How did Goldman do it?

Goldman Sachs was playing in the subprime sandbox just like Citigroup and Merrill Lynch. Somehow, however, Goldman has avoided the dirt and mess flowing from the summer squeeze with minimal subprime related writedowns.

The Times UK points out that Goldman's $1.7 billion write down appears frugal next to Merrill's $7.9 billion.

Goldman CEO Lloyd Blankfein does not foresee any subprime related writedowns according to The Street.com. In fact, Goldman is gearing up for business while its competitors are struggling to pacify investors.

The question is, how did Goldman do it?

Part of the answer are hard to value "level three" assets that add up to $72 billion, according to The Times UK.

The difficulty in valuing assets after the credit market turmoil of the summer has plagued investment banks. Where assets cannot be "marked to market" because no market is available, a "marked to model" system is used.

This process has been derided by critics as "marking to myth".

But Goldman said that of the $72 billion level three assets, it wholly-owned only $51 billion worth and that private equity investments and real estate comprised half of the remainder.

Read the article here.

If the words "mark to market" sound eerily familiar, you too must have watched The Smartest Guys In The Room on your last plane trip.

The Enron documentary explains the crucial role this accounting method of valuing assets based on their market price, or the price of a similar asset, played in the Enron scandal.

When it comes to Goldman's large position in the fan dangled level three assets, which are traded over the counter (OTC), the notion of a market becomes pliable.

Consider a basic barter exchange: two market participants agree on a price and perform a transaction. The asset is exchanged for the agreed value. Hence, in the desert a glass of water can buy you a diamond ring.

Unlike bond markets, which are also OTC, there are no market makers when it comes to structured mortgage backed securities.

Without market makers to place indicative bids and sells, participants are left to estimate asset values themselves. This is pretty much what Goldman is doing with mark to model.

The problem is not with the system, however, but with its accuracy. If Goldman's model adequately estimates risk and correctly values the assets, the bank is set to enjoy smooth sailing through the subprime seas.

If the model is wrong, Blankfein will pay for his bravado as Goldman writes down the losses.