All The Devils Are Here: Unmasking the Men Who Bankrupted the World (53 page)

The group that met that day included Viniar, Sparks, and various members of “the Federation,” the back office risk managers and accounting people. They reviewed Goldman’s exposures, including that ABX position, the securities, the warehouse lines—and the bad loans that Goldman was trying to get New Century and other originators to repurchase. Out of that meeting came a mandate from the top that the firm needed to “get smaller, reduce risks, and get closer to home,” as Birnbaum later put it. It was agreed that Goldman would pull back from its long position so that the firm wouldn’t get caught if the mortgage market continued to sink, as the firm now expected. In an e-mail, Sparks listed his follow-ups, which included “Reduce exposure, sell more ABX index outright,” and “Distribute as much as possible on bonds created from new loan securitizations and clean previous positions.” The next day, Viniar chimed in: “[L]et’s be very aggressive distributing things because there will be very good opportunities as the markets [sic] goes into what is likely to be even greater distress.”

In the coming months, the Goldman team would do all of the above and more. Birnbaum bought all the short positions he could in the ABX.
Goldman demanded collateral from hedge fund clients that had bought mortgage-backed securities on margin, earning it the enmity of many fund managers. It also followed Viniar’s directive to be “aggressive” about “distributing things.” And the firm was able to “amass large amounts of cheap single name protection,” as Birnbaum later wrote in a self-review, because “CDO managers were in denial.” Goldman, however, wasn’t, which is why it was so anxious to reduce its risks as quickly as possible. As another Goldman trader wrote on February 11, “The cdo biz is dead we don’t have a lot of time left.”

Among Goldman’s deals:

• Because it did business with New Century, Goldman was carrying New Century mortgages and securities on its balance sheet. But a CDO it sold in late February 2007 served to reduce that exposure. This was a CDO called Anderson Mezzanine Funding, which consisted of sixty-one credit default swaps totaling $305 million on mostly triple-B-rated securities backed by mortgages produced by New Century and other subprime lenders. Although 70 percent of the CDO was rated triple-A, buyers were so reluctant to invest that Sparks, at one point, suggested liquidating the transaction. To get the deal done, Goldman ended up with a chunk of the equity and the lower-rated securities. On the deal itself, Goldman contends it lost money, something the firm says it did on many such deals. But the Senate Permanent Subcommittee says that Goldman kept a large chunk of the short position for itself, which created a hedge against its New Century exposure.

The subcommittee would also allege that buyers weren’t told that Goldman would profit if the securities tanked; some of the e-mails that were exchanged as Anderson was being marketed certainly suggest that was the case. One potential client asked, “How did you get comfortable with all the New Century collateral in particular the New Century serviced deals—considering you are holding the equity and their servicing may not be around … ?” And a Goldman salesperson asked for additional ammunition so that he could “position the trade as an opportunity to get exposure to a good pool of assets” and not “as a risk reduction/position cleanup trade.” Which is exactly what it was. At the time the deal was done, the underlying mortgages in some of the securitizations were already close to double-digit default rates. Buyers of the triple-A-rated piece clearly believed that the rating meant that their investment was sufficiently insulated from those losses. They were wrong.

Within seven months, the deal was downgraded to junk.

• In May 2006, Goldman helped underwrite $495 million of bonds backed by second-lien mortgages made by Long Beach. It was a terrible deal. Although two-thirds of the tranches had been rated triple-A, the loans in the securitization were some of the worst subprime mortgages imaginable, and the default rate was very high. According to an analysis later done by a research firm called Amherst Holdings, only 32 percent of the loans had full documentation, and the weighted average loan to value was almost 100 percent. As early as 2007, Goldman was demanding that Long Beach buy back defaulted loans; within two years, the triple-A tranches had been downgraded to default status. Didn’t Goldman have a responsibility to investigate the loans before selling them? Of course: as Goldman’s general counsel later wrote in a letter to the Financial Crisis Inquiry Commission, “the federal securities laws effectively impose a ‘gatekeeper’ role on the underwriter.” Goldman claimed that it did due diligence on both the mortgage originators it did business with and the loans themselves. But the quality of both has to make you wonder about how closely Goldman—or for that matter any of the Wall Street underwriters—looked. In any event, the advent of credit default swaps on mortgage-backed securities made it possible for Goldman to underwrite such a deal while mitigating any risk to its own bottom line: in this particular case, Goldman took care of itself by buying $10 million worth of protection on those securities. “Ultimately, in this transaction, Goldman Sachs profited from the decline of the very security it had earlier sold to clients,” as Senator Carl Levin, the chairman of the Senate Permanent Subcommittee, later put it.

