Money and Power (86 page)

At the same time that a standardized CDS contract for mortgages came into being and
John Paulson was starting to buy increasing amounts of CDS against mortgages, Wall Street also got together and created an index composed of securities backed by home loans issued to borrowers with weak credit that, for the first time, allowed investors to bet on the performance of the subprime mortgage market. This new index—the
ABX.HE, or
ABX for short—was the brainchild of people like Rajiv Kamilla, at Goldman Sachs, then in his early thirties and a former nuclear physicist. The idea, Birnbaum said, was to create “an index that was a portfolio that everyone could agree upon that was representative of the subprime market, and then instead of trading each single name, you would trade this portfolio and it could be more liquid and maybe you could trade it as a hedge instrument, maybe as a speculative
instrument.”

An obscure partnership—with the odd name of
CDS IndexCo LLC—owned by sixteen investment banks, including Goldman, created the index in January 2006 and for the first time, investors had a way to bet on the performance of the subprime mortgage market. (Brad Levy, a Goldman partner, served as CDS Index’s chairman). Another firm—Markit.com, based in London, and of which Goldman also owned a piece—collected and
published on a daily basis the data from Wall Street firms related to the securities in the ABX index, effectively administering the index.
(
Markit.com was, in 2009, the subject of an investigation by the Justice Department, which, according to
Forbes,
“wants to know if the firms”—like Goldman and
JPMorgan—“benefited from the way prices of credit indexes were posted on
Markit.com. These prices, taken from the average of quotes from the dealers themselves, could only be accessed in the afternoon via the site. Otherwise, the buying and selling of credit derivatives has been completely invisible to the investing public.”)

Before the creation of the ABX index in January 2006, if the mortgage-backed securities market sold off, no one really knew for sure by
how much. But with the creation of the ABX, there was now a published index that people could observe and, more important, could short to hedge whatever risks they perceived existed in the mortgage market.

The more he heard about the ABX, the more interested Birnbaum became in the possibility of trading it. This, he thought, might be his next opportunity and a way for him to stay at Goldman. (In a January 2006 presentation to a mortgage client, Goldman’s bankers described the January 19 launch of the ABX index as “THE market event” of the first half of the year.) When his managers at Goldman, Mike Swenson and Dan Sparks, agreed to let Birnbaum trade
the index, he decided he would stay and do it. “The thinking was that I had all that flow experience,” he said, “but I also knew the guts of the mortgage cash flows very well. This was something where knowing both would be really useful to you.” Birnbaum recalled that Swenson, known around the office as “Swenny,” was particularly supportive of the idea. A former hockey player at Williams College with four children, a preppy demeanor, and a
wry sense of humor, Swenson had been at Goldman since 2000. “He’s one of these guys who has a great nose for kind of knowing when people are going to be good at something,” Birnbaum said. Birnbaum gave Swenson “a lot of credit” for bringing to that desk “the right guys” with “complementary skills” and “not worrying about turf wars or ego or politics.” The idea was to put the best team together, one that
would outsmart and outhustle the competition.

In early January 2006, Birnbaum moved to the desk where the ABX index would be traded. It was about four or five rows of desks away from where he had been sitting. The move was a little unusual, but all parties to it embraced the idea as a good one. The first ABX trade occurred on January 19. “At the time nobody had any sense that ABX or the credit-default swap market and mortgages would be anything close to what it ultimately was,” he said. “But it
was still a very interesting product.… I think that Goldman—and myself personally—we had a very bullish view on what the index would do in terms of trading flows and just what the business prospects were in terms of having an index trading business, more so than I think any other bank.”

