Money and Power

by William D. Cohan

  Warren Buffett might consider this one of the eureka moments in the creation of financial weapons of mass destruction, as he referred to derivatives and credit-default swaps. “This was the trade, basically,” Sparks said. “CDOs were writing protection on CDS and doing synthetic CDOs. Most of the guys that bought the protection were hedge funds and then we, or others, might be in the middle of that trade. Now there was a period of time where hedge funds bought protection on individual RMBS deals from the Street, and then the Street bought protection from CDOs, and everybody knew what trade they were doing. The CDO buyers knew they were getting long credit risk and the hedge funds knew they were getting short credit risk and the Street was doing their job as a trader.… It seems crazy—based on what’s happened—but, for a period of time, it was very important to a lot of your clients to be able to give them risk and buy protection from them.”

  To Birnbaum and Tourre, it was more like genius, providing Goldman with yet another product to sell. In a December 10 e-mail to David Lehman, one of the co-heads of Birnbaum’s group, Tourre wrote that he believed “managed synthetic CDOs,” where Goldman would find investors for a fee, was an “opportunity” for 2007, along with the idea of renting the firm’s synthetic CDO platform—known as Abacus—to “counterparties focused on putting on macro short [trades] in the sector.” There seemed to be nobody at Goldman, or at the other firms on Wall Street, questioning whether this was the kind of business the firm should be doing or wondering how far things had strayed beyond Goldman’s traditional role of raising capital for clients and of providing M&A advice. Some even saw an ironic benefit in the synthetic CDO, in that the risk that borrowers might fail to pay their mortgages could be taken without actually having to create any more risky mortgages. “It was a totally fundamental change in the nature of collateralizing a CDO deal,” Birnbaum said. “All you had to do was go out to Wall Street and say, ‘Where do you bid protection on the following names?’ And then based on that and writing those trades you now had synthetic collateral—like that!—to put into your CDO deal.… It just took a lot less time to amass a critical mass of collateral. When the collateral was securities, you can only buy the securities one by one and they tend to be small or notional.… If you’re putting a synthetic in or creating a synthetic out of thin air, you just have to have a counterparty who is really willing to facilitate that trade.”

  It turned out that John Paulson was one such useful counterparty willing and eager to facilitate such a trade, and in December 2006 Paulson asked Goldman to work with his firm in creating a $2 billion synthetic CDO—to be known as ABACUS 2007-AC1—where he would be willing to buy the protection on a bunch of mortgage securities (i.e., bet that they would fail) while other sophisticated investors would take the opposite position. This was just another one of the many bets Paulson was making that the mortgage market would collapse, although by that time very few, if any, of them had paid off for the hedge-fund manager.

  Goldman put Tourre in charge of creating, marketing, and selling the deal. This in itself was bit odd in that a trader—rather than a banker—structured and sold a deal that had more of the look and feel of a private placement rather than a pure trade (Goldman in fact did put an end to that practice in early 2011). The Paulson team had identified more than one hundred BBB-rated residential mortgage-backed securities that it thought could run into trouble, and they wanted the ABACUS deal to reference—or provide insurance on—these troubled bonds. During the last few weeks of December, Tourre and his team concentrated on finding a “portfolio manager” to select the securities to be referenced, and this led to some internal debate about which firm would want to be involved with Paulson. For instance, on December 18, Tourre suggested a firm but then thought better of it. “They will never agree to the type of names [P]aulson want[s] to use,” Tourre wrote to his colleagues. “I don’t think [redacted] will be willing to put [redacted’s] name at risk for small economics on a weak quality portfolio whose bonds are distributed globally.” Geoffrey Williams, who was helping Tourre with the deal, responded, “The way I look at it, the easiest managers to work with should be used for our own axes”—being those securities Goldman itself or other people would like to sell quickly, hopefully at acceptable prices. “Managers that are a bit more difficult should be used for trades like Paulson given how axed”—or anxious to do a trade—“Paulson seems to be (i.e. I’m betting they can give on certain terms and overall portfolio increase).”

