Money and Power (100 page)

The next day was even better. Birnbaum’s trading bet was up $373 million. Goldman then used the cover of Birnbaum’s extraordinary profits to write down further the value of the CDOs the firm retained, and could not sell, as well as other mortgage-related residuals. Together, the write-offs in these long positions cost the firm $322 million, but because of Birnbaum’s short position, the mortgage group was still able to show a profit for the day of $48.7 million. “Tells you what might be happening to people who don’t have the big short,” Viniar wrote to Cohn that day. On July 26, Montag wrote to Blankfein and Cohn that “mortgages goi[n]g to show up [$]135 [million] or so today it seems.” Blankfein responded: “Is that right?” And then Montag increased the estimate to $170 million “hopefully.” Blankfein wondered, “I assume we are properly marking down our longs?” To which Montag responded that the firm had “marked things down [$]100 [million] yesterday. Could have done [$]15 [million] or more today but don’t know.” He added the thought that there was “not a lot left” to mark down. No doubt pleased with the firm’s good fortune, Blankfein replied, “If the shorts went up today, shouldn’t the longs have dropped (unless they’re already at zero … [?]).”

Birnbaum understood why the firm would net its mortgage losses against his gains, but it still rankled. “The firm was a great beneficiary of the idea that ‘it’s very easy to have a clear head and to look at something in an unbiased way when marking things correctly isn’t going to hurt you,’ ” he said. “Right? Because our desk was as short as it was and we were making money on the way down, we effectively had all this dry powder in terms of P&L to play with.” Another trader echoed this sentiment: “If we’re making $50 million in one day on our desk, it was not unusual to say, ‘Okay, we got $50 million to play with. These CDOs, let’s mark them down further.’ And it would drive us crazy because, you know, we’d be high-fiving, going, ‘We made 100 million bucks today.’ I mean it was unheard of in one day to make $100 million. And then when the P&Ls would actually go through, you’d be like, ‘Oh, the department’s up $20 million.’ ”

This set Goldman apart in the market and caused a fair amount of resentment at other firms that resisted marking their books to the real market, because doing so would mean having to absorb some serious losses. “Other firms didn’t have that luxury,” Birnbaum explained. “Everybody else couldn’t afford to mark this stuff ’cause they had so much of this shit, they couldn’t mark it.… They were in denial. If they took the full extent of our marks, these guys would have failed earlier.
Everyone was trying to buy time. Just what any trader who’s losing money would try to do.”

Another part of Birnbaum’s hedging strategy had nothing to do with mortgages, or the ABX index, or credit-default swaps. Rather, it was a simple bet that the equity of the firms most heavily involved in the mortgage sector would fall. He made these bets by buying put options, whereby he paid a premium to a third party who was willing to take the opposite side of the trade. Birnbaum was betting the stocks would fall in price by a given date, and the seller of the put option was betting the opposite—that the price of the stocks would go up. According to a July 24 e-mail from Birnbaum, his put options had made a profit of $49 million since he had bought them. Among those companies whose stock he bet would fall were
Bear Stearns,
Moody’s,
Washington Mutual,
Capital One Financial, and National City.

It is not clear from the note when Birnbaum started buying the
puts, but it is clear that he began sometime before June 21, since that was the date, he wrote, that his group “paused” in “our equities trading while we worked with management and market risk to come up with quantitative limits for these positions.” He wrote that he thought “we are getting close” to an agreement on the limits but in the meantime he wanted approval “to opportunistically buy puts” on those companies with exposure to the mortgage market. He cited specifically thirteen companies he wanted to buy puts for, including Bear Stearns, Lehman Brothers,
Merrill Lynch,
Morgan Stanley, and
Countrywide.
Donald Mullen, then head of Goldman’s U.S. credit sales and trading, having joined Goldman from Bear Stearns in 2001, wrote to Sparks the day after receiving Birnbaum’s memo with a sharp rebuke: “He is too large [redacted]. Bruce [Petersen, another Goldman managing director] is going to discuss w[ith] him today.”

