Gary Rivlin, Michael Hudson
Part 4 - THE BIG SHORT
People inside Goldman Sachs were growing nervous. It was the fall of 2006 and, as Daniel Sparks, the Goldman partner overseeing the firm’s 400-person mortgage trading department, wrote in an email to several colleagues, “Subprime market getting hit hard.” The firm had lent millions to New Century, a mortgage lender dealing in the higher-risk subprime market. And now New Century was late on payments. Sparks could see that the wobbly housing market was having an impact on his department. For 10 consecutive trading days, his people had lost money. The dollar amounts were small to a behemoth like Goldman: between $5 million and $30 million a day. But the trend made Sparks jittery enough to share his concerns with the Goldman’s top executives: President Gary Cohn; David Viniar, the firm’s chief financial officer; and CEO Lloyd Blankfein.
Sparks, a Cohn protégé, was running the mortgage desk that his mentor, only a few years earlier, had built into a major profit center for the bank. In 2006 and 2007, a report by the Senate Permanent Subcommittee on Investigations found, the two “maintained frequent, direct contact” as Goldman worked to jettison the billions in subprime loans it had on its book. “One of my jobs at the time was to make sure Gary and David and Lloyd knew what was going on,” Sparks told William Cohan, author of the 2011 book “Money and Power: How Goldman Sachs Came to Rule the World.” “They don’t like surprises.” Viniar summoned around 20 traders and managers to a 30th floor conference room inside Goldman headquarters in lower Manhattan. It was there, on an unseasonably warm Thursday in December 2006, that the firm decided to initiate what people inside Goldman would eventually dub “the big short.”
One name tossed around during the three-hour meeting was that of John Paulson. Paulson (no relation to Goldman’s former CEO) would later attain infamy when it was revealed that his firm, Paulson & Co., made roughly $15 billion betting against the mortgage market. (His personal take was nearly $4 billion.) At that point, though, Paulson was a little-known hedge fund manager who crossed Goldman’s radar when he asked the firm to create a product that would allow him to take a “short position” on the real estate market — laying down bets that a large number of mortgage investments were going to plummet in value. Goldman sold Paulson what’s called a credit-default swap, essentially an insurance policy that would pay off if homeowners defaulted on their mortgages in large enough numbers. The firm would create several more swaps on his behalf in the intervening months. Eventually, as mortgage defaults began to mount, people inside Goldman Sachs came to see Paulson as more of a prophet than a patsy. Some sitting around the conference table that December day wanted to follow his lead.
“There will be big opportunities the next several months,” one Goldman manager at the meeting wrote enthusiastically in an email sent shortly after it ended. Sparks weighed in by email later that night. He wanted to make sure Goldman had enough “dry powder” — cash on hand — to be “ready for the good opportunities that are coming.” That Sunday, Sparks copied Cohn on an email reporting the firm’s progress on laying down short positions against mortgage-backed securities it had put together. The trading desk had already made $1.5 billion in short bets, “but still more work to do.”
Cohn was a member of Goldman’s board of directors during this critical time and second in command of the bank. At that point, Cohn and Blankfein, along with the board and other top executives, had several options. They might have shared their concerns about the mortgage market in a filing with the SEC, which requires publicly traded companies to reveal “triggering events that accelerate or increase a direct financial obligation” or might cause “impairments” to the bottom line. They might have warned clients who had invested in mortgage-backed securities to consider extracting themselves before they suffered too much financial damage. At the very least, Goldman could have stopped peddling mortgage-backed securities that its own mortgage trading desk suspected might soon collapse in value.
Instead, Cohn and his colleagues decided to take care of Goldman Sachs.
Goldman would not have suffered the reputational damage that it did — or paid multiple billions in federal fines — if the firm, anticipating the impending crisis, had merely shorted the housing market in the hopes of making billions. That is what investment banks do: spot ways to make money that others don’t see. The money managers and traders featured in the film “The Big Short” did the same — and they were cast as brave contrarians. Yet unlike the investors featured in the film, Goldman had itself helped inflate the housing bubble — buying tens of billions of dollars in subprime mortgages over the previous several years for bundling into bonds they sold to investors. And unlike these investors, Goldman’s people were not warning anyone who would listen about the disaster about to hit. As federal investigations found, the firm, which still claims “our clients’ interests always come first” as a core principle, failed to disclose that its top people saw disaster in the very products its salespeople were continuing to hawk.
