As 2007 unfolded, the investors who bought the mortgage securities Goldman underwrote were suffering. In December 2007, the Massachusetts attorney general began an investigation into whether Goldman’s participation in the underwriting of mortgage-backed securities had facilitated the origination and sale of “unfair”—as defined by Massachusetts law—residential mortgages to some seven hundred or so Massachusetts borrowers. The state attorney general wanted to know, among other things, “whether securitizers may have failed to make available to potential investors certain information concerning allegedly unfair or problem loans, including information obtained during loan diligence and the pre-securitization process, as well as information concerning their practices in making repurchase claims relating to loans both in and out of securitizations.”
Without admitting to anything, Goldman settled the matter, in May 2009, with the Commonwealth of Massachusetts for what amounted to chump change. First, the firm agreed to pay $10 million to the state. Second, Goldman agreed to make modifications to various Massachusetts mortgages that it still had on its books or, if they had been packaged up and sold off, to facilitate changes to those mortgages through Litton, its servicing arm, or through other mortgage loan servicing companies. The cost to Goldman Sachs of changes to these various mortgages has been estimated to be $50 million. In sum, Goldman coughed up a mere $60 million, far less than 1 percent of its 2009 pretax earnings of $19.9 billion, to settle the Massachusetts dispute. “Since I became Attorney General, our office has sought accountability at all levels of the subprime lending crisis,” explained Massachusetts attorney general Martha Coakley. “We are pleased that Goldman cooperated during this investigation and that it has committed to working with our office to help Massachusetts borrowers who are struggling with unsustainable subprime loans.”
The investors in GSAMP Trust 2006-S2 fared worse—for the time being anyway—than those aggrieved Massachusetts investors. New Century, the originator of the mortgages packaged into GSAMP 2006-S2, filed for bankruptcy protection in April 2007. In September 2009, the Public Employees Retirement System of Mississippi, which provides current and future benefits to some three hundred thousand Mississippians and was an investor in the GSAMP securities, filed a complaint against Goldman and its affiliates, plus Goldman’s Dan Sparks and Jonathan Egol individually, as well as the three most prominent ratings agencies (S&P, Moody’s, and Fitch). It claimed that Goldman’s prospectus “contained untrue statements of material fact, omitted facts required to be stated therein or omitted to state material facts necessary to make the statements therein not misleading” and alleged that Goldman’s prospectus failed to share with investors that New Century had not followed its own underwriting standards, that appraisals on the properties being mortgaged overstated the properties’ values, and that the ratings on the securities were flawed and based on outdated and irrelevant models. As a result, the complaint alleged, the securities Goldman offered to investors were “far riskier than represented” and were not “equivalent to other investments with the same credit ratings.”
The Mississippi complaint referred often to a 581-page report written by a Washington lawyer appointed to figure out what went wrong at New Century. That report cited “serious loan quality issues” at New Century as early as 2004 and the “failure of New Century’s senior management and board of directors” to do anything about it until it was “too late to prevent the consequences of longstanding loan quality problems in an adversely changing market.” The report also discussed New Century’s “brazen obsession” with increasing mortgage originations and concluded that the company “engaged in a number of significant improper and imprudent practices.” Three causes of action were alleged against Goldman and a jury trial requested.
The last word from Goldman—at least as filed publicly with the SEC—about the GSAMP Trust 2006-S2 underwriting came on October 11, 2007. That day, Goldman filed with the SEC a final supplement to the original March 28, 2006, prospectus. The document was filled with the gory details of the practices that led to New Century’s Chapter 11 bankruptcy filing and how that filing would likely affect New Century’s ability—as Goldman had warranted to investors of the securities would happen—“to repurchase or substitute mortgage loans as to which a material breach of representation and warranty exists or to purchase mortgage loans as to which an early payment default has occurred.” Oddly left out of the narrative leading up to New Century’s bankruptcy filing was how on Valentine’s Day 2007, a wave of shareholder lawsuits had been filed against it and that Goldman had negotiated for itself a safety valve with New Century.
