By Kwanwoo Jun
LOWER MANHATTAN, New York -- Five years ago when Christmas was near at hand, a conference room on the 30th floor of Goldman Sachs’ shiny 43-story global headquarters in Lower Manhattan was full of mortgage-market traders, experts and executives. No holiday mood was in the air. The housing loan market was teetering on the brink of collapse.
After hours of an in-depth market review during the meeting on Dec. 14, 2006, Goldman executives concluded the market would be in a meltdown. They decided to cash in on the crisis – an adept judgment that beat other Wall Street rivals.
Next day, Chief Financial Officer David Viniar said in an e-mail, “There will be very good opportunities as the markets [go] into what is likely to be even greater distress and we want to be in a position to take advantage of them.” Goldman traders acted accordingly, and the bank outperformed its rivals in the crisis. It was a big success.
Five years later, the e-mail was cited verbatim in a Senate report – in a totally negative context. The 639-page report, titled “Wall Street and the Financial Crisis,” portrayed Goldman as a greedy investment bank that misled and defrauded its clients for its own interests in the run up to the financial crisis.
Some of Goldman’s former clients have sued the bank for fraud over their massive investment losses. The federal regulator, the Securities and Exchange Commission, last year slapped Goldman with a $550-million penalty – the heaviest fine paid by a single company on Wall Street in history – in a pre-trial settlement.
Ronald Filler, professor and director of the Center on Financial Services Law at
New York Law School, however, said the SEC-Goldman settlement did not draw a clear-cut line. “Goldman Sachs did not admit nor did it deny the allegations brought by the SEC,” Filler said.
Goldman has admitted to making “a mistake” in its marketing materials for clients, but it has denied fraud charges against it. Lawsuits filed against Goldman over its alleged fraudulent business practice are in a dormant state as they drag on.
The bank denies that it knew the mortgage market would collapse. “No one can ‘know’ the future direction of the market or economy,” Goldman said in its reply brief on June 15 this year in a civil case against South Korea’s Heungkuk Life Insurance Co., one of Goldman’s loss-making clients who have sued the bank for fraud.
But a closer look at various documents -- including previously confidential prospectuses, private e-mails exchanged among Goldman employees, the Senate report and legal complaints -- shows that the bank certainly duped its clients.
After the meeting on Dec. 14, 2006, Goldman traders rushed to shed mortgage-related assets from its portfolio and moved to bet billions of dollars against the housing loan market, according to the Senate report.
Unlike many other Wall Street banks, Goldman offers no retail banking services. Its customers are corporations, financial firms, funds and some very wealthy individuals. The 142-year-old bank manages $870 billion in total assets.
Founded in 1869, New York-based Goldman had provided investment advice to corporate clients, handled mergers and acquisitions for them and organized financing for customers through stock and bond offerings. Since1999 when federal regulations on investment banks became relaxed, Goldman has increasingly acted as a Wall Street trading house, structuring and financing financial products and deals for corporate clients and hedge funds, and engaging in proprietary trading activities for its own benefits.
At the center of the 2007-2008 housing market turmoil was a Goldman-designed complex financial product, known as the collateralized debt obligation (CDO) based on subprime mortgages. Goldman also helped create an index for investors to easily bet for or against the market for mortgage-related securities.
Goldman played a multiple role as “a market maker, underwriter, placement agent and broker-dealer” of complex financial products, the Senate report said.
At the Senate hearing last year, Goldman was under fire over allegations that the bank had designed and peddled the CDO deals while betting against them or shorting in the market. Goldman used the technique of credit default swaps (CDS), an insurance policy where the issuer makes up for a loss if an asset goes bad.
The Goldman-structured CDO deals quickly turned useless in value and wiped out investors’ money when the market collapsed, but Goldman could stay safe from the fallout of the meltdown and even profitable thanks to the CDS.
Goldman had designed mortgage-related financial products, including 27 CDO deals, with a total value of about $100 billion, the Senate report said. In the run up to the crisis that started in mid-2007, Goldman was marketing two major CDO deals, called Abacus and Timberwolf respectively.
Former Goldman clients, who had invested in Abacus and Timberwolf on the recommendation of Goldman traders, helplessly watched their money quickly evaporate. Goldman, however, raked in billions of dollars during the market collapse.
