Bought and Paid For

by Charles Gasparino

  Ken Lewis, the soon-to-be-ex-CEO of Bank of America, was under investigation by former Housing and Urban Development (HUD) secretary and current New York attorney general Andrew Cuomo for his role in the bank’s controversial purchase of Merrill Lynch. I won’t dwell on Lewis’s legal problems here, but I will point out what he told the markets about the bank’s postbailout progress: Bank of America, with hundreds of billions in bad loans, which inherited Merrill’s portfolio of bad debt, made a profit in both January and February 2009, and it would continue to make money for most of the rest of the year.

  How can all of this be possible? Miller thought. He considered the three banks in question: Citigroup was drowning in a sea of subprime loans. A few months ago it had been basically insolvent, and it was now a virtual ward of the state (the government took a 30 percent ownership in Citi in return for its bailouts). Bank of America, based on its holdings of toxic assets, wasn’t far behind Citi in terms of the state of its balance sheet, and the government owned a piece of it as well. Jamie Dimon and JPMorgan Chase had escaped the worst of the subprime crisis, but even they weren’t without their problem loans and issues. And then there was the fact that the future, at least on paper, didn’t look too bright. Wall Street had gotten itself into the mess in the first place by holding onto bonds tied to the real estate market. And as Miller’s tour of Fort Myers real estate revealed, housing prices showed little sign of recovering or even stabilizing.

  Paul Miller is a good analyst, but like most analysts, he was rarely allowed to explore the inner workings of “the machine,” as the trading operations of Wall Street are known. Among the reasons why the burgeoning financial crisis had escaped the notice of most Wall Street researchers (and of most journalists, as well) is that the trading desks are considered off limits to all but a chosen few. The reason for this is simple: The trading desks are the Fort Knox of Wall Street. Over the past thirty years, the trading desk, particularly the bond trading desk, was where the big money had been made.

  The profit margins for creating and trading a mortgage-backed security dwarfed those of any other business on Wall Street. Why offer stodgy merger advice to a corporation or tell a small investor where to put his retirement savings when you can create a mortgage bond and basically print money? The result was that traders like Lloyd Blankfein were picked ahead of the bankers to fill the management ranks.

  One of the big ironies of the financial collapse was that while the likes of Blankfein were making so much money for Goldman, they were also creating the situation that led to its demise. Bankers used to love to brag that the mortgage-backed security did so much social good, allowing people who couldn’t afford homes access to loans so they could achieve the American dream. Maybe so, but consider the following: All the trading and risk taking with mortgage bonds, particularly bonds for which there was no public market and no way to truly gauge their value, had led to the financial collapse of 2008. Under Blankfein, Goldman had made a decidedly left-hand turn with its support of political liberals like the president and the Democrats who ran Congress, and Goldman was one of the top underwriters of mortgage debt. But that didn’t stop the firm, when it saw the crisis coming, from shorting (betting against) the very bonds that Big Government fans touted as vehicles toward universal homeownership. The “big short,” as it was known inside Goldman, had made the firm billions in profits. But Goldman wasn’t the only bank that benefited. Indeed, another large benefactor of this process was Fortress Capital, the giant hedge fund that had hired former liberal presidential candidate John Edwards in 2006. It should be noted that Edwards, for all his lofty rhetoric as a U.S. senator from North Carolina, a vice presidential candidate, and later a presidential candidate, had something in common with his liberal soul mate Lloyd Blankfein: Both apparently saw nothing wrong with profiting off the demise of the American economy as Fortress, too, was making money betting against the subprime market.

  And now, in another irony, it was that same trading that was returning Wall Street to the profitability that even informed skeptics like Paul Miller couldn’t believe was happening.

  The reason was simple: Miller and his colleagues weren’t allowed anywhere inside the Fort Knox-like secrecy that surrounded the trading desks, because if they had been, they would have seen that the Wall Street money machine wasn’t a function of brilliant bets on the bond markets (as the firms would later try to spin their return to profitability) but rather another, less publicized bailout engineered yet again by Wall Street’s friend, Big Government.

  The program was billed as a way to revive mortgage lending to consumers, which had virtually dried up. By purchasing an unbelievable $1.2 trillion in mortgage bonds and Treasury bonds (that’s almost $4,000 worth of bonds, many of them near-worthless toxic assets, for every single person in the United States), the Federal Reserve would stimulate the lending markets by lowering interest rates, thus reviving the mortgage bond market that allowed banks to make loans to consumers. Forget the fact that the mortgage bond market itself was the reason why so many lousy loans had been made in the first place; it was fairly clear from the beginning that it would be Wall Street rather than consumers that would see the immediate benefits from the program.

  “The government stepping in and buying mortgage securities accomplished two things for the banks,” Miller later reflected, as he began making sense of the situation. “It not only gave them a trading partner for all these illiquid assets, but it essentially allowed them to reprice their balance sheet.”

