Money and Power

by William D. Cohan

  This was easier said than done. One Goldman trader remembered a number of critical and contentious meetings at Goldman where different constituents around the firm would submit, in writing, their thoughts about the valuation of the residuals. “I remember looking at one of these sheets,” he said. “There were huge differences of opinion on this issue. They were very vehement. There are a lot of senior guys at the firm who have since changed their story very much—and were like, ‘Oh, there’s no fucking way that stuff’s worth that. You guys are crazy.’ Some of the more negative people in our group who were more bearish would really be pushing the short trades in general. Some of the senior people thought we were a little nuts”—here he did not want to say which senior Goldman executives felt this way. “Ultimately you had the research guys saying, ‘This stuff’s worth below fifty,’ when it was marked at one hundred.” The debate led to a grand compromise. “Fuck it, mark it at seventy,” the Goldman trader said, recalling how the decision got made.

  By April, Birnbaum had won the internal debate. Not only did Sparks agree with Birnbaum, he became increasingly concerned about the rapidly declining value of Goldman’s $10 billion mortgage-backed securities portfolio, as more and more home buyers began to default on their home mortgages and the market for the securities tied to them began to cool. He took the laboring oar in convincing the senior Goldman executives that the time had come to move. “We’ve got a big problem,” Sparks told Viniar and Cohn. The decision was made to sell as much of Goldman’s $10 billion portfolio as rapidly as possible, even if the markdowns required to do so were drastic. In the first few weeks of April, the e-mails were flying fast and furious with the mandate to sell the firm’s new “axes,” composed of the residual CDO inventory.

  On April 5, Thomas Cornacchia, head of Goldman’s mortgage sales group, sent around a list of thirty positions, totaling $450 million, that Goldman wanted to sell immediately. “Get this done please,” he ordered, and then added a little bit of competitive verve: “Who is the better salesperson??” Within the hour, Mehra Cactus Raazi, Goldman salesperson extraordinaire, had sent the list to Brad Rosenberg, at Paulson & Co., and urged him to take a look. “These are all dirty ’06 originations that we are going to trade as a block,” he wrote. “You are not the only client seeing this[,] so time will be of the essence. Save the price discussion for later—at the moment you might want to figure out whether this portfolio suits your objectives.” Later that day, another internal list of “axes” got circulated. “Over the past few weeks[,] we’ve continued to move several CDO and subprime positions,” Anthony Kim, another mortgage trader, wrote to the senior members of the mortgage group. He then summarized for them that $859.4 million worth of the stuff had sold from Goldman’s inventory. In a separate e-mail, a congratulatory note went around to the group thanking Robert Gaddi, another trader, for doing a “great job” for “moving us out of [$]6mm of our BBB-, Fremont, subprime risk” along with the request to “continue to focus” on the additional long list of bonds. On April 11, another list circulated. “Please continue to focus on the axes below—they remain a high priority for the desk,” the note read. The list came with a further admonition to the sales force: “We are very axed to move” several tranches of the still unsold Timberwolf CDO. The message included the news that the desk was having trouble selling the deal at prices anything like what it had been selling the securities for, and that no longer mattered. “We need levels from accounts that will move this risk,” the message said. “We are planning to pay in the context of $20/bond,” meaning Goldman was willing to sell the bonds at a sufficient discount to get them sold.

  By April 19, Sparks was geared up to deal. Attaching the list of the securities Goldman was anxious to sell, he wrote to V. Bunty Bohra, on the structured products syndicate desk, “Why don’t we go one at a time with some ginormous credits—for example, let’s double the current offering of credit for [T]imberwolf” to make it look more attractive to a buyer. Minutes later, Bohra responded, “We have done that with [T]imberwolf already. Don’t want to roll out any other focus axes until we get some traction there but at the same time, don’t want to stop showing the inventory.” Birnbaum recalled how the frustrations with trying to sell the residual inventory at gradual markdowns reverberated through the firm, until it dawned on people that more drastic steps were needed.