——

O
N
A
UGUST
9, evidence of the international spread of America’s subprime crisis showed up in Paris when
BNP Paribas, France’s largest bank, blocked withdrawals from three investment funds, which had about $2 billion in assets on August 7, because the bank could no longer “fairly” value them due to a “complete evaporation of liquidity in certain market segments of the U.S. securitization market.” BNP’s action followed an August 3 announcement by
Union Investment Management, Germany’s third-largest mutual fund manager, that it had stopped permitting withdrawals from one of its funds after investors pulled out 10 percent of the fund’s assets. Also on August 9, the
European Central Bank injected £95 billion into the overnight lending market “in an unprecedented response to a sudden demand for cash from banks roiled
by the
subprime crisis,” Bloomberg reported, and more than the central bank had lent after the
September 11 attacks.

Hank Paulson, who had been treasury secretary for a year, had been worried about just such a “crisis in the financial markets” since he took his post. He kept his weekly breakfast appointment that day with
Ben Bernanke, the chairman of the Federal Reserve, and managed to gobble up his usual bowl of oatmeal, orange juice, ice water, and Diet Coke. “
Ben shared my concerns with the developments in Europe,” Paulson wrote later in his memoir,
On the Brink.

When he got back to his office he spoke with Wall Street CEOs, including Blankfein,
Richard Fuld at Lehman,
Stephen Schwarzman at
Blackstone Group, and
Stanley O’Neal at
Merrill Lynch. “
All these CEOs were on edge,” Paulson wrote. O’Neal, for one, remembered that call with Paulson. “
If you had called me a couple of days ago I would have been more sanguine,” he told Paulson. “I’m not anymore.” Paulson asked why. “Because you had overnight secured lending fail between rated banks,” he told Paulson. “There’s something more going on, and it means there are potential risks [to the system, beyond] what we think we see on the surface.” O’Neal also knew that Merrill had tens of billions of dollars of CDOs marked at or near par, a ticking time bomb.

On August 17, the Federal Reserve began to take its first steps to try to stanch the bleeding. The central bank cut
interest rates by 50 basis points in recognition that “financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward.” The Fed pledged to “act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.” The Fed also announced that banks could borrow from the discount window “for as long as 30 days, renewable by the borrower,” in order for banks to have “greater assurance about the cost and availability of funding.” The new plan would remain in effect “until the Federal Reserve determines that market liquidity has improved materially.” The two-pronged approach of lowering interest rates and effectively substituting the Fed’s balance sheet for the balance sheets of the country’s financial institutions, whether troubled or not, arose from a Fed offsite in Jackson Hole, Wyoming, during the third week of August 2007. New York Fed president Tim Geithner dubbed this new approach to the growing crisis “the
Bernanke Doctrine.”

As the contagion of the emerging credit crisis began being felt across the globe in the late summer of 2007, Goldman continued to rake in the profits from Birnbaum’s hedges. “Department-wide P&L for the week was $375mm,” Sparks wrote to Montag on July 29, and then added that the
trading “P&L on the week was $234mm, with CMBS, CDOs and RMBS/ABX shorts all contributing.” Two days later, Montag updated Blankfein—in a mostly incomprehensible e-mail—on the profits and the market, as well as the firm’s ongoing efforts to cover short positions and reduce the VAR associated with Birnbaum’s hedging. In a presentation that Sparks prepared for Montag to give to Goldman’s
Management Committee on August 6, Swenson and Birnbaum reported that it was “a phenomenal week for covering our Index shorts” with one desk buying “$3.3 [billion] of ABX index across various vintages and ratings over the past week,” with $1.5 billion being used to “cover shorts.”

By the following week, though, the VAR police were back on the prowl. One of them pointed out in a widely circulated internal e-mail that Birnbaum’s trading group’s VAR seemed to be around $100 million, well above its $35 million limit. “[A]re you getting any more heat to cut/cover risk?” Birnbaum wrote to
Deeb Salem, on August 9. Birnbaum wrote that he had asked about the VAR police only because he saw the “note about mortgages dropping back down to a permanent limit of [$]35mm (which we are way over). [T]his would mark a change of their recent policy to just keep increasing ou[r] limit. [M]akes me a little nervous that we may be told to do something stupid.” Salem quickly understood Birnbaum’s point. “[I] do think that is a real concern,” he replied. “[H]ow quickly can you work with [the VAR police] to get them to revise our VAR to a more realistic number?” Birnbaum replied that he had a meeting with them on Tuesday, where apparently he was able to get the VAR limit of $110 million extended until August 21. But, on August 13, when VAR for trading overall had increased to $159 million, from $150 million, Viniar was explicit. “No comment necessary,” he wrote. “Get it down.”
Gary Cohn echoed Viniar’s comment two days later, after the trading VAR had increased to $165 million. “There is no room for debate,” he wrote. “We must get down now.”