That first day, Birnbaum did some thirty different trades involving the ABX index and made $1 million in profit. The next closest bank trading the index had made five trades. “We approached it as a great opportunity,” he said. “We were a liquidity provider from day one and printing a lot of trades. Other banks had more trepidation: ‘What is this index? How does this affect our business? How does this affect what was traditionally a
long-only asset-backed business?’ We were, like, this is a new regime. This is going to be a two-way business in mortgage credit from
now on, and there’s a potential flow product with a lot of interest from lots of different kinds of market participants. From day one that thesis was corroborated by virtue of the net we made”—the $1 million—“and the number of trades we did first versus our competitors. So out of the
gate we were really, really happy.” At first, Birnbaum traded the index on behalf of his clients and made money buying and selling as in any “flow product,” he explained. At that moment, neither he nor the firm had any “conviction” about the direction the mortgage market would move in, and so he and his colleagues were just content to make markets for clients and take what amounted to a fee. “We hadn’t necessarily formed a view one way
or the other,” he said. “We were trading the market more agnostically on behalf of our clients at that point on day one. The view at that point was simply this is a great business opportunity. The view wasn’t, ‘We’re going to buy it and we’re going to sell it and we’re going to take a huge position.’ It was, ‘This is a great opportunity to have this product to trade at this time.’ ”

——

A
T THE SAME
time that Birnbaum and his colleagues (among them
Deeb Salem and
Jeremy Primer, in addition to Swenny) on the structured products desk at Goldman were gearing up to trade the ABX index and wondering about if, and when, to get some “conviction” on the direction the mortgage market might take during the next six months or so, other parts of the firm—then composed of
22,500 people—were continuing to go about their business. One such group was still busy aggregating mortgages from mortgage originators, such as
Countrywide or New Century, and getting ready to package the mortgages up and sell them to hungry investors in the form of mortgage-backed securities.

One of those mortgage-backed securities—awkwardly named GSAMP Trust 2006-S2—was a nearly $700 million deal underwritten and sold by Goldman Sachs to investors at the peak of the market in the spring of 2006. It provides an exquisite example of its ill-conceived genre, right down to the fact that there was no way to ever figure out, in all of its prospectus’s life-sustaining two hundred or so pages, how much money Goldman made from it.
Considering that Goldman exists to “make money with money,” according to
David Viniar, the firm’s longtime chief financial officer, this fundamental bit of opacity would be troubling if it weren’t so essential to the firm’s success.

Like insects preserved in amber, among the many hidden secrets the GSAMP Trust 2006-S2 document reveals is a world of rampant greed and risk taking run amok, encased in a nearly incomprehensible language that only a securities lawyer could truly love. It was designed to
befuddle all but the most sophisticated investor. Here, in March 2006, as signs of an impending financial crisis were beginning to be revealed, Goldman Sachs—while taking very
little risk itself—had put the considerable cachet and imprimatur of its storied 137-year history on the line in order to offer investors the opportunity to buy pieces of a pool of 12,460
second
mortgages on homes from one end of the country to the other.

And what a collection of borrowers and properties it was. Not only did another creditor have the
first
mortgage on the homes—meaning a priority claim on all payments related to it—but also some 29 percent in number and 43 percent in value of the mortgages had been made to home owners in California. Some 6.5 percent of the mortgages came from Florida, and some 5.6 percent of the mortgages came from New York. The California borrowers had an average
credit rating score of 672—out of a possible score of 850—and owed an average of $87,915 on their second mortgage. Only 32 percent of these mortgages resulted from
“full-doc” loans, meaning loans that had been made based upon a comprehensive understanding of borrowers’ financial capability to repay them; the remaining 68 percent were based on a far more flimsy underwriting, a combination of unverified facts and
circumstances about the borrowers. Not surprisingly, given the risk involved, the average interest rate charged on the California second mortgages was a healthy 10.269 percent.

What’s more, 99.82 percent of the mortgages in the pool of California residences had a loan-to-value ratio in excess of 80 percent. These homes were leveraged to the max, and the slightest drop in the value of the home would immediately impair the underlying second mortgage and thus the value of the mortgage-backed securities that Goldman was underwriting. Fortunately, thanks to required disclosures, Goldman was willing to concede this point in the prospectus.
“Mortgage loans with higher original combined loan-to-value ratios may present a greater risk of loss than mortgage loans with original combined loan-to-value ratios of 80 percent or below,” the lawyers wrote on Goldman’s behalf in the prospectus.