  The difficulty Goldman faced in April trying to sell its “axes” into a market that no longer wanted to buy what it was trying to sell, came to a head in mid-May. “Sparks and the [mortgage] group are in the process of considering making significant downward adjustments to the marks on their mortgage portfolio, especially CDOs and CDO squared,” Craig Broderick, Goldman’s global head of risk management, wrote to his team in his famous May 11 e-mail. “This will potentially have a big P&L impact on us, but also to our clients due to the marks and associated margin calls on repos, derivatives, and other products. We need to survey our clients and take a shot at determining the most vulnerable clients, knock-on implications, etc. This is getting lots of 30th floor attention right now.” Recalled Birnbaum: “So we marked the positions. And started telling the world.”

  CHAPTER 22

  MELTDOWN

  Of all of the momentous decisions that Goldman—nearly uniquely among Wall Street investment banks—had been making to curb drastically its exposure to what the firm was increasingly convinced would be a near-complete collapse of the mortgage market, the decision to mark down significantly its own residual mortgage-related portfolio in the spring of 2007 would reverberate the most profoundly through the metaphorical canyons of Wall Street, touching off one conflagration after another for the next eighteen months until Wall Street itself nearly collapsed in September and October 2008.

  The firm knew its marks would shock its clients and counterparties, and it braced itself for some anger, since the Goldman marks would sooner or later have to be matched by others with similar securities in their portfolios. Birnbaum was not a salesman, so he was not on the front line of the calls made to clients, but he was aware of their being made. They were the marks heard ’round the world. “Definitely some people were shocked,” Birnbaum said. “Some people [started saying,] ‘Conspiracy theory, Goldman Sachs: Oh, you guys are short. You’re just trying to drive the market down.’ The reality was, though, that at that point in time it wasn’t completely known in the market that we were short. Up until probably March I’d say the consensus on Wall Street was that Goldman Sachs was long. We did a fantastic job of not letting the Street know which way we were going.”

  The impact was felt almost immediately. Nowhere did Goldman’s seismic change of heart about the value of its mortgage-backed securities portfolio have a bigger impact than on the fate of the two Bear Stearns hedge funds run by Cioffi and Tannin. For forty straight months, the funds had made money for investors. The unblemished record of the two Bear Stearns hedge funds began to get sullied in February 2007, when the newer of the two funds—the Enhanced Leverage Fund—recorded its first monthly loss of 0.08 percent, the first time either fund had lost money since Cioffi started the first Bear hedge fund in 2003. In March, Bear’s High-Grade Fund lost 3.71 percent for the month, and the Enhanced Leverage Fund lost 5.41 percent. In April, the bottom fell out of the two funds, in large part because of Goldman’s new thinking.

  Once upon a time, the problems of one discrete set of investment decisions would have had little bearing, if any, on what happened elsewhere. But somewhere along the line, financial services firms became connected to one another in much the same way roped-up mountaineers are connected on an alpine ascent. If one hiker falls into a crevasse, it can very quickly lead to every hiker being dragged down right behind him, unless immediate and significant remedial steps can be implemented. It turned out that by the spring of 2007, Wall Street and Wall Street hedge funds were every bit as intertwined as mountain climbers on the face of K2.

  The way hedge funds—such as those run by Cioffi and Tannin—are re
quired by the Securities and Exchange Commission to value the securities they own is plenty arcane. But it is based on the idea of taking an average of the prices other Wall Street firms and other traders are finding in the market for similar securities, most of which were thinly traded from one firm to another and were rarely traded by retail investors or on exchanges, as with stocks. With these illiquid securities, hedge-fund managers had to wait until the end of each month to get the marks from other brokers and dealers, then average them, and then report the “net asset value,” or NAV as it is known on Wall Street, to investors.

  For the first forty months of Cioffi’s tenure as a hedge-fund manager at Bear Stearns, the marks and the funds’ NAVs went up. “Clearly as this market started to get a little bit dicier, in 2007, it was harder to get marks in shops,” explained one Bear executive. “People didn’t want to value things. They were worried about their own valuations. But we were showing valuations that went from one hundred cents on the dollar down to like ninety-eight. They were going down. But they were going a little bit down.” The losses, though, were magnified by the amount of leverage sitting on those assets.

