Money and Power

by William D. Cohan

  The call between Goldman and Rosenfeld did not go as Goldman had hoped. She ended up passing. “At this point in time we are not going to be able to participate in Anderson,” she wrote to Ha on March 13. “There are many concerns regarding the percent of NC”—New Century—“originated and serviced collateral.” A few days later, several other potential Anderson investors dropped out, also because of “New [C]entury issues.” Smith Breeden Associates, a global asset management company, dropped out as well over concerns the deal would get downgraded and because there would not be sufficient cash flow to cover the interest payments. Scott Wisenbaker, the Goldman banker on the deal, agreed to speak with Smith Breeden to “make sure they understand the deal correctly, but regardless, it looks like they are lower probability to be involved.” This was not the answer Peter Ostrem, a more senior Goldman banker and the head of the CDO group, was looking to hear. “Yeah?” he fired back to Wisenbaker. “So—fix the miscommunication so the probability goes up.”

  Nerves seemed to be getting frayed throughout Goldman. There was growing pressure to deal with what appeared to be the increasing likelihood of a financial crisis brought on by the problems in the mortgage market. On March 14, the firm sent around an internal economic research report that contained an interesting nugget that caught the attention of the firm’s senior executives and got them even more worried than they already were. “New data from the Mortgage Bankers Association show that mortgage credit quality problems go well beyond the subprime sector,” according to the report. “This can be seen from the fact that delinquencies on prime adjustable-rate mortgages are rising quickly—much more quickly, in fact, than those of subprime fixed-rate loans.” When Winkelried read this he grew concerned. “[D]elinquencies in PRIME adjustables with teaser rates growing fast,” he wrote to Blankfein, Cohn, and Viniar, plus Ruzika and Sparks, the two guys running the mortgage group. “[I] think this may be a big problem and a lot worse than currently thought. [I] think lending standards are highly variable among originators and [W]all [S]treet focus (servicers and dealers) on quality control has been lost for a while. [D]an, are we doing things to prepare for bleed into prime space?”

  Sparks responded quickly. “Trying to be smaller and buying puts on companies with exposure to overall mortgage market,” he wrote to the same august group. “We are also short a bunch of sub-prime AAA index.” Goldman’s schizophrenic behavior continued, though. The same day that Sparks was writing to Winkelried, Cohn, and Blankfein about being short the ABX index and buying puts on companies with exposure to the mortgage market, he also sent Montag an e-mail titled “Cactus Delivers,” about Mehra Cactus Raazi, a Goldman bond salesman and former Rolling Stone ad salesman, urging Montag to congratulate Raazi on selling off a $1.2 billion short position the firm had in A-rated mortgage securities to Stanfield Capital Partners, a New York–based CDO manager. “He did a great job filling our ax,” Sparks wrote to Montag, who then sent the whole e-mail chain on to Blankfein with a note: “Covered another [$]1.2 billion in shorts in mortgages[,] almost flat”—a reference to being neither too short nor too long the mortgage market—“now need to reduce risk.” On March 20, after Blankfein received the daily firmwide “net revenues” estimate that showed the firm had generated $111 million in revenues that day—and $37 million in pretax earnings—but had lost $21.4 million in mortgages, he sent an e-mail to Cohn. “Anything noteworthy about the losses in mortgages?” he wanted to know. Cohn replied, “No[.] [M]arket rallied a bit[.] [S]till short.”

  The next day, this little executive-level colloquy trickled downstream.

  “Did Josh get out of index trade?” Montag asked Sparks and Bill McMahon, a reference to Birnbaum’s short position on the ABX that had started to—briefly—move against him. “I had him liquidate S&P’s”—a bet made on the S&P 500 stock index—“and cut equity put position in half yesterday.” He then explained what the group was focused on, strategically, which no doubt pleased the VAR police but was equally disheartening to Birnbaum. “Overall as a business, we are selling our longs and covering our shorts,” Sparks wrote, “which is what this quarter is really about, as well as protecting ourselves on counterparty risk, planning for the new resi[dential mortgage] world, and trying to be opportunistic. We have shorts that we need to provide overall protection in case we get further move downs—and those shorts have been hurting us.”