The filing did contain information about how—by October 2007—the three major ratings agencies had downgraded scores of previously AAA-rated mortgaged-backed securities, including some of those that were packaged and sold as 2006-S2. But the supplement failed to make clear that nearly all of the original securities that Goldman offered for sale had been downgraded. Of course, there was little investors could do with the information that their securities had been downgraded—in many cases to junk status—except to take their hits and sell the securities at a steep losses, assuming buyers could be found at all. Of course by the fall of 2007—some three months after the liquidation of the two Bear Stearns hedge funds—there would be no practical way to avoid discussing in such a document the ongoing meltdown in the mortgage securities market.
Goldman and its lawyers had the decency to try to confront the calamity head-on, only to produce statements of masterful legal understatement. “In recent years, borrowers have increasingly financed their homes with new mortgage loan products, which in many cases have allowed them to purchase homes that they might otherwise have been unable to afford,” Goldman wrote, trying at first to put a positive spin on the growing disaster. “Recently, the subprime mortgage loan market has experienced increasing levels of delinquencies, defaults and losses, and we cannot assure you that this will not continue. In addition, in recent months housing prices and appraisal values in many states have declined or stopped appreciating, after extended periods of significant appreciation. A continued decline or an extended flattening of those values may result in additional increases in delinquencies, defaults and losses on residential mortgage loans generally, particularly with respect to second homes and investor properties and with respect to any residential mortgage loans whose aggregate loan amounts (including any subordinate liens) are close to or greater than the related property values.”
According to Matt Taibbi, a contributing editor at Rolling Stone, in his famous anti–Goldman Sachs screed in the magazine in July 2009, “In other words, the mortgages it was selling were for chumps. The real money was in betting against those same mortgages.” In the Rolling Stone article, Taibbi asked an unnamed hedge-fund manager about Goldman’s seemingly duplicitous behavior and was told, “That’s how audacious these assholes are. At least with other banks, you could say that they were just dumb—they believed what they were selling, and it blew them up. Goldman knew what it was doing.” Incredulous, Taibbi pressed on, wondering how the firm could get away with playing on both sides of the ball with impunity. Wasn’t that securities fraud, he wondered? “It’s exactly securities fraud,” the hedge-fund manager said. “It’s the heart of securities fraud.” That remained to be seen, of course, but many people sensed intuitively that there seemed to be something immoral about the behavior. Observed Sylvain R. Raynes, an expert in structured finance at R & R Consulting in New York and a former Goldman employee, “The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen. When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson.”
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ONE OF THE problems created by Goldman continuing to package mortgages and to sell them as securities in the market at the same time that Birnbaum
and Swenson were implementing “the big short” was that sometimes Goldman’s message to the marketplace got muddled. Dealing with the conflicting messages coming out of Goldman about its feeling about the mortgage market also got dumped in Sparks’s lap. This was very hard work. “We started marking our clients” in the first half of 2007 “where we thought the market was,” Sparks said. “The rest of the Street said that we were totally wrong. Our clients complained vigorously to everybody. We had major issues because we did what we felt was right.… We said, ‘We think this bond is worth eighty.’ Another broker/dealer said it was ‘worth ninety-nine,’ and the clients would be very unhappy with us. But we said, ‘OK, well, we’ll sell you some at eighty then.’ ” Sometimes this strategy worked; sometimes it didn’t.
The market was rife with confusion. “Seems to me,” Harvey Schwartz, the head of Goldman’s capital markets business, wrote to Sparks on March 8, “one of our biggest issues is how we communicate our views of the market—consistently with what the desk wants to execute. Dan—realize the desk is swamped—but clearly marketing and sales leadership [can’t] operate in a vaccum [sic]—so need someone that will represent trading in driving our communication broadly with marketing[.] [H]ow should we approach … as this has been difficult in the past when markets were calmer and less demanding of the [desk’s] attention[?] If best talked offline … no worry.”
