This part of the memo ( pages 7-10 with footnotes omitted) explains Goldman Sachs's Conflict Between Proprietary and Client Trading, and its Shorting the Mortgage Market. It is easy to see the role that Goldman Sachs played in bringing the financial system to its knees and the CEO was not above lying about the profits GS made.
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Goldman Sachs Shorting the Mortgage Market. Goldman Sachs senior management closely monitored the holdings and the profit and loss performance of its mortgage department. In late 2006, when high risk mortgages began showing record delinquency rates, and the value of RMBS and CDO securities began falling generally, Goldman Sachs Chief Financial Officer David Viniar convened a meeting on December 14, 2006, to examine the data and consider how to respond.
Beginning in early 2007, Goldman Sachs initiated an intensive effort to not only reduce its mortgage risk exposure, but profit from high risk RMBS and CDO securities incurring losses. A presentation to the Goldman Sachs Board of Directors identified a number of actions taken during the year, including: “Shorted synthetics” and “Shorted CDOs and RMBS.”
The 2009 Goldman Sachs annual report states that the firm “did not generate enormous net revenues by betting against residential related products.” Documents obtained by the Subcommittee, however, indicate otherwise. Two top Goldman mortgage traders, Michael Swenson and Joshua Birnbaum, discussed in their 2007 performance self-evaluations the “very profitable year” and “extraordinary profits” that came from shorting the mortgage market that year. One bragged about “aggressively” entering into “efficient shorts in both the RMBS andCDO space,” while the other reported that “contrary to the prevailing opinion” that the firm needed only to “get close to home,” he “concluded that we should not only get flat, but get VERY short.” Goldman Sachs documents show that the firm was short in the mortgage market throughout 2007, and that, twice in 2007, it established and then cashed in very large short positions in mortgage related securities, generating billions of dollars in gross revenues.
At times, the net short position accumulated by Goldman Sachs was as large as $13.9 billion. The short positions held by the firm’s mortgage department became so large that according to the Goldman Sachs risk measurements, the positions comprised 53 percent of the firm’s overall risk, according to Goldman Sachs own Value-at-Risk (VaR) measures. Senior management had to repeatedly allow the mortgage department to exceed the VaR limits that had been established by the firm.
Beginning in July 2007 and continuing into the next year, credit rating agencies downgraded hundreds of RMBS and CDO securities. On one day in October 2007, they downgraded $32 billion in mortgage related securities, causing substantial losses for investors. A Goldman Sachs manager reacted to the news by noting that Goldman had bet against those securities by purchasing credit default swaps. His colleague responded:“Sounds like we will make some serious money.” The reply: “Yes we are well positioned.” In the end, Goldman Sachs profited from the failure of many of the RMBS and CDO securities it had underwrote and sold. As Goldman Sachs CEO Lloyd Blankfein explained in a November 2007 email: “Of course we didn’t dodge the mortgage mess. We lost money, then made more than we lost because of shorts.”
Conflict Between Proprietary and Client Trading. After Goldman Sachs decided to reduce its mortgage holdings, the sales force was instructed to try to sell some of its mortgage related assets, and the risks associated with them, to Goldman Sachs clients. In response, Goldman Sachs personnel issued and sold to clients RMBS and CDO securities containing or referencing high risk assets that Goldman Sachs wanted to get off its books. Three examples demonstrate how Goldman Sachs continued to sell mortgage related products to its clients, while profiting from the decline of the mortgage market.