• In the spring of 2007, as the clock was ticking on the mortgage market, Goldman created a $1 billion CDO squared that was a mixture of cash and synthetic collateral called Timberwolf. Part of the collateral for that CDO included credit default swaps that referenced securities backed by Washington Mutual pay option ARMs. Timberwolf also included Abacus CDO securities in its collateral.

Once again, Goldman had to push hard to sell the deal. Finally, though, Goldman was able to sell about $300 million of Timberwolf securities to Bear Stearns Asset Management. The firm sold another $78 million—at a sizable discount—to an Australian fund called the Basis Yield Alpha Fund, which at the time had only $500 million under management. According to a $1 billion lawsuit Basis later filed—a suit whose central claim is that the Timberwolf purchase forced Basis into insolvency—Goldman told Basis that the
market was stabilizing. And while the Timberwolf prospectus states that Goldman owned equity in Timberwolf, the Senate Permanent Subcommittee would later highlight that Goldman also had a substantial short position. “Goldman was pressuring investors to take the risk of toxic securities off its books with knowingly false sales pitches,” said Basis’s lawyer. Goldman called the lawsuit “a misguided attempt by Basis, a hedge fund that was one of the world’s most experienced CDO investors, to shift its investment losses to Goldman Sachs.” One fund manager who knows Basis has a different take: “Dumb money,” he says.

Within a year, Timberwolf’s triple-A securities had been downgraded to junk, as the WaMu option ARMs defaulted. The Goldman trader responsible for managing the deal later characterized the issuance of Timberwolf as “a day that will live in infamy.” Tom Montag put it more bluntly. “Boy that timeberwof [sic] was one shi**y deal,” he wrote on June 22, 2007. Once again, Goldman insists that it lost hundreds of millions of dollars on the Timberwolf deal, but to the extent that the deal provided a way for Goldman to exit or hedge existing positions, the firm lost less than it would have otherwise.
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• And then there was Abacus 2007-AC1, the most infamous of all the Goldman synthetic CDO deals. Nearly three years after the deal was completed, the SEC would charge Goldman with fraud, alleging that the firm made “materially misleading statements and omissions” in connection with the deal. Goldman heatedly disputed the SEC’s charges at first, but ended up settling the case for the record sum of $550 million and conceding that the marketing materials were “incomplete.” But in truth, the legal issues were far from the most disturbing thing about Abacus 2007-AC1.

It began with John Paulson, then a little-known hedge fund manager, who along with Andrew Redleaf, Michael Burry, and a handful of others, had been painstakingly buying credit default swaps on subprime mortgage-backed securities. Paulson and his staff were convinced that the entire mortgage market was poised to collapse. Their analysis, in retrospect, was prescient. As a Paulson employee wrote in January 2007, “[T]he market is not pricing the subprime RMBS wipeout scenario. In my opinion this situation is due to the fact that rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while ‘real money’ investors have neither the analytical tools nor the institutional framework.” Anticipating that “wipeout scenario,” Paulson was seeking to do something that would have a big potential payoff. He wanted to make an industrial-sized short by betting against all the triple-A tranches of a single synthetic CDO—a CDO, in fact, that he would secretly help construct. In other words, he would make money if homeowners couldn’t pay their mortgages—and to improve his odds, he was going to, in effect, select which homeowners he thought were least likely to pay.

