to fully comprehend the timing issue when dealing with the financial investment strategies of Goldman Sachs, the perception of timing and speculation go hand in hand. Emanuel (2002, p.7) uses statistical investigations and formulas to study the relationship between risk and return and the time factor that investors take into account. Emanuel (2002, P.7) states that, “in highly speculative and rapidly developing market sectors where relevant news arrives frequently, expectations can suddenly soar and investors may have very short term horizons”. This may explain the fatigue that went through Citibank last summer as touched on by Rosenbush (2007, p.9). 5. Why You Are Doing This Topic Chapters I am doing this topic because I want to specialize in finance with an emphasis on risk management. The topic of risk management really interests me and I am always intrigued on how banks manage their risk since they are exposed to so many dangers in comparison to other organizations. It is necessary to compare the speculation, hedging and diversification strategies employed by these three financial giants before, during and after the subprime crisis at the end of 2007. No such thorough review exists at this time that looks and compares these three US financial institutions in relation to the subprime. Hence this dissertation topic will give me an in depth exposure to my chosen career field within Finance. On an academic level, I wish to pursue further studies in the risk management. I am already looking at specialist MSC’s and the PhD programs that can prepare me for such path and doing an MBA dissertation in risk management will only help me in the future. 6. Timing Mileposts You must reach stage 8 at least three weeks before your deadline, a month contingency provision is also advisable to allow for slippages. You should produce this proposal in between one and two months from classroom date. After three months your progress may be put before the Academic Progress Committee Milestone Description Due date Remarks 1 Stage 1: Area of interest identified Nov 12,07 Done and submitted 2 Stage 2: Specific topic selected Nov 12, 07 Done and approved 3 Stage 3: Topic refined to develop dissertation proposal Nov 29, 07 Done and refined 4 Stage 4: Proposal written and submitted Jan 28, 08 In progress, refined and submitted 5 Stage 5: Collection of data and information In progress 6 Stage 6: Analysis and interpretation of collected data/information In progress 7 Stage 7: Writing up 8 Stage 8: Final draft prepared – submission of dissertation 9 Final Deadline – eight months from classroom date. Bibliography (2007) ‘Goldman Sachs Bets lift Profits’. [Online] BBC News. Available from: http://news.bbc.co.uk/2/hi/business/7005769.stm(Accessed: January 25, 2008) (2007) ‘A Year to Separate the Men from the Boys’, Euromoney, 38(463), EBSCOhost [Online]. Available from: http://web.ebscohost.com.ezproxy.liv.ac.uk/ehost/detail?vid=13&hid=105&sid=e850e9a7-06dd-4821892a 3ba692850ac1%40sessionmgr106 (Accessed: January 25, 2008) Chen, Y. & Liang, B. (2007). ‘Do Market Timing Hedge Funds Time the Market’, Journal of Financial and Quantitative Analysis, 42(4), pp. 827 856, EBSCOhost [Online]. Available from: http://web.ebscohost.com.ezproxy.liv.ac.uk/bsi/results?vid=2&hid=115&sid=ebef45ad faaf-42ae-beab-99da6d0ced05%40sessionmgr102 (Accessed: 21 February 21, 2008) Derman, Emanuel. (2002) ‘The Perception of time, risk and return during periods of speculation’, Quantitative Finance, 2(4), pp. 282-296, EBSCOhost [Online]. Available from: http://www.informaworld.com.ezproxy.liv.ac.uk/smpp/content~content=a714024638 (Accessed: February 17, 2008) Goldman Sachs (2008). Conservative Liability Structure [Online]. Available from: http://www2.goldmansachs.com/our-firm/investors/creditor information/liquidity-risk-management-files/conservative-liability-structure.html (Accessed: February 17, 2008) Hennigan, Michael. (2007). ‘How Goldman Sachs made Money from US Subprime Mortgages on Way up and Down’. [Online] News International. Available from: http://www.finfacts.com/irelandbusinessnews/publish/article_1011979.shtml (Accessed: January 31, 2008) Levy, Haim. (2005). Investments. 1st ed. Harlow: Pearson Education Ltd. Loomis, Carol. (2007). Robert Rubin on the job he never wanted [Online] Fortune Magazine. Available from: http://money.cnn.com/2007/11/09/news/newsmakers/merrill_rubin.fortune/index.htm (Accessed: February 17, 2008) Rosenbush, Steve. (2007). ‘Goldman’s Verdict: No Contagion Yet’, Business Week Online, pp 9-9, Business Source Premier [Online]. Available from: http://web.ebscohost.com.ezproxy.liv.ac.uk/bsi/detail?vid=5&hid=107&sid=f3736716-91f7-4b3b-886d bd263010b12c%40sessionmgr108 (Accessed: February 17, 2008) Spence, John. (2007) ‘Goldman Seen Reaping Subprime Windfall’. [Online]. MarketWatch. Available from: http://www.marketwatch.com/news/story/goldman-seen-profiting-subprimemess/story.aspx?guid={11BD69BE-9657-4705-B6DC F94B52213D70}&dist=TNMostRead (Accessed: February 05, 2008) Teach, Edward. (2008). ‘A Hedge-Fund mystery’, CFO, 24(1), pp. 29-30, EBSCOhost [Online]. Available from: http://web.ebscohost.com.ezproxy.liv.ac.uk/bsi/detail?vid=3&hid=104&sid=50601b06-6479-4b75-a7b4 dfdc9e122eca%40sessionmgr103 (Accessed: February 21, 2008) Read More