  Prices for mortgage-backed securities had fallen to historically low levels during the height of the financial crisis and immediately thereafter, resulting in massive losses in the banking system. Meanwhile, no trading was occurring with these bonds because no one wanted to be holding illiquid mortgage debt—it was a multitrillion-dollar game of hot potato, as it were, and the big financial firms were caught with the bonds nobody wanted. But now, with Uncle Sam coming in and buying those mortgages, the bonds were no longer illiquid. They were being priced, and priced higher because the Fed was essentially bidding up the prices of the debt from their rock-bottom levels. As a result, the banks were able to mark up the prices of many of these assets and book profits.

  “It diminished the possibility for more write-downs,” Miller would recall, “and it turbocharged their trading business.”

  While the banks’ trading business got roaring once the Fed started buying this near-worthless mortgage debt, the point of the whole exercise—to get banks making loans again to small business and consumers—was lost. The reason the Fed cared about the banks’ balance sheets and their giant holdings of toxic debt was that these massive losses on their balance sheets prevented the banks from making new loans: How could they give away cash when their own balance sheets were hundreds of billions in the red? Now that the banks’ books were healthier, they would go back to lending money.

  Or so the thinking ran. But what appeal does lending—which is time-consuming and carries risk even if it does provide a societal good—have, when trading, traditionally a riskier activity, could now be carried on virtually risk free courtesy of Uncle Sam?

  The answer? None.

  According to the Wall Street Journal, banks are nowhere close to meeting the borrowing needs of small businesses—only 50 percent of those polled say they received sufficient loans from their banks, compared with 90 percent just a few years ago. When asked about the paucity of bank lending, Jamie Dimon once told the president that as a result of the burgeoning recession, people and businesses weren’t borrowing, while JPMorgan Chase needed to preserve capital because it was still saddled with lots of bad debt on its books, the legacy of the financial crisis that will take years to wash away.

  The president, I am told, accepted Dimon’s explanation, but maybe he shouldn’t have, given all the special benefits Dimon and his fellow CEOs were receiving. Combined with near-zero interest rates and “too big to fail” protections, the Fed’s mortgage buying spree made Wall Street tra
ding a no-lose proposition. While small businesses were laying off workers and desperately hoarding cash to survive, Wall Street, just months after staring death in the face, was once again hiring traders. In the fourth quarter of 2008, Citigroup recorded over $8 billion in trading-related losses, according to SNL Financial. But by the first quarter of 2009, the battered bank had churned out over $3.5 billion in trading profits, lifting it to a $1.5 billion profit for the quarter—this after a record $17 billion loss just the previous quarter.

  Bank of America’s trading profits were even better. With the integration of Merrill Lynch, which it had acquired at the height of the crisis, combined with its existing force of fixed-income traders, Bank of America’s trading force generated $7.5 billion in profits, lifting its total quarterly profit to $4.2 billion. But it was Goldman Sachs whose results in the second quarter of 2009 finally made Miller a believer: The company, even though it was smaller than many of its competitors, recorded an incredible $8.3 billion in trading profits.

  This was no fluke. The government spigot pouring money into Wall Street’s coffers had been opened up all the way.

  “The government basically created an environment where Wall Street couldn’t lose,” Miller later remarked. “They bought product from the banks, and that buying not only helped their trading activity, but it also helped establish a higher price for many of these assets. It was a win-win.”

  It was the summer of 2009, and Lloyd Blankfein, the diminutive CEO of Goldman Sachs, was basking in the twin achievement of having not only saved Goldman Sachs from extinction but also returned the firm to the profitability that its partners had grown used to for so long. The firm was on its way to its best year ever—annual profits of about $13.4 billion. And that meant that bonuses would return to prebailout levels; at least, that’s what Blankfein’s senior staff began telling the big earners at the firm who would receive these multimillion-dollar bonuses.

  It was once again a good time to be a Goldman Sachs executive. Blankfein himself, if the firm kept on its current pace, could make as much as $100 million in 2009, nearly double his record-breaking CEO payday of approximately $67 million for 2007.

  That, perhaps not coincidentally, was the year when Goldman came up with the idea to short the housing market, while much of the rest of the Street kept drinking the Kool-Aid and buying and holding mortgage bonds that would eventually implode. Goldman’s short sale of housing-related debt was fairly controversial on Wall Street. Competitors accused the firm of betting against mortgage bonds it sold to customers or, even worse, knowingly selling toxic mortgage debt to customers while it profited on the demise of the mortgage bond market and the entire financial system. (The SEC would eventually charge the firm with failing to disclose to its clients that it was peddling them toxic debt that was basically created to fail with the help of famed hedge fund manager John Paulson, who made billions of dollars also by shorting housing bonds in 2007.)

  Goldman, of course, denied the charge and insisted its remarkable 2007 performance was nothing more than “hedging,” or good risk management. (It would also insist, just a little later, that because of its savvy business practices, it really didn’t need any bailout money but was forced to take it by those in Washington.) And now it was attempting another spin, saying its massive trading profits during in 2009 were once again the result of its exceptional abilities to trade better than the next guy.