  “Going into the month of May, when we were waiting for our April marks, there were no cash trades that you could look at,” the Bear Stearns executive explained. “That said to us, ‘Wow, this market was falling like a rock.’ But when we were waiting for the April marks, [Cioffi and Tannin] were like, ‘No, let’s see where they come out. We think they’re going to be down. But we don’t think they’re going to be down outrageously.’ And sure enough, we get in all these marks. And the marks are ninety-nine, ninety-eight, ninety-seven. They’re still in that same ballpark. It was enough to have a second bad month. It was like down six percent but not disastrous. Not good, but not disastrous.” Cioffi published the NAV for the Enhanced Leverage Fund for April at minus 6.5 percent.

  A week later, “knowing full well we’ve published our NAV,” according to this executive, Goldman Sachs sent, by e-mail, its April marks on the securities to Cioffi. “Now there’s a funny little procedure that the SEC imposes on you, which is that even if you get a late mark, you have to consider it,” he said. “Suddenly we get these marks. Except these marks are not marks from ninety-eight to ninety-seven. They go from ninety-eight to fifty and sixty. Okay? You get it? They give us these fifty and sixty prices. What we got from the other counterparties is ninety-eight. The SEC rules say that when you do this, you either have to average them—but they’re meant to be averaging ninety-sevens and ninety-eights, not fifties and ninety-eights—or you can go and ask if those are the correct marks. But you can’t ask the low mark. You’ve got to go back and ask the high mark. Everybody knows the procedure. So we got to go ask the high mark. We ask the ninety-eight guy—another major Wall Street firm—and you know what he says? Remember, he knows he’s high now. He goes, ‘You’re right. We were wrong. It’s ninety-five.’ In other words, he gave himself a margin of error, and he said, ‘I’m going to drop it severely.’ He looked at it with great intensity and said ninety-five. Now, we got nothing we can do but take the fifty and the ninety-five and average them. We have to repost our NAV. And now we go from minus 6 to minus 19”—minus 18.97 to be exact—“and that is game fucking over. By the way, the firm”—Goldman Sachs—“that sent us the fifty made a shit pot full of money in 2007 shorting the fucking market.”

  The effect of the new marks from Goldman Sachs on Cioffi’s hedge funds was immediate and devastating. “Let me see if I can make this clear for you,” the Bear executive continued. “Minus six percent announced this week. Oops—minus nineteen percent announced next week. Number one, nineteen percent is a pretty damn big number. So we announce minus nineteen percent. So what happens? Two fundamental things. One, this thing is in free fall—nineteen percent down. Number two, these guys are fucking idiots—six percent one week, nineteen percent the next week. How could that be?” Harder to understand, he said, was that Goldman’s marks had been at 98 percent the month before. “Ninety-eight to fifty?” he asked, incredulous. “They were at ninety-eight the month before. There were no cash trades to imply anything like that. Nothing. There was nothing. And you know what? The way the procedure works, all we could [do] was go, ‘But, but, but, but, but …’ ” After the decision to send out the revised, significantly lower NAV, Cioffi e-mailed John Geissinger, one of his Bear Stearns colleagues: “There is no market. Don’t know what more to say about it at this time[.] [I]ts [sic] all academic anyway[.] 19% is doomsday, −18% does not matter one way or another John. We can keep it at 65. Or 50 or 0.” The marks had had their devastating impact. “Bear is the canary in the mine shaft at this time,” Bill Jamison, of Federated Investors (one of Bear Stearns’s largest short-term lenders), wrote in a June 21 e-mail.

  In an interview, Gary Cohn, Goldman’s president, said the market changed dramatically through the course of the year and Goldman simply reacted to it. “We respect the markets,” he said, “and we marked our books where we thought we could transact because some of this stuff wasn’t transacting. Or where we actually had transacted. We were not misleading ourselves or our investors. We got blamed for this, by the way. We were not misleading people that bought securities with us at ninety-eight on the first of the month, and we didn’t feel like, ‘Oh, my God, we sold these to investors at ninety-eight. How can we mark them any lower than ninety-three?’ We sold stuff at ninety-eight and marked it at fifty-five a month later. People didn’t like that. Our clients didn’t like that. They were pissed.”

