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VI. INVESTMENT BANK ABUSES:
CASE STUDY OF GOLDMAN SACHS AND DEUTSCHE BANKC. Failing to Manage Conflicts of Interest: Case Study of Goldman Sachs
(3) Overview of Goldman Sachs Case Study
This Report looks at two activities undertaken by Goldman in 2006 and 2007. The first is Goldman's intensive effort, beginning in December 2006 and continuing through 2007, to profit from the subprime mortgage market collapse, particularly by shorting subprime mortgage assets. The second is how, in 2006 and 2007, Goldman used mortgage related CDOs to unload the risk associated with its faltering high risk mortgage assets onto clients, help a favored client make a $1 billion gain, and profit from the failure of the very CDO securities it sold to its clients.
These activities raise questions related to Goldman's compliance with its obligations to provide suitable investment recommendations to its clients and disclose its material adverse interests to potential investors. They also raise questions about whether some of Goldman's incomplete disclosures were deceptive, and whether some of its activities generated conflicts of interest in which Goldman placed its financial interests before those of its clients. They also raise questions about the high risk nature of some structured finance products and their role in U.S. financial markets.
(a) Overview of How Goldman Shorted the Subprime Mortgage Market
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. |1545| The second net short, referred to by Goldman Chief Financial Officer David Viniar as "the big short," |1546| 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. |1547| Altogether in 2007, Goldman's net short positions from derivatives generated net revenues of $3.7 billion. |1548| 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. |1549| At one point in 2007, Goldman's Value-at-Risk measure indicated that the Mortgage Department was contributing 54% of the firm's total market risk, even though it ordinarily contributed only about 2% of its total net revenues. |1550|
To build its net short positions, Goldman's Mortgage Department personnel used structured finance products to engage in multiple, complex transactions. Its efforts included selling high risk loans, RMBS, CDO, ABX, and other mortgage related assets from its inventory and warehouse accounts; shorting RMBS and CDO securities, either by shorting the assets themselves or by taking the short side of CDS contracts that referenced them, in order to profit from their fall in value; and shorting multiple other mortgage backed assets simultaneously, including different tranches of the ABX Index, tranches of CDOs, and CDS contracts on such assets. To lock in its profits after the short assets fell in value, Goldman often entered into offsetting CDS contracts to "cover its shorts," as explained below. Senior Goldman executives directed and monitored these activities.
The evidence reviewed by the Subcommittee shows that some of the transactions leading to Goldman's short positions were undertaken to advance Goldman's own proprietary financial interests and not as a function of its market making role to assist clients in buying or selling assets. In the end, Goldman profited from the failure of many of the RMBS and CDO securities it had underwritten and sold. As Goldman CEO Lloyd Blankfein explained in an internal email to his colleagues in November 2007: "Of course we didn't dodge the mortgage mess. We lost money, then made more than we lost because of shorts." |1551|
Covering Shorts to Lock In Profits. To understand how Goldman profited from its short positions, it is important to understand references in its internal documents to "covering" or "monetizing" its shorts. When Goldman built its short positions, it generally used CDS contracts to short a variety of mortgage related securities, including individual RMBS and CDO securities and baskets of 20 RMBS securities identified in the ABX indices. Goldman's shorts then gained or lost value over time, depending upon how the underlying referenced assets performed during the same period.
Most CDS contracts expire after a specified number of years. As explained earlier, during the covered period, the short party makes periodic premium payments to the opposing long party in the CDO. The short party is essentially betting that a "credit event" will take place during the covered period that will result in the long party having to provide it with a large payment that outweighs the cost of the short party's premium payments. |1552| However, the short party does not have to wait for a credit event in order to realize a gain on its CDS contract.
One possible alternative is for the short party simply to sell its short position to another party for a profit. If, however, the short party does not want to sell or has no ready buyer, the short party can still lock in a gain by entering into a second, offsetting CDS contract in which it takes the long position on an offsetting asset, an action often referred to as "covering the short."
In practice, there were several different, technical methods for a party to cover its short positions. The simplest example is if the short party bought a $100,000 CDS contract whose reference asset is a single RMBS security. Suppose after one month the RMBS security performs so poorly that the market value of the short position increases to $150,000. If the short party wanted to lock in the $50,000 gain, it could do so simply by entering into a new offsetting CDS contract, referencing the same RMBS security, in which it takes the long position with a new party who takes the short position at the new higher market value of $150,000. The result would be that the original short party would own a short position and a long position that offset each other, and would lock in the $50,000 difference in value as profit.
During 2007, Goldman executives repeatedly directed the Mortgage Department to "cover its shorts" and lock in the gains from the increased value of its short positions. When it covered its short positions by entering into offsetting contracts, the Mortgage Department simultaneously "monetized" its short positions – recorded the locked in profit. That is because, when it covered a short by entering into an offsetting contract, the Mortgage Department's general practice was to record a profit on its books equal to the gain on the original short position. Because the original purchase price of the CDS was known and fixed, and the new higher price obtained in the offsetting transaction was known and fixed, the Mortgage Department was able to capture the difference between the two prices as profit.