  Through the back and forth with Paulson and Paulson’s deputy Paolo Pellegrini, a former Lazard M&A banker turned hedge-fund analyst, in the creation of the Paulson ABACUS deal, the Paulson team also revealed its growing concern for the financial viability of Wall Street itself. This proved to be a bit of a revelation to the Goldman team. In an e-mail sent late on the afternoon of January 6, Tourre reported to Sparks, Swenson, and Lehman that there was “one issue” outstanding for Paulson about the potential transaction. “[I]t is related to the fact that Paulson is concerned about Goldman’s counterparty risk in this illiquid CDO transaction, even with the existing CSA”—a “credit support agreement” that provides for collateral payments between counterparties—“that is binding Goldman and Paulson,” Tourre wrote. Incredibly, Paulson was so worried about taking the risk of having Goldman as a counterparty that he demanded a structure that would insulate him from Goldman’s own credit risk. “As an FYI,” Tourre wrote, “for single name CDS trades that Paulson is executing with dealers such as Goldman [and two unnamed others], they are buying large amounts of corporate CDS protection (on the broker dealer reference entities)”—or insurance in case say Bear Stearns, Lehman Brothers, or Goldman were to default on their debt—“to hedge their counterparty credit risk!!!”

  This was quite a revelation in that Paulson—in early 2007—was worrying that Wall Street firms might get into financial trouble and he wanted to be insulated from it. “I cannot believe it!!!” Swenson replied to this news. “Absolutely amazing.” An hour later, Tourre elaborated with more news, this time about the risks Paulson perceived about doing business with Bear Stearns, where Paulson once worked. “The meeting itself was surreal,” he continued. “Am hearing that Paulson bought $2bn of [redacted] CDS protection, sucking all the liquidity on that name in the corporate CDS market. Also, on the side, [redacted] mentioned to me that he had heard from many different sources that one reason the ABX market was trading down so much in December was related to [redacted] building a sizable short and buying large amounts of ABX protection from the market.” The mystery firm—on which firm Paulson had been buying insurance—would be revealed by Swenny two minutes later. “I wonder who gave [B]ear the liquidity,” he wondered. In other words, Swenson wanted to know who had sold the CDS to Paulson on the Bear Stearns debt.

  There was no answer—at least on e-mail—from Tourre, but chances are good that Paulson made an additional bundle betting his old firm would collapse. At the end of December 2006, the cost of buying insurance against a default on Bear Stearns debt was 0.18 cents per dollar of protection. Since Paulson had bought $2 billion worth of protection, his cost would have been $3.6 million. During the week before JPMorgan Chase bought Bear Stearns, on March 16, 2008, and saved its debt from defaulting, the cost of buying that insurance had skyrocketed to 7.5 cents per dollar of protection. Assuming Paulson sold his protection before JPMorgan bought Bear—and rendered that protection worthless since the risk of default had evaporated with the merger agreement—Paulson would have pocketed tens of millions. Within months, Goldman had mimicked Paulson’s bet that Bear Stearns would collapse.

  ——

  TOURRE HAD FOUND a firm—ACA Management, LLC—and a senior managing director there, Laura Schwartz, to help to choose the securities that would serve as the reference bonds for ABACUS, to vet Paulson’s proposal, and to act as the portfolio selection agent for the deal. By this time ACA had already managed twenty-two CDOs representing some $15.7 billion of assets. The ABACUS deal was to be the twenty-t
hird CDO sponsored by ACA and the fifth “synthetic” using residential mortgage-backed securities. ACA’s main business had been insuring municipal bonds, but after Bear Stearns Merchant Banking invested $115 million in the company, in September 2004, for a 28 percent stake, ACA replaced its longtime management and began to get involved in the far more risky business of CDO asset management, including taking principal positions in CDO deals by insuring their risk. (In the end, this proved disastrous, and by April 2008, ACA would go out of business, although what’s left of ACA is pursuing litigation against Goldman for this ABACUS deal.)

