That first day, Birnbaum did some thirty different trades involving the ABX index and made $1 million in profit. The next closest bank trading the index had made five trades. “We approached it as a great opportunity,” he said. “We were a liquidity provider from day one and printing a lot of trades. Other banks had more trepidation: ‘What is this index? How does this affect our business? How does this affect what was traditionally a long-only asset-backed business?’ We were, like, this is a new regime. This is going to be a two-way business in mortgage credit from now on, and there’s a potential flow product with a lot of interest from lots of different kinds of market participants. From day one that thesis was corroborated by virtue of the net we made”—the $1 million—“and the number of trades we did first versus our competitors. So out of the gate we were really, really happy.” At first, Birnbaum traded the index on behalf of his clients and made money buying and selling as in any “flow product,” he explained. At that moment, neither he nor the firm had any “conviction” about the direction the mortgage market would move in, and so he and his colleagues were just content to make markets for clients and take what amounted to a fee. “We hadn’t necessarily formed a view one way or the other,” he said. “We were trading the market more agnostically on behalf of our clients at that point on day one. The view at that point was simply this is a great business opportunity. The view wasn’t, ‘We’re going to buy it and we’re going to sell it and we’re going to take a huge position.’ It was, ‘This is a great opportunity to have this product to trade at this time.’ ”
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AT THE SAME time that Birnbaum and his colleagues (among them Deeb Salem and Jeremy Primer, in addition to Swenny) on the structured products desk at Goldman were gearing up to trade the ABX index and wondering about if, and when, to get some “conviction” on the direction the mortgage market might take during the next six months or so, other parts of the firm—then composed of 22,500 people—were continuing to go about their business. One such group was still busy aggregating mortgages from mortgage originators, such as Countrywide or New Century, and getting ready to package the mortgages up and sell them to hungry investors in the form of mortgage-backed securities.
One of those mortgage-backed securities—awkwardly named GSAMP Trust 2006-S2—was a nearly $700 million deal underwritten and sold by Goldman Sachs to investors at the peak of the market in the spring of 2006. It provides an exquisite example of its ill-conceived genre, right down to the fact that there was no way to ever figure out, in all of its prospectus’s life-sustaining two hundred or so pages, how much money Goldman made from it. Considering that Goldman exists to “make money with money,” according to David Viniar, the firm’s longtime chief financial officer, this fundamental bit of opacity would be troubling if it weren’t so essential to the firm’s success.
Like insects preserved in amber, among the many hidden secrets the GSAMP Trust 2006-S2 document reveals is a world of rampant greed and risk taking run amok, encased in a nearly incomprehensible language that only a securities lawyer could truly love. It was designed to befuddle all but the most sophisticated investor. Here, in March 2006, as signs of an impending financial crisis were beginning to be revealed, Goldman Sachs—while taking very little risk itself—had put the considerable cachet and imprimatur of its storied 137-year history on the line in order to offer investors the opportunity to buy pieces of a pool of 12,460 second mortgages on homes from one end of the country to the other.
And what a collection of borrowers and properties it was. Not only did another creditor have the first mortgage on the homes—meaning a priority claim on all payments related to it—but also some 29 percent in number and 43 percent in value of the mortgages had been made to home owners in California. Some 6.5 percent of the mortgages came from Florida, and some 5.6 percent of the mortgages came from New York. The California borrowers had an average credit rating score of 672—out of a possible score of 850—and owed an average of $87,915 on their second mortgage. Only 32 percent of these mortgages resulted from “full-doc” loans, meaning loans that had been made based upon a comprehensive understanding of borrowers’ financial capability to repay them; the remaining 68 percent were based on a far more flimsy underwriting, a combination of unverified facts and circumstances about the borrowers. Not surprisingly, given the risk involved, the average interest rate charged on the California second mortgages was a healthy 10.269 percent.
