Unlike at most other Wall Street firms, pedigree seems to be of little moment at Goldman Sachs. While it is certainly true that the firm has its pick—year after year—of the smartest graduates of the nation’s best colleges and universities as well as of its top graduate schools, the firm’s hiring process seems to revolve largely around merit. Whereas other firms—such as Lazard or Morgan Stanley—prized the hiring of scions of the rich and famous politicians or CEOs and sought them out, Goldman seems to be swayed less by what your last name is and more by how bright you are. Goldman’s obsession with finding the smartest people in any room became such that even Bill Gates noticed. He once remarked that Microsoft’s biggest competitor was not another software company but rather Goldman Sachs. “It’s all about IQ,” Gates said. “You win with IQ. Our only competition for IQ is the top investment banks.”
Fortunately for Goldman, the firm hired, nurtured, and promoted Josh Birnbaum, whose insights and business acumen played a huge role in Goldman’s astonishing Houdini act during the cataclysmic market collapse that began in 2007. Raised for a time in Paris with his two sisters, he eventually moved with his family to Oakland, California, where his father wrote software for a computer company. Birnbaum attended the Head-Royce School, a private day school in Oakland, from which he graduated in 1990. His interest in finance was encouraged by an uncle—whom he greatly admired—and who one day showed his nephew the Wall Street Journal’s options table. His fascination with options and how much money potentially could be made from them grew out of that moment. He was twelve years old. He had his own trading account at Charles Schwab, and although he said he does not know “what the audited returns” in it were, he was “very focused on finance from a young age.”
To further pursue that interest after high school, Birnbaum headed to the University of Pennsylvania’s Wharton School, where he majored in finance, as did most of his classmates, and dreamed of getting a job on Wall Street. After his sophomore year at Wharton, he wanted to get an internship in finance but knew that since he was only in his second year, his appeal to Wall Street would be limited because it would be two years before he was able to start working full-time. But Birnbaum was crafty; he had sufficient credits under his belt to claim to be a junior. So he headed to the school’s placement office and started scanning into a computer the piles of business cards that Wall Street executives had left there during the job interview process. He then sent out hundreds of letters trying to convey the idea each time that he had always wanted to work at that particular firm.
He received many responses, but the two that were the most intriguing were from J.P. Morgan and Goldman Sachs. The Goldman letter came from the mortgage department, which at the time was run by Mike Mortara, the transfer from Salomon Brothers. Mortara had worked with the legendary Lew Ranieri—the godfather of the securitization business on Wall Street, where mortgages and other cash-flow streams, such as credit-card receivables and auto-loan receivables, are packaged up into securities and sold off to investors. Birnbaum’s first interview at Goldman was with Gary Gensler, who was then a partner and a trader in the mortgage department, trading collateralized mortgage obligations, which were known around Wall Street as CMOs. According to an internal Goldman “mortgage primer” document, CMOs “are created by pooling” various kinds of home or commercial mortgages “and splitting their cashflows into a number of tranches.”
Birnbaum wanted to be a summer CMO analyst. He even knew what CMOs were, even though he was barely nineteen years old. He got the job at Goldman, in part because of his palpable intelligence and in part because he looked like a textbook Goldman employee: he was handsome and athletic, favoring tightly fitting spread-collar shirts.
In the early 1990s, there were often debates among the best and brightest young finance students about whether it was better—more lucrative, that is—to be a banker or to be a trader. This had been a perennial question on Wall Street for at least a generation. Some years the bankers would be the Kings of Wall Street, garnering the highest compensation, the most prestige, and the magazine covers; other years, the traders would be the Big Swinging Dicks, as they were known, and bring home the fattest paychecks. But Birnbaum had no such conflicts about whether he wanted to be a banker or a trader. “Trading appealed to me always just because it was more mathematics,” he said. “I was always a math guy.”
