Money and Power (91 page)

In fact, the CDO managers—those bankers still putting together CDOs and selling them off to investors—thought they had their own major opportunity on their hands. “What the CDO community was doing in December and January is they were buying a lot of risk,” Birnbaum said. “What they viewed as a great buying opportunity because in [the first quarter of 2007] they were going to turn around and sell liabilities on these deals at yesterday’s spreads in their mind and they were going to make a huge profit.” In other words, other Wall Street dealers were betting the market for these mortgage securities would soon recover and the value of the CDOs they were manufacturing would recover their previous
pricing and they would lock in a big profit. Birnbaum was, of course, betting the opposite would happen, and in a big way.

Those bankers looking to construct and sell new CDOs during these two months were busy collecting some $20 billion of collateral—other debt securities, including mortgages—to put into their CDOs. On Wall Street, this practice was known as “
ramping,” and the $20 billion was a very large amount relative to other periods of time, suggesting that many on Wall Street believed the market for these CDOs was soon to recover and they wanted to have the product on hand to sell. Birnbaum bet against them. “During that period of time we were attempting to buy protection”—taking a short position—“on as much subprime as we possibly could within the context of reasonableness,” he said. “So we were always looking to be the best bid for protection during that period of time and we purchased approximately
half
of the available amount that was out for bid. That meant that Goldman effectively was able to buy protection on approximately ten billion dollars in subprime during that two-month time frame. It’s a huge, huge number.” Being able to buy so much credit protection during these two months allowed Goldman “to flip the risk,” Birnbaum said, and to become “significantly short” the market by the end of January 2007. “It’s hard for me to imagine any bank having that kind of market share—north of fifty percent—for a twenty-billion-dollar buying program,” he said. “It’s a short period of time.”

A natural question for Birnbaum and his colleagues at Goldman was how much impact did
John Paulson and his huge bet against the mortgage market—a trade Goldman was intimately familiar with by the end of 2006—have on Goldman’s decision to also short the mortgage market? According to Birnbaum, not much. “I think he influenced us more from the perspective of here’s a gorilla who’s trading in our market.” Birnbaum said he thought Paulson might have had more influence on his thinking had he had some involvement with mortgage securities before he had become a hedge-fund manager, rather than a mediocre M&A banker at
Bear Stearns. But, he conceded, the fact that Paulson was an outsider and had very little direct experience in mortgages turned out to be the key to his extraordinary success. “The beauty of what he did though—and that really no other real mortgage guys did with very few exceptions—was that he wasn’t colored by all sorts of preconceptions of the past in terms of analyzing the mortgage market,” Birnbaum said. “So he was able to just look at it with a totally clean slate and say, ‘This doesn’t add up.’ ”

O
ne of
Fabrice Tourre’s responsibilities at Goldman was to create and sell what were known as “
synthetic CDOs,” or collateralized debt obligations that contained no mortgages or other debt obligations at all but rather just the
risk
associated with them. This was kind of a mind-blowing concept. Tourre, a twenty-eight-year-old vice president in Birnbaum’s group in 2007, had been a straight-A student at the Lycée Henri-IV, one of France’s most prestigious schools, housed in a sixth-century abbey in Paris, and then studied math at the École Centrale Paris, one of the top French universities, before getting a master’s in management science and engineering from Stanford University. Tourre and Goldman would construct these securities, for a fee, at the request of those clients looking to assume the risk that the underlying debts would get paid and for other clients looking to bet that the underlying debts would not get paid. These were the very securities that Tourre referred to as “monstrosities” and that he hoped might “make capital markets more efficient” in one of his now-infamous e-mails.

The supposed genius of the synthetic CDO was that instead of having to accumulate mortgages in a warehouse until you had enough to build and then sell a CDO, Goldman could create the CDO virtually overnight using credit-default swaps, those insurance contracts offering a holder protection on whether a debt security would fail or not. It would be as if you could buy and sell the
idea
of selling cakes without actually having to buy the ingredients for the cakes, make them, and then sell them.

Warren Buffett might consider this one of the eureka moments in the creation of financial weapons of mass destruction, as he referred to derivatives and credit-default swaps. “
This was the trade, basically,” Sparks said. “CDOs were writing protection on CDS and doing synthetic CDOs. Most of the guys that bought the protection were
hedge funds
and then we, or others, might be in the middle of that trade. Now there was a period of time where hedge funds bought protection on individual RMBS deals from the Street, and then the Street bought protection from CDOs, and everybody knew what trade they were doing. The CDO buyers knew they were getting long credit risk and the hedge funds knew they were getting short credit risk and the Street was doing their job as a trader.… It seems crazy—based on what’s happened—but, for a period of time, it was very important to a lot of your clients to be able to give them risk and buy protection from them.”