What’s more, 99.82 percent of the mortgages in the pool of California residences had a loan-to-value ratio in excess of 80 percent. These homes were leveraged to the max, and the slightest drop in the value of the home would immediately impair the underlying second mortgage and thus the value of the mortgage-backed securities that Goldman was underwriting. Fortunately, thanks to required disclosures, Goldman was willing to concede this point in the prospectus. “Mortgage loans with higher original combined loan-to-value ratios may present a greater risk of loss than mortgage loans with original combined loan-to-value ratios of 80 percent or below,” the lawyers wrote on Goldman’s behalf in the prospectus.
The prospectus contained plenty of other warnings, too. For instance, right up front Goldman announced the sobering risk that the underwriting standards on the underlying mortgages were probably lousy. The “assets of the trust” backing the securities being sold “may include residential mortgage loans that were made, in part, to borrowers who, for one reason or another, are not able, or do not wish, to obtain financing from traditional sources,” the prospectus read. “These mortgage loans may be considered to be of a riskier nature than mortgage loans made by traditional sources of financing, so that the holders of the securities may be deemed to be at greater risk of loss than if the mortgage loans were made to other types of borrowers.”
In typical Wall Street fashion, Goldman had not made any of these home loans itself. It had no idea who the borrowers were or whether they could repay the mortgages. Goldman knew something about their credit scores but that was about it. It was counting on both the perceived power of the ongoing housing bubble to keep housing values inflated and a diversified portfolio to spread the risk across the pool of geographically diverse mortgages in order to minimize the risk of any one individual borrower or group of borrowers. Of course, Goldman had no intention of keeping the mortgages itself but rather bought them for the sole purpose of packaging them together and selling them off to investors for a fee determined by the difference between the price it paid for them and the price it sold them for. In other words, pretty standard Wall Street practice.
By the spring of 2006, Goldman was considered a respectable underwriter of mortgage-backed securities, ranking twelfth worldwide in 2005 in the underwriting of so-called structured finance deals—those for asset-backed securities, residential and commercial mortgage-backed securities, and collateralized debt obligations—worth $102.8 billion. By 2006, Goldman had moved up to tenth in the league tables—underwriting 204 deals globally, worth $130.7 billion—but still was far behind Lehman Brothers, Deutsche Bank, Citigroup, Merrill Lynch, and Bear Stearns. These other firms were coining money underwriting mortgage-backed securities and became so concerned about having access to a steady flow of mortgages to package up and sell that they all bought mortgage origination firms—Bear bought EMC Mortgage; Merrill bought First Franklin Financial Corp. from National City Bank in December 2006—at the top of the market—for $1.7 billion. Goldman was content being in the middle of the pack when it came to this activity, and the firm never bought a mortgage origination company, despite having numerous opportunities to do so. “Exactly what we didn’t want to do,” explained Viniar. That being said, Goldman did buy, for $14 million, Senderra Funding, a small South Carolina–based subprime lender, in February 2007; and, for $1.34 billion—a tidy sum—Litton Loan Servicing, a mortgage servicing business, in December 2007; and Money Partners LP, a British mortgage lender, soon thereafter.
But aside from that particular corporate bias—against buy
ing a significant mortgage origination business and toward servicing those mortgages—Goldman was no different in its approach to the business than other Wall Street firms. According to a lawsuit filed in September 2009 by aggrieved investors in GSAMP Trust 2006-S2, “[W]ith the advent and proliferation of securitizations, the traditional model gave way to the ‘originate to distribute’ model, in which banks essentially sell the mortgages and transfer credit risk to investors through mortgage-backed securities. Securitization meant that those originating mortgages were no longer required to hold them to maturity. By selling the mortgages to investors, the originators obtained funds, enabling them to issue more loans and generate transaction fees. This increased the originators’ focus on processing mortgage transactions rather than ensuring their credit quality. Wall Street banks, including Goldman Sachs, entered into the high-margin business of packaging mortgages and selling them to investors as MBS, including mortgage pass-through certificates. As is now evident, far too much of the lending during that time was neither responsible, prudent, nor in accordance with stated underwriting practices.”
