Money and Power (85 page)

At this moment of frustration, Birnbaum asked to move over to the trading desk—from the structuring desk—to get more action. Goldman accommodated him. “They were willing to try to make me happy and keep me intrigued, and that was a great move for me,” he said. Working with the more senior traders, he started buying and selling balloon mortgages, fifteen-year mortgages, and thirty-year mortgages. He made markets for Goldman’s clients.
He made proprietary trades for Goldman
itself. He traded with other big institutions as well as with
Fannie Mae and
Freddie Mac, which had started buying mortgages for their own portfolios. He also began exercising that part of his brain intrigued by options and option trading and somehow came to focus on buying and selling options on mortgages and asking the more senior traders on the desk such esoteric existential
questions as, “If you own a call option on a mortgage and a mortgage itself is short a call option, what do you end up owning?” (His boss replied that the answer was “complicated” and “not worth going into.” In other words, he had no idea what the answer was.)

Birnbaum immersed himself in trading mortgages. “I traded pretty much every seat in that business,” he said. “It gave me a ton of exposure with accounts and sales forces around the world, with flow trading. It’s a unique skill set all its own. I remember one of the guys on the desk early in my career said of trading, ‘The best analogy I can make is to quote from Chuck Yeager: the more sorties you do, the better you are, and you
can’t underestimate the value of experience.’ Well, the more trades you’ve done, the more times you’ve been put in the line of fire, you’re just going to be that much better than the new guy that comes in.” Birnbaum also began to get exposure to the most senior executives of the firm, especially to
Jon Corzine. Corzine would come around and chat with the mortgage traders, including Birnbaum, on a regular basis.
“He’d just reach out and chat with the mortgage traders for long periods of time,” he said of Corzine, “and I thought that was pretty cool that the head of the firm thought our area was that important.”

Goldman soon promoted Birnbaum to a full-fledged associate after the end of his two-year post-college stint as an analyst. In 1998, Birnbaum became “intrigued,” as he said, with the growing intersection between the mortgage market and what was known as the “swaps market,” which traditionally had been for those investors who had a fixed-rate debt instrument and for whatever reasons wanted a floating-rate debt instrument. In the swaps
market—for a fee—an investor could swap the fixed for the floating and everybody would be happy. “But you could kind of swap anything,” he explained. “One guy wants one thing, another guy wants another thing.” In mortgages, the perennial issue had always been what the prepayment rate on mortgages would turn out to be as people inevitably sought to refinance their home loans. “So there was an idea: ‘Hey, why don’t we
create some swaps that are based on the realized prepayment experience of a certain type of mortgage?’ And that was the first time that the swaps concept was applied to mortgages, and ultimately, fast-forward the clock all the way to the CDS [credit-default swaps] market, that was based on credit and that was what ultimately brought down
AIG and other places like that. But the first time that swaps appeared in mortgages was based on betting on prepayments.
I thought that was a very interesting business.”

At first, Birnbaum did deals between those counterparties who were willing to bet prepayments would be low and those willing to bet prepayments would be high. That was a nice business. But things got much more interesting and lucrative when Birnbaum started to come up with some innovative, interesting new structures. One of these he dubbed a “synthetic CMO,” based upon certain investors wanting one part of a CMO but not another. Some investors found some
parts of the CMO cheaper than other parts based upon the collateral associated with it. Birnbaum exploited these differences. “Our concept was why don’t we isolate a portion of the CMO deal that we view as being expensive and why don’t we just facilitate the underwriting to that and take that risk instead of selling all the parts,” he said. Whatever Birnbaum had come up with precisely, Goldman made a lot of money from it, and Birnbaum’s career began
to take off.

He was soon promoted to be head of Goldman’s swaps business; as that did increasingly well, he was promoted further to be head of Goldman’s mortgage derivatives business. Four years into his tenure at Goldman, he was promoted to vice president, like every other person who had been at the firm for four years. “The VP designation is typically robotic,” he said. “You don’t get it earlier if you’re killing it or later if
you’re underperforming. You just get it kind of in four years.” Goldman was trying—it seemed to him—to distinguish his pay from that of his peer group. “They were doing their job and paid me just enough to keep me around,” he said.