The concern about the rising VAR on the mortgage trading desk revealed a larger debate then percolating around Goldman: how to take advantage of the misery being felt by other firms as the mortgage markets started to collapse. The problem was that Birnbaum and company continued to see huge profit opportunities to buy when others were forced sellers, but this required putting more capital at risk, which increased the VAR and upset the police, as well as
David Viniar and Gary Cohn. There may have been no room for debate, according to Cohn, but the debate was raging all the same.

Sparks took a stab at trying to explain the opportunity up the chain of command. “Mortgage CDO market has continued to be hammered
with combination of the large downward move in subprime RMBS, rating agencies action, and no liquidity,” he wrote to Montag, Viniar, Cohn, and others. He then gave them the example of how Goldman’s own Timberwolf deal, which had been marked at 80 cents on the dollar at the end of May, was then—on August 14—marked at around 20 cents on the dollar. “[I]t’s not just liquidity,” he wrote, “there are fundamental cashflow issues.” He then explained that the “best opportunity to make a bunch of money” in the near term was to buy the AAA ABX index as well as other residential mortgage-backed securities. He wrote that he thought that the market seemed to be overreacting and that the mortgage desk had been covering its shorts—at a big profit—but “we will likely come to you soon and say we’d like to get long billions” while also staying short the riskier part of the mortgage market. Cohn responded to Sparks that he wanted him to “talk to me before you go long,” suggesting that the decision would not be reached simply.

By August 20, Sparks had begun to further flesh out the trade. In an e-mail to Cohn, Winkelried, Viniar, Montag, and Mullen, titled “Big Opportunity,” he reviewed for his bosses the ongoing market meltdown. “We are seeing large liquidations,” he wrote, brought on by a need for liquidity and that was “fear and technically driven.” He mentioned that CIT—the large commercial lender—had called and wanted Goldman to buy $10 billion worth of its loans. “We think it is now time to start using balance sheet,” he continued, “and it is a unique opportunity with real upside … there’s the opportunity for us to make 5–10+ points if we have a longer term hold.” Winkelried responded to Sparks, in part, “Clearly [an] opportunity.”

The next day, Birnbaum wrote to many of the same executives with his version of what Sparks had described the day before: “The mortgage department thinks there is currently an extraordinary opportunity for those with dry powder to add AAA subprime risk in either cash or synthetic form,” he continued. He suggested that the trade would reduce the mortgage department’s VAR by $75 million and that the arbitrage opportunity implied by the trade could result in big profits. He thought there would be plenty of distressed sellers to provide the supply and that he intended to “share this trade quietly with selected risk partners.”

The proposal was a bold one, and the profit potential huge if Birnbaum and company were correct. But there also seemed to be some concern at the firm’s highest levels that the group’s recent success had made them a bit cocky. “It would help to manage these guys if u would not answer these guys and keep bouncing them back to Tom [Montag] and I,” Mullen wrote to Winkelried and Cohn. Cohn responded, “Got that
and am not answering” but then had to admit the trade had merit. “I do like the idea but you call,” he replied to Mullen. Montag then weighed in. “Just to be clear,” he wrote, “[t]his is buy and hold not buy and sell strategy,” suggesting that the firm’s capital would be committed for some time. Cohn got that. In the end, Sparks and Birnbaum got the green light to “opportunistically … buy assets” at the same time that the mortgage trading group was “significant[ly] covering [its] short positions,” according to a presentation given to the Goldman board of directors in September 2007.

By the end of August (and Goldman’s third quarter), there was no denying the Birnbaum juggernaut. His structured products trading group was carrying the mortgage business at the firm and keeping it profitable at a time when Goldman’s main competitors on Wall Street were struggling mightily. According to a September 17 presentation delivered to the Goldman board of directors, during the firm’s third quarter, the mortgage origination machine at the firm lost some $200 million—mostly from writing down the value of soured loans—while Birnbaum and company racked up revenue, which was close to pure profit, of $731 million. Indeed, of the $735 million of gross revenues made by Goldman’s mortgage business in the third quarter of 2007, $731 million, or 99.5 percent, came from Birnbaum’s desk. What’s more, of the $1.017 billion of gross revenues the mortgage business generated through the first nine months of 2007, $955 million—or close to Birnbaum’s “bilsky”—came from his desk.