Sparks plunged right in, though, in an e-mailed reply to Schwartz and others. Perhaps because he was responding to the partner running the firm’s underwriting business, Sparks put the highest priority on continuing to package up and sell Goldman’s warehoused mortgages, if for no other reason than to get them off Goldman’s books, and fast. “Our current largest needs are to execute and sell our new issues—CDOs and RMBS—and to sell our other cash trading positions,” he wrote. “There is the perception out there—I heard it twice today from issuers/managers—that we are having trouble moving cash securities, that it is causing our view of the markets to be overly negative, and that the result is worse execution for them. I tend to think we are just realistic and others are hoping the market is better than it really is, but we have significant positions that we need to move, and I think our offerings should look cheap”—be priced to move—“relative to where it sounds like competitors are. I can’t overstate the importance to the business of selling these positions and new issues.”
Goldman also used its many tentacles to look for financial opportunities among the increasingly distressed carcasses of the companies that once originated the mortgages that Goldman was so busy packaging up and selling as securities. In addition to New Century, among those that ran into trouble by March 2007—in part because of Goldman’s decision to pull back their financing—were Accredited Home Lenders, Inc., and Fremont General, both of which soon enough joined New Century in filing for bankruptcy protection. On March 9, Sparks wrote to his bosses, including Cohn, Winkelried, and Viniar, about what the firm was doing to take advantage of the distress of these mortgage originators. With Accredited, Goldman was working with Cerberus, the hedge fund, as well as Goldman’s own private-equity arm plus banking and the mortgage group to consider an investment to help the company stave off a covenant default. With Fremont, Sparks noted that famed bank investor and billionaire Gerald Ford—not to be confused with the former U.S. president—was looking to make an investment in the company. “We will try to tag along and are trying to get Cerberus included,” he wrote. With New Century, Sparks wrote that “Cerberus is looking at something and may include us, but we don’t think there is much there” and besides, “they are in the worst shape.” Goldman was also an unsecured creditor to New Century and was thinking about buying assets from the company as a way to offset what it owed Goldman. Cohn passed the e-mail on to Blankfein.
There was little question, though, that Birnbaum’s strategy of shorting the mortgage market was resulting in growing profits for Goldman Sachs, a point underscored by Sheara Fredman, a Goldman vice president, in a March 9 memo to Viniar in preparation for Goldman’s first-quarter earnings conference call. In the first quarter, the mortgage group made $266 million in revenues—“a record quarter for the business,” Fredman wrote—thanks in large part to Birnbaum’s “synthetic short positions.” His trading gains had been offset by losses on the long side of the mortgage portfolio, “most notably in our warehousing of financial assets to be securitized in connections with CDOs.” In a presentation about Goldman’s mortgage business being prepared for the March 2007 meeting of the Goldman board of directors, Sparks thought it important to add some information about the “various things we have done” in the quarter to implement “the big short”: on Sparks’s list was an alphabet soup consisting of “getting short CDS on RMBS and CDOs, getting short the super-senior BBB- and BBB index, and getting short AAA index as overall protection.” Then referring to the new strategy of buying puts on failing mortgage originators, he added, “The puts have also been good.” The board presentation also ended up including the idea that Goldman had started the quarter with a notional long of $6 billion on the ABX index but had ended the quarter net short a notional amount of $10 billion.
To the “Firmwide Risk Committee,” at its March meeting, Sparks made clear why Birnbaum had been given the green light to execute “the big short.” He said it was “Game Over” and “an accelerating meltdown” for subprime lenders, such as New Century and Fremont General. What’s more, he told his colleagues—in March 2007—“[T]he Street is highly vulnerable, [with] potentially large [mortgage] exposures at Merrill and Lehman.” He said Goldman’s mortgage group was “currently closing down every subprime exposure possible” and the “current strategies” were to “liquidate positions” or “put back inventory” to the mortgage originators. He also suggested that there was a problem brewing in commercial real estate because of “subprime woes.” He closed with the thought that hedge funds were making money but that “it was difficult to tell how much others are losing because many CDOs with subprime assets are not” marked to market.
