Authors: Charles Ferguson
In fairness to Mr Lewis, it
is
true that in several major cases—most notably Citigroup, Merrill Lynch, Lehman, and Bear Stearns—senior management was indeed disconnected and
thus clueless, allowed their employees to take advantage too long, and therefore destroyed their own firms. Unquestionably, the general atmosphere of adrenaline, testosterone, and money also played
a role, infecting many in the banks who should have known better. But even within these firms, there were groups that started dumping bad assets on unsuspecting customers and profiting by betting
against their own securities. In 2011 the SEC tried to settle a case against Citigroup in which senior CDO traders profited by holding the “short side” of bad securities. A US federal
judge rejected the SEC’s proposed settlement on the grounds that it was too lenient.
2
Moreover, cluelessness was most definitely
not
an issue with the senior managements of Goldman Sachs, JPMorgan Chase, and Morgan Stanley. As we saw, Morgan Stanley started betting against
the bubble as early as 2004 but made a tactical error in doing so, one that cost them $9 billion. The fact that they underestimated the scale of the collapse does not excuse them, nor does it mean
that they didn’t realize
there was a bubble. They realized it very clearly, and ruthlessly tried to exploit it.
Conversely, JPMorgan Chase just stayed away; they sold some toxic stuff, but mostly just remained prudently above the junk mortgage fray. JPMorgan Chase’s senior management sometimes
countenanced extremely unethical, even illegal behaviour, but they weren’t stupid or complacent, and they kept their employees firmly under control. It probably also helped that Jamie Dimon
only became CEO of JPMorgan Chase in 2005, and that he had just come from a troubled bank in Chicago that he had needed to rescue.
But it was also clear that Dimon was paying attention. In May 2007 Bill Ackman, the hedge fund manager who was shorting MBIA, delivered a presentation to an investment conference, bluntly
entitled “Who’s Holding the Bag?” It dissected the bubble and its imminent collapse with devastating thoroughness. I have read it; the presentation was sixty-three pages long and
left absolutely nothing to the imagination. It ranged from high-level questions of corporate governance and incentive structures to the conflicts of interest at the rating agencies, to the very
fine-grained details of how many hundreds of billions of dollars of adjustable-rate mortgages would reset at higher interest rates in the coming year, with an inevitable wave of defaults to follow.
Ackman’s presentation was widely circulated among the investment banks. A few months afterwards, Ackman encountered Jamie Dimon at the US Open tennis tournament. Ackman said to Dimon,
“You should read my presentation,” to which Dimon replied, “I already have.”
Goldman Sachs, though, was in a class by itself. They made billions of dollars by betting against the very same stuff that they had been making billions selling only a year or two before,
profiting from the foolishness of AIG, Morgan Stanley, and, allegedly, Lehman Brothers. We consider them next; but first, a brief digression.
The coming end of the bubble produced one final, wonderfully poisonous financial innovation, whose invention and widening use proves that many people on Wall Street knew
exactly
what was
going on.
Creating Something Special Just for the Innocents and Fools
BY LATE 2005
and certainly by 2006, even the most fraudulent subprime mortgages were becoming harder to find. Borrowers had all the financing they could
take, and even the most crooked mortgage broker would soon have been reduced to making loans to dead people, pets, and aliens. But there were still so many naively greedy investors out there who
were willing to
buy
toxic securities. What to do? Wall Street came up with something brilliant. Once again, derivatives came to the rescue. The bankers’ insight was to realize that
many investment managers in the world were so innocent, avaricious, and/or foolish that they would buy mortgage securities even when they knew that their interest payments came not from real
mortgages, but rather from clever people betting that their securities would collapse.
Enter a new product, the synthetic CDO. (We encountered it earlier, briefly, as the way Morgan Stanley ripped off the pension fund of the Virgin Islands.) Synthetic CDOs permitted banks to
generate hundreds of billions in new high-risk paper, out of thin air, when they could no longer find subprime mortgages to buy. All it took was a computer, a flair for math, and complete
amorality.