  On January 8, 2007, Tourre had a meeting at Paulson’s office with teams from both Paulson and ACA to construct the ABACUS deal. The next day, Goldman forwarded to ACA a list of the 123 2006-vintage mortgage securities Paulson wanted to bet against. That same day, ACA performed an “overlap analysis” and determined it had already purchased 62 of the 123 securities on Paulson’s list. Tourre informed ACA that he “was very excited by the initial portfolio feedback” because it looked like the deal could come together. Goldman was to make a $15 million fee for constructing ABACUS. On January 10, Tourre sent ACA an e-mail confirming ACA’s role in the deal that Paulson would “sponsor,” and where the “starting portfolio would be ideally” Paulson’s list “but there is flexibility around the names.” Four days later, Schwartz was concerned that she had somehow offended Tourre during a phone call and that ACA might lose the business. She wrote in an e-mail that she hoped she “didn’t come across too antagonistic” but that the “structure looks difficult from a debt investor perspective.” She wrote that she could understand “Paulson’s equity perspective but for us to put our name on something, we have to be sure it enhances our reputation.” One of Tourre’s Goldman colleagues replied, “Absolutely not—[F]abrice and the team hold you in the highest regard and would very much like to have you involved in this transaction, but only if you are comfortable with it.” On January 18, Tourre confirmed to his colleagues that “ACA is going to be ok acting as portfolio selection agent for Paulson, in exchange for a portfolio advisory fee of at least $1mm per year.”

  On January 22, ACA sent to Tourre a list of 86 “sub-prime mortgage positions that we would recommend taking exposure to synthetically,” 55 of which were on Paulson’s original list of 123 names. Three days later, Goldman sent Schwartz a draft of an engagement letter for the deal. She then replied she had a few questions, about ACA’s potential fees for the deal and a preferred legal counsel ACA would like to use. She also seemed worried still that ACA might lose the deal. “[D]o you believe that we have this deal?” she asked. “[D]o we need to do the work on the engagement letter before we know if we have the deal?” Thirty minutes later, Tourre responded that “Paolo at Paulson is out of the office until Wednesday of next week”—he was skiing with his family in Jackson Hole, Wyoming. “We are trying to get his feedback on the target portfolio you have in mind, as well as on the compensation structure we have been discussing with you. Subject to Paolo being comfortable with those 2 aspects, it sounds like we will be in a position to engage you on this transaction.”

  By a strange coincidence, Schwartz also happened to be in Jackson Hole and ran into Pellegrini. They agreed to meet for a drink on the afternoon of January 27 to discuss the proposed portfolio to be included in the ABACUS deal. They met at the bar, both with their laptops. “[H]e may [be] as much of a nerd as I am since he brought a laptop to the bar,” Schwartz wrote. “[A]nd he also seemed to have a worksheet from DB [Deutsche Bank] and another manager.” They talked about what collateral the ABACUS deal should reference and Schwartz noted that Pellegrini seemed to have plenty of data about each mortgage-backed security that might be referenced in the deal. He wanted to know why so many securities needed to be part of the deal. “I said Goldman needed 100 [individual securities] to help sell the debt,” she later reported to Tourre. “We left it that we would both work on our respective engagement letters this week,” she wrote. “I certainly got the impression that he wanted to go forward on this with us.” Tourre responded, “[T]his is confirming my initial impression that Paolo wanted to proceed with you subject to agreement on portfolio and compensation structure.” They agreed to meet on February 5 to work more on the deal.

  A few days before the Jackson Hole rendezvous, on January 18, Gillian Tett, a columnist for the Financial Times, wrote a column featuring a number of foreboding messages she had received about how the real-estate debt bubble might end poorly. “Hi Gillian,” Tett quoted one correspondent. “I have been working in the leveraged credit and distressed debt sector for 20 years … and I have never seen anything quite like what is currently going on. Market participants have lost all memory of what risk is and are behaving as if the so-called wall of liquidity will last indefinitely and that volatility is a thing of the past. I don’t think there has ever been a time in history when such a large proportion of the riskiest credit assets have been owned by such financially weak institutions … with very limited capacity to withstand adverse credit events and market downturns. I am not sure what is worse, talking to market players who generally believe that ‘this time it’s different,’ or to more seasoned players who … privately acknowledge that there is a bubble waiting to burst but … hope problems will not arise until after the next bonus round.” Tett also recounted how she had spoken to an analyst at JPMorgan who made the case for the “CDO boom” and how “there is a very strong case to be made that the CDO market has played a major role in driving down economic and market volatility over the past 10 years.” Tett concluded with the prescient thought that “if there is any moral from my inbox, it is how much unease is bubbling, largely unseen, in today’s Brave New financial world.”