  Some Goldman clients, though, turned to Goldman to help them buy insurance on CDOs they were worried about. For instance, on May 25, Avanish Bhavsar, vice president in the convertible bond group, wrote to Deeb Salem that the firm had a new client looking to buy credit-default swaps on CDOs sold in late 2006 and early 2007 as well as wanting to buy residential mortgage-backed securities from the second half of 2006. “They are axed to buy protection,” he wrote. After some back-and-forth about what securities Goldman could offer “protection on,” Swenson wrote to Salem that Goldman should start taking advantage of the market’s reaction by offering “senior protection” to the “[S]treet on tier one stuff to cause maximum pain.” Two days later, the same client wanted to buy more protection, and Swenson again believed Goldman was in a position to make some money by taking advantage of the increasing fear. “We should start killing the [senior] shorts in the [S]treet,” he wrote to Salem on May 29. “Let’s pick some high quality stuff that guys are hoping is wider today and offer protection tight—this will have people totally demoralized.”

  In his 2007 end-of-year self-evaluation, Salem wrote about how Goldman took advantage of the fear in the market. “In May, while we … remained as negative as ever on the fundamentals in sub-prime, the market was trading VERY SHORT, and was susceptible to a squeeze. We began to encourage this squeeze, with plans of getting very short again, after the short squeeze caused capitulation of these shorts. The strategy seemed do-able and brilliant, but once the negative fundamental news kept coming in at a tremendous rate, we stopped waiting for the shorts to capitulate, and instead just reinitiated shorts ourselves immediately.”

  Others in the market just seemed confused about pricing in general. For instance, at one point, Goldman offered to sell the securities to KKR Financial Holdings, a specialty finance company affiliated with KKR, the buyout firm. Cohn called up Nino Fanlo, one of the founders of KKR Financial Holdings, and offered to sell him Goldman’s entire $10 billion portfolio at around 55 cents on the dollar, well below what the securities seemed to be trading for in the market. Fanlo called Cohn back and told him, “You’re way off market. Everyone else is at eighty or eighty-five.” If that was the case, Cohn told Fanlo, then KKR could have the windfall of buying the securities at 55 cents and selling them at 80 cents. Twenty-five cents’ profit on $10 billion face amount of securities was a cool $2.5 billion. “You can sell them to every one of those dealers,” Cohn told him. “Sell eighty, sell seventy-seve
n, sell seventy-six, sell seventy-five. Sell them all the way down to sixty. And I’ll sell them to you at my mark, at fifty-five.” Cohn said he was anxious to get the securities out of Goldman’s inventory. “So if you can do that,” he said he told Fanlo, “you can make yourself five billion dollars”—actually half that—“right now.” Cohn had been trying to sell the securities at 55 cents on the dollar for a period of time and people would just hang up on him. A few days later, Fanlo called Cohn back. “He came back and said, ‘I think your mark might be right,’ ” Cohn said. “And that mark went down to thirty.”

  At the time, one Goldman executive explained, dealers and counterparties across Wall Street were being similarly disingenuous—claiming the market still valued these squirrelly securities near par (100 cents) but refusing to buy any of them at Goldman’s highly discounted marks. “This is something that I think is missed,” he said, “and we’re vilified when I think we certainly shouldn’t be because our prices were indicative of where we were willing to deal.… If it’s an opportunity and we’re pricing it at sixty and someone else is eighty, they can buy it at sixty from us. But the reality is everyone was kind of—I’m not gonna say living a lie—but they were in dreamland, to a certain extent, and they weren’t willing to own up to it.” He recalled a conversation that transpired between Goldman and AIG about the value of one security that AIG had insured and Goldman felt had declined in value and was seeking more collateral from AIG as compensation. “There was a back and forth exchange with some of the AIG employees that was on a taped phone conversation,” he recalled. “The conversation was something like: ‘Where do you think the market could be?’ and he was like, ‘I don’t know, ninety? Could be eighty. I don’t know.’ And then there’s a part where he says, ‘I could probably buy some here, but then any accountant in the world would make me mark it down.’ The answer is absolutely true. And so what do some of these shops do? They don’t trade, so they don’t have to take the markdown. We don’t do that at Goldman Sachs.”