Instead of going to all the trouble of defrauding borrowers, you simply used existing mortgage-backed securities as a reference or index. You then created a two-sided wager. On one side, an
investor purchased the “long side” of the synthetic CDO, receiving payments that mimicked the performance of some “real” CDO (or an index of CDO prices). But the payments to
the investor didn’t come from real mortgages; rather, they came from the opposite side of the bet—someone willing to pay an interest rate, often a surprisingly low rate, in return for
the right to collect money
if the referenced securities failed
. So a synthetic CDO basically turned an “investor” into a seller of CDS insurance, on whatever stuff had been used
as the reference or index. The investors’ “interest payments” were actually
the bets being placed by the other side on the reference securities’
failure.
What is interesting—and very dangerous—about this is that even as the
housing
bubble ended and the flow of real mortgages dried up, the investment banks were able to prolong
the
financial
bubble (and worsen the eventual crisis) by selling synthetic CDOs. They used them to bet against the very securities they had created and sold, as Morgan Stanley did with
Libertas and Goldman Sachs did repeatedly; to bet against the market generally; and to collect transaction fees by matching fools with sharks (e.g., hedge funds), structuring and selling both sides
of the deal. Since synthetic CDOs can exist only if someone is willing to bet against the “long side”, their sharp rise was a clear indication that Wall Street knew not only that there
was a bubble, but also that its end was imminent. It was no coincidence that synthetics grew strongly after home price increases levelled out in 2006.
And this was most emphatically
not
a small business catering to a few adorably cranky contrarian individuals. A reasonable estimate is that by the end of 2006, the volume of synthetic, or
primarily synthetic, CDOs was approaching $100 billion, while about a quarter of the assets in “conventional” CDOs were also synthetic. By the first half of 2007, just before the market
collapsed, synthetic CDOs were almost certainly the majority of the total CDO market.
And nobody knew more about this business than Goldman Sachs, John Paulson, Magnetar, and Tricadia.
Goldman Sachs, the Really Big Short, Gaming the Crisis, Lying to Congress
THE NINE-HUNDRED–PLUS PAGES
of documents and e-mails gathered by the US Senate Permanent
Subcommittee on Investigations, supplemented by the Levin hearings of April 2010 and other records, lay out a remarkable narrative of how Goldman Sachs profited from the collapse. Two conclusions
dominate.
The first is that Goldman’s management was tough and competent. In contrast to Jimmy Cayne, Stan O’Neal, and Chuck Prince (CEO of Citigroup), who had no clue
or apparent concern about what their traders were doing, Goldman’s executives closely monitored and understood both the wider market and their own position. Helicopter golf and bridge
tournaments did not take precedence. They called the end of the bubble accurately, shifted their strategy to betting against it, and implemented their decision with great discipline, speed, and
foresight.
The second clear lesson, from the way they dumped their “shitty” assets, gamed the industry, failed to warn regulators of impending crisis, and later misrepresented their behaviour,
is that they could be utterly cold-blooded bastards. We’ll look first at their trading and asset-shedding strategies in 2006–2007, then their brilliant, ruthless manipulation of the
industry in 2007–2008, and finally, their not-so-honest Senate testimony in 2010.
E-mail records reveal Goldman’s strategic shift. The first step was a full-scale “drilldown” on the company’s entire mortgage portfolio, conducted in mid-December 2006.
The working group produced a listing of all its mortgage positions and hedges, and a position-by-position list of loss exposures that added up to $807 million in potential losses.
David Viniar, the Goldman CFO, sat down with the entire mortgage team on 14 December and decided on an approach. The objective was to “reduce exposure . . . distribute [sell] as much as
possible on bonds created from new loan securitizations and clean previous positions.”
Just four days later, Fabrice Tourre, a thirty-one-year-old senior account manager based in London, made a special inquiry about buying some selected bonds because he was aware that
“we
have a big short on”
[italics mine].
3
Goldman reduced its bids on new loans, loaded up on mortgage index shorts, and bought credit default
protection on individual bonds. To avoid revealing its strategy, Goldman continued to be active in buy-side markets but deliberately lowered its bids in order to win as few auctions as
possible.