To Birnbaum and Tourre, it was more like genius, providing Goldman with yet another product to sell. In a December 10 e-mail to
David Lehman, one of the co-heads of Birnbaum’s group, Tourre wrote that he believed “managed
synthetic CDOs,” where Goldman would find investors for a fee, was an “opportunity” for 2007, along with the idea of renting the firm’s synthetic CDO platform—known as Abacus—to “counterparties focused on putting on macro short [trades] in the sector.” There seemed to be nobody at Goldman, or at the other firms on Wall Street, questioning whether this was the kind of business the firm should be doing or wondering how far things had strayed beyond Goldman’s traditional role of raising capital for clients and of providing M&A advice. Some even saw an ironic benefit in the synthetic CDO, in that the risk that borrowers might fail to pay their mortgages could be taken without actually having to create any more risky mortgages. “It was a totally fundamental change in the nature of collateralizing a CDO deal,” Birnbaum said. “All you had to do was go out to Wall Street and say, ‘Where do you bid protection on the following names?’ And then based on that and writing those trades you now had synthetic collateral—like that!—to put into your CDO deal.… It just took a lot less time to amass a critical mass of collateral. When the collateral was securities, you can only buy the securities one by one and they tend to be small or notional.… If you’re putting a synthetic in or creating a synthetic out of thin air, you just have to have a counterparty who is really willing to facilitate that trade.”

It turned out that
John Paulson was one such useful counterparty willing and eager to facilitate such a trade, and in December 2006 Paulson asked Goldman to work with his firm in creating a $2 billion synthetic CDO—to be known as ABACUS 2007-AC1—where he would be willing to buy the protection on a bunch of mortgage securities (i.e., bet that they would fail) while other sophisticated investors would take the opposite position. This was just another one of the many bets Paulson was making that the mortgage market would collapse, although by that time very few, if any, of them had paid off for the hedge-fund manager.

Goldman put Tourre in charge of creating, marketing, and selling the deal. This in itself was bit odd in that a trader—rather than a banker—structured and sold a deal that had more of the look and feel of a private placement rather than a pure trade (Goldman in fact did put an end to that practice in early 2011). The Paulson team had identified more than one hundred BBB-rated residential mortgage-backed securities that it thought could run into trouble, and they wanted the ABACUS deal to reference—or provide insurance on—these troubled bonds. During the last few weeks of December, Tourre and his team concentrated on finding a “portfolio manager” to select the securities to be referenced, and this led to some internal debate about which firm would want to be involved with Paulson. For instance, on December 18, Tourre suggested a firm but then thought better of it. “They will never agree to the type of names [P]aulson want[s] to use,” Tourre wrote to his colleagues. “I don’t think [redacted] will be willing to put [redacted’s] name at risk for small economics on a weak quality portfolio whose bonds are distributed globally.” Geoffrey Williams, who was helping Tourre with the deal, responded, “The way I look at it, the easiest managers to work with should be used for our own axes”—being those securities Goldman itself or other people would like to sell quickly, hopefully at acceptable prices. “Managers that are a bit more difficult should be used for trades like Paulson given how axed”—or anxious to do a trade—“Paulson seems to be (i.e. I’m betting they can give on certain terms and overall portfolio increase).”

Through the back and forth with Paulson and Paulson’s deputy
Paolo Pellegrini, a former Lazard M&A banker turned hedge-fund analyst, in the creation of the Paulson ABACUS deal, the Paulson team also revealed its growing concern for the financial viability of Wall Street itself. This proved to be a bit of a revelation to the Goldman team. In an e-mail sent late on the afternoon of January 6, Tourre reported to Sparks, Swenson, and Lehman that there was “one issue” outstanding for Paulson about the potential transaction. “[I]t is related to the fact that Paulson is concerned about Goldman’s counterparty risk in this illiquid CDO transaction, even with the existing CSA”—a “
credit support agreement” that provides for collateral payments between counterparties—“that is binding Goldman and Paulson,” Tourre wrote. Incredibly, Paulson was so worried about taking the risk of having Goldman as a counterparty that he demanded a structure that would insulate him from Goldman’s own credit risk. “As an FYI,” Tourre wrote, “for single name CDS trades that Paulson is executing with dealers such as Goldman [and two unnamed others], they are buying large amounts of corporate CDS protection (on the broker dealer reference entities)”—or insurance in case say Bear
Stearns, Lehman Brothers, or Goldman were to default on their debt—“to hedge their counterparty credit risk!!!”