In 2001, he came up with another new innovation: something he called “CMM,” for constant maturity mortgage, a kind of interest-rate product tied to mortgage rates, instead of LIBOR (for London Interbank Offered Rate). A CMM was “an attempt to simplify the trading of mortgage price risk by transforming the most liquid portion of the mortgage market into a rate-based market” and can “be used to hedge for mortgage products that are
sensitive to changes in mortgage rates.” Regardless of whether mere mortals understood the new product (or not), Birnbaum’s point about it was “that it was another innovation that did well and made good money doing it,” of around $100 million a year or so. At one point, in July 2002, Birnbaum, along with Goldman colleague Ashwin Rao, published “A Simple Algorithm to Compute Short-Dated CMM Forwards,” which of course was anything but
simple. Still, the short paper, filled with such complex ideas as “
P
_C
(
x
) =
P
_C
(
E
[
x
]) +
Dur
_C
(
E
[
x
])
*
∆
x
+ ½
* Conv
_C
(
E
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x
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(∆
x
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,” or, roughly translated, as Birnbaum’s
calculation
that mortgages prices were “purely quadratic functions of the level of swap rates,” must have impressed Goldman’s clients.

In the thirteen years Birnbaum had been at Goldman, much had changed at the firm and on Wall Street. Inside 85 Broad Street the firm had been transformed from one where investment bankers held sway to one where traders, and trading, were the dominant force in the building. The 1999 IPO accelerated this trend because the money raised gave the firm even more capital with which to trade. What’s more, it was other people’s money with the extra benefit that the
rewards—in the billions of dollars annually—for taking risks with it went mostly to the Goldman employees and the losses, should anything go wrong, belonged to the firm’s shareholders and creditors.

During Birnbaum’s career at Goldman, Wall Street had changed in other ways as well. Whereas in 1992, LBO firms, or leveraged-buyout firms, were few and far between—once you got beyond the well-known firms such as KKR and
Forstmann Little—by 2005, buyouts firms, now known as private-equity firms, were everywhere. Goldman, which had a $1 billion fund in 1992, was on its fifth fund by 2005, with $8.5 billion to
invest. (Goldman is now on its sixth fund, with $20.3 billion to invest.) This was just one of many such funds at Goldman, which also included a technology fund, an infrastructure fund, a loan fund, a real-estate fund, a mezzanine fund, and a little-known fund of partners’ money, which for instance had made an absolute killing (that few people knew about) investing in
Jinro Ltd., a Korean liquor manufacturer that had been in receivership.
“They got
enormous
in this thing and it made multiple, multiple, multiples!” recalled one impressed hedge-fund manager.

More important, from Birnbaum’s perspective, were the surprising number of former Goldman bankers and traders who had left the firm to start their own hedge funds and were making tens of millions of dollars in annual compensation—in some cases, hundreds of millions of dollars and even billions of dollars in compensation. Among them were people such as
Thomas Steyer,
Daniel Och,
Richard Perry,
Jonathan Savitz,
Eric Mindich,
Edward Mule,
David Tepper,
David Einhorn,
Edward Lampert, and
Mark McGoldrick (who used to be in charge of Goldman’s Special Situations Group). Birnbaum, though a few years younger than most of these men, became increasingly tempted by the idea of the mountains of money he thought he could make on
his own or working as a principal at another hedge fund.

Goldman certainly recognized Birnbaum’s talent and was doing what it could to keep him at the firm. “I was still there,” he said. “I was still listening. They weren’t saying the wrong things. But it was more
driven by just an intellectual desire to try to maximize my potential.” One of the more intriguing opportunities that Birnbaum spied in the market by the end of 2005 was the increasing use of
credit-default swaps, or CDS—a form of insurance that could be bought on whether a debt would in fact be paid—in the mortgage or any other debt market. Increasingly, insurance companies, such as AIG, or other Wall Street firms were willing to sell protection on whether the mortgages that went into mortgage-backed securities would in fact be paid. To get the insurance, buyers had to pay premiums to the issuers, as they did to obtain any other form of insurance. Instead
of buying life insurance, or fire insurance on your house, or auto insurance on your car, buying a credit-default swap allowed investors to make bets on whether people ended up paying their mortgages.