  Sparks’s logic may have been flawless, but Montag had little patience, it seemed, for a bet that might pay off down the road but that was moving against the firm in the short term, especially after Blankfein had made his inquiries. “Liquidity is better,” Montag conceded, “but actual performance can be much worse obviously.” Then he took a swipe at Birnbaum: “Unfortunately[,] the trader [J]osh has not demonstrated a track record of controlling his position.… Instead of these lousy hedges he should just be selling his position.” Sparks tried to defend Birnbaum. “He has had a very good run in this activity,” he wrote to Montag and promised that before long Birnbaum would “lay out [a] plan” for how to proceed and get Montag to sign off on it.

  On March 26, Goldman management gave the Goldman board of directors a presentation on the subprime mortgage market. The twenty-four-page document contained a page titled “The Subprime Meltdown,” which traced the collapse of New Century’s stock and the financial carnage among the subprime mortgage originators, including the fifteen companies that had already been liquidated or filed for bankruptcy. The presentation also described Goldman’s dual, schizophrenic role in the market: one as a buyer, packager, and seller of mortgages and mortgage-related securities to investors for a fee—Goldman “exits loan purchases by structuring and underwriting securitization and distributing securities back by mortgage loans on a principal basis and for clients,” the presentation explained—the other as a trader of mortgages and derivatives related to mortgages “to hedge our long credit exposure” in a bet that the mortgage market would collapse. It was quite a pas de deux.

  Goldman’s management also created a timeline of the firm’s reactions to worsening market conditions in the subprime mortgage sector. For instance, in the second half of 2006 and the first quarter of 2007, Goldman “reduces CDO [origination] activity” and “residual assets marked down to reflect market deterioration.” Then, the board was told, “GS reverses long market position through purchase of single name CDS”—credit-default swaps—“and reductions of ABX.” The gross revenues of Goldman’s mortgage business reflected the changing dynamics as well. In 2005, the firm made $885 million in revenues on the mortgage desk, mostly from the origination of residential and commercial real-estate securities. In 2006, Goldman underwrote $29.3 billion of subprime mortgage securities, a ranking of sixth overall, and underwrote close to $16 billion in collateralized debt obligations, ranking fifth. That year, the mortgage-related revenues increased 16 percent with the origination business staying essentially flat, but with Birnbaum’s group generating $401 million in revenue, up 64 percent from the $245 million generated the year before. That revenue generation accelerated in the first four and a half months of fiscal 2007, where Birnbaum’s group had produced $201 million in revenue, already half of what had been generated for all of 2006. Meanwhile, the residential mortgage security origination business had fallen off the cliff by the first part of 2007, with a $19 million loss in gross revenue. The Goldman board also was shown that the firm was long some $12.9 billion in various mortgage securities, which was offset by a $7.2 billion short bet against the ABX and another $5.5 billion negative bet against mortgages, obtained through the purchase of credit-default swaps. Goldman’s net exposure as of March 15, 2007, was some $200 million on the long side, or virtually flat. In March 2007, after Goldman’s first-quarter performance was released, Viniar said, “Subprime is under stress, it appears to have been overheated. It’s pretty clear there will be a shakeout. It will be a reasonably sized, but smaller market than it has been over the last several months.” As to the firm’s ongoing role in the m
ortgage market, he said, “When we extend credit we tend to have security and other terms that will protect us. We do what we can to mitigate our losses, we do what we can to protect ourselves.”

  Incredibly, many others—among them Ben Bernanke, the Fed chairman, and Henry Paulson, the treasury secretary—were missing the problems that Goldman Sachs and John Paulson were seeing in the mortgage market. “The impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained,” Bernanke testified before the Joint Economic Committee of Congress on March 28. That same day, Paulson told a House Appropriations subcommittee: “From the standpoint of the overall economy, my bottom line is we’re watching it closely but it appears to be contained.”

  Bear Stearns was also projecting a very different outlook on the opportunities in the mortgage market than was Goldman. In a March 29 “Investor Day” presentation, Jeffrey Mayer and Thomas Marano, two of the most senior executives in Bear’s fixed-income group, were trumpeting the fact that the firm’s “leading mortgage franchise continues to grow.” The hits just kept on coming: net revenues had doubled since 2002 to $4.2 billion in 2006; Bear was the “top ranked” underwriter of mortgage-backed securities and asset-backed securities; the firm had expanded its mortgage origination capabilities by purchasing Encore Credit Corporation—a “sub-prime wholesale originator”—to complement Bear Stearns Residential Mortgage Corporation and EMC Mortgage Corporation; and Bear ranked fifth in the underwriting of CDOs, with a volume of $23 billion in 2006, with “volume nearly doubling from last year.” The men also boasted of being “well-positioned to handle disruption in the sub-prime market.”