This was quite a revelation in that Paulson—in early 2007—was worrying that Wall Street firms might get into financial trouble and he wanted to be insulated from it. “I cannot believe it!!!” Swenson replied to this news. “Absolutely amazing.” An hour later, Tourre elaborated with more news, this time about the risks Paulson perceived about doing business with Bear Stearns, where Paulson once worked. “The meeting itself was surreal,” he continued. “Am hearing that Paulson bought $2bn of [redacted] CDS protection, sucking all the liquidity on that name in the corporate CDS market. Also, on the side, [redacted] mentioned to me that he had heard from many different sources that one reason the ABX market was trading down so much in December was related to [redacted] building a sizable short and buying large amounts of ABX protection from the market.” The mystery firm—on which firm Paulson had been buying insurance—would be revealed by Swenny two minutes later. “I wonder who gave [B]ear the liquidity,” he wondered. In other words, Swenson wanted to know who had sold the CDS to Paulson on the Bear Stearns debt.

There was no answer—at least on e-mail—from Tourre, but chances are good that Paulson made an additional bundle betting his old firm would collapse. At the end of December 2006, the cost of buying insurance against a default on Bear Stearns debt was 0.18 cents per dollar of protection. Since Paulson had bought $2 billion worth of protection, his cost would have been $3.6 million. During the week before
JPMorgan Chase bought Bear Stearns, on March 16, 2008, and saved its debt from defaulting, the cost of buying that insurance had skyrocketed to 7.5 cents per dollar of protection. Assuming Paulson sold his protection before JPMorgan bought Bear—and rendered that protection worthless since the risk of default had evaporated with the merger agreement—Paulson would have pocketed tens of millions. Within months, Goldman had mimicked Paulson’s bet that Bear Stearns would collapse.

——

T
OURRE HAD FOUND
a firm—
ACA Management, LLC—and a senior managing director there,
Laura Schwartz, to help to choose the securities that would serve as the reference bonds for ABACUS, to vet Paulson’s proposal, and to act as the portfolio selection agent for the deal. By this time ACA had already managed twenty-two CDOs representing some $15.7 billion of assets. The ABACUS deal was to be the twenty-third CDO sponsored by ACA and the fifth “
synthetic” using residential
mortgage-backed securities. ACA’s main business had been insuring municipal bonds, but after
Bear Stearns Merchant Banking invested $115 million in the company, in September 2004, for a 28 percent stake, ACA replaced its longtime management and began to get involved in the far more risky business of CDO asset management, including taking principal positions in CDO deals by insuring their risk. (In the end, this proved disastrous, and by April 2008, ACA would go out of business, although what’s left of ACA is pursuing litigation against Goldman for this ABACUS deal.)

On January 8, 2007, Tourre had a meeting at Paulson’s office with teams from both Paulson and ACA to construct the ABACUS deal. The next day, Goldman forwarded to ACA a list of the 123 2006-vintage mortgage securities Paulson wanted to bet against. That same day, ACA performed an “overlap analysis” and determined it had already purchased 62 of the 123 securities on Paulson’s list. Tourre informed ACA that he “was very excited by the initial portfolio feedback” because it looked like the deal could come together. Goldman was to make a $15 million fee for constructing ABACUS. On January 10, Tourre sent ACA an e-mail confirming ACA’s role in the deal that Paulson would “sponsor,” and where the “starting portfolio would be ideally” Paulson’s list “but there is flexibility around the names.” Four days later, Schwartz was concerned that she had somehow offended Tourre during a phone call and that ACA might lose the business. She wrote in an e-mail that she hoped she “didn’t come across too antagonistic” but that the “structure looks difficult from a debt investor perspective.” She wrote that she could understand “Paulson’s equity perspective but for us to put our name on something, we have to be sure it enhances our reputation.” One of Tourre’s Goldman colleagues replied, “Absolutely not—[F]abrice and the team hold you in the highest regard and would very much like to have you involved in this transaction, but only if you are comfortable with it.” On January 18, Tourre confirmed to his colleagues that “ACA is going to be ok acting as portfolio selection agent for Paulson, in exchange for a portfolio advisory fee of at least $1mm per year.”