The prospectus contained plenty of other warnings, too. For instance, right up front Goldman announced the sobering risk that the underwriting standards on the underlying mortgages were probably lousy. The “assets of the trust” backing the securities being sold “may include residential mortgage loans that were made, in part, to borrowers who, for one reason or another, are not able, or do not wish, to obtain financing from traditional
sources,” the prospectus read. “These mortgage loans may be considered to be of a riskier nature than mortgage
loans made by traditional sources of financing, so that the holders of the securities may be deemed to be at greater risk of loss than if the mortgage loans were made to other types of borrowers.”

In typical Wall Street fashion, Goldman had not made any of these home loans itself. It had no idea who the borrowers were or whether they could repay the mortgages. Goldman knew something about their credit scores but that was about it. It was counting on both the perceived power of the ongoing housing bubble to keep housing values inflated and a diversified portfolio to spread the risk across the pool of geographically diverse mortgages in order to minimize the risk
of any one individual borrower or group of borrowers. Of course, Goldman had no intention of keeping the mortgages itself but rather bought them for the sole purpose of packaging them together and selling them off to investors for a fee determined by the difference between the price it paid for them and the price it sold them for. In other words, pretty standard Wall Street practice.

By the spring of 2006, Goldman was considered a respectable underwriter of mortgage-backed securities, ranking twelfth worldwide in 2005 in the underwriting of so-called structured finance deals—those for asset-backed securities, residential and commercial mortgage-backed securities, and collateralized debt obligations—worth $102.8 billion. By 2006, Goldman had moved up to tenth in the league tables—underwriting 204 deals globally, worth
$130.7 billion—but still was far behind Lehman Brothers,
Deutsche Bank,
Citigroup, Merrill Lynch, and Bear Stearns. These other firms were coining money underwriting mortgage-backed securities and became so concerned about having access to a steady flow of mortgages to package up and sell that they all bought mortgage origination firms—Bear bought EMC Mortgage; Merrill bought
First Franklin Financial
Corp. from
National City Bank in December 2006—at the top of the market—for $1.7 billion. Goldman was content being in the middle of the pack when it came to this activity, and the firm never bought a mortgage origination company, despite having numerous opportunities to do so. “Exactly what we didn’t want to do,” explained Viniar. That being said, Goldman did buy, for $14 million,
Senderra
Funding, a small South Carolina–based
subprime lender, in February 2007; and, for $1.34 billion—a tidy sum—
Litton Loan Servicing, a mortgage servicing business, in December 2007; and
Money Partners LP, a British mortgage lender, soon thereafter.

But aside from that particular corporate bias—against buying a significant mortgage origination business and toward servicing those mortgages—Goldman was no different in its approach to the business than other Wall Street firms. According to a lawsuit filed in September
2009 by aggrieved investors in GSAMP Trust 2006-S2, “[W]ith the advent and proliferation of securitizations, the traditional model gave way to the
‘originate to distribute’ model, in which banks essentially sell the mortgages and transfer credit risk to investors through mortgage-backed securities. Securitization meant that those originating mortgages were no longer required to hold them to maturity. By selling the mortgages to investors, the originators obtained funds, enabling them to issue more loans and generate transaction fees. This increased the originators’ focus on processing mortgage transactions
rather than ensuring their credit quality. Wall Street banks, including Goldman Sachs, entered into the high-margin business of packaging mortgages and selling them to investors as MBS, including mortgage pass-through certificates. As is now evident, far too much of the lending during that time was neither responsible, prudent, nor in accordance with stated underwriting practices.”

——

F
OR
GSAMP T
RUST
2006-S2, as it had many times before and would many times after, Goldman bought the mortgages it wanted to securitize and sell off from third-party mortgage originators. In this case, Goldman bought all of the mortgages from
NC Capital, an affiliate of
New Century Financial Corporation. In other underwritings, Goldman had also bought mortgages from—to
name a few—Fremont Investment & Loan, an indirect subsidiary of Fremont General Corporation;
Long Beach Mortgage Company;
Argent Mortgage Company;
Countrywide Financial;
First National Bank of Nevada; and
GreenPoint Mortgage Funding, Inc. By buying the mortgages from others, Goldman effectively abdicated any role in the underwriting process of the mortgages, relying
instead on the judgment of others, again a fairly typical practice on Wall Street, especially late in the cycle as underwriting standards deteriorated and greed prevailed.