Going Past Home: The First Net Short. Because Goldman's activities were so varied and complex during the period reviewed, this overview provides a brief summary of the key events detailed in the following sections. The review begins in mid to late 2006, when Goldman realized that the market for subprime mortgage backed securities was beginning to decline, and the large long positions it held in ABX assets, loans, RMBS and CDO securities, and other mortgage related assets began to pose a disproportionate risk to both the Mortgage Department and the firm. |1553| In October 2006, the Mortgage Department designed a synthetic CDO called Hudson Mezzanine 2006-1, which included over $1.2 billion of long positions on CDS contracts to offset risk associated with ABX assets in Goldman's own inventory and another $800 million in single name CDS contracts referencing subprime RMBS securities that Goldman wanted to short; the Mortgage Department then sold the Hudson securities to its clients. |1554| While this CDO transferred $1.2 billion of subprime risk from Goldman's inventory to its clients and gave Goldman an opportunity to short another $800 million in RMBS securities it thought would perform poorly, the Mortgage Department still held billions of dollars of long positions in subprime mortgage related assets, primarily in ABX index assets. |1555|
On December 14, 2006, as Goldman's mortgage related assets continued to lose value, Goldman's Chief Financial Officer, David Viniar, held a meeting with key Mortgage Department personnel and issued instructions for the Department to "get closer to home." |1556| By "closer to home," Mr. Viniar meant for the Mortgage Department to assume a more neutral risk position, one that was neither substantially long nor short, but actions taken by the Mortgage Department in response to his instructions quickly shot past "home," resulting in Goldman's first large net short position in February 2007. |1557|
The actions taken by the Mortgage Department included selling outright from its inventory large numbers of subprime RMBS, CDO, and ABX assets, even at a loss, while simultaneously buying CDS contracts to hedge the long assets remaining in its inventory. The Mortgage Department also halted new RMBS securitizations, began emptying its RMBS warehouse accounts, and generally stopped purchasing new assets for its CDO warehouse accounts. It also purchased the short side of CDS contracts referencing the ABX index for a basket of AAA rated subprime residential loans, as a kind of "disaster insurance" in the event that even AAA rated mortgages started defaulting.
Within about a month of the "closer to home" meeting, in January 2007, the Mortgage Department had largely eliminated or offset Goldman's long positions on subprime mortgage related assets. The Mortgage Department then started to build a multi-billion-dollar short position to enable the firm to profit from the subprime RMBS and CDO securities starting to lose value. By the end of the first quarter of 2007, the Mortgage Department had swung from a $6 billion net long position in December 2006, to a $10 billion net short position in late February 2007, a $16 billion reversal. |1558| A senior Goldman executive later described a net short position of $3 billion in subprime mortgage backed securities as "huge and outsized." |1559| But Goldman's net short position in February 2007 was $10 billion – more than triple that size.
In late February, Goldman's Operating Committee, a subcommittee of its Firmwide Risk Committee, became concerned about the size of the $10 billion net short position. The Firmwide Risk Committee (FWRC) was co-chaired by Mr. Viniar, and Messrs. Cohn and Blankfein regularly attended its meetings. |1560| The concern arose, in part, because the $10 billion net short position had dramatically increased the Mortgage Department's Value-at-Risk or "VAR," the primary measure Goldman used to compute its risk. The Committee ordered the Department to lock in its profits by "covering its shorts," as explained above. The Mortgage Department complied by covering most, but not all, of the $10 billion net short and brought down its VAR. It then maintained a relatively lower risk profile from March through May 2007.
Attempted Short Squeeze. In May 2007, the Mortgage Department's Asset Backed Security (ABS) Trading Desk attempted a "short squeeze" of the CDS market that was intended to compel other market participants to sell their short positions at artificially low prices. |1561| Goldman's ABS Desk was still in the process of covering the Mortgage Department's shorts by offering CDS contracts in which Goldman took the long side. The ABS Desk devised a plan in which it would offer those CDS contracts to short parties at lower and lower prices, in an effort to drive down the overall market price of the shorts. As prices fell, Goldman's expectation was that other short parties would begin to sell their short positions, in order to avoid having to sell at still lower prices. The ABS Desk planned to buy up those short positions at the artificially low prices it had caused, thereby rebuilding its own net short position at a lower cost. |1562| The ABS Desk initiated its plan, and during the same period Goldman customers protested the lower values assigned by Goldman to their short positions as out of line with the market. Despite the lower prices, the parties who already held short positions generally kept them and did not try to sell them. In June, after learning that two Bear Stearns hedge funds specializing in subprime mortgage assets might collapse, the ABS Desk abandoned its short squeeze effort and recommenced buying short positions at the prevailing market prices.
The Big Short. In mid-June 2007, the two Bear Stearns hedge funds did collapse, triggering another steep decline in the value of subprime mortgage assets. In response, Goldman immediately went short again, to profit from the falling prices. Within two weeks, Goldman had massed a large number of CDS contracts shorting a variety of subprime mortgage assets. On June 22, 2007, Goldman's net short position reached its peak of approximately $13.9 billion, as calculated by the Subcommittee. |1563| That total included the $9 billion in AAA ABX assets that Goldman had earlier acquired as "disaster protection," in case the subprime market as a whole lost value. The resulting net short, referred to by Mr. Viniar as the "big short," was nearly 40% larger than its first net short which had peaked at $10 billion in February 2007.
To lock in its profits on the $13.9 billion short, the Mortgage Department began working to cover its shorts, buying long assets and entering into offsetting CDS contracts in which it took the long position. On July 10, 2007, the credit rating agencies issued the first of many mass rating downgrades that affected hundreds and then thousands of RMBS and CDO securities, whose values began to fall even more rapidly. |1564| The Mortgage Department was able to purchase long assets at a low cost, managed to cover most of its short positions, and locked in its profits. At the same time, the Mortgage Department maintained a net short position in higher risk subprime RMBS securities carrying credit ratings of BBB or BBB-, betting that those securities would lose still more value and produce still more profits for the firm. In August, however, Goldman senior management again became concerned about the size of the Department's net short position and its VAR levels, which had reached record levels. On August 21, 2007, Goldman's Chief Operating Officer Gary Cohn ordered the Mortgage Department to "get down now."