During the summer of 1992, as Wall Street was slowly emerging from a deep credit crunch brought on by the aftermath of the crash of 1987, investment banks were competing fiercely to underwrite CMOs, even though there was not a lot of money in doing so. Mortara and Goldman were busy fighting it out with Kidder, Peabody, and its star trader, Michael Vranos. In 1993, Kidder paid Vranos $15 million—a huge amount at the time (and still, frankly)—and he was often referred to as “the most powerful man on Wall Street,” since Kidder underwrote twice the volume of CMOs as its nearest competitor. “There was a big land grab for league tables,” Birnbaum explained, referring to the way Wall Street keeps score of how much business it does in a particular product area.
Birnbaum sat on the CMO trading desk during his summer internship and worked on structuring the debt securities. What made his experience so unusual was that it wasn’t about networking or booze cruises or rotating from one product area to another during the course of the summer. “This was a trial-by-fire, put-your-butt-in-a-seat, we-really-need-you-to-structure-stuff-right-now kind of thing,” he said. “There’s no orientation, there’s none of that crap. It was just a phenomenal experience for me to be able to do something real in a very hot area at the time.” Goldman asked him to return the following summer. Once again, he structured CMOs. “It was still a great time to do it in 1993,” he said. “There was a steep yield curve”—meaning the cost of debt was higher the longer someone could take to pay it back—“so intellectually it was an interesting thing.” He had straight As when he graduated from the Wharton undergraduate program in December 1993—a semester early—and because of that, and having Goldman Sachs on his résumé for two summers, he had any number of job offers to choose from. But he decided to return to Goldman, as do the vast majority of people who work there during the summers before they graduate. “I had a lot of goodwill built up already,” he said, “and it was a great firm. I was interested in the products. I liked the people. In terms of really seriously considering other things, I didn’t.”
He continued doing what he had done the previous summers, structuring CMOs. For the uninitiated (which would be almost everyone before the financial crisis of 2007), Birnbaum’s job was to buy mortgages from mortgage originators—at the time, other Wall Street dealers or mortgage bankers, such as Countrywide and New Century Financial Corporation. The originators would, in turn, ask Fannie Mae or Freddie Mac—the two quasi-government mortgage agencies—to “wrap” the mortgages. Meaning Fannie and Freddie would—for a fee—guarantee the timely payment of the principal and interest on the mortgages. In those days, the mortgages were sold in small lots, so it was the job of Birnbaum and his colleagues to buy up a bunch of the mortgages so they could be packaged together into securities and sold off to investors. It was the Wall Street version of a factory floor. “The traders who were trading mortgages would sit on a row,” Birnbaum explained, “and then a row behind that would be the mortgage banking sales force, and they would sit there on two phones and they would say, ‘Countrywide has two million Fannie Mae six percents for sale, what do you bid?’ And then the guy would yell out, ‘I’ll bid ninety-nine and seven-eighths!’ and nothing was electronic back then, so there was a lot of yelling and it was kind of an exciting environment to work in, especially as a young and impressionable kid.” While Birnbaum would sit nearby calculating internal rates of return on his Lotus 1-2-3 software, there was a “constant flow of this kind of chatter,” he said. At that time there was a huge wave of mortgage refinancing.
The art of the deal was to figure out ways to structure the CMO securities to appeal to different types o
f investors. CMOs “are able to satisfy disparate investors’ needs for cash flows with varying levels of average lives, coupons, and stability profiles,” according to Goldman’s marketing material. “The primary purpose of this structure is to create [mortgage-backed securities] with varying average lives and to redistribute prepayment risk.” For instance, the steady stream of mortgage payments appealed to commercial banks as short-term investments as did the price of the securities relative to more expensive—but less risky—U.S. Treasury securities. The problem for banks was that if borrowers started to refinance their mortgages—which usually happened when interest rates fell—what they thought would be a long-term, fixed-rate asset would suddenly be gone. People like Josh Birnbaum were in business to chop up these streams of mortgage payments into different cash payments—tranches, they were called on Wall Street—so that investors who wanted a fixed-rate, long-term return could get that and those willing to take more risk (of, say, a refinancing) could get paid a higher interest rate to take that risk. “The whole concept behind the CMO was to be able to give the more risk-adverse investors a portion, which is going to be less risky, or [have] less variability in terms of the cash flow,” Birnbaum explained, “and then, if you will, subordinated investors—or what they called ‘support tranches’—would bear more variability.… The CMO would do that.”