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FOR GSAMP TRUST 2006-S2, as it had many times before and would many times after, Goldman bought the mortgages it wanted to securitize and sell off from third-party mortgage originators. In this case, Goldman bought all of the mortgages from NC Capital, an affiliate of New Century Financial Corporation. In other underwritings, Goldman had also bought mortgages from—to name a few—Fremont Investment & Loan, an indirect subsidiary of Fremont General Corporation; Long Beach Mortgage Company; Argent Mortgage Company; Countrywide Financial; First National Bank of Nevada; and GreenPoint Mortgage Funding, Inc. By buying the mortgages from others, Goldman effectively abdicated any role in the underwriting process of the mortgages, relying instead on the judgment of others, again a fairly typical practice on Wall Street, especially late in the cycle as underwriting standards deteriorated and greed prevailed.
New Century, formed in 1995 by three entrepreneurs, ended its first full year in business, in 1996, with 300 employees and a “loan production” volume of $350 million. In 1997, the company went public. By 2003, the company employed 3,700 people and had originated some $27 billion in mortgage loans since its inception. By 2005, New Century employed 7,200 full-time employees and had originated some 310,389 mortgages with a face value of $56.1 billion.
Many pages in Goldman’s GSAMP Trust 2006-S2 prospectus were given over to explaining New Century’s underwriting standards as a way, presumably, to give comfort to investors about the company’s rigor (and to try to be absolved of blame if things went sour). According to Goldman, New Century’s underwriting standards “are primarily intended to assess the borrower’s ability to repay the related mortgage loan, to assess the value of the mortgaged property and to evaluate the adequacy of the property as collateral for the mortgage loan. All of the mortgage loans were also underwritten with a view toward the resale of the mortgage loans in the secondary mortgage market. While New Century’s primary consideration in underwriting a mortgage loan is the value of the mortgaged property, New Century also considers, among other things, a mortgagor’s credit history, repayment ability and debt-service-to-income ratio, as well as the type and use of the mortgaged property.”
The underwriting standards of the issuers of the mortgages—such as they were—was the first line of defense against borrowers’ failure to make their mortgage payments. The next level of supposed protection for investors in these mortgage-backed securities came from the ratings agencies—primarily Standard & Poor’s and Moody’s—which were required to rate the securities being issued and in return received fees from the underwriters such as Goldman Sachs and Lehman Brothers. The ratings agencies were careful to caveat their ratings with the idea that investors were aware that their ratings were just opinions about the likelihood that the principal and interest on the mortgages would be paid, not any kind of guarantee that they would be paid. “Ratings on mortgage-backed securities address the likelihood of receipt by security holders of all distributions on the underlying mortgage loans or other assets,” the Goldman prospectus said. “These ratings address the structural, legal and issuer-related aspects associated with such securities, the nature of the underlying mortgage loans or other assets and the credit quality of the guarantor, if any.” But among the many voices raised during the crisis was that of Jules Kroll, the founder of the eponymous financial investigation firm. He told The New Yorker, in October 2009, that the ratings agencies’ arguments were deeply flawed. “Credit ratings turned out to be a false god,” he said, while also acknowledging that he planned to start a competing service. “People relied on those ratings. Now they’re saying, ‘Oh, we gave it a high rating but we were just expressing an opinion.’ And that’s bullshit. These structured instruments—why shouldn’t we be able to rely on these ratings, as investors?”