Goldman still held billions of mortgages on its books in December 2006 — mortgages that Cohn and other Goldman executives suspected would soon be worth much less than the firm had paid for them. So, while Cohn was overseeing one team inside Goldman Sachs preoccupied with implementing the big short, he was in regular contact with others scrambling to offload its subprime inventory. One Goldman trader described the mortgage-backed securities they were selling as “shitty.” Another complained in an email that they were being asked to “distribute junk that nobody was dumb enough to take first time around.” A December 28 email from Fabrice “Fabulous Fab” Tourre, a Goldman vice president later convicted of fraud, instructed traders to focus on less astute, “buy and hold” investors rather than “sophisticated hedge funds” that “will be on the same side of the trade as we will.”
At Goldman Sachs, Cohn was known as a hands-on boss who made it his business to walk the floors, talking directly with traders and risk managers scattered throughout the firm. “Blankfein’s role has always been the salesperson and big-thinker conceptualizer,” said Dick Bove, a veteran Wall Street analyst who has covered Goldman Sachs for decades. “Gary was the guy dealing with the day-to-day operations. Gary was running the company.” While making his rounds, Cohn would sometimes hike a leg up on a trader’s desk, his crotch practically in the person’s face.
At 6-foot- 2, bullet-headed and bald with a heavy jaw and a fighter’s face, Cohn cut a large figure inside Goldman. Profiles over the years would describe him as aggressive, abrasive, gruff, domineering — the firm’s “attack dog.” He was the missile Blankfein launched when he needed to deliver bad news or enforce discipline. Cohn embodied the new Goldman: the man who would run through a brick wall if it meant a big payoff for the bank.
A Bloomberg profile described his typical day as 11 or 12 hours in the office, a bank-related dinner, then phone calls and emails until midnight. “The old adage that hard work will get you what you want is 100 percent true,” Cohn said in a 2009 commencement address at American University. “Work hard, ask questions, and take risk.”
There’s no record of how often Cohn visited his stomping grounds after hours in the early months of 2007, but emails reveal an executive demanding — and getting — regular updates. On February 7, one of the largest originators of subprime loans, HSBC, reported a greater than anticipated rise in troubled loans in its portfolio, and another, New Century, restated its earnings for the previous three quarters to “correct errors.” Sparks wrote an email to Cohn and others the next morning to reassure them that his team was closely monitoring the pricing of the company’s “scratch-and-dent book” and already had a handle on which loans were defaults and which could still be securitized and offloaded onto customers. An impatient Cohn sent a two-word email at 5 o’clock that evening: “Any update?” The next day, an internal memo circulated that listed dozens of mortgage-backed securities with the exhortation, “Let all of the respective desks know how we can be helpful in moving these bonds.” A week later, Sparks updated Cohn on the billions in shorts his firm had bought but warned that it was hurting sales of its “pipeline of CDOs,” the collateralized debt obligations the firm had created in order to sell the mortgages still on its books.
In early March, Cohn was among those who received an email spelling out the mortgage products the firm still held. The stockpile included $1.7 billion in mortgage-related securities, along with $1.3 billion in subprime home loans and $4.3 billion in “Alt-A” loans that fall between prime and subprime on the risk scale. Goldman was “net short,” according to that same email, with $13 billion in short positions, but its exposure to the mortgage market was still considerable. Sparks and others continued to update Cohn on their success offloading securities backed by subprime mortgages through the third quarter of 2007. One product Goldman priced at $94 a share on March 31, 2007 was worth just $15 five months later. Pension funds and insurance companies were among those losing billions of dollars on securities Goldman put together and endorsed as a safe, AAA-rated investments.
The third quarter of 2007 was ugly. A pair of Bear Stearns hedge funds failed. Merrill Lynch reported $2.2 billion in losses — its largest quarterly loss ever. Merrill’s CEO warned that the bank faced another $8 billion in potential losses due to the firm’s exposure to subprime mortgages and resigned several weeks later. The roiling credit crisis also took down the CEO of Citigroup, which reported $6.5 billion in losses and then weeks later, warned of $8 billion to $11 billion in additional subprime-related write-downs.
