Authors: William D. Cohan
Kevin Gasvoda, a managing director who attended the Viniar meeting, wasted little time in directing the troops to begin aggressively unloading Goldman’s long mortgage positions, even if it meant selling into a market without many buyers and taking losses. The new mantra was being broadcast. “Although liquidity will be light the next few weeks[,] pl[ea]s[e] refocus on retained new issue bond positions and move them out,” he wrote. “There will be big opportunities the next several months and we don’t want to be hamstrung based on old inventory. Refocus efforts and move stuff out even if you have to take a small loss. Talk to me if you have concerns or questions but we need to be turning risk over aggressively to stay well positioned.”
According to Sparks’s summary of the meeting—contained in an e-mail to Montag and Ruzika written the same day—the group reviewed six areas of risk related to
subprime mortgages, including the ABX index, credit-default swaps, and CDO warehouses. According to Sparks, there were seven “follow-ups” from the meeting, number one being “[r]educe exposure, sell more ABX index outright.” Other conclusions were to “distribute as much as possible on bonds created from new loan securitizations and clean previous positions”—in other words, get rid of Goldman’s long mortgage positions as quickly as possible. The group also agreed to “[s]tay focused on the credit of the [mortgage] originators”—such as New Century—“we buy loans from and lend to” because they were likely to fail. In sum, the idea was to “[b]e ready for the good opportunities that are coming (keep powder dry and look around the market hard).” After the meeting, at 1:00 a.m., Montag forwarded Sparks’s e-mail to Viniar and asked him, “Is this a fair summary?,” prompting Viniar to respond that morning that it was. “Dan and team did a very good job going through the risks,” Viniar wrote. “On ABX, the position is reasonably sensible but just too big. Might have to spend a little to size it appropriately.
On everything else, my basic message was let’s be aggressive distributing things”—selling off the long positions—“because there will be very good opportunities as the markets goes into what is likely to be even greater distress and we want to be in a position to take advantage of them.”
So Viniar and his colleagues quickly decided to reduce Goldman’s risk in this area to as close to zero as possible. “
The words we used were, ‘Let’s get closer to home,’ ” Viniar said. He figured the mortgage market would continue to fall—again he did not realize how far and how fast—but by reducing the firm’s exposure in December 2006 and in subsequent months, Goldman would be in position to buy when others were forced to sell and would benefit.
The next day, Birnbaum wrote to a colleague, “[W]e’ve had good traction moving risk through our franchise on a variety of fronts.” But not always fast enough for the team. For instance, on December 15, Swenson reported that Salomon Brothers sold to Goldman, for 65 cents on the dollar, an undisclosed amount of a GSAMP security that Goldman had sold earlier in the year at 100 cents on the dollar. It was not clear from the Swenson e-mail whether Goldman believed the GSAMP deal made sense at 65 cents or whether Goldman felt it had to make a market for a counterparty. In any event, Deeb Salem, Birnbaum’s colleague, replied about the trade, “This is worth 10”—meaning the GSAMP bonds were worth 10 cents on the dollar, not 65 cents. “It stinks.… I don’t want it in our book.” Swenson replied, “It is not that bad.” But Salem would have none of his colleague’s modest optimism. “[Credit-default swap market] thinks that deal is one of the worst of the year … hopefully they r wrong.”
Sparks began implementing the new orders almost immediately. On December 17—a Sunday—he reported to Viniar, Montag, Ruzika, and McMahon, and copied
Gary Cohn, that “[w]e made progress last week” in reducing the firm’s long exposures to the mortgage market—on BBB-rated securities—“but still more work to do.” In the three days at the end of that week, Sparks reported to his bosses that his group had reduced the firm’s long exposure by $1.5 billion in BBB- and BBB-minus-rated securities that had been originated in 2005 and 2006, but to reduce the long exposure to flat, Goldman still needed “to lay off about another $1 billion notional.” He worried, though, about how much more he could sell in the last two weeks of the year because of the “ability/motivation for certain hedge funds to shove market either way with respect to year-end performance measures” and because of the “noise” in the mortgage origination market. “[M]ore will go down (when not if),” he wrote. “Trading desk is looking to buy puts”—make bets the companies will fail—“on a few [mortgage] originators.”