In this particular case, there were ten tranches of securities offered for sale—A1 to A3 (the senior tranches) and then M1 to M7 (the subordinated tranches)—each with different risk profiles and thus a different interest rate. (Often, Wall Street firms were forced to keep for themselves the even riskier tranches of these securities because they were so difficult to sell.) All three A classes were rated AAA by both S&P and Moody’s, meaning the likelihood of default was supposed to be minimal. Only six companies in the United States were rated AAA—Johnson & Johnson, ExxonMobil, Berkshire Hathaway, Automatic Data Processing, Microsoft, and Pfizer—in 2009. The fact that both credit-rating agencies had bestowed AAA ratings on $505.6 million—or 72.4 percent—out of the total $698.4 million of the mortgage-backed securities Goldman was selling in April 2006 no doubt conveyed a level of security to investors that probably never existed, especially since investors did not do their own detailed due diligence on the underlying mortgages but rather instead just relied upon the Goldman imprimatur and that of the ratings agencies to make their investment decisions. (Goldman’s similar behavior vis-à-vis the ratings agencies leading up to the Penn Central bankruptcy springs to mind; it’s déjà vu all over again, as Yogi Berra would say.)
By spring 2006, investors were probably not aware of the growing internal doubts of analysts at both S&P and Moody’s about the mortgage-backed securities they were rating. For instance, at a weeklong housing conference, held on Amelia Island, Florida, in April 2005, two S&P credit analysts noted that the housing market seemed to be getting a little frothy and that the financial risks to the industry were ratcheting up as housing prices skyrocketed and lending standards deteriorated. “Despite these risks,” explained Ernestine Warner, a director in S&P’s residential mortgage-backed securities surveillance business, “there isn’t any performance information available on any of these products just yet because they are still very new to the market. Due to the time lag associated with delinquencies and losses in RMBS”—residential mortgage-backed securities—“pools, and the nature of these risks, it will be several years before the product performance is tested.” The Amelia Island conference followed Paul Volcker’s speech at Stanford University, where he had observed that the growing risks in the housing market left him thinking that “we are skating on increasingly thin ice.”
In a January 19, 2006, paper S&P stated its belief “that there are increasing risks that may contribute to deteriorating credit quality in U.S. RMBS transactions; it is probable that these risks will be triggered in 2006.” Four months later, in April 2006—just after Goldman brought GSAMP Trust 2006-S2 to market—S&P announced it was updating its “mortgage analytic model,” and then on June 1, 2006, the firm put out a research note that said that based on a study of the results from the new model, the “propensity of low FICO borrowers to default was higher than we previously believed”—not exactly a shocking conclusion, but one that at least acknowledged a deteriorating credit and housing environment, not that many people had noticed.
As delinquencies and defaults on both subprime and so-called Alt-A mortgages—made to those people
with better credit than subprime—ticked up heading into the fourth quarter of 2006, S&P’s own structured finance specialists began to worry. “Ratings agencies continue to create [an] even bigger monster—the CDO Market,” E. Christopher Meyer, an associate director in the Global CDO Group at the firm, wrote in an e-mail to a colleague on the evening of December 15. “Let’s hope we are all wealthy and retired by the time this house of cards falters.” He then used an emoticon signifying a wink and a smile. Meyers’s colleague, Nicole Billick, responded to Meyer’s e-mail, in part, by writing that if he was right, then this “is a bigger nightmare that I do not want to think about right now.”
As S&P kept slapping investment-grade ratings on soon-to-be-shaky new issues, Raymond McDaniel Jr., the CEO of Moody’s, S&P’s major competitor, held a series of town hall–style meetings for Moody’s professionals. At one, McDaniel told his managing directors about his perception of the growing problems in the mortgage market: “The purpose of this town hall is so that we can speak as candidly as possible about what is going on in the subprime market. What happened was it was a slippery slope. What happened in 2004 and 2005 with respect to subordinated tranches is that our competition, Fitch and S&P, went nuts. Everything was investment grade. It didn’t really matter. We tried to alert the market. I said we’re not rating it. This stuff isn’t investment grade. No one cared, because the machine just kept going.”
At S&P, meanwhile, the inmates seemed to be running the asylum, according to one text-message exchange between two analysts, Rahul Dilip Shah and Shannon Mooney, on April 5, 2007. “Btw, that deal is ridiculous,” Shah wrote to Mooney about some mortgage securities they were rating.
Money and Power Page 68