And then there was Goldman Sachs, which reported a $2.9 billion profit that quarter. For the moment, the financial press seemed in awe of Blankfein, Cohn, and the rest of the team running the firm. Fortune headlined an article “How Goldman Sachs Defies Gravity” that said Goldman’s “huge, shrewd bet” against the mortgage market “would seem to confirm the view Goldman is the nimblest, and perhaps the smartest, brokerage on Wall Street.” A Goldman press release drily noted that “significant losses” in some areas — the subprime mortgages it hadn’t managed to unload — had been “more than offset by gains on short mortgage products.” A Goldman trader who played a central role in the big short was not so demure when making the case for a big bonus that year. John Paulson was “definitely the man in this space,” he conceded, but he’d helped make Goldman “#1 on the street by a wide margin.”
Disaster struck nine months into 2008 with the collapse of Lehman Brothers, in large part the result of its exposure to subprime losses. Hank Paulson, the Treasury secretary and former Goldman CEO, spent a weekend meeting with would-be suitors willing to take over a storied bank that on paper was now worth virtually nothing. He couldn’t find a buyer. Nor could officials from the Federal Reserve, who were also working overtime to save the investment bank, founded in 1850, that was even older than Goldman Sachs. Shortly after midnight on Monday, September 15, 2008, Lehman announced that it would file for bankruptcy protection when the courts in New York opened that morning — the largest bankruptcy in U.S. history.
Goldman Sachs wasn’t immune from the crisis. The week before Lehman’s fall, Goldman’s stock had topped $161 a share. By Wednesday, it dropped to below $100. It had avoided some big losses by betting against the mortgage market, but the wider financial crisis was wreaking havoc on its other investments. On paper, Cohn had personally lost tens of millions of dollars. He hunkered down in an office with a view of Goldman’s trading floor and worked the phone, trying to change the minds of major investors who were pulling their money from Goldman, fearful of anything riskier than stashing their cash in a mattress.
The next week, Goldman converted from a free-standing investment bank to a bank holding company, which made it, in the eyes of regulators, no different from Wells Fargo, JPMorgan Chase, or any other retail bank. That gave the firm access to cheap capital through the Fed but would also bring increased scrutiny from regulators. The bank took a $10 billion bailout from the Troubled Asset Relief Program and another $5 billion from Warren Buffett, in return for an annual dividend of 10 percent and access to discounted company stock. The firm raised additional billions through a public stock offering.
The biggest threat to Goldman was the economic health of the American International Group. Among other products, AIG sold insurance to protect against defaults on mortgage assets, which had been central to Goldman’s big short. Of the $80 billion in U.S. mortgage assets that AIG insured during the housing bubble, Goldman bought protection from AIG on roughly $33 billion, according to the Wall Street Journal. When Lehman went into bankruptcy, its creditors received 11 cents on the dollar. Executives at AIG, in a frantic effort to avoid bankruptcy, had floated the idea of pushing its creditors to accept 40 to 60 cents on the dollar; there was speculation creditors like Goldman would receive as little as 25 percent. Goldman and its clients were looking at multibillion-dollar hits to their bottom line — a potentially fatal blow.
But as Goldman learned a century ago, it pays to have friends in high places. The day after Lehman went bankrupt, the Bush administration announced an $85 billion bailout of AIG in return for a majority stake in the company. The next day, Paulson obtained a waiver regarding interactions with his former firm because, the Treasury secretary said, “It became clear that we had some very significant issues with Goldman Sachs.” Paulson’s calendar, the New York Times reported, showed that the week of the AIG bailout, he and Blankfein spoke two dozen times. While creditors around the globe were being forced to settle for much less than they were owed, AIG paid its counterparties 100 cents on the dollar. AIG ended up being the single largest private recipient of TARP funding. It received additional billions in rescue funds from the New York Federal Reserve Bank, whose board chair Stephen Friedman was a former Goldman executive who still sat on the firm’s board. The U.S. Treasury ended up with greater than a 90 percent share of AIG, and the U.S. government, using taxpayer dollars, paid in full on the insurance policies financial institutions bought to protect themselves from steep declines in real estate prices — chief among them, Goldman Sachs. All told, Goldman received at least $22.9 billion in public bailouts, including $10 billion in TARP funds and $12.9 billion in taxpayer-funded payments from AIG.
Goldman, once again, had come out on top.