Money and Power (93 page)

On February 8, Sparks provided his bosses with another update and this time also posted
Gary Cohn and
Jon Winkelried, the Goldman co-presidents. Essentially, there was more bad news. “
Subprime environment—bad and getting worse,” he wrote. “Every day is a major fight for some aspect of the business (think whack-a-mole). Trading position has basically squared”—news that the long risk had been finally mitigated—“plan to play from short side. Loan business is long by nature and goal is to mitigate. Credit issues are worsening on deals and pain is broad (including investors in certain GS-issued deals)”—oops! “Distressed opportunities will be real, but we aren’t close to that time yet.” He also addressed a question from Winkelried about whether Goldman was establishing the new trading prices or “chasing them down,” meaning following the leads of other traders. “We have been chasing them down based on loan performance data as it comes out,” he continued. At the end of the same day, Cohn asked Sparks for an update. After reviewing the situation throughout the day with the traders and the controllers, Sparks wrote to Cohn—soon after 11:00 p.m.—that the two constituents agreed Goldman’s loss on the securities should be reflected at $28.4 million, higher than the original thought that it would be a $22 million loss.

Just before midnight, Tourre e-mailed Serres in London. He sent to her an internal analysis by a vice president in mortgage credit trading about the increasingly gloomy outlook for subprime mortgage-backed
securities. “There has been an increase in early delinquencies and defaults in the Subprime market, most notably those deals backed by … collateral originated in mid-to-late 2005 and 2006,” it read. “We have seen this trend in our 2006 Subprime … deals,” including GSAMP S2. The analysis went on in that depressing vain for several more pages. “You should take a look at this,” Tourre wrote to his girlfriend.

The next day, the push to sell Goldman’s long positions in mortgage securities continued. A list of around thirty of the long positions Goldman owned and wanted to sell fast was circulated. “Below are our updated RMBS axes,” the memo stated, using the argot of traders looking to unload positions. “The focus continues to be on moving credit positions. Again, these are priority positions that should be a focus for everyone before quarter-end.… Let all of the respective desks know how we can be helpful in moving these bonds.” At the end of the day, Walter Scott informed the mortgage group that “this week, a total of [$]169+mm in axe positions were sold” but that “obviously we need to continue to push credit positions across subprime and second liens. We are working with both the desks and the strats to do so.” Kevin Gasvoda replied, “Great job syndicate and sales, appreciate the focus.”

A few hours later, just before midnight, Gasvoda sent Montag a detailed accounting of the financial risks in Goldman’s mortgage portfolio. He explained that the firm had taken around $70 million of write-downs on the overall mortgage portfolio in the first five weeks of 2007, with another $70 million more likely to come. He said the losses had all been in those securities in HPA—home price appreciation—sensitive sectors. “They’ve crumbled under HPA slowdown as these are the most levered borrowers.” Gasvoda told Montag that to “mitigate” these losses, Goldman had stopped buying subprime second liens in the summer of 2006 and instead focused on prime mortgages and what were known as Alt-A mortgages, those between subprime and prime. Goldman had also focused on selling new mortgage-backed securities “at any clearing levels,” or whatever price the market would bear, to get rid of them and had given traders, such as Birnbaum, the authority to sell any remaining “retained bonds.”

Three days later, on Sunday, Montag passed Gasvoda’s analysis on to Winkelried and Blankfein. “Very good writeup of our positions in each sector[,] hedges we have on and potential for further write-down over next six months,” he wrote. Fourteen minutes later, Blankfein responded, wanting to know the “short summary of our risk” and what “further writedowns” would be. Montag replied with a summary of Gasvoda’s analysis, although it was not that easy to follow. “If things got
no worse,” he concluded, “the desk—perhaps in wishful mode—feels they have gains we haven’t shown. [T]hey did make [$]21[mm] on Friday outside of write down.” Blankfein replied in short order, “Tom, you refer to losses stemming from residual positions in old deals. Could/should we have cleaned up these books before, and are we doing enough right now to sell off cats and dogs in other books throughout the division[?]” This question got Montag thinking. “Should we have done before?” he replied, rhetorically. “Most likely.” He then explained the steps the firm had taken but added that he thought the cleanup had been ongoing “for years” and took credit himself for moving “residuals out of origination and into traders” for them to sell.