It was an astonishingly brazen idea—like “a bettor asking a football owner to bench a star quarterback to improve the odds of his wager against the team.” That was the description Scott Eichel, a Bear Stearns trader, gave to Gregory Zuckerman, the
Wall Street Journal
reporter whose book
The Greatest Trade Ever
documented Paulson’s audacious short. Eichel explained to Zuckerman that when Paulson broached his idea with Bear Stearns, it said no. “[I]t didn’t pass the ethics standards,” said Eichel
. It didn’t pass Bear Stearns ethics standards?
The same Bear Stearns that had created some truly terrible subprime securities without batting an eyelash? Yet Goldman Sachs had no such qualms.

Paulson knocked on Goldman’s door at a fortuitous moment. The firm had begun thinking about “ABACUS-rental strategies,” as Tourre described it in an e-mail. By that, he meant that Goldman would “rent”—for a hefty fee—the Abacus brand to a hedge fund that wanted to make a massive short bet. Paulson’s idea fit perfectly.

Paulson paid Goldman $15 million to rent the Abacus name. The buyers of the CDO—the longs on the other side of the Paulson short—assumed it was a deal instigated by Goldman, since Abacus was a Goldman platform. They had no idea that Paulson was helping to select the securities that would make up the deal. Indeed, as the deal was nearing completion, the Paulson
team decided to throw out mortgages originated by Wells Fargo. Wells Fargo mortgages, after all, might actually perform. Goldman’s failure to disclose Paulson’s involvement in selecting the securities in its marketing material for the transaction became the heart of the SEC’s case against the firm.

(According to one person familiar with the deal, Goldman even contemplated keeping the short position for itself instead of giving it to Paulson, who was not considered an important client. The irony is rich: had Goldman kept the short position for itself, it would have double-crossed Paulson, but the SEC would have had no case.)

There were no clean hands here. In renting the Abacus platform and helping to select the referenced securities, Paulson was doing something that may have been perfectly legal, but was awfully sleazy. He wound up shorting most of the $909 million super-senior tranche. The rating agencies were cooperative, as always, even though the Abacus deal was specifically stocked with securities that had been chosen in the expectation that they would fail. Eric Kolchinsky, the Moody’s analyst who oversaw the rating process, later testified that he hadn’t known about Paulson’s involvement and that it was “something that I personally would have wanted to know.” He added, “It just changes the whole dynamic of the structure, where the person who’s putting it together, choosing it, wants it to blow up.” But this was a lame excuse. If there was one party with a duty to do its own due diligence on the securities Abacus referenced, surely it was the rating agencies.

The CDO manager that was supposed to be choosing the securities, a firm called ACA Management, took its fees and appeared to look the other way—exactly what Goldman hoped it would do. E-mails show that one CDO manager had even turned the deal down “given their negative views on most of the credits that Paulson had selected,” as Tourre wrote. (The SEC claimed that ACA didn’t understand that Paulson was going to short the deal, which is a little hard to believe.) ACA also invested $42 million in the securities, and its insurance arm took the other side of the Paulson bet by guaranteeing the $909 million in super-senior tranches.

The final counterparty was an Abacus veteran: IKB. IKB was no lamb being led to slaughter. It had bragged incessantly about its expertise in the CDO market and, according to a lawsuit later filed against it by the French bank Calyon, was trying to off-load its own bad deals onto others. In June 2007, IKB also created a structured investment vehicle called Rhinebridge. Rhinebridge, like other SIVs, issued debt that it then used to buy mortgage-backed securities and CDOs like Abacus. The debt issued by Rhinebridge,
which was rated triple-A, was bought by, among others, King County, Washington, which managed money on behalf of one hundred other public agencies. This was money used to run schools and fix potholes and fund municipal budgets. Rhinebridge was wound down in the fall of 2008, with its investors getting fifty cents on the dollar. In a lawsuit, King County alleged that IKB created Rhinebridge “for the purpose of moving investment losses off of its own balance sheet.” For all of Goldman’s later claims that it dealt only with the most sophisticated of investors, the fact remained that those investors could be fiduciaries, investing on behalf of school districts, fire departments, pensioners, and municipalities all across the country. It was their money, at least in part, that was funding the CDO games Wall Street was playing.