There were a number of reasons that the markets for mortgages and for credit-default swaps started to intersect in the summer of 2005. First, there was the sheer magnitude of the market for mortgage-backed securities. By the first quarter of 2004, the market for mortgage-backed securities was $6.9 trillion, some 40 percent larger than the market for U.S. corporate debt, which was $5 trillion, and the market for U.S. Treasury debt, which was $4.9
trillion. The mortgage market had more than doubled in ten years. As a result, on a sheer volume basis alone there would likely be increased demand for protection against default, especially since some prognosticators, such as
David Rosenberg, the chief North American economist at
Merrill Lynch, had started publishing research, in August 2004, questioning whether the real-estate market was heading for trouble. Under the headline “If
Not a Bubble Then an Oversized Sud,” Rosenberg wrote, “We assess the likelihood that the housing sector has entered into a ‘bubble’ phase. There are numerous shades of gray, but when we examine the classic characteristics of a ‘bubble’ (extended valuation, over-ownership, excessive leverage, a surge in supply, complacency (denial?), and speculative behavior), it seems to fit the bill. At the very least, housing is overextended, and even the
Fed has acknowledged as much. The next question is what pricks the ‘bubble’ if in fact there is one?”

In February 2005,
Paul Volcker, the former
Federal Reserve chairman, picked up that thread in a speech at Stanford University, where he indicated he was increasingly worried about the bubble he thought might be forming in the real-estate market. “There has been a lot of good news in the past couple of years,” he said that day, but “I have to tell you my old central banking blood still flows. Under the placid
surface, at least the way I see it, there are really disturbing trends: huge imbalances, disequilibria,
risks—call them what you will. Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot. What really concerns me is that there seems to be so little willingness or capacity to do much about it.” Volcker’s observations came some four months after
Alan
Greenspan, the Federal Reserve chairman at the time, gave a speech in Washington where he allowed that although “pockets of severe stress within the household sector … remain a concern,” the likelihood of “housing price bubbles” appeared small. By January 2006, even Goldman itself was claiming that “the oft predicted, overly anticipated
subprime blow up MAY occur” in 2006 but then
dampened that by suggesting that “a blow up” was less likely than a “fizzle out.” Still Goldman’s economists believed U.S. housing prices to be “overvalued by 15%+.”

The other reason for the increasing use of CDS in the mortgage market by the end of 2005 was more technical. In June 2005, the Wall Street firms got together and “standardized” the CDS contracts that were used to insure the risks in the mortgage market.

The combination of the standard contract for credit insurance, plus the explosion of mortgage issuance—especially to borrowers of lower and lower credit quality—and the outlines of concern as a result, led to a noticeable increase in the purchase of CDS on mortgages. “Particularly in the fall of 2005, you really had some of the early hedge-fund trades, significant hedge-fund trades … but this was when [hedge-fund manager]
John Paulson first crept up and started doing some trades,” Birnbaum recalled. According to Goldman, there were $150 billion of credit-default swaps outstanding on “structured product” at the end of 2005, up exponentially from $2 billion the year before. The use of CDS to protect against mortgage-securities’ defaults “[g]rew faster than even we predicted,” Goldman wrote in its marketing documents.

At the same time, Birnbaum had also noticed that the cost of the premiums to buy the insurance on the mortgage payments had spiked upward, tripled in price really, from costing 1 percent of the aggregate amount being insured to 3 percent of the aggregate amount being insured. Like any market, the cost of the insurance is driven by supply and demand—the greater the demand to insure a certain debt, the greater the likelihood of a higher cost associated with it. In
this market at that time, since it was so thinly traded, a sudden increase in demand can have a particularly noticeable effect on the price of the insurance. “It was just like this huge, ‘What the heck’s going on?’ ” he said. “The Street got blindsided.” Birnbaum was not trading the CDS on mortgages at that time, but he was fairly sure that John Paulson—and perhaps another
hedge-fund manager—was
starting to build his portfolio of CDS. They were buying credit protection against the default of individual
tranches of mortgage-backed securities. “All I know is there was a very thin market, so probably this much inquiry for protection would probably create a huge change,” he said. Curious about this new dynamic in this obscure market, Birnbaum decided to buy some credit-default swaps on his trading desk—just to dabble in the market,
really—and then sold them relatively quickly, making enough money to impress his colleagues. “Oh, nice job doing that,” one of them told him, although it was just one trade. “It was an alert to a lot of folks who had never looked at this market that ‘hey, there’s something interesting going on here,’ ” he said.