  Tett’s column made the rounds in Birnbaum’s structured finance group at Goldman. On January 23, Tourre forwarded it to Marine Serres, his “gorgeous and super-smart” French girlfriend living in London, and suggested she read it because it was “very insightful.” Tourre rambled on to Serres, in an odd mixture of worry, self-deprecating humor, and love note. She was also working at Goldman at the time, as an associate in the structured products sales department. “More and more leverage in the system,” he wrote to her, and then went on briefly in French, which has been translated as “the entire system is about to crumble at any moment.… The only potential survivor, the fabulous Fab.” Tourre then switched back to writing in English, following the “fabulous Fab” comment with “as Mitch would kindly call me, even though there is nothing fabulous abt me, just kindness, altruism and deep love” for Serres. (Mitch Resnick was a Goldman mortgage-backed securities salesman.) He wrote to her that he was “standing in the middle of all these complex, highly levered, exotic trades he created without necessarily understanding all the implications of those monstruosities [sic]!!! Anyway, not feeling too guilty about this, the real purpose of my job is to make capital markets more efficient and ultimately provide the US consumer with more efficient ways to leverage and finance himself, so there is a humble, noble and ethical reason for my job … amazing how good I am at convincing myself!!! Sweetheart, I am now going to try to get away from ABX and other ethical questions, and immediately plunge into Freakonomics,” the best-selling book she had recommended to him. (“I love when you advise me on books I should be reading,” he continued before waxing poetic about his love for her.)

  Tourre seemed to be increasingly stressed by the ABACUS assignment. On January 29, he started a long e-mail chain, in French, to Fatiha Boukhtouche, a postdoctoral fellow at Columbia University, where she was researching the causes of autism. Boukhtouche and Tourre appeared to be friends with benefits, despite Tourre’s pledge of love a few days earlier to Serres, then far off in London. “Yep, work is still as laborious, it’s bizarre I have the sensation of coming each day to work and re-living the same agony—a little like a bad dream that repeats itself,” he wrote to Boukhtouche. “In sum, I’m trading a product which a month ago was worth $100 and which today is only worth $
93 and which on average is losing 25 cents a day.… That doesn’t seem like a lot but when you take into account that we buy and sell these things that have nominal amounts that are worth billions, well it adds up to a lot of money.

  “When I think,” he continued, “that I had some input into the creation of this product (which by the way is a product of pure intellectual masturbation, the type of thing which you invent telling yourself: ‘Well, what if we created a “thing,” which has no purpose, which is absolutely conceptual and highly theoretical and which nobody knows how to price?’) [I]t sickens the heart to see it shot down in mid-flight … it’s a little like Frankenstein turning against his own inventor;) Anyway I don’t want to bore you with my stories, I’m going to look in the yellow pages for the phone number of the ABX market and I’ll send it to you, because I believe that a soft and sensual feminine intervention is necessary for Fab’s survival[.] Kisses Fab).” Her response, filled with more “bizzzzzzzzzoux” (kisses), was to wonder how she could help him in a way that was “soft and sensual.”

  Despite his concern that Frankenstein might be turning on him, he continued to market his monstrous creations. That same day, he shared with his Goldman colleagues that he had received a new-business inquiry from GSC—a firm that had passed on the ABACUS deal before ACA took it, “given their negative views on most of the credits that Paulson had selected,” Tourre wrote—wanting “to see from us a trade” using the same structure as the ABACUS deal but with a different portfolio of securities. “This is a trade we would show to IKB”—a large German bank that couldn’t seem to get enough of the long side of these trades—“for the reverse inquiry program we have been working with them on.” In response to a question from a colleague, Tourre explained a “few nice things about this idea,” which he summarized by saying, “In a nutshell, we have a lot of flexibility from a risk management standpoint, while committing to take little risk”—a thought that may best summarize one of the more important of Goldman’s business aspirations after nearly 140 years of existence. The digital conversation was clearly not sitting well with Jonathan Egol. “Where are you going with this?” he asked. To which Tourre replied, in Goldman fashion, “LDL.”