Big Short Profits. In response, the Mortgage Department began another round of covering its shorts and locking in its profits, including the shorts referencing BBB and BBB- rated RMBS securities. In the third quarter of 2007, the SPG Trading Desk reported record revenues from its short positions totaling $2.8 billion. |1565| By the end of 2007, the SPG Trading Desk in the Mortgage Department recorded year-end net revenues totaling $3.7 billion, which were used to offset losses on other desks, leaving the Mortgage Department as a whole with record net revenues of over $1.2 billion for the year. |1566| The head of the SPG Desk, Michael Swenson, later wrote that 2007 was "the [year] I am most proud of to date," because of the "extraordinary profits" from the short positions he had advocated. |1567| His colleague, Joshua Birnbaum who headed the ABX Desk within SPG, also reviewed the year in terms of the profitable short positions it built. He wrote: "The prevailing opinion within the department was that we should just ‘get close to home' and pare down our long," but he decided his ABS Desk should "not only ... get flat, but get VERY short." |1568| He wrote: "[W]e implemented the plan by hitting on almost every single name CDO protection buying opportunity in a 2-month period. Much of the plan began working by February as the market dropped 25 points and our very profitable year was under way." When the subprime mortgage market fell further in July after the credit rating mass downgrades, he wrote: "We had a blow-out [profit and loss] month, making over $1Bln that month." |1569|
The $3.7 billion in net revenues from the SPG's short positions helped to offset other mortgage related losses, and, at year's end, at a time when mortgage departments at other large financial institutions were reporting record losses, Goldman's Mortgage Department reported overall net revenues of $1.2 billion. |1570|
This Report also examines four CDOs that Goldman originated, underwrote, and marketed in the years leading up to the financial crisis: Hudson Mezzanine 2006-1, Anderson Mezzanine 2007-1, Timberwolf I, and Abacus 2007-AC1. Hudson was conceived in 2006, and issued its securities in December 2006, as Goldman began its concerted effort to sell its mortgage holdings. Anderson, Timberwolf, and Abacus issued their securities in 2007, as RMBS and CDO securities were losing value, and Goldman was shorting the subprime mortgage market.
During 2007, as Goldman built and profited from its net short positions in the first and third quarters of the year, it continued to design, underwrite, and sell CDO securities. Due to waning investor interest, in February 2007, Goldman conducted a review of the CDOs in its pipeline. The Mortgage Department decided to cancel four pending CDOs, downsize another two, and bring all of its remaining CDOs to market as quickly as possible. Also in February 2007, the Mortgage Department limited its CDO Origination Desk to carrying out only the CDO transactions already underway.
"Gameplan" for CDO Valuation Project. In the first quarter of 2007, Goldman's Mortgage Department worked to sell the warehouse assets from the discontinued CDOs, the securities issued by past Goldman-originated CDOs, and the new securities from CDOs being originated by Goldman in 2006 and 2007. In May 2007, as CDO sales slowed dramatically, Goldman became concerned about the lack of sales prices to establish the value of its CDO holdings. Goldman needed accurate values, not just to establish its CDO sales prices, but also to value the CDO securities for collateral purposes and in compliance with Goldman's policy of using up-to-date market values for all of its holdings. |1571| On May 11, 2007, Goldman senior executives, including Mr. Cohn and Mr. Viniar, Mortgage Department personnel, controllers, and others held a meeting and developed a "Gameplan" for a CDO valuation project. |1572| The Gameplan called for the Mortgage Department, over the course of about a week, to use three different valuation methods to price all of its CDO warehouse assets, unsold securities from past CDOs, and new securities from the CDOs currently being marketed to clients. |1573|
While the CDO valuation project was underway, Goldman senior executive Thomas Montag asked Daniel Sparks for an estimate of how much the firm would need to write down the value of its CDO assets. Mr. Sparks responded that "the base case from traders is down [$]382 [million]." He also wrote: "I think we should take the write-down, but market [the CDO securities] at much higher levels." |1574| Another Goldman senior executive, Harvey Schwartz, expressed concern about selling clients CDO securities at one price and then immediately devaluing them: "[D]on't think we can trade this with our clients andf [sic] then mark them down dramatically the next day." |1575| At the same time, Goldman's Chief Credit Risk Officer Craig Broderick told his staff to anticipate deep markdowns and highlighted the need to identify clients that might suffer financial difficulty if Goldman devalued their CDO securities and demanded they post more cash collateral.
On May 20, 2007, the Gameplan results were summarized in an internal presentation. |1576| It projected that Goldman would have to take from $248 to $440 million in writedowns on unsold CDO securities and warehouse assets, making it clear to Goldman executives that its CDO assets were losing value rapidly. |1577| In several drafts of the presentation, the Mortgage Department had also written that Goldman's CDOs were expected "to underperform," but that statement was removed from the final presentation given to senior executives. |1578|
Targeted Sales. The Gameplan also recommended a two-pronged approach to selling the firm's remaining CDO assets. First, it recommended transfer of the CDO warehouse assets to the Mortgage Department's SPG Trading Desk for further valuation and sale. Second, it recommended that the Mortgage Department use a "targeted" approach to sell off the existing and new securities from Goldman-originated CDOs, naming four hedge funds as the primary targets and providing a list of another 35 clients as secondary targets. |1579|
At the same time, Mr. Sparks named David Lehman, a commercial mortgage backed securities trader, as the new head of the CDO Origination Desk. Shortly thereafter, Goldman dismantled the CDO Origination Desk and moved all remaining CDO securities to the SPG Trading Desk, where he was based. The SPG Trading Desk, which was a secondary trading desk and had little experience with underwriting, assumed responsibility for marketing the remaining unsold Goldman-originated CDO securities. The SPG Trading Desk's lack of underwriting experience meant that it was less familiar with the obligations of underwriters and placement agents to disclose all material adverse interests to potential investors.
The SPG Trading Desk worked with Goldman's sales force to market the CDO securities. Goldman employed "hard sell" tactics, repeatedly urging its sales force to sell the CDO securities and target clients with limited CDO familiarity. |1580| After trying the Gameplan's "targeted" client approach during May, June, and July 2007, the Mortgage Department switched back to issuing sales directives or "axes" to its entire sales force, including sales offices abroad. Axes on CDOs generally went out at weekly or monthly intervals, identified specific CDO securities as top sales priorities, and offered additional financial incentives for selling them. Despite the CDOs' declining value, the sales force succeeded in selling some of the CDO securities, primarily to clients in Europe, Asia, Australia, and the Middle East, but was unable to sell all of them.
The four CDOs that the Subcommittee examined illustrate a variety of conflict of interest issues related to how Goldman designed, marketed, and administered them.
