Inside Job (20 page)

To be fair, when Goldman managers referred to their mortgage business as “modest”, they were telling the truth. Full-year 2007 mortgage revenues were about $1.2 billion. But that is
what makes Goldman’s performance so impressive; they understood that in the new financial world of derivatives and massive leverage, even a modest business could suddenly generate
catastrophic, multibillion-dollar losses if they were caught unprepared. Contrast that with, say, Citigroup’s behaviour, not to mention Jimmy Cayne’s. Even though Citigroup had a much
larger position—more than $50 billion of high-risk home mortgages
on their books—senior management didn’t even know they had a problem until the market
cratered.

So full marks to Goldman for cleverness. But their strategy wasn’t just to short the mortgage market, because sometimes it was better to sell off the riskiest assets instead of paying
for insurance on them. Once again, this was accomplished with impressive efficiency, but also with a near-total disregard for ethics, integrity, and their customers’ welfare. Whether their
behaviour meets the standard of criminal fraud may never be entirely known, but without question it was really, really greasy.

In reading what follows, you might measure Goldman’s conduct against its pretentious corporate declaration that “integrity and honesty are at the heart of our business. We expect our
people to maintain high ethical standards in everything they do.”
¹⁰

IT WAS ONE
thing to decide to sell off risky assets, but quite another to find people still willing to buy them in late 2006 and 2007. Clever people
were already out of the question; only fools would do. In December 2006, Fabrice (“Fabulous Fab”) Tourre vetoed a list of sales prospects because it was “skewed towards
sophisticated hedge funds . . . most of the time they will be on the same side of the trade as we will, and . . . they know exactly how things work.”
¹¹

Luckily there were fools still to be found. The sales team started circulating “axes” (meaning sales priorities) in December 2006. A few months earlier, a trader had mentioned that
“sales people view the syndicate ‘axe’ e-mail we have used in the past as a way to distribute junk that nobody was dumb enough to take first time around.”
¹²

“The key,” according to a March 2007 memo, was “getting new clients/capital into the opportunity quickly.” In effect, dumb money, or as another note put it,
“non-traditional buyers”. A salesman pushing
one of Goldman’s most toxic offerings to a Korean client thought he could expand the sale, but wanted a better
commission “as we are pushing on a personal relationship” [i.e., I only screw my friends if I am paid well for it]. Sparks agreed.
¹³

One of the earliest house-cleaning operations was a $2 billion synthetic CDO called Hudson Mezzanine Funding 2006-1. The sales presentation is almost completely misleading. Goldman’s
intent, it said, “is to develop a long term association with selected partners” by creating “attractive proprietary investments.” Goldman, it claimed, had “aligned
incentives with those of the investors.” The presentation materials stated that “Goldman Sachs CDO desk pre-screens and evaluates assets for portfolio suitability . . . and reviews
individual assets in conjunction with respective mortgage trading desks.” True, in a sense—because it was the CDO desk that was choosing the assets they wanted to get rid
of.
¹⁴
“Assets sourced from the Street. Hudson Mezzanine Funding is not a Balance Sheet CDO.” This last statement, however, was a lie. It was
made to reassure investors who had already learned to be sceptical of banks unloading bad inventory.
¹⁵

Which was
exactly
what Goldman was doing. When the deal was executed, cheers resounded through the trading group—they had engineered a big reduction of risk and booked $8.5 million
in earnings. A few months later, after shedding more risk through another sale, Sparks commended the team for having “structured like mad, and travelled the world, and worked their tails off
to make some lemonade out of some big old lemons.”
¹⁶

But Goldman had even more tricks to play on the Hudson investors. Virtually all the Hudson securities were severely downgraded in October 2007, which qualified as a liquidation event. As the
liquidation agent, Goldman was supposed to sell the securities at the best available price and supervise the settlements with investors. Instead, Goldman told investors that it would delay
liquidation until it could find a more experienced agent (!). The price of the securities continued to plummet; instruments worth 60 cents on the dollar in October were worth only
16 cents by January. An asset manager from Morgan Stanley
³
wrote to Goldman in February, “No good reason to wait other than to devalue
our position. It’s a shame . . . one day I hope to get the real reason why you are doing this to me.” Well, the real reason they were doing it to him was that Goldman had
shorted
the securities, so every additional drop in price transferred more wealth from the investors to Goldman.
¹⁷

And then there was Timberwolf, another synthetic CDO in the amount of $1 billion—the one that was immortalized by Senate hearings, and that prompted a suggestion for paying
“ginormous” sales credits. Here is an e-mail trail prompted by a note from sales saying they had just closed a sale on part of Timberwolf at 65 percent of its original value.

Goldman management was happy to get rid of it. A 28 March 2007 e-mail to the sales syndicate reads: “
GREAT JOB
. . .
TRADING US OUT OF OUR ENTIRE
TIMBERWOLF SINGLE-A POSITION
.”
¹⁹

In June, with $300 million of Timberwolf assets still to be sold, Tom Montag, Dan Sparks’s boss, made the comment quoted later at Senate hearings, writing, “boy that timberwolf was
one shitty deal.”
²⁰
But, of course, Goldman kept on selling it.

Later, in September 2007, Tourre asked for a specific Goldman deal
that a potential client could use as an example for a hedging strategy. Two traders exchanged e-mails on
the specifics:

But Tourre’s question prompts a double take. Why would a customer sales guy want to advertise a product with such dreadful performance?

