WALL STREET:Goldman Sachs is one of the only Wall Street firms to not only have anticipated the turnaround in mortgage fortunes, but to have utilised that to turn a profit – so why is it denying its brilliance?
WHEN THE masters of the universe at Goldman Sachs stop crowing about their financial prowess and pretend to be just as dumb as everyone else, you know things have changed on Wall Street.
But such are the political dynamics now in Washington and in Brussels that Goldman would prefer us to think that it barely scraped by during the financial crisis of 2007 and 2008, rather than acknowledge the truth contained in the hundreds of documents released a year ago by a United States senate subcommittee investigating the causes of the crisis: that, beginning in 2006, Goldman’s traders and executives – alone among big Wall Street firms – correctly perceived the problems brewing in the market for mortgage-related securities and resolved, in December 2006, to make a huge, multibillion dollar proprietary bet against the mortgage market using a clever combination of complex trading strategies.
When the market for those types of securities did, in fact, collapse in 2007 – just as Goldman suspected it would – the firm reaped billions of dollars in profits.
The odd part of the story, though, is that this is not the way Goldman wants us to think about what happened. It wants us to think the firm just got very lucky. That’s a bunch of malarkey.
Here’s why: at first, Goldman viewed the mortgage market in much the same way its competitors did – as a way to reap millions of dollars in fees by packaging up home mortgages into securities and selling those securities, most of which were rated AAA by ratings agencies well paid to do so, to investors the world over. This was never a big business at Goldman, usually about sixth in the league tables for underwriting mortgage securities, far behind Merrill Lynch, the industry leader. But it was steadily profitable, and the firm continued to buy home mortgages in the market and package them up into securities and sell them to investors at full price well into 2007, even though by then the firm had decided to use billions of its own money to short the mortgage market in late 2006. (A moral and ethical dilemma at the very least.)
The firm’s thinking about mortgages evolved throughout 2006. At the beginning of the year, Goldman helped create what became known as the ABX Index, a basket of mortgage-related securities which, for the first time, allowed investors to bet more easily whether the market for mortgage-related securities would continue to go up – as it had for years – or begin to crack and lose value.
Hedge-fund manager John Paulson was one investor with a serious conviction that the mortgage market would soon collapse. And he bet billions of dollars of his own and his investors’ money that he was right. In many ways, Paulson’s bet was irresponsible; he was an unknown investor who had previously worked as a banker at Bear Stearns. Had he been wrong, he would have lost his investors billions of dollars. Many firms on Wall Street – including his former firm, Bear Stearns – declined to help Paulson establish his big bet against mortgages.
But Goldman Sachs was willing to help him, for a fee. For the first six months or so of the year, Goldman executed ABX-related trades for Paulson. But Goldman’s traders began to wonder if Paulson might be on to something. One of them, Josh Birnbaum, met Paulson in the summer of 2006, after which, Goldman soon changed its view from being “agnostic” about the mortgage market to believing the firm needed to be “directionally short”.
Not surprisingly, the firm’s relationship with Paulson was transformed. Virtually overnight, Paulson Co went from being a good client of Goldman to becoming a competitor of Goldman. Much to the consternation of many of its clients, it was a dynamic that had occurred often at the firm, especially since Goldman went public in 1999, as it had seriously bulked up its proprietary trading, its hedge-fund business and its private-equity business, and found itself competing with some clients in those businesses.
As Birnbaum says: “Obviously if I am looking to short the market, and if you’re John Paulson and you’re looking to short the market and you call me up, it’s not my favourite phone call any more. We’ll make a market for you, but we may not be the best price any more to sell you protection, whereas three or six months earlier you might have been the best price. So there was a change.”
At an all-hands-on-deck, nearly three-hour meeting on December 14th in Goldman chief financial officer David Viniar’s 30th-floor conference room, the Goldman executives made the final decision to, as Viniar put it, “get closer to home” in the mortgage market. This meant Goldman traders were now authorised to aggressively mark down the value of Goldman’s long portfolio of mortgage securities – and get rid of them – while also aggressively building its huge proprietary bet against the mortgage market. While the level of Goldman’s conviction about the wisdom of the bet would change during the next five or six months – more than once, Goldman got cold feet and reduced its shorts – the firm was the only Wall Street firm to be consistently net short throughout 2007. It ended up making a fortune (as, of course, did Paulson).