Hudson Mezzanine 2006-1. Hudson Mezzanine 2006-1 (Hudson 1) was a $2 billion synthetic CDO comprised of $1.2 billion in ABX assets from Goldman's own inventory, and $800 million in single name CDS contracts on subprime RMBS and CDO securities that Goldman wanted to short. It was called a "mezzanine" CDO, because the referenced RMBS securities carried the riskier credit ratings of BBB or BBB-. Goldman used the CDO to transfer the risk associated with its ABX assets to investors that bought Hudson 1 securities. Goldman also took 100% of the short side of the CDO, which meant that it would profit if any of the Hudson securities lost value. In addition, Goldman exercised complete control over the CDO by playing virtually every key role in its establishment and administration, including the roles of underwriter, initial purchaser of the issued securities, senior swap counterparty, credit protection buyer, collateral put provider, and liquidation agent.
Goldman began marketing Hudson 1 securities in October 2006, soliciting clients to buy Hudson securities. It did not fully disclose to potential investors material facts related to Goldman's investment interests, the source of the CDO's assets, and their pricing. The Hudson 1 marketing materials stated prominently, for example, that Goldman's interests were "aligned" with investors, because Goldman was buying a portion of the Hudson 1 equity tranche. |1581| In its marketing materials, Goldman did not mention that it was also shorting all $2 billion of Hudson's assets – an investment that far outweighed its $6 million equity share and which was directly adverse to the interests of prospective investors. In addition, the marketing materials stated that Hudson 1's assets were "sourced from the Street" and that it was "not a balance sheet CDO." |1582| However, $1.2 billion of the Hudson assets had been selected solely to transfer risk from ABX assets in Goldman's own inventory.
Goldman also did not disclose in the materials that it had priced the assets without using any actual third party sales. The absence of arm's length pricing was significant, because the Hudson CDO was designed to short the ABX Index using single name RMBS securities, and there was a pricing mismatch between the two types of assets. |1583| Goldman not only determined the pricing for the RMBS securities purchased by Hudson 1, but retained the profit from the pricing differential. The marketing materials did not inform investors of Goldman's role in the pricing, the pricing methodology used, or the gain it afforded to Goldman. In addition, the marketing materials stated Hudson 1 was "not a balance sheet" CDO, without disclosing that Hudson had been designed from its inception to remove substantial risk from Goldman's balance sheet.
The Hudson 1 Offering Circular contained language that may have also misled investors about Goldman's true investment interest in the CDO. The Offering Circular stated:
"[Goldman Sachs International] and/or any of its affiliates may invest and/or deal, for their own respective accounts for which they have investment discretion, in securities or in other interests in the Reference Entities, in obligations of the Reference Entities or in the obligors in respect of any Reference Obligations or Collateral Securities ... , or in credit default swaps ... , total return swaps or other instruments enabling credit and/or other risks to be traded that are linked to one or more Investments." |1584|
This provision seems to inform investors that Goldman "may invest" for its own account in the CDO's securities, reference obligations, or CDS contracts, while withholding the fact that, by the time the Offering Circular had been drafted, Goldman had already determined to take 100% of the short position in the CDO, an investment which was directly adverse to the interests of Hudson securities investors.
Once Hudson issued its securities, Goldman placed a priority on selling them, and delayed the issuance of a CDO on behalf of another client in order to facilitate Hudson sales. Goldman sales representatives reported that clients expressed skepticism regarding the quality of the Hudson assets, but Goldman continued to promote the sale of the CDO.
In 2008, as Hudson's assets lost value and received rating downgrades from the credit rating agencies, Goldman, in its role as liquidation agent, was tasked with selling those assets to limit losses to the long investors. The major Hudson investor, Morgan Stanley, pressed Goldman to do just that. Goldman, however, delayed selling the assets for months. As the assets dropped in value, Goldman's short position increased in value. Morgan Stanley's representative reported to a colleague that when Goldman rejected the firm's request to sell the poorly performing Hudson assets, "I broke my phone." |1585| He also sent an email to the head of Goldman's CDO Desk saying: "[O]ne day I hope I get the real reason why you are doing this to me." |1586| Morgan Stanley lost nearly $960 million on its Hudson investment.
Anderson Mezzanine 2007-1. Anderson Mezzanine 2007-1 (Anderson) was another synthetic CDO referencing BBB and BBB- rated subprime RMBS securities. It was issued in March 2007. Among other roles, Goldman served as the CDO's placement agent, initial purchaser, collateral put provider, and liquidation agent. Goldman hired another firm, a New York hedge fund founded by former Goldman employees, GSC Partners, to act as the collateral manager. Goldman took a short position on approximately 40% of the $305 million in assets underlying Anderson.
Anderson referenced a number of poor quality assets. Those assets had been selected by GSC Partners, with the approval of Goldman. Over 45% of the referenced subprime RMBS securities contained mortgages originated by New Century, a subprime lender known within the industry, including Goldman, for issuing poor quality loans and which was experiencing financial problems while Anderson was being structured and marketed. |1587| Inside Goldman, staff were aware of New Century's problems and were taking action to return substantial numbers of substandard loans purchased from New Century and demand repayment for them. |1588| Other assets in the Anderson CDO were also performing poorly, and at one point, Goldman personnel estimated its warehouse assets had fallen in value by $22 million. |1589| Due to the asset quality problems, the Mortgage Department head, Daniel Sparks, initially decided to cancel Anderson, but later changed his mind and decided to market the CDO as quickly as possible, using the $305 million in assets already in its warehouse account, rather than wait to accumulate all of the $500 million in assets initially planned.
When Anderson issued its securities in March 2007, Goldman placed a high priority on selling them, even delaying another CDO – Abacus 2007-AC1 which was being organized at the request of the Paulson hedge fund – to allow its sales force to concentrate on promoting Anderson. Potential investors raised questions about the quality of its underlying assets, especially the New Century loans, and Goldman provided its sales representatives with talking points to dispel concerns about the New Century assets. When one client asked how Goldman had gotten "comfortable" with the New Century loans, Goldman did not disclose to the client its own negative views of New Century loans or that it had 40% of the short side of the CDO.
Goldman marketed Anderson securities to a number of its clients, including pension funds, and recommended using Anderson securities as collateral security in other CDOs. |1590| In the end, Goldman sold only $102 million or about one third of the Anderson securities. |1591| Seven months after the securities were issued, they suffered their first credit rating downgrade. Currently, all of the Anderson securities have been reduced to junk status, and the Anderson investors have lost virtually their entire investments.