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THE PROBLEMS AT New Century and Fremont quickly began to ripple through the market. On March 12, as previously instructed, the ABACUS deal team, including Egol and Tourre, presented ABACUS to Goldman’s “Mortgage Capital Committee” to get its approval. According to the memo about the deal, Goldman stood to make between $15 million and $20 million for acting as an intermediary between Paulson and ACA. There appeared to be little discussion of the reputational risk the firm might suffer as a result of the deal, which had been the reason Tourre had been instructed to get the committee’s approval even though Goldman did not appear, at first, to be committing any capital. Indeed, according to Egol and Tourre, ABACUS had it all. “This transaction is a new and innovative transaction for Goldman Sachs and the CDO Market,” they wrote. After noting the deal’s highly technical “firsts,” they continued, “This transaction addresses the objectives of multiple clients of the firm: it helps ACA increase [its] assets under management and [its] fee income; it enables Paulson to execute a macro hedge on the RMBS market; it offers to CDO investors an attractive product relative to other structured credit products available in the market. Our ability to structure and execute complicated transactions to meet multiple clients needs and objectives is key for our franchise.” The committee approved the deal.
That afternoon, Jörg Zimmerman, a vice president at IKB Credit Asset Management, a big German bank in Düsseldorf that was taking the long side of the ABACUS deal, wrote to Michael Nartey, the Goldman banker in London, with copies to Tourre and Egol, that IKB wanted to remove both the Fremont and New Century bonds from the reference list for the ABACUS deal, no doubt because of the two companies’ ongoing financial difficulties. Zimmerman wrote that he wanted to go back to IKB’s “advisory comitee [sic]” and “would need consent on” removing these securities from the ABACUS deal. This was not such great news. “Paulson will likely not agree to this unless we tell them nobody will buy these
bonds if we don’t make that change,” Tourre wrote to Egol, who wrote back wanting to know what “we say to Joerg [sic]?” “As discussed with Nartey,” Tourre replied, “we are taking his feedback into account and once we have gotten more feedback from accounts across the cap structure we will decide what the best cours[e] of action is.” Tourre’s head fake was typical of bankers looking to make it seem there was competition for a deal when clearly there was not. Indeed, IKB may have been one of the few investors the world over willing to take the long side of such a trade with so many red flags emerging about the problems in the mortgage market. (There is no additional documentation about whether Goldman agreed to take out the New Century and Fremont mortgages, but the final ABACUS deal did include mortgages serviced by both companies in the reference portfolio; Zimmerman did not respond to a request for an interview.)
New Century’s problems were also giving pause to Rabobank, a big Dutch bank, which was considering investing in Anderson Mezzanine Funding, another Goldman-architected $305 million CDO also coming to market in March. Unlike the ABACUS deal, in the Anderson deal, Goldman was underwriting the equity portion and expected to keep half of it as a principal investment. This prompted Olivia Ha, a 1998 Harvard graduate and Goldman vice president, to e-mail the Anderson deal team at Goldman with a question about how it got comfortable with the New Century collateral since Ha’s client at Rabobank, Wendy Rosenfeld, had expressed her concerns about it. “[H]ow did you get comfortable with all the [N]ew [C]entury collateral in particular the [N]ew [C]entury serviced deals[,] considering you are holding the equity and their servicing may not be around[?] [I]s that concerning to you at all?” Rosenfeld needed “more comfort” because she was “getting credit resistance on the [N]ew [C]entury concentration.” Eventually, several members of the Anderson deal team at Goldman got on the phone with Wendy to “allay her [N]ew [C]entury concerns.… This will be our opportunity to help arm her with ammo for her credit [committee] who is getting jittery on the [N]ew [C]entury exposure/servicing concentration.”
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