Why, indeed. Well, we don’t know the rest of that particular conversation, but there is ome very logical explanation for what Fabulous Fab was doing. He, and Goldman, wanted to do business
not only with fools, but also with clever people, that is, people who were looking for things to short. People who even wanted Goldman to help them construct securities specifically tailored to
fail. People like John Paulson.

The SEC started investigating the Paulson short in late 2008, but not until 2009, with the publication of Greg Zuckerman’s
The Greatest Trade Ever
, was it widely known that Goldman
had built a deal just for Paulson to short. ABACUS 2007-AC1, known as AC-1 within Goldman, mostly comprised a menu of bonds chosen by Paulson for being particularly bad, in a market where bad was
average.

FUND MANAGERS HAD
been shorting the housing market long before John Paulson; we saw that Morgan Stanley started in 2004. But as Morgan Stanley learned
to its dismay, market bubbles can outlast bearish investors’ resources, and as time passed and the bubble and its inevitable collapse became more obvious to insiders, it became more expensive
to short housing.

Paulson ran several hedge funds and had the resources to lose money for a long time. But, convinced as he was of a coming “subprime RMBS wipeout”, even he worried about the opacity
and complexity of mortgage securities. So Paulson explored whether an investment bank might
custom-design
one, so that he could know and even choose exactly what went inside. Even Bear
Stearns, not exactly a paragon of ethics in mortgage dealings, turned Paulson down because his request seemed “improper”.
²²
As we saw
earlier, Bear Stearns behaved in an extraordinarily unethical way, but although they weren’t concerned about ethics, they did appear to fear potential prosecution for fraud. Happily for
Paulson, Goldman seemed to have no such scruples.

Fabulous Fab Tourre designed the deal, communicating with investors and overseeing the preparation of marketing materials. To make the deal easier to sell to the long investors, aka suckers,
Tourre needed an independent manager supposedly responsible for selecting the investment assets. In internal correspondence Goldman traders worried that such a manager might not “agree to the
type of names Paulson want to use” or would refuse to “put its name at risk . . . on a weak quality portfolio.” ACA Management LLC, which had worked as manager on other Goldman
deals, got the assignment.
²³

ACA was never told the real purpose of the transaction. They were aware that Paulson would be involved in the deal, but not that his real goal was to bet on its failure. Paulson provided Goldman
with a list of 123 bonds he wanted to short; the list was supplied to ACA, and
meetings were held between ACA, Paulson, and Goldman. Although ACA was occasionally puzzled by
the names Paulson recommended, or the strong ones he vetoed, an agreement was worked out on a ninety-bond portfolio, which included fifty-five of Paulson’s original names. At one point in the
discussions, Tourre e-mailed a colleague at Goldman, “I am at this aca paulson meeting, this is surreal.”
²⁴

All the materials strongly emphasized ACA’s role; none mentioned Paulson’s. The marketing emphasized the deal’s attractions for the long investor. The heart of the sales book,
for example, is an eighteen-page statement on the credit selection skills of ACA. Sample quotes: “Asset selection . . . premised on credit fundamentals” . . . “alignment of
economic interest with that of investors” . . . none of “ACA’s CDOs have ever been downgraded.” And much more in that vein, including a detailed presentation of the very
rigorous ACA credit review process.
²⁵

The final deal was yet another synthetic CDO, the $2 billion ABACUS 2007-AC1, the majority of whose reference securities had been handpicked for their poor quality. Through the magic of the
rating agencies, the majority of the securities were rated AAA. Goldman later said that they lost $90 million on the transaction. This seems unlikely, because Goldman’s own internal documents
state that they would not be taking any risk on the deal. But perhaps even Goldman was sometimes gamed by its own employees. Maybe Goldman was unable to sell all of it, was pressured to repurchase
some of it, or had some form of liability for losses.
²⁶

The targeted customer was IKB Industrie Deutschebanke AG. It was classic uninformed money—a small bank, based in Düsseldorf, with little access to background research. IKB was an
eager buyer in CDO markets, and its sponsored hedge fund, Rhinebridge Capital, was one of the first to collapse in the summer of 2007. IKB bought $150 million of the AAA rate notes in April.

Well before the year end, AC-1 was nearly worthless, and Goldman transferred essentially all of IKB’s $150 million to Paulson. Then through complex side deals, some of the long side became
a liability of the Royal Bank of Scotland. ACA failed at the end of the year
and in early 2008 partial settlements were made, some of which presumably went to Goldman, and
from Goldman to Paulson. In August 2008 Royal Bank of Scotland made an $841 million settlement with Goldman on its part of the failed deal, which also would have gone to Paulson.
²⁷

The SEC quietly opened an investigation into the Paulson trade in August 2008, and in April 2010 filed a civil fraud complaint in US federal court—its one and only attempt to pursue
Goldman Sachs for its behaviour during the bubble and crisis. After declaring that it had done nothing wrong, Goldman settled in July 2010, agreeing to a $550 million fine. In its consent to the
judgement, Goldman stipulated that it was “a mistake” to state that ACA had selected the portfolio “without disclosing the role of Paulson & Co. . . . Goldman regrets that the
marketing materials did not contain that disclosure.”
²⁸