Timberwolf I CDO. Timberwolf I was a $1 billion hybrid CDO2 transaction that referenced single-A rated securities from other CDOs. Those CDO securities referenced, in turn, RMBS securities carrying lower credit ratings, primarily BBB. Altogether, Timberwolf referenced 56 unique CDO securities that had over 4,500 unique underlying assets. Goldman served as the CDO's placement agent, initial purchaser, collateral put provider, and liquidation agent. It also hired a hedge fund with former Goldman employees, Greywolf Capital Management, to act as the collateral manager. Greywolf selected the CDO's assets, with Goldman's approval. Goldman took a short position on approximately 36% of the $1 billion in assets underlying Timberwolf. |1592|
Timberwolf's securities began losing value almost as soon as they were purchased. In February 2007, Goldman's Mortgage Department head told a senior executive that Timberwolf was one of two deals "to worry about." He also wrote that the assets in the Timberwolf warehouse account had declined so much in value that they had already exhausted Greywolf's responsibility to pay a portion of any warehouse losses, and any additional losses would be Goldman's exclusive obligation. |1593| Goldman rushed Timberwolf to market, and it closed on March 27, 2007, approximately six weeks ahead of schedule. |1594| Almost as soon as the Timberwolf securities were issued, they too began to lose value.
Despite doubts about its performance and asset quality, Goldman engaged in an aggressive campaign to sell the Timberwolf securities. As part of its tactics, Mr. Lehman instructed Goldman personnel not to provide written information to investors about how Goldman was valuing or pricing the Timberwolf securities, and its sales force offered no additional assistance to potential investors trying to evaluate the 4,500 underlying assets. Mr. Sparks and Mr. Lehman sent out numerous sales directives or "axes" to the Goldman sales force, stressing that Timberwolf was a priority for the firm. |1595| In April, Mr. Sparks suggested issuing "ginormous" sales credits to any salesperson who sold Timberwolf securities, only to find out that large sales credits had already been offered. |1596| In May, while Goldman was internally lowering the value of Timberwolf, it continued to sell the securities at a much higher price than the company knew it was worth. At one point, a member of the SPG Trading Desk issued an email to clients and investors, advising them that the market was rebounding and the downturn was "already a distant memory." |1597| Goldman also began targeting Timberwolf sales to "non-traditional" buyers and those with little CDO familiarity, such as increasing its marketing efforts in Europe and Asia.
On June 18, 2007, Goldman sold $100 million worth of Timberwolf securities to an Australian hedge fund, Basis Capital. Just 16 days later, on July 4, Goldman informed Basis Capital that the securities had lost value, and it had to post additional cash collateral to secure its CDS contract. On July 12, Goldman told Basis Capital that the value had dropped again, and still more collateral needed to be posted. In less than a month, the value of Timberwolf had fallen by $37.5 million. Basis Capital posted the additional capital, but soon after declared bankruptcy. On June 1, Goldman Sachs sold $36 million in Timberwolf securities to a Korean life insurance company, Hungkuk Life, that had little familiarity with the product. The head of the Korean sales office said his office was willing to sell the company additional securities, if assured the office would receive a 7% sales credit. Goldman agreed, and said "get ‘er done." The sales office sold another $56 million in Timberwolf securities to the life insurance company which paid $76 per share when Goldman's internal value for the security was $65. Within ten days of that sale, Thomas Montag, a senior Goldman executive, sent an email to the Mortgage Department head, Daniel Sparks, stating: "boy that timeberwof [Timberwolf] was one shitty deal." |1598| Despite that comment, Goldman continued to market Timberwolf securities to its clients.
Goldman had also arranged for its subsidiary, Goldman Sachs International (GSI), to act as both the primary CDS counterparty and the collateral put provider in Timberwolf. |1599| Although GSI received a fee for serving as the collateral put provider, GSI began to refuse to approve Timberwolf's purchase of new collateral securities whose values might decline below par value and put Goldman at risk of having to make up the difference. Instead, GSI pressured Timberwolf to keep its collateral in cash, even though an internal Goldman analysis had confirmed that cash collateral produced lower returns for Timberwolf investors than collateral securities. When Greywolf objected to this practice, Goldman backed down and allowed the purchase of a narrow range of very safe, short term asset backed securities as collateral.
In the fall of 2007, a Goldman analyst provided executives with a price history for Timberwolf A2 securities. It showed that, in five months, Timberwolf securities had lost 80% of their value, falling from $94 in March to $15 in September. Upon receiving the pricing history, the Timberwolf deal captain, Matthew Bieber, wrote that March 27 – the day Timberwolf issued its securities – was "a day that will live in infamy." |1600| Timberwolf was liquidated in 2008.
Abacus 2007-AC1. Abacus 2007-AC1 was a $2 billion synthetic CDO that referenced BBB rated mid and subprime RMBS securities issued in 2006 and early 2007. It was a static CDO, meaning once selected, its reference obligations did not change. It was the last in a series of 16 Abacus CDOs that referenced primarily mortgage backed assets and were designed by Goldman. Those Abacus CDOs were known as single tranche CDOs, structures pioneered by Goldman to provide customized CDOs for clients interested in assuming a specific type and amount of investment risk. They enabled the client to select the assets, the size of the investment, the amount of subordination or cushion before the securities would be exposed to loss, and could be issued with a single tranche. |1601| The Abacus CDOs also enabled investors to short a selected group of RMBS or CDO securities at the same time. Goldman used the Abacus CDOs not only to sell short positions to investors, but also as a way for Goldman itself to short mortgage assets in bulk. |1602|
Abacus 2007-AC1 was the first and only Abacus transaction in which Goldman allowed a third party client to essentially "rent" its CDO structure and play a direct, principal role in the selection of the assets. Goldman did not itself intend to invest in the CDO. |1603| Instead, it functioned primarily as an agent, earning fees for its roles in structuring, underwriting, and administering the CDO. Those roles included Goldman's acting as the placement agent, collateral securities selection agent, and collateral put provider. Unlike previous Abacus CDOs, Goldman employed a third party to serve as the portfolio selection agent, essentially using that agent to promote sales and mask the role of its client in the asset selection process.
