Tuesday, April 27, 2010

Shorts vs. Net Shorts

I don't want to put myself in the awkward position of defending a bunch of overpaid bankers from Goldman Sachs, but today's Congressional questioning was a bit ridiculous. The first thing that struck me was how evasive many of the current and former executives of Goldman Sachs were. However, this was no surprise. After all, these guys are being sued by the SEC. They must be very careful about what they say.

The second thing that struck me was Senator Carl Levin's apparent misunderstanding of short positions and net short positions. Goldman CFO David Viniar kept trying to explain to Senator Levin that Goldman's net short position wasn't material. Yet Levin did not want to hear it. Instead, he kept trying to get Viniar to admit that Goldman had a large short position.

Viniar is right. In order to understand Goldman's exposure, you must compare the size of its short position to the size of its long position. It is meaningless to say that the company made a lot of money on its shorts unless you also consider how much money it lost on its longs. Senator Levin did not seem to understand this point.

By way of comparison, suppose an individual with $1,000 to his name borrows $100,000 and puts the full amount into his savings account. Senator Levin would argue that the value of his assets went up materially. That's true, but it's meaningless because the value of his liabilities also went up by the same amount. In fact, this individual's net worth hasn't changed at all. You can't look at just one side of the balance sheet.

If you make a lot of money on a trade, the IRS does not tax you on that trade alone. Instead, it allows you to net your gains against your losses and taxes you only on your net gains. Why can't Senator Levin understand a concept as simple as this?

Goldman may have done a lot of things wrong, but David Viniar is absolutely right to insist that examining the company's short position in isolation is completely misleading.