There was also an element of salesmanship to the business. “What’s the art of arbitrage?” Birnbaum continued. “There was some combination of math skills and sales skills and trading skills. You were generally never selling the whole thing. So the art was a combination of those things. You know you needed to sell your sales force in order for them to sell their clients. But you also needed to be able to know how to price risk because you were taking risk for the firm, you were putting stuff on the firm’s balance sheet, and you needed to understand the math of these structures because they were complicated. How to optimize how much of a structure would be safe versus less safe was not something that most people kind of do in their head. Typically the senior guys on those desks were really good math guys.”
What started out as a simple idea—say, prioritizing cash flows to certain types of investors—had become quite complicated by the time Birnbaum made his way to Goldman’s mortgage desk. “These CMOs were being divided into—in some cases—more than one hundred different classes, and you weren’t just playing games with them,” he said. “Let’s say that it’s trading at one hundred and five cents. But you have a buyer who doesn’t want to pay more than one hundred cents. So you could actually take that tranche or that collateral and you could divide it into two pieces: one that’s got a coupon that’s lower that trades at one hundred and one that’s got a really high coupon, in some cases only a coupon that you would sell to a more speculative investor. Or you might have an investor that says, ‘I don’t want any fixed-rate risk—I’m a floating-rate investor, I want floaters,’ so you create a floater. What is the opposite of a floater? Inverse floater. So you have this whole conservation of cash flows and kind of giving people what they want.” The idea was not dissimilar to buying all the disparate ingredients to make cakes in a bakery and then selling the finished cakes for more than the cost of the ingredients.
This bit of Wall Street alchemy represented a serious evolution of the way mortgages were previously bought and sold. Once upon a time, a local banker would provide a mortgage to his neighbor so that he could buy his own home and have a small slice of the American Dream. Before making the loan, the banker would know all about the fellow—his reputation, his standing in the community, his income, his net worth, and his prospects for repaying the borrowed money. That mortgage would then sit on the local bank’s balance sheet for thirty years, unless paid off sooner, and the bank’s profits—its ability to make money from money—would be determined in large part by how good a credit risk the borrower turned out to be. If he paid the interest and principal on the mortgage on time, it was a good bet the loan would be profitable for the bank. Knowing your customer was good business.
That tried-and-true formula began to change in 1977 when the Brooklyn-born Lew Ranieri came up with the clever idea that everyone would be better off—the borrower, the bank, and of course Salomon Brothers, his employer—if there were a way to buy up the mortgages from the local banks, put them all together, thereby spreading the risk presented by any one borrower across a broad portfolio of borrowers, and sell pieces of the resulting securities backed by these mortgages to investors the world over, offering varying rates of interest depending on an investor’s risk appetite. Ranieri, who started at Salomon in the mail room, assembled a team of PhDs to package, slice, and sell the mortgages after he realized mortgages were “just math” and streams of cash flows that investors might want to buy. This powerful idea—dubbed “securitization”—was one of those once-in-a-generation innovations that revolutionized finance. Ranieri’s idea caught on and, so the theory goes, helped reduce the cost of mortgages for borrowers all over the country, since the market for the mortgages was far more liquid than when they simply sat on a bank’s balance sheet tying up capital for thirty years.
Ranieri brought a similar magician’s skill to the streams of payments for car and credit-card receivables, which were also securitized and sold off to investors worldwide. Salomon Brothers—and Ranieri—made a fortune from implementing Ranieri’s insight. In 2004, BusinessWeek dubbed Ranieri “one of the greatest innovators of the past 75 years.” But what Ranieri and his innovation really did was change forever the ethic of Wall Street from one where a buyer knew a seller, and vice versa, to one where the decision to buy something was separated from traditional market forces. No longer was a buyer making an affirmative decision to buy something from a seller he knew; now he was buying a slice of a package of stuff wrapped in a pretty bow that had the appearance of being worth what was advertised, but wasn’t really. “When securitization arrived,” explained Salim “Sandy” Lewis, a onetime Wall Street arbitrageur, “the ‘I buy’ moment in mortgage making evaporated. Accountability vacated. Fees replaced liability, as liability was sent offshore, on advice of compliant, crooked counsel. This is enabling. All of them did it.”