Indeed, while its competitors suffered mightily in the second half of 2007 – both Stan O’Neal, chief executive of Merrill Lynch, and Chuck Prince, chief executive of Citigroup, were fired as their firms lost billions, and Bear Stearns suffered its first loss in its 85-year history – Goldman thrived.
In 2007, Goldman earned $17.6 billion (€12.3 billion) in pre-tax profits – its second most profitable year – and its top four executives split among themselves $273 million in bonuses. Lloyd Blankfein, then in his second year as Goldman’s chief executive, took home close to $72 million, the most money paid to the chief executive of a publicly traded Wall Street firm ever.
Yet, Goldman has consistently denied doing what it obviously did. Consider this exchange, from the April 27th, 2010, US Senate hearing, between Democrat senator Carl Levin, chairman of the permanent subcommittee on investigations, and Blankfein:
Levin: The question is, did you bet big time in 2007 against the housing mortgage business? And you did.
Blankfein:No, we did not.
Levin: Okay. You win big in shorts.
Blankfein: No, we did not.
This disconnect with Levin had followed Blankfein’s opening statement, where he denied the firm had made a bet against the housing market in 2007.
“Much has been said about the supposedly massive short Goldman Sachs had on the US housing market,” he said. “The fact is, we were not consistently or significantly net-short the market in residential mortgage-related products in 2007 and 2008. Our performance in our residential mortgage-related business confirms this. During the two years of the financial crisis, while profitable overall, Goldman Sachs lost approximately $1.2 billion from our activities in the residential housing market. We didn’t have a massive short against the housing market, and we certainly did not bet against our clients.”
Levin isn’t buying it. In the 650-page report he released on April 13th about the causes of the financial crisis, he wrote: “Beginning in December 2006 and continuing through 2007, Goldman twice built and profited from large net short positions in mortgage-related securities, generating billions of dollars in gross revenues for the mortgage department. Its first net short peaked at about $10 billion in February 2007, and the mortgage department as a whole generated first-quarter revenues of about $368 million, after deducting losses and writedowns on subprime loan and warehouse inventory.
“The second net short, referred to by Goldman chief financial officer David Viniar as ‘the big short’, peaked in June at $13.9 billion. As a result of this net short, the SPG trading desk generated third-quarter revenues of about $2.8 billion, which were offset by losses on other mortgage desks, but still left the mortgage department with more than $741 million in profits. Altogether in 2007, Goldman’s net short positions from derivatives generated net revenues of $3.7 billion. These positions were so large and risky that the mortgage department repeatedly breached its risk limits, and Goldman’s senior management responded by repeatedly giving the mortgage department new and higher temporary risk limits to accommodate its trading.”
Such is Levin’s level of pique at Blankfein and his refusal to come clean about what Goldman did that he and his colleague, senator Tom Coburn, wrote a letter on May 3rd to both the justice department and the Securities and Exchange Commission urging them to investigate Blankfein and his fellow Goldman executives on possible perjury charges, for having potentially lied in their sworn testimony before Levin’s committee in April.
Attorney general Eric Holder confirmed, in testimony before Congress the same day, that the US Department of Justice is studying the Levin report to see if any charges should be brought against Blankfein and Goldman. The commission is also said to be studying the report to determine whether charges should be brought against Goldman Sachs. Goldman believes that Levin’s vendetta is politically motivated, wildly off-target and patently unfair.
Goldman thinks Levin has ignored the fact that the firm had billions of dollars on the long side of the mortgage market and its “big short” was just prudent risk management in the face of a rapidly deteriorating market. The firm’s executives argue that Goldman’s “hedge” looks clever now, in retrospect, but the truth is Goldman could very easily have been wrong and been the first firm to fail instead of Bear Stearns.
Whether Blankfein and company “perjured” themselves in their testimony before Levin remains to be seen. In the meantime, the real mystery is why Goldman hasn’t been able to admit that it was not only smarter than every other firm in sensing trouble in the mortgage market but also had the courage to do something about it.
When it comes to Goldman Sachs, we can handle a little well-deserved boasting; it’s the persistent refrain of obfuscation and false modesty that insults our intelligence and makes a mockery of our understanding of what happened in this crisis and why.
William D Cohanis the author of The House of Cardsand The Last Tycoons. A contributing editor at Vanity Fair, he is a former managing director at JP Morgan Chase. His new book How Goldman Sachs Came to Rule the Worldis published by Doubleday