But there were plenty of crosscurrents buffeting the mortgage market in February 2007 and plenty of people who disagreed with Goldman’s decision to get short the mortgage market. For instance, the next day—February 12—Gyan Sinha, a senior managing director at
Bear Stearns in charge of the firm’s market research regarding asset-backed securities and collateralized debt obligations, held a conference call for some nine hundred investors where he spelled out his beliefs about the market’s reaction to the news that New Century, the mortgage lender, was having financial trouble. To that point, Sinha had been very well respected and had even testified in front of Congress about the subprime mortgage market. “It’s time to buy the [ABX] index,” he said, adding that based on his modeling, “the market has overreacted” and predictions of rising problems in the mortgage market should be taken “with a large grain of salt.” Many investors shared Sinha’s view.

Two days later, on Valentine’s Day, New Century announced that a wave of shareholder lawsuits had been filed against it and that after two weeks of tough negotiations, Goldman Sachs had agreed to a three-month extension of a line of credit to the company that had been set to expire the next day. Goldman had extracted its pound of flesh by insisting on the ability to get out of the agreement “at the first hint of trouble.” At 6:33 that morning, Sparks, who had long been worried about this kind of problem, wrote himself an e-mail, titled “Risk,” to help keep track of the increasingly volatile events. “Bad week in subprime,” he wrote. He noted that “originators”—such as New Century—“are really in a bad spot. Thinly capitalized, highly levered, dealing with significant loan put-backs … now having trouble selling loans above par when it cost them 2 points to produce. Will have to … really tighten credit standards which will cut volume significantly.” He wondered what the next area of “contagion” might be and answered himself that it would be CDOs, “which have been the buyer of most single name mezz[anine] subprime risk for
the past year.” He noted that Goldman was doing four things to reduce its risk: finding warehouse “risk partners,” giving the secondary trading desk at Goldman—essentially Birnbaum and company—the ultimate authority “so all risk housed and managed by traders,” buying protection on CDOs, and “executing deals.”

None of this was communicated to Goldman’s clients, of course.

Later that morning, Sparks summarized Goldman’s “risk reduction program” for his bosses, including Montag, Viniar, Ruzika, and
Gary Cohn. He copied Winkelried on the memo. The strategy consisted, he wrote, of selling the ABX index, of buying CDS on individual tranches of mortgage-backed securities, buying CDS—some $3 billion worth—on the “super-senior portions of BBB/BBB- index” and which seemed to be significantly in the money. “This is good for us position-wise,” he wrote, “[but] bad for accounts who wrote that protection [to us] (M[organ] S[tanley] Prop[rietary trading desk],
Peleton [a hedge fund], ACA, Harvard) but could hurt our CDO pipeline position as CDOs will be harder to do.” Cohn sent Montag’s e-mail on to Blankfein, without comment.

——

O
N
F
EBRUARY
17, the
Wall Street Journal
interviewed
Lew Ranieri and reported that the “rumpled 60-year-old says he is worried about the proliferation of risky mortgages and convoluted ways of financing them. Too many investors don’t understand the dangers.… The problem, he says, is that in the past few years the business has changed so much that if the U.S. housing market takes another lurch downward, no one will know where all the bodies are buried. ‘I don’t know how to understand the ripple effects throughout the system today,’ he said during a recent seminar.” The growing problem was that 40 percent of the subprime borrowers in 2006 were not required to produce pay stubs or other proof of their net worth, according to
Credit Suisse Group, and lenders were relying more and more on computer models to estimate the value of homes. “We’re not really sure what the guy’s income is and … we’re not sure what the home is worth,” Ranieri said. “So you can understand why some of us become a little nervous.” He worried further that with so many mortgages being packaged by Wall Street into CDOs and sold in slices to investors all over the world, U.S. home mortgage risks were being spread to a “much less sophisticated community.” The
Journal
made it clear that “Mr. Ranieri isn’t predicting Armageddon. Some of the riskier new types of mortgages probably will perform ‘horribly’ in terms of defaults, leading to losses for some investors. But, he says, the ‘vast majority’ of mortgages outstanding are based on sounder lending principles and should be fine.”

