07/25/2010 11:15 am ET Updated May 25, 2011

Goldman's Half Trillion With a Hedge Fund Is Too Big to Ignore

In June 2008, Goldman Sachs wasn't subject to the kind of regulatory scrutiny imposed on commercial banks. If it were, a government auditor would have asked a very obvious question: "What are you doing with half a trillion dollars in notional exposure to a hedge fund?" To characterize that dollar amount as suspicious would be an understatement. Goldman's fourth largest counterparty exposure for credit derivatives, about $590 billion, was to a hedge fund called Blue Mountain Credit Alternatives Master Fund, L.P. According to numbers compiled by the Financial Crisis Inquiry Commission, Goldman did more credit derivatives business with this hedge fund than with JPMorgan Chase, UBS or Barclays. With a credit default swap, you can lose 100% of the notional amount.

Derivatives exposure can be measured all sorts of different ways, so Goldman might claim that the net number is, in fact, much smaller. For instance, Goldman bought $566 million in credit protection on AIG from Blue Mountain, but it also sold $581 million in credit protection to Blue Mountain. So if AIG had gone bankrupt, Goldman would have owed $15 million to Blue Mountain. The net is reasonably small. Even so, that kind of execution risk on a single hedge fund, founded in 2003 with 115 employees, would set off alarm bells with most auditors. Blue Mountain had $3.2 billion in funds under management as of January 1, 2007. The FCIC should dig much deeper.

The primary reason why the amount looks so weird is that derivatives trading is dominated by the too-big-to-fail crowd, global banks like Deutsche and Barclays, plus, (before we learned that Lehman was too big to fail) large U.S. brokerage firms. The Office of Currency Control, which compiles exposures on all U.S. bank holding companies, showed that by year-end 2008, U.S. banks held $15 trillion in notional exposure on credit derivatives. About 90% of that total, or $13.4 trillion, was concentrated among the big three -- JPMorgan Chase, Citibank, and Bank of America. Three months later, when Goldman, Morgan Stanley, and Merrill Lynch (embedded within BofA) were added to the list, the aggregate number doubled to $30 trillion. Almost all the exposure was concentrated among the big five.

Look at the trading counterparties with whom Goldman bought and sold credit default swaps on AIG. The big numbers are all with huge global financial institutions, except for Blue Mountain. This is very suspicious because credit default swaps offer all sorts of opportunities for insider trading and market manipulation. A CDS is very different from an interest rate or foreign currency derivative, which references a vast impersonal financial market. It would be very hard for a single bank or hedge fund to manipulate the yield curve or the price of the yen.

A credit default swap is the bet on the failure of a single entity, such as AIG, Greece or a CDO. Because there is no transparency in credit derivatives trading, there are opportunities for, among other things, round tripping, wherein trades go back and forth in order to establish trumped-up price quotes.

The OCC quarterly report, which also compiles the derivative trading revenues of all bank holding companies, discredits the testimony of Goldman CFO David Viniar, who told the FCIC that his firm did not break down derivative exposures. And now that Goldman's story about being fully hedged on AIG seems to be falling apart, there's no reason why we should take anything they say at face value.