Of course, as with any innovation on Wall Street—the introduction of junk bonds in the 1980s (courtesy of Michael Milken, at Drexel Burnham Lambert), the bridge loan in the 1980s (courtesy of the late Bruce Wasserstein, then at First Boston), or the Internet IPO in the late 1990s based on nothing more than the number of claimed “eyeballs” on a fledgling website (courtesy of Frank Quattrone, then at Morgan Stanley)—it was just a matter of a short amount of time before the new idea was replicated, and often improved upon, by the competition, especially when there was money—always lots of money—to be made. Warren Buffett has referred to this phenomenon as the “three I’s of new markets”: the Innovators, the Imitators, and the Idiots, who end up taking a fine idea and pushing it to the brink of lunacy. “People don’t get smarter about things that get as basic as greed,” Buffett once said. “You can’t stand to see your neighbor getting rich. You know you’re smarter than he is, but he’s doing all these [crazy] things, and he’s getting rich … so pretty soon you start doing it.”
Such was the life cycle of Ranieri’s brainchild—the mortgage-backed security. Over time, Ranieri’s lieutenants—including Mortara—were hired away by other firms and began to build important mortgage businesses at Salomon’s competitors, like Goldman Sachs and Merrill Lynch.
For all the envy it inspired and the prestige it radiated among its Wall Street peers, when it came to financial innovation Goldman Sachs was more akin to Microsoft than to Apple—as Mark Schwartz had pointed out in his speech to the incoming Goldman partners at Arrowwood—in the sense that product innovations were never particularly its greatest strength. But the firm was sufficiently astute to recognize the innovations of others and their moneymaking potential and was able to quickly deconstruct their technology and copy it.
Mortara, one of the original
innovators of securitization, helped Goldman catch up with its peers at Salomon Brothers and Kidder, Peabody in the world of selling and trading mortgage-backed securities. “He was the most dynamic guy I’ve ever worked for, without a doubt,” Birnbaum explained. “He was very respected. He carried around—playfully—a baseball bat, and he’d sit there in meetings with his little bat. He definitely toed the line from where you’re supposed to be feared versus loved.” In 1992 and 1993, during his summer internships at Goldman, the CMO market was hot and Goldman was turning out the securities “like it was a fortune cookie factory,” Birnbaum said.
But by 1994, his first year as a full-time Goldman employee and one of Goldman’s periodic anni horribiles, the market for CMOs slumped dramatically, and the pace of work on the mortgage desk slowed considerably. “Doing a CMO was a much riskier endeavor, or was perceived to be a much riskier endeavor, so you weren’t allowed to print a CMO deal in the mortgage department unless Michael approved it, and that was a big departure,” Birnbaum said. He had spent much of the year redesigning Goldman’s financial model for structuring mortgage-backed securities to make it more automated and more proprietary, a source of pride and competitive advantage at the firm. He also helped to create and to automate a database of all the mortgage-related deals priced in the secondary market so that the trading desk would have the best possible information. Most nights, he worked until eleven o’clock. “But there was almost no issuance [as 1994 progressed], so we were like, ‘Oh, God, I created this great package and I’m not even sure when we’re going to do more CMOs.’ ”
At this moment of frustration, Birnbaum asked to move over to the trading desk—from the structuring desk—to get more action. Goldman accommodated him. “They were willing to try to make me happy and keep me intrigued, and that was a great move for me,” he said. Working with the more senior traders, he started buying and selling balloon mortgages, fifteen-year mortgages, and thirty-year mortgages. He made markets for Goldman’s clients. He made proprietary trades for Goldman itself. He traded with other big institutions as well as with Fannie Mae and Freddie Mac, which had started buying mortgages for their own portfolios. He also began exercising that part of his brain intrigued by options and option trading and somehow came to focus on buying and selling options on mortgages and asking the more senior traders on the desk such esoteric existential questions as, “If you own a call option on a mortgage and a mortgage itself is short a call option, what do you end up owning?” (His boss replied that the answer was “complicated” and “not worth going into.” In other words, he had no idea what the answer was.)
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