  Soon after Goldman’s March 2007 board of directors meeting, the Goldman mortgage group began closing one challenging CDO underwriting assignment after another, including those for Timberwolf, Anderson Mezzanine, and—soon enough, on April 26—ABACUS, which had been such a roller-coaster ride for Fabrice Tourre. One way the Timberwolf deal got done, according to an internal Goldman memorandum, was because the two hedge-fund managers at Bear Stearns Asset Management, Cioffi and Tannin, bought $400 million worth of the $600 million security—by far the largest chunk—at prices that ranged from just below par (99.7 percent of par) to par.

  On Wall Street, Cioffi and Tannin were well-known buyers of squirrelly securities such as CDOs, CDOs of CDOs (known as CDO squareds), and synthetic CDOs. Indeed, in October 2006, Goldman had created a $900 million synthetic CDO squared known as ABACUS 2006 HGS1—a different ABACUS deal than the famous one Tourre worked on—expressly for the two Bear Stearns hedge-fund managers. The security referenced a mix of credit-default swaps on A-rated bonds and synthetic asset-backed securities, “the sweet spot right now” in the market at that time, one trader told Derivatives Week in December 2006. Cioffi and Tannin made the Timberwolf deal on March 27, 2007, thanks to the salesmanship of Andrew Davilman, then a Goldman vice president. Some six months later—after the value of Timberwolf had collapsed to around 15 cents on the dollar, Goldman trader Matthew Bieber referred to March 27 as “a day that will live in infamy.” Meanwhile one of the Bear Stearns hedge-fund investors, who lost all that he had invested, observed, tongue firmly implanted in his cheek: “Nice trade, Ralph.” (According to Michael Lewis, writing in The Big Short, at the same time that Davilman was selling Cioffi most of Timberwolf at par, he was buying insurance from AIG, in the form of credit-default swaps, on behalf of Goldman, as principal, betting that similar CDO securities—although apparently not Timberwolf itself, according to a November 2007 AIG memorandum—would collapse.) Indeed, in Sparks’s March 9 memo—the one where he wrote that the “#1 priority” was to sell “new issues”—he specifically cited Davilman for making a “major contribution” in helping sell the trading “desk’s priorities.” A few days after Cioffi bought the senior tranches of Timberwolf, Mehra Cactus Raazi was able to sell $16 million of a lower-rated tranche of the same deal. “Great job Cactus Raazi trading us out of our entire Timberwolf single-A position,” an internal memo fairly screamed.

  Meanwhile, Tourre was still pounding the pavement trying to sell the ABACUS deal. On March 30, he reported to Sparks that he had been visiting with “selected accounts” during the previous few weeks, many of whom had passed on investing in Timberwolf and Anderson. But there were $200 million of orders—from IKB (apparently having overcome its concern about New Century mortgages being included) and from ACA, the portfolio selection agent. The plan was, he explained, to close the sales of those tranches at the end of the following week and then to try to move the lower-rated tranches shortly thereafter. He urged his colleagues to “steer” accounts “towards available tranches” of ABACUS “since we make $$$ proportionately” when the tranches are sold off.

  On April 3, he sought trade approval to sell Paulson & Co. credit protection on $192 million worth of the ABACUS deal, allowing Goldman to book a $4.4 million fee for providing the insurance. He asked Goldman’s credit group to make sure it was OK with the traders. By April 11, though, perhaps because of some push back from the credit group, Tourre was also worried about making sure Goldman maximized its ability to profit from its trading relationship with Paulson & Co., especially after ABACUS closed. He wrote to Cactus Raazi that he needed to ask the Goldman credit department to perform an “updated review” of Paulson “to enable us to put more trades on with these guys” since “it appears” that since the beginning of 2007, Paulson had shorted, through Goldman, $2 billion notional amount of residential mortgage-backed securities, “which is utilizing most of the credit capacity we have for Paulson.” Tourre explained to Raazi that “[w]e need to be sensitive of the profitability of these trades vs. the profitability of ABACUS—we should prioritize the higher profit margin business with Paulson.” By the next day, it seemed, Tourre had received credit’s approval to do the trades with Paulson, and Raazi booked the trades, much to his dismay—apparently—because he suspected Goldman would get stuck on the losing side. “[S]eems we might have to book these pigs,” Raazi wrote to Daniel Chan, his Goldman colleague.