Hudson Mezzanine 2006-1 (“Hudson 1”) was a synthetic CDO that referenced $2 billion in subprime BBB-rated RMBS securities. This CDO was underwritten and sold by Goldman Sachs in December 2006. Goldman Sachs selected the referenced assets, collaborating with its mortgage traders to identify BBB rated assets on its books. About $800 million in subprime RMBS securities and $1.2 billion in ABX index contracts were referenced in the CDO. Goldman executives told the Subcommittee that the company was trying to remove BBB assets from the company books during this period of time. Goldman Sachs was the sole short investor in this proprietary deal, buying protection on all $2 billion in referenced assets and essentially placing a bet that the assets would lose value. Goldman Sachs personnel placed a high priority on selling the Hudson securities. Evidence of this is illustrated by the Hudson 1 deal being pushed ahead of a client transaction. One Goldman Sachs employee noted that a client was“upset that we are delaying their deal. They know that Hudson Mezz (GS prop deal) is pushing their deal back.” Less than 18 months later, the AAA securities had been downgraded to junk status. Goldman Sachs as the sole short investor would have been compensated for these losses, and investors who purchased the Hudson securities would have lost an equivalent amount. Goldman Sachs profited from the loss in value of the very CDO securities it had sold to its clients.
Anderson Mezzanine Funding 2007-1 was a synthetic CDO referencing about $300 million in subprime RMBS BBB securities. Goldman Sachs structured the deal and participated as one of the short investors, buying loss protection for $140 million, or nearly 50 percent, of the referenced assets. During the first calendar quarter of 2007, Goldman Sachs underwrote and sold the Anderson CDO securities. Most of the referenced assets were subprime RMBS securities, backed by high risk mortgages. The largest originator of the high risk mortgages was New Century Mortgage, a lender which was known for poor quality loans and which Goldman Sachs knew was in poor financial condition. Goldman senior managers directed their sales force to sell the Anderson securities quickly due to “poor subprime news.” In fact, Goldman manager Jonathan Egol advised Goldman personnel to sell the Anderson securities before completing an Abacus deal: “Given risk priorities, subprime news and market conditions, we need to discuss side-lining this deal ([Abacus 2007-]AC1) in favor of prioritizing Anderson in the short term.” The top rating given to the Anderson securities was BBB; about 7 months after the securities were sold, Anderson was downgraded to junk status.
A third example involves Timberwolf I, a hybrid cash/synthetic $1 billion CDO squared, which Goldman Sachs underwrote and sold in the first calendar quarter of 2007. A significant portion of the referenced assets were CDO securities backed by subprime RMBS mortgages. Some of the referenced assets were backed by Washington Mutual Option ARM mortgages, high risk mortgages whose value was dropping as housing prices declined. A memorandum sent to the Goldman Sachs Mortgage Capital Committee indicated that the Timberwolf CDO would contain 50 percent CDO securities and 50 percent collateralized loan obligation (“CLO”) securities, but Goldman Sachs told the Subcommittee that, since the value of the CLOs had improved, the firm had sold the best-performing CLO securities separately. In the end,Timberwolf referenced assets consisted of 94 percent CDO securities, including about $15 million in Abacus CDO securities. Goldman Sachs was the short investor for many of the Timberwolf referenced assets, including the Abacus securities, betting that they would decline in value.
A senior executive in Goldman Sachs sales expressed concern about what representations might be made to clients about the Timberwolf CDO squared, but other Goldman personnel urged the sales force to treat Timberwolf securities as a priority. An email from Dan Sparks, head of the Goldman Sachs mortgage department, urged Goldman personnel working on a potential Korean sale to “[g]et ‘er done,” and sent a mass email to the sales force promising“ginormous credits” for selling the securities. A congratulatory email was sent to an employee who sold a number of the securities: “Great job … trading us out of our entire Timberwolf Single-A position.” In mid-spring, Goldman Sachs sold about $300 million of Timberwolf securities to Bear Stearns Asset Management, one of the offshore hedge funds that collapsed during the summer. Within five months of issuance, the CDO lost 80 percent of its value, and was later liquidated in 2008. The AAA securities issued in March 2007, were downgraded to junk status in just over a year. The Goldman trader responsible for managing the deal later characterized the day that Timberwolf was issued as “a day that will live in infamy.” A senior Goldman executive described the deal as follows: “Boy that timeberwof [sic] was one shi**y deal.”
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The entire document can be read here