Goldman originated Abacus 2007-AC1 in response to a request by Paulson & Co. Inc. ("Paulson"), a hedge fund that was among Goldman's largest customers for subprime mortgage related assets. Paulson had a very negative view of the mortgage market, which was publicly known, and wanted Goldman's assistance in structuring a transaction that would allow it to take a short position on a portfolio of subprime mortgage assets that it believed were likely to perform poorly or fail. Goldman allowed Paulson to use the Abacus CDO for that purpose. In entering into that arrangement with Paulson and simultaneously acting as the placement agent responsible for marketing the Abacus securities to long investors, Goldman created a conflict of interest between itself and the investors it would be soliciting to buy the Abacus securities.
Paulson established a set of criteria to select the reference assets for the Abacus CDO to achieve its investment objective. |1604| After establishing those parameters, Paulson worked with the actual portfolio section agent to select the assets. Documents show that Paulson proposed, substituted, rejected, and approved assets for the reference portfolio. Goldman was aware of Paulson's investment objective, the role it played in the selection of the reference assets, and the fact that the selection process yielded a set of poor quality assets. Of the final set of 90 assets referenced in the Abacus CDO portfolio, 49 had been initially proposed by Paulson. Yet Goldman did not publicly disclose the central role played by Paulson in the asset selection process or the fact that the economic interest held by an entity actively involved in the asset selection process was adverse to the interest of investors who would be taking the long position.
ACA Management LLC, the company hired by Goldman to serve as the portfolio selection agent, told the Subcommittee that, while it knew Paulson was involved, it was unaware of Paulson's true economic interest in the CDO. The ACA Managing Director who worked on the Abacus transaction stated that ACA believed that Paulson was going to invest in the equity tranche of the CDO, thus aligning its interests with those of ACA and other investors. |1605| ACA and its parent company both acquired long positions in the Abacus CDO as did a third investor. The Abacus securities lost value soon after purchase. The three long investors together lost more than $1 billion, while Paulson, the sole short investor, recorded a corresponding profit of about $1 billion. Today, the Abacus securities are worthless.
In addition to not disclosing the asset selection role and investment objective of the Paulson hedge fund, Goldman did not disclose to investors how its own economic interest was aligned with Paulson. In addition to accepting a sizable placement fee paid by Paulson for marketing the CDO securities, Goldman had entered into a side arrangement with the hedge fund in which it would receive additional fees from Paulson for arranging CDS contracts tied to the Abacus CDO that included low premium payments falling within a specified range. |1606| While those lower premium payments would benefit Paulson by lowering its costs, and benefit Goldman by providing it with additional fees, they would also reduce the amount of cash being paid into the CDO, disadvantaging the very investors to whom Goldman was marketing the Abacus securities. Goldman nevertheless entered into the arrangement, contrary to the interests of the long investors in Abacus, and failed to disclose the existence of the fee arrangement in the Abacus marketing materials.
On April 16, 2010, the SEC filed a complaint against Goldman and one of the lead salesmen for the Abacus CDO, Fabrice Tourre, alleging they had failed to disclose material adverse information to potential investors and committed securities fraud in violation of Section 17(a) of the Securities Act of 1933 and Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. On July 14, 2010, Goldman reached a settlement with the SEC, admitting:
"[T]he marketing materials for the ABACUS 2007-AC1 transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state that the reference portfolio was ‘selected by' ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson's economic interests were adverse to CDO investors." |1607|
Goldman agreed to pay a $550 million fine.
The Hudson, Anderson, Timberwolf, and Abacus CDOs provide concrete details about how Goldman designed, marketed, and administered mortgage related CDOs in 2006 and 2007. The four CDOs also raise questions about whether Goldman complied with its obligations to offer suitable investments that it believed would succeed, and provide full disclosure to investors of material adverse interests. They also illustrate a variety of conflicts of interest in the CDO transactions that Goldman resolved by placing its financial interests and favored clients before those of its other clients.
Each of the four CDOs examined by the Subcommittee presents conflict of interest concerns and elements of deception related to how information about the CDO was presented to investors, including disclosures related to the relevant CDO's asset selection process, the quality and value of the CDO's assets and securities, and the nature and size of Goldman's proprietary financial interests. The Subcommittee's investigation raises questions regarding whether Goldman complied with its obligations to disclose material information to investors, including its material adverse interests, and to refrain from making investment recommendations that are unsuitable for any investor by recommending financial instruments designed to lose value and perform poorly. A key issue underlying much of this analysis is the structuring of and disclosures related to financial instruments that enable an investment bank to bet against the very financial products it is selling to clients.