Most Wall Street investors and executives were not sure just what
to do. Were the cracks in the mortgage market, as reflected in the decline of the ABX, a buying opportunity, as Bear’s Sinha suggested? Or were the cracks the first small fissures in what soon would be a spectacular collapse of the market for mortgages and mortgage-backed securities? Major proponents of the glass-is-half-full thinking were the two Bear Stearns hedge-fund managers,
Ralph Cioffi and
Matthew Tannin. Apparently unbeknownst to many of their investors who thought Cioffi and Tannin had invested in less risky securities, the two Bear Stearns hedge funds—which together had around $1.5 billion of investor money riding—were heavily invested in mortgage-backed securities, including the
synthetic CDOs Goldman had been selling. Like their Bear colleague Sinha, Cioffi and Tannin were generally of the view that the dip in the ABX index was a buying opportunity.

On February 21, Tannin sent an e-mail to his colleagues at Bear in which he sounded quite happy about all the doom and gloom over subprime mortgages in the marketplace. He cited such a negative report from a rival hedge-fund manager and said, “This piece is mostly unhelpful and more than a bit misleading. Scare mongering. I used to fly into a rage when I would read this stuff but now it makes me happy. We need some caution and naysayers in our market—it keeps spreads wider. So I’m glad this has been printed.” A week later, Cioffi wrote to the team that he was thinking of “very selectively buying at these levels” since that “in and of itself would stabilize the markets.” Tannin responded that he thought it would be a good idea. “Fear + illiquidity + a CDO ready and waiting ⁼ a good trade.” That same day,
Ben Bernanke, the chairman of the
Federal Reserve, testified on Capitol Hill that he did not believe a “housing downturn” was a “broad financial concern or a major factor in assessing the state of the economy.”

Meanwhile, at Goldman, Sparks reported to his bosses that Goldman’s negative bets were continuing to pay off. He wrote to them, in an e-mail, that the firm was up $69 million on the day because the “market sold off significantly.” He also shared with them that Goldman had covered its short positions—at a profit—on more than $400 million of bets on single tranches of mortgage securities. “Still significant work to do,” he wrote. Within a minute, Winkelried wrote to Sparks from his BlackBerry, “Another downdraft?” To which Sparks responded, “Very large—it’s getting messy.” Winkelried then asked for some details, if possible, because “I’ve been on the road in euirope [
sic
] all week with clients so out of touch with it.” Later that night, Sparks responded to Winkelried that there was “[b]ad news everywhere” including that
NovaStar, a subprime mortgage originator, announced bad earnings and lost one-third of its
market value in one day and that
Wells Fargo had fired more than three hundred people from its subprime mortgage origination business. But, he was happy to report, Goldman was “net short, but mostly in single name CDS and some tranched index vs the s[a]me index longs. We are working to cover more, but liquidity makes it tough. Volatility is causing our VAR [value at risk] numbers to grow dramatically,” which soon enough would make Goldman’s top brass concerned about the level of the firm’s capital being committed to these trades.

Not surprisingly, in the midst of all of this intellectual and financial jousting in the market, Goldman’s senior executives occasionally wavered from the clear message that Viniar delivered in December 2006. At one point before the magnitude of the problem became crystalline, Viniar thought that Goldman had become too bearish and insisted that the firm’s traders reverse course somewhat. One of those moments was in and around February 21, when the directive came from Viniar to close out some of Birnbaum’s shorts. Sparks’s e-mail that day was meant to be an update on the process following Viniar’s new orders. This was plenty controversial on Birnbaum’s desk, since he thought he was just beginning to mint money. To close out the positions meant leaving potentially billions in profits on the table, or worse, putting them in the hands of hedge funds, like
Philip Falcone’s
Harbinger Capital Partners, that could cash in on Birnbaum’s ideas. But Viniar insisted that the group was taking too much risk.
Jonathan Egol, a trader on the structured products desk, identified four trades that the desk could do if “we want to close down shorts.” On February 22, Sparks took Egol’s list to Birnbaum, Swenny, and
David Lehman, another trader, and wrote a cover message to them, urging that some of their short trades be unwound. “We need to buy back $1 billion single names and $2 billion of the stuff below—today,” he wrote. “I know that sounds huge, but you can do it—spend bid/offer, pay through the market, whatever to get it done.” Then he tried to buck up the traders, who he knew would be disappointed with this directive from on high. “It is a great time to do it,” he continued. “Bad news on HPA”—home price appreciation—“[mortgage] originators pulling out, recent upticks in unemployment, originator pain.… This is a time to just do it, show respect for risk, and show the ability to listen and execute firm directives. You called the trade right, now monetize a lot of it. You guys are doing very well.”