On December 20,
Stacy Bash-Polley, a partner and the co-head of fixed-income sales, noted that Goldman had been successful in finding buyers for the super-senior and equity tranches of CDOs, but the mezzanine tranches remained a challenge. She suggested the mezzanine tranches be packaged up and sold as part of other CDOs. “We have been thinking collectively as a group about how to help move some of the risk,” she wrote in an e-mail released in January 2011 by the
Financial Crisis Inquiry Commission. “While we have made great progress moving the tail risks—[super-senior] and equity—we think it is critical to focus on the mezz risk that has been built up over the past few months.… Given some of the feedback we have received so far [from investors,] it seems that cdo’s maybe the best target for moving some of this risk but clearly in limited size (and timing right now not ideal).”
Goldman reduced its exposure to mortgages “early,” Viniar said, “before most people had a view that the world was getting worse.” One of the ways Goldman was able to “get closer to home” and reduce its exposure to the mortgage market was to sell the mortgages it owned, for whatever price they could garner in the deteriorating market. But that strategy could get the firm only so far, since too much selling would force the price of the securities lower and lower and defeat the purpose of trying to get out at a decent price. And some buyers were starting to balk. For instance, back in October 2006, in an e-mail correspondence between two Goldman executives about trying to sell off pieces of one CDO,
Tetsuya Ishikawa wrote his colleague
Darryl Herrick that another colleague thought one Goldman client was “too smart to buy this kind of junk” and then had gone radio silent. “Very interesting,” Herrick replied. At the end of December 2006, one Goldman vice president tried to steer his colleague away from trying to sell the increasingly squirrelly securities to sophisticated investors, who he figured should know better. It was just the fact that “[t]his list [of potential buyers] might be a little skewed towards sophisticated hedge funds with which we should not expect to make too much money since (a) most of the time they will be on the same side of the trade as we will, and (b) they know exactly how things work and will not let us work for too much $$$, vs. buy-and-hold rating-based buyers who we should be focused on a lot more to make incremental $$$ next year.”
Another way for Goldman to protect itself was to buy credit-default swaps—insurance policies that paid off when the debt of other companies lost value—on the debt of individual companies as well as on individual mortgage-backed securities, such as GSAMP Trust 2006-S2. A third way for Goldman to hedge its exposure to the mortgage market was
for Goldman’s traders to short the ABX index—the very trade that Birnbaum was now advocating in the wake of his meeting with Paulson.
Sparks then “backed them up during heated debates about how much money the firm should risk” betting against the
subprime market. There was always some understandable tension about how much of the firm’s capital to risk on any given day, in any given opportunity. The structured products group not only made markets in securities for Goldman’s clients but it also had the authority to “
trade Goldman’s own capital to make a profit” if and when “it spots opportunity,” according to the
Wall Street Journal.
Even harder to do, with all these high-powered traders, was to take risk
away
from them by not permitting them to make the bets they were all geared up to make.
Following the December 2006 meeting in Viniar’s thirtieth-floor conference room, Goldman decided in earnest that “getting closer to home” meant finding a way to hedge the firm’s long exposure to the subprime market as a result of its ongoing underwriting of mortgage-backed securities. In manufacturing and selling these securities, of course, the goal was always to hold on its own balance sheet as few of the securities as possible. But as the market began to crack at the end of 2006 and the beginning of 2007, Goldman—like other Wall Street firms—ended up getting stuck with more and more of the riskiest tranches of the securities. It turned out, according to one Goldman partner, that across Wall Street the quantitative analytics behind the risks of the mortgage-backed securities were deeply flawed. That instead of relying upon what the mathematical whiz kids assumed was the proper assumptions for risks and defaults, a more direct approach was needed. “
What you really needed was very hands-on people saying if this happens, this is what our risk is,” the partner said, instead of just relying on a computer approximation of what the consequences of too much risk might be.
