In February 1996, President Bill Clinton nominated Alan Greenspan for a third term as Fed chief. Accommodating monetary policy during Clinton’s first four years in office led to a booming stock market, which helped Clinton get re-elected.

In its first ninety-six years, the Federal Reserve did not purchase a single mortgage bond.  Yet by the end of President Obama's first term in office, they had bought $1.25 trillion.  A few months before election day that year, the Fed launched its third round of unsterilized bond purchases, dubbed QE3.  In a statement on September 13, 2012, then-Fed chair Ben Bernanke announced $40 billion per month in additional bond-buying, which would include mortgage-backed securities (MBS).  What most people didn't realize was that the Fed's purchases would most likely be in shorter-dated MBS, so MBS with longer durations would likely fall in value.

Convexity is a measure of curvature in the relationship between bond prices and yields, which shows how the duration of a bond changes as interest rates move.  Generally, interest rates and bond prices move in opposite directions.  Negative convexity means the opposite: those bonds lose value when interest rates fall.  Most mortgage-backed securities are negatively convex, as illustrated with a downward sloping curve:

The day before the Fed's formal statement, Goldman Sachs published a note to clients suggesting that they unload their older mortgage-backed securities that would most likely take a hit.  Professional traders got the message, and then some.  They shorted MBS and made a fortune.  At a speech at the Mises Circle in Manhattan the following morning, David Stockman described the frenzied trading at institutional desks around the globe on Goldman's advice:

Yesterday, the smart guys knew there were certain kinds of MBS, mortgage-backed securities, to buy because they were going to rally on the Fed's announcement that they were going to buy forty billion a month, but there were also certain kinds of MBS to sell, because these were older MBS with higher interest rates, and now that the Fed is driving the mortgage rate down even lower, those are going to prepay at a higher rate than previously assumed. The negative convexity is going to eat people alive, and so yesterday, some people shorted negative convexity, and bought the MBS that the Fed is going to be buying, made a killing, and this is supposed to be a capital market! Now for some reason, Goldman Sachs printed the day before exactly what the Fed was going to do, and if they were so bold, I might say, to print it in a message to their unwashed clients, I can imagine what they were telling the real insiders.

To be precise, the Fed announcement hit the wires at around 4:00pm EDT, after the close of trading.  One hundred basis points might not seem like a lot in nominal terms, but the sheer volume of the market allows for quite a bit of leverage.  According to Stockman’s calculations, the “real insiders” made $50 billion in less than an hour.  He continues:

Now, my point is that, if you saw what happened yesterday coming, and it was well telegraphed, I believe a couple of thousand people made fifty billion dollars yesterday in fifty minutes as a result of the radical, sudden, lurching moves that occurred in the fixed income markets as a result of this announcement. The MBS, the mainstream Fannie Mae three percent coupons, rallied in a few minutes by one percent. Now when you realize there's about five or six trillion in mortgage-backed securities, Fannie, Freddie, Ginnie Mae and then a couple trillion or so that are left from the private label issuance, all of those were powerfully and massively affected yesterday by the announcement of the Fed, and the smart traders were positioned, laughed all the way to the bank, and captured the windfall.

In March, Fed chairwoman Janet Yellen finally got around to addressing this type of skulduggery.  “It is unfortunate that I need to underscore this, but we expect the firms we oversee to follow the law and to operate in an ethical manner,” she said to a gathering at the Citizens Budget Commission in New York.  “Too often in recent years, bankers at large institutions have not done so, sometimes brazenly,” she concluded.

The fact that somebody at Goldman casually issued a report on Fed policy one day before the actual announcement is a non-starter.  What's important to remember here is that ordinary Americans don't have the information or computing power that institutions do.  A mortgage bond that was ultimately shorted on September 13, 2012 might well have included a note held by a working-class person who was diligently making payments on it before the financial crisis swept it away, and with it his home.

Four years prior, in September 2008, Goldman Sachs was in the same ICU ward and hooked up to the same ventilator as Lehman Brothers, but then-Treasury Secretary Henry Paulson rescued Goldman and pulled the plug on Lehman.  Why?  Here's a trivia question: where did Hank Paulson work for 32 years (including as CEO) before becoming treasury secretary?