Notes
1545. See net short chart prepared by the Subcommittee, below; 9/17/2007 1545 Presentation to GS Board of Directors, Residential Mortgage Business at 5, GS MBS-E-001793845, Hearing Exhibit 4/27-41; 3/10/2007 email to Daniel Sparks, "Mortgage Presentation to the board," GS MBS-E-013323395, Hearing Exhibit 4/27-17. [Back]
1546. 7/25/2007 email from Mr. Viniar to Mr. Cohn, "Private & Confidential: FICC Financial Package 07/25/07," GS MBS-E-009861799, Hearing Exhibit 4/27-26. [Back]
1547. 10/2007 Global Mortgages, Business Unit Townhall at 4-5, GS MBS-E-013703463, Hearing Exhibit 4/27-47. [Back]
1548. 4Q07 Fact Sheet prepared for David Viniar, GS MBS-E-009724276, Hearing Exhibit 4/27-159. [Back]
1549. See discussion of risk limits, VAR measurements, and risk reports, below. [Back]
1550. Id. "Value-at-Risk" or VAR is a key risk measurement system used by Goldman. A 1550 t a 95% confidence level, VAR represents the dollar amount a business unit could expect to lose once every 20 trading days or about once per month. Subcommittee interview of Craig Broderick (4/9/2010). See also Philippe Jorion, "Value at Risk: The New Benchmark for Managing Financial Risk," at 20 (3d ed. 2007). [Back]
1551. 1551 11/18/2007 email from Lloyd Blankfein, "RE: NYT," GS MBS-E-009696333, Hearing Exhibit 4/27-52. [Back]
1552. Under standard CDS contracts designed by the International Swaps and 1552 Derivatives Association (ISDA), a credit event is defined as a (1) bankruptcy; (2) failure to pay; (3) restructuring; (4) repudiation of or moratorium on payment in the event of an authorized government intervention; or (5) an acceleration of an obligation. Another common credit event is incurring a credit rating loss. [Back]
1553. See, e.g., 10/17/2006-10/18/2006 email from Tom Montag to Daniel Sparks, "3 things," GS MBS-E- 010917469 (acquisition of a large net long position described as "slipp[ing] up a bit"). In an email to Goldman Co- President Gary Cohn, Richard Ruzika criticized the accumulation of the large net long position: "You know and I know this position was allowed to get too big – for the liquidity in the market, our infrastructure, and the ability of our traders. That statement would be the same even if we had gotten the market direction correct – although the vultures wouldn't be circling. You also know that we probably would have gotten the position correct had I been involved a year ago – I probably would have gotten short to protect our warehouse and general hedge against the business given our outlook in the space." 2/5/2007 email from Richard Ruzika to Gary Cohn, "Are you living Morgatages? [sic]," GS MBS-E-016165784. [Back]
1554. For more information about the Hudson CDO, see below. [Back]
1555. See, e.g., 12/7/2006 email from Tom Montag, GS MBS-E-009756572 ("I don't think we should panic regarding ABX holdings"). [Back]
1556. 12/14/2006 email from Daniel Sparks, "Subprime risk meeting with Viniar/McMahon Summary," GS MBS-E- 009726498, Hearing Exhibit 4/27-3. [Back]
1557. Subcommittee interview of David Viniar (4/13/2010). [Back]
1558. 3/10/2007 email to Daniel Sparks, "Mortgage Presentation to the b 1558 oard," GS MBS-E-013323395, Hearing Exhibit 4/27-17. 12/13/2006 Goldman email, "Subprime Mortgage Risk," Hearing Exhibit 4/27-2. [Back]
1559. 8/23/2007 email from Tom Montag, "Current Outstanding Notional SN ames," GS MBS-E-010621231. [Back]
1560. 11/13/2007 Goldman email, GS MBS-E-010023525 (attachment, 11/14/2007 "Tri-Lateral Combined Comments," GS MBS-E-010135693-715 at 695). [Back]
1561. 9/7/2007 Fixed Income, Currency and Commodities Annual Individual Review Book, Self-Review of Deeb Salem, GS-PSI-03157-80 at 72 (hereinafter "Salem 2007 Self-Review"). [Back]
1563. See chart entitled, "Goldman Sachs Mortgage Department Total Net Short Position, F 1563 ebruary-December 2007 in $ Billions," prepared by the Permanent Subcommittee on Investigations, Hearing Exhibit 4/27-162 (April 2010 version), updated January 2011 (updated version), derived from Goldman Sachs Mortgage Strategies, Mortgage Dept Top Sheets provided by Goldman Sachs (hereinafter "PSI Net Short Chart"), See Section C(4)(g). [Back]
1564. For more information about the mass rating downgrades, see Chapter V, above. See also 7/10/2007 Goldman email, "GS Cashflow/Abacus CDOs Mentioned in S&P Report on CDO Exposure to Subprime RMBS," GS MBS-E- 001837256. [Back]
1565. 10/2007 Global Mortgages, Business Unit Townhall at 4-5, GS MBS-E-013703463, Hearing Exhibit 4/27-47. [Back]
1566. Quarterly Breakdown of Mortgage P/L, GS MBS-E-009713204 at 205. Goldman's gross revenues from all derivative products, without deduction of related losses, were apparently $5.9 billion. 4Q07 Fact Sheet prepared for David Viniar (FY07 P&L [profit and loss]: . . . derivatives +5.9B), GS MBS-E-009724276, Hearing Exhibit 4/27- 159. [Back]
1567. Swenson self evaluation, Hearing Exhibit 4/27-55b. [Back]
1568. Birnbaum self 1568 evaluation, Hearing Exhibit 4/27-55c. [Back]
1570. Quarterly Breakdown of Mortgage P/L, GS MBS-E-009713204 at 205. [Back]
1571. 5/11/2007 email from Daniel Sparks, "You okay?," GS MBS-E-019659221. [Back]
1572. Id.; 5/14/2007 email from David Lehman, "Gameplan – asset model analysis," G 1572 S MBS-E-001865782 (last email in a longer email chain). [Back]
1573. Id.; 5/14/2007 email from Elisha Weisel, "Modelling Approaches for Cash ABS CDO/CDO^2," GS MBS-E- 001863618. [Back]
1574. 5/14/2007 email from Tom Montag to Daniel Sparks, GS MBS-E-019642797. [Back]
1575. 5/11/2007 email from Harvey Schwartz to Daniel Sparks, Tom Montag, and others, GS MBS-E-010780864. [Back]
1576. 5/20/2007 email, "Viniar Presentation - Updated," GS MBS-E-010965211 (attached file, "Mortgages Department, May 2007," Goldman presentation, GS MBS-E-010965212); see also 5/19/2007 "Mortgages CDO Origination – Retained Positions & Warehouse Collateral, May 2007," Goldman presentation, GS MBS-E- 010951926. [Back]
1577. 5/19/2007 "Mortgages CDO Origination – Retained Positions & Warehouse Collateral, May 2007," Goldman presentation, GS MBS-E-010951926. [Back]