Unlike other firms, though, Goldman had the collective wherewithal to do what it could to hedge its exposure. That meant shorting the ABX index at a time when doing so was a relatively inexpensive proposition, since much of the rest of the world still wanted to be
long
mortgage securities. The short trade was therefore unpopular and inexpensive. But the market was not robust and so it took time—some two months—for Goldman to accumulate enough credit-default swaps and other hedges to be confident that its long exposure would be covered. “There was increasing strain in pricing for a lot of stuff,” Birnbaum recalled, “and we had not fully articulated our short strategy at that point because the timing was such that we had certain businesses that were exposed to mortgage credit. We were taking the risk down in those businesses in the
second half of 2006 and when we really had an opportunity to flip the switch and get short that happened in December and January.” Birnbaum attributed Viniar’s willingness to make this decision—in effect supporting the arguments being made by him and Swenny—to the virtues of Goldman’s culture, which encouraged prudent risk taking and giving voice to contrarian points of view. “One of the reasons that Goldman was able to navigate this crisis so well was it had a senior management, and Viniar being one of them, that was very receptive to the views and the desires of their traders,” he explained. “And it’s not to say there weren’t other smart traders on Wall Street who may have held similar views, but they simply were not given the rein to trade the way we were.… In a dynamic where these are smart guys, you give them an idea … and they’re going to be responsive to that. The bank was simply able to switch directions or put on significant trades in a short period of time that other banks, I don’t think, would give traders the rein to do.”
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B
UT THERE WERE
moments of intense fear and nervousness at Goldman as the firm wrote down the value of its mortgage-related products and took its losses at a time when other Wall Street firms were still coining profits in the product. Goldman also angered clients by shutting down entire lines of business—such as providing financing to mortgage originators. “
I had senior guys come to me and say, ‘What are you doing? The guys at Merrill Lynch hedged out all their risk,’ ” Sparks recalled. “It was a very tough time here. We were taking these losses. We were doing what we felt was right. We kind of thought of ourselves as doing the right thing but we didn’t know for sure. We took losses. We shut deals down, angered clients, and then we cut our positions down.”
The pressure on Sparks and his team ratcheted up. For six months straight, he was the only guy on the risk committee at Goldman who was talking about the dangers lurking in the mortgage department. “
It was
tough,
okay?” he said. “And I mean
tough.
Everybody communicates well, but the rigor that Goldman Sachs puts on people is
unbelievable
. Especially when there’s a problem, a problem meaning a concern or issue. I went up there to the thirtieth floor and said, ‘Hey, look, I’ve got a problem’—I probably said this to them like five times—‘We have a problem. Here it is. Here’s what’s going on. Here’s what I don’t understand. Here’s what I’m worried about.’ As soon as you do that, to their credit they get the risk controllers and all kinds of people involved—people that may not understand exactly what you do—but I mean they’re all over it. That’s the right way, I think, in that business you need to be, but it was hard. There’s always a peanut gallery of people who
don’t have all the facts but want to just be compensated. I was really proud of my team for the way they dealt with what I thought was a really challenging situation; people generally didn’t lose their cool. They were all trying to do the right thing. And the firm just came in and did what it’s supposed to do. It was a very confusing time for everybody because I was talking about how concerned I was about things and it wasn’t showing up in any other market. Some people just thought I was wrong. Or maybe what was happening in my world was just kind of a—maybe I was too conservative or it was just an outlier. It was a very hard time because nobody knew what the right answer was.”
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B
IRNBAUM BEGAN PUTTING
on “the big short”—as Viniar would later refer to Birnbaum’s bet in a July 2007 e-mail to
Gary Cohn—in December 2006 and January 2007. His group’s long positions had, by that time, been sufficiently neutralized that the bet began to make financial sense. “If you want to talk about historic moments,” Birnbaum said, “this is when stuff really was historic and I think changed the direction for the bank, forever.” What made the bet so heroic—and risky—was that the rest of the market, Paulson and a few others aside, still had not come around to this way of thinking and were only too happy to bet against Goldman. “You had a two-month period when you had a big difference of opinion out there in the investment community as to what was happening in the mortgage credit market,” he said. “On the one hand, you had prices that were coming down, like the ABX index, which always had been kind of [traded] right around one hundred and was starting to trade into the low nineties. You had a CDO-manager community that was looking at the index, and discounting it as being just a technical vehicle that hedge funds are trading and it was depressed based on technical arguments, but the names that they were putting into their deals were good names and in fact this weakness in the mortgage credit market was a buying opportunity.”