  On May 8, Tourre updated Sparks on the ongoing ABACUS saga, which he referred to as the “short we are brokering for Paulson.” He explained that the “supersenior tranche” of the deal would “most likely” be executed with ACA, through another bank—ABN Amro, a large Dutch bank—as “intermediation counterparty.” Goldman was to “buy protection” on $1 billion of the security and then Paulson was to short a big chunk of it. (How do they think up these things?) But Tourre was worried that Paulson may have changed his mind about doing the deal as originally conceived. There were now two options for Goldman: one would be a “risk-free” deal where Goldman would make $14 million; the other would make Goldman $18 million but expose the firm to $100 million of risk being long a portion of the deal, although Tourre wrote that he felt confident that risk could be sold at a profit. A week later, with the ABX index rallying, Tourre reported that there was a “90% chance” that ACA and ABN Amro would go through with the deal, but that he was increasingly concerned that Paulson “is starting to get ‘cold feet’ ” on going through with his side of the trade because of the ABX rally. Tourre wanted Sparks’s permission for Goldman to “take down,” or assume the short side of the trade, instead of Paulson, “in order to avoid loosing [sic]” the ACA/ABN Amro order.

  Two weeks later, Tourre provided the group another update. Paulson had now agreed to his side of the trade—for $1 billion—and ACA/ ABN Amro had agreed to buy $909 million, leaving Goldman with $91 million it was unable to place, although “we are showing this tranche to a few accounts,” he wrote. Finally, the next day, the deal was really done, along the lines Tourre had described the day before. Melanie Herald-Granoff, a Goldman vice president in the mortgage-trading group, wrote to Tourre and David Gerst, in the structured products trading group: “Fabrice & David—Thank you for your tireless work and perseverance on this trade!! Great job.” By June 5, Gerst was offering up Goldman’s $91 million re
sidual—that piece that neither Paulson nor ACA purchased—to Bear Stearns Asset Management, or BSAM, at par, or 100 cents on the dollar, with a coupon of Libor plus 0.75 percent. With plenty of its own problems by then, BSAM declined Goldman’s kind offer, leaving Goldman itself on the hook for this piece of the ABACUS deal. After some six months of hard work on the ABACUS deal, Tourre headed to Belgium and then London, in part to visit his girlfriend. “Just made it to the country of your favorite clients [Belgians],” Tourre wrote to Serres on June 13. “I’ve managed to sell a few [ABACUS] bonds to widows and orphans that I ran into at the airport, apparently these Belgians adore synthetic abs [CDO] squared!! Am in great shape, ready to hold you in my arms tonite.”

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  AT AROUND THIS time—with Birnbaum’s short bets paying off big—the decision was made to allow his desk to get control of the firm’s growing inventory of those parts of CDOs it could not sell to investors, known as residuals. He and Swenson began to give serious thought to the price it would take to move these residuals off Goldman’s books and into the hands of other investors. Driven in large part by a combination of what the traders were seeing in the market and Jeremy Primer’s models, which kept spitting out lower and lower valuations for the residuals, Birnbaum began to think that the time had come to seriously write down the value of the firm’s CDOs, in order to move them out the door. “Part of it was just a general discipline where we had legacy positions that—frankly—we did not like,” Birnbaum explained. “This is part of the growing purview that our desk had in terms of all the legacy positions. Looking around, we were like, ‘We got to get rid of this shit.’ And when you think it’s worth par, selling it into a ninety-five bid feels pretty bad. But when you think it’s worth seventy, selling it into a ninety-five bid sounds pretty darn good even if you’re taking a five-point loss, right? So, the first thing was just to get the culture of Goldman around that concept. The same percolation upward that was occurring with these short trades was also happening with this valuation question on CDOs.”