  Goldman’s explanation was only half right. Yes, Goldman was an exceptional firm; in 2007 it foresaw the housing bubble’s collapse while firms like Citigroup, Merrill, Lehman, and Bear Stearns continued to double down on the market. But in doing so, Goldman didn’t just “hedge” its own positions; a growing body of evidence began to build that the firm relished making money by screwing those of its clients who were either too stupid or just too blinded by profits during the bubble years to see the looming collapse. Goldman did this by selling these clients, mainly large banks and other sophisticated investors, mortgage bonds and other derivatives of these bonds that its own traders had described as “crap.”

  Goldman had spent much of the end of 2008 arguing in the press that it had been forced to accept bailout money it really didn’t need, including the $180 billion government bailout of the once-mighty insurer AIG. That bailout ensured that AIG could make good on insurance policies known as credit-default swaps, which covered the value of hundreds of billions of dollars’ worth of near-worthless toxic debt on Goldman’s balance sheet. Thus, the bailout of AIG was in effect a backdoor bailout of Goldman; without the government rescue, AIG wouldn’t have been able to fully insure the debt held by Goldman, and Goldman would have had to take massive losses.

  At least that was the opinion of the federal government, namely the men trying to stabilize the financial system during the meltdown of 2008, then Treasury secretary Hank Paulson and New York Fed president Tim Geithner. They argued that in order to prevent a complete meltdown of every bank in the world, the largest ones in the United States needed to be saved by pumping as much money into AIG as humanly possible.

  The result was a windfall for Goldman—it was paid one hundred cents on the dollar for bonds worth far less. But Goldman was far less generous in thanking the American people. In fact, it thanked no one except itself. Goldman’s PR chief, Lucas van Praag, a smart, sharp-tongued Englishman with a gift for biting remarks, became the main conduit of Goldman’s campaign to make the bailouts seem like a nonevent and attribute the firm’s good fortune to its own “risk-management” techniques.

  By early 2009, having avoided the fate of Lehman Brothers and Bear Stearns and making gobs of money once again, Goldman and Van Praag began to fine-tune their talking points to fit the changing times. They took the position that the near-zero interest rates and the too-big-to-fail status that meant Goldman was classified as a bank by the government rather than as the hedge fund it really was, not to mention the Fed’s mortgage-bond purchases, really weren’t the causes of the trading profits that kept piling up.

  No, according to Van Praag, Goldman was making money because it was really, really smart.

  “We’re simply good at what we do,” he told me.

  At Morgan Stanley’s headquarters in Midtown Manhattan, the mood was less jovial. Morgan’s CEO, John Mack, was widely regarded inside Morgan as having saved the firm from imminent collapse by securing a massive investment from the Japanese bank Mitsubishi, even if he had also needed the government bailouts to make it completely through the crisis. In the end, Mack had been shaken by the financial crisis and decided to step down by the end of 2009. He was, after all, the architect of the firm’s foray into risk that had resulted in billions of dollars of losses, including a massive $8 billion loss from just one trading desk, possibly the biggest single trading loss in Wall Street history. With that, Mack vowed to change the firm’s direction: Morgan was going back to its roots as a financial adviser to individuals through its brokerage (it was now in the process of buying pieces of Citigroup’s brokerage business, Smith Barney) and to large companies through its investment bank.

  The firm would deemphasize trading, which, along with the Citigroup deal, accounted for its first-quarter loss. Mack also wanted nothing to do with Goldman’s spin. He had ordered his PR staff to do the exact opposite of what Goldman was doing; instead of laying the credit for its eventual recovery on its own brilliance, Morgan would thank the government and the American taxpayer at every chance it got.

  The straight talk from Morgan Stanley’s PR staff paid off—the firm remained out of the headlines as Goldman began to get crushed with bad publicity—but Mack’s other edict seemed to backfire. While Goldman was killing the markets with massive trades and investments in esoteric bonds, Morgan’s new approach resulted in a shocking first-quarter loss. That’s when the spin at Morgan began: Executives blamed the loss on the expensive acquisition of the Smith Barney brokerage firm from Citigroup as Pandit began to unload assets to satisfy his new shareholders, the federal bureaucrats, who, be
cause of the government’s continued ownership stake in Citi (as of the writing of this book, the feds are still looking to sell their share and unwind their stake), were now practically running the daily operations of the big bank.

  But inside Morgan, board members were seething. Mack may have wanted to do the right thing by leaving the gambling to Goldman, but it was costing the firm money. Within days of the announced losses, Morgan announced that it had gone out and hired a couple of hundred traders. And presto, the profits began to soar, as did the firm’s bonus pool.

  But by now, the press was on to a new angle in the continued drama of the financial crisis, and it was one that especially resonated with the general public: Only a year after the bailouts the very same people who were saved by the American taxpayer were now enriching themselves with huge bonuses. The biggest and most conspiracy theory-esque attack came from writer Matt Taibbi of Rolling Stone, who took special aim at Goldman Sachs, calling it a great “vampire squid” that had used its connection to government to make money when the markets tanked and was now making money while setting the stage for yet another meltdown. Among the article’s shortcomings (and there were many hidden inside its well-written passages) was its insistence that Goldman was somehow more of a financial menace than its rivals. Taibbi asserted without much real evidence that Goldman stood at the center of nearly every financial scandal “since the 1920s,” looting and pillaging its way to massive amounts of wealth and power inside the federal government.