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:

  1. They should never have done those trades in the first place, and
  2. 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.

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 the stock price at the time of the trade or 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. Source: Bloomberg

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