1578. Compare 5/19/2007 "Mortgages CDO Origination – Retained Positions & Warehouse Collateral, May 2007," Goldman presentation, GS MBS-E-010951926, with 5/20/2007 "Mortgages Department, May 2007," Goldman presentation, GS MBS-E-010965212. [Back]
1579. 5/19/2007 "Mortgages CDO Origination – Retained Positions 1579 & Warehouse Collateral, May 2007," Goldman presentation, GS MBS-E-010951926; 5/20/2007 email from Lee Alexander to Daniel Sparks, Donald Mullen, Lester Brafman, Michael Kaprelian, "Viniar Presentation - Updated," GS MBS-E-010965211 (attached file "Mortgages V4.ppt," "Mortgages Department, May 2007," GS MBS-E-010965212). [Back]
1580. See discussions of Hudson, Anderson, Timberwolf, and Abacus sales efforts, below. [Back]
1581. 10/2006 Goldman Sachs report, "Hudson Mezzanine Funding, 1581 2006-1, LTD.," at 4, GS MBS-E-009546963, Hearing Exhibit 4/27-87. [Back]
1583. For more information on this pricing mismatch, see the Hudson discussion, below. [Back]
1584. 12/3/2006 Hudson Mezzanine 2006-1, LTD. Offering Circular, GS MBS- E-021821196 at 251 (emphasis added). [Back]
1585. 2/6/2008 email from John Pearce to Michael P 1585 etrick, HUD-CDO-00005146. [Back]
1586. 2/7/2008 email from John Pearce to David Lehman, HUD-CDO-00005147. [Back]
1587. In April 2007, the month after Anderson issued its securities, New Century announced it would have to restate its earnings. It declared bankruptcy soon after. For more information about New Century, see Chapter IV, section E(2)(c). [Back]
1588. See, e.g., 3/2007 Goldman internal email, GS MBS-E-002146861, Hearing Exhibit 4/27-77 ("I recommend putting back 26% of the pool....if possible."). See also 2/2/2007 email from Matthew Nichols to Kevin Gasvoda, GS MBS-E-005556331 ("NC is running a 10% drop rate [due diligence drop] at ~6 points / drop and 4% EPD rate at close to 20 points."). 2/8/2007 email from John Cassidy to Joseph Ozment, others, GS MBS-E-002045021 ("Given the current state of the company I am no longer comfortable with the practice of taking loans with trailing docs . . . that we need in order to conduct compliance testing. . ."). [Back]
1589. 3/16/2007 GSI Risk Committee Memo, "GSI Warehousing for Structured 1589 Product CDOs," GS MBS-E- 001806010. [Back]
1590. 3/12/2007 email from Robert Black to Matthew Bieber and others, GS MBS-E-000898037. [Back]
1591. See Goldman response to Subcommittee QFR at PSI_QFR_GS0223 and PSI_QFR_GS0235. [Back]
1592. Among other assets, Goldman sold $15 million in certain Abacus securities to the Timberwolf CDO. Goldman held 100% of the short side of the relevant Abacus CDO. Its sale of the Abacus securities meant that Goldman held the short side of those assets, while Timberwolf investors took the long side. [Back]
1593. 2/26/2007 email between Tom Montag and Daniel S 1593 parks, GS MBS-E-019164806. [Back]
1594. 3/2007 Goldman internal email chain, GS MBS-E-001800634. [Back]
1595. See, e.g., 6/2007-8/2007 Goldman internal emails, "Timberwolf Sales Efforts," Hearing Exhibit 4/27-166; 3/2007 Goldman internal email, "GS Syndicate Structured Product CDO Axes," Hearing Exhibit 4/27-100. [Back]
1596. 4/19/2007 email chain between Daniel Sparks and Bunty Bohra, GS MBS-E-010539324, Hearing Exhibit 4/27- 102 (Mr. Bohra responds, "[w]e have done that with Timberwolf already."). [Back]
1597. 5/14/2007 email from Edwin Chin, GS MBS-E-012553986. [Back]
1598. 6/2007 Goldman internal email to Daniel Sparks, Hearing Exhibit 4/27-105. [Back]
1599. In synthetic CDOs, the cash proceeds from the sales of the CDO 1599 securities were used to purchase "collateral debt securities." Later, when cash was needed to make payments to a long or short party, those collateral securities were sold, and the cash was used to make the payments. In the event the collateral securities used to pay the short party (called "default swap collateral") could not be sold for face (par) value, Goldman, the short party, absorbed the loss, effectively serving as the default swap collateral put provider. For more information, see discussion of Goldman's actions taken while the collateral put provider of Timberwolf, below. [Back]
1600. 9/17/2007 email from Matthew Bieber to Christopher Creed, GS MBS-E-000766370, Hearing Exhibit 4/27-106. [Back]
1601. 6/2007 Goldman document, "CDO Platform Overview," at 31, GS MBS-E-001918722 ("ABACUS is the Goldman brand name for single-tranche CLN [credit linked note] issuances referencing portfolios comprised entirely of structured products."); 4/2006 Goldman presentation "Overview of Structured Products," GS MBS-E-016067482. [Back]
1602. 3/12/2007 Goldman internal memorandum to Mortgage Capital Committee, "ABACUS Transaction sponsored by ACA," GS MBS-E-002406025, Hearing Exhibit 4/27-118. [Back]
1603. As collateral put provider, which it performed for a fee, Goldman did carry 1603 risk in the Abacus 2007-AC1 transaction. In addition, shortly before the Abacus 2007-AC1 transaction closed, Goldman agreed to take the long side of a CDS contract on the performance of a small portion of the underlying assets when Paulson wanted to increase its short position at the last minute. Goldman tried to find an investor to assume its small long position, but was unable to do so. [Back]
1604. April 27, 2010 Subcommittee Hearing at 82. [Back]
1605. Subcommittee interview of Laura Schwartz (ACA) (4/23/2010). See also In the Matter of Abacus 2007-AC1 CDO, File No. HO-10911 (SEC), Statement of Laura Schwartz (January 21, 2010), ACA ABACUS 00004406 at 408. (hereinafter "Statement of Laura Schwartz"). [Back]
1606. 3/12/2007 Goldman memorandum to Mortgage Capital Committee, 1606 "ABACUS Transaction sponsored by ACA," GS MBS-E-002406025-28, Hearing Exhibit 4/27-118. [Back]
1607. Securities and Exchange Commission v. Goldman, Sachs & Co. and Fabrice Tourre, Case No. 10-CV-3229, (S.D.N.Y.), Consent of Goldman Sachs, (July 14, 2010), at 2. [Back]
Back to Contents (2) Goldman Sachs Background (4) How Goldman Shorted the Subprime Mortgage Market
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