Almost immediately afterwards, the mortgage market started deteriorating
badly. A medium-sized subprime lender, Ownit, filed for bankruptcy in late December, and two big
originators admitted to major problems in the first week of February 2007. HSBC announced large subprime losses, while New Century, one of the most important subprime originators, announced it
would restate its 2006 earnings—what had appeared to be large profits became substantial losses. New Century’s stock went off a cliff, and it filed for bankruptcy soon afterwards. The
spread, or risk premium, on a widely used subprime mortgage index jumped from 3 percent to 15 percent.
By that time, however, Dan Sparks, the head mortgage trader, could advise his bosses that his “trading position has basically squared”—in other words, the $807 million exposure
was almost gone, although “credit issues are worsening on deals and pain is broad (including investors in certain GS-issued deals).” He also advised his management that his
group’s estimates of the real value of Goldman’s holdings was dropping even faster than market prices.
The main reason for this is that most of the other investment banks didn’t react the same way; virtually all of them kept their marks (i.e., valuations) much higher than
Goldman’s, which made Goldman’s market exit all the easier.
4
This difference between the behaviour of Goldman Sachs and the other banks was
the combined result of three forces we have discussed previously. The first was that many traders were gaming the system, keeping the bubble going as long as they could for their own personal
benefit. The second was the compartmentalization of information. And the third force, of course, was the obliviousness of the senior management of some of the large banks, which allowed their
employees to keep going too long.
Sparks continued his shorting and said that his group had continued to make aggressive markdowns, which were “good for us position-wise, bad for accounts who wrote that [CDS]
protection.”
5
It appears that Goldman had bought all the CDS protection it could while protection was still cheap, and
then
, as soon as it
had protected itself, wrote the securities down and demanded payment from its protection suppliers.
(We will see this again, on steroids, when we come to AIG.) A week later,
with the market collapsing, Sparks ordered the team to “monetize” their positions. This meant that they locked in a limited but guaranteed profit, which they could start booking
immediately for that year’s earnings, rather than waiting until their protection contracts ended. “This is the time to just do it, show respect for risk, and show the ability to listen
and execute firm directives. . . . You guys are doing very well.”
6
Sparks told his bosses, “We are net short,”
7
but that he was still worried. He needn’t have been. Mortgage trading had a record first
quarter in 2007, booking $266 million in revenues, at the same time that it accomplished major position reductions. The overall mortgage inventory was down from $11 billion to $7 billion, with the
subprime component down by a net $4.8 billion. From that point onward, Goldman was safe—unless the whole financial system melted down, a contingency for which, we shall see, they started to
prepare. In late July 2007, after two Bear Stearns mortgage hedge funds had blown up, Goldman Sachs’s copresident Gary Cohn commented to David Viniar, Goldman’s CFO, on the sudden
carnage. Viniar replied, “Tells you what might be happening to people who don’t have the big short.”
8
Although Goldman made large profits on its mortgage shorts, it could have made much more. But top management—Viniar, Cohn, and Lloyd Blankfein, the CEO—decided against truly massive
short bets. They loved beating their competitors, but they wanted to stay safe, preferring to lock in smaller immediate profits as protection against the risks posed by the fear, uncertainty, and
destruction cascading throughout the entire global financial system as the crisis widened. One of Goldman’s traders, Josh Birnbaum, later lamented that his desk could have made more money
than John Paulson’s fabled “Greatest Ever Trade” if only management had let him.
9
But this would have required making significant
investments in buying short positions and also postponing the booking of profits from them, a strategy that carried with it the risk that investors would panic if Goldman reported losses in 2007 or
2008.
As a result of Goldman’s foresight and caution, 2007 was the best year ever for its mortgage business. By the end of the third quarter, and as Table 1 below
illustrates, mortgage revenues were nearly equal to full-year 2006 revenues, the previous high. The revenue jump came from the shorts, which were concentrated in the structured products desk. The
losses in residential mortgages came from Goldman’s decision to mark down its remaining long positions.