In 2007, Goldman posted a record net earning of $11.6 billion, $3.7 billion of which came from its short positions – a bet on a downturn of financial products in value -- in the mortgage market, according to the bank’s filing to SEC.
Lloyd Blankfein, chairman and chief executive of Goldman Sachs Group Inc., took a $68.5-million bonus home in 2007, and Viniar, chief financial officer of Goldman Sachs Group, received a $57.5-million bonus in 2007, according to Goldman’s proxy statement issued on March 7, 2008.
Goldman’s large-bonus payment to its executives was a stark contrast to other Wall Street banks’ treatment of their top managers in 2007. E. Stanley O’Neal, chairman and chief executive of Merrill Lynch, and Charles Prince, chief executive of Citigroup – had to resign respectively over massive losses of their companies.
Goldman attributed its outstanding 2007 performance to its employees’ hard work. “The talent of our people and our focus on teamwork were at the core of our ability to support our clients while delivering strong returns for our shareholders," Blankfein said, announcing a 13-page annual earnings report on Dec. 18, 2007.
But the top Goldman executive later downplayed Goldman traders’ financial prowess when the Senate’s subcommittee, led by Senator Carl Levin, began looking into the bank’s controversial business practice as a possible cause of the financial crisis.
Goldman has been busy denying what it clearly did.
“We didn’t have a massive short against the housing market and we certainly did not bet against our clients,” Blankfein said at a Senate hearing on April 27, 2010.
Chief Financial Officer Viniar also testified that Goldman’s profitable short positions just offset its loss-making long positions in 2007. At the Senate hearing, he highlighted the fact that Goldman’s long positions in the mortgage market resulted in a combined loss of $1.2 billion for two years until 2008. But he omitted the fact that Goldman’s short positions in the mortgage market created a profit of $3.7 billion in 2007 only.
The Senate report, released on April 13 this year, said, “Goldman’s denials of its net short positions in the subprime mortgage market, and the large profits produced by those net short positions, are directly contradicted by its own financial records.”
Senators Carl Levin and Tom Coburn, who organized the hearing, were so outraged by Goldman’s denials that they asked the Justice Department and the SEC to investigate Blankfein and other Goldman executives for possible perjury charges.
Goldman has also faced a slew of lawsuits by its clients who complain that the bank misled them into loss-making investments. ACA Financial Guaranty Corporation, a US bond insurer, is one of them. On January 6 this year, ACA sued Goldman for $120 million -- $30 million in compensatory damages and $90 million in punitive damages.
The ACA complaint was similar to the complaint that the SEC filed against Goldman on April 16 last year. The SEC alleged that Goldman defrauded investors by omitting a key fact that billionaire hedge-fund manager John Paulson helped design the Abacus deal in the way that investors would profit if the market collapses.
The federal regulation, called “SEC Rule 10b-5,” stipulates that it is strictly banned “to make any untrue statement of a material fact or to omit to state a material fact” in connection with the purchase or sale of any securities on Wall Street.
In the 24-page complaint filed in New York State Supreme Court, ACA said Goldman failed to tell them important information about how the Abacus deal had been designed: Hedge-fund Paulson & Co. picked many of the mortgage-backed securities that would go into the Abacus deal, and Paulson would take a short position – exactly the opposite way ACA would invest.
Goldman spokesman Michael DuVally declined to comment on the Goldman-Paulson relationship. Paulson was not available for comment on it.
In the Abacus deal, Paulson actually bet $1 billion on the collapse of the mortgage-linked security market. HedgeTracker.com, an online resource that closely follows major hedge funds, says Paulson raked in over $3billion in profit from the bet. Forbes says Paulson’s profits from shorting in the market reached $3.5 billion.
“Goldman Sachs knew and intentionally failed to disclose to ACA that Paulson had a short position in Abacus with the intent that ACA rely and act upon a false belief that Paulson was the equity investor in Abacus,” ACA said in the complaint.
The Senate report, after interviewing Goldman executives and traders, says Paulson initially proposed 49 out of the total 90 residential mortgage-backed securities underlying the Abacus deal, but it still remains unclear how Paulson came to make the portfolio selection of those lousy securities.
Born in Queens, New York City, Paulson, 55, studied finance at New York University and earned his master of business administration from Harvard University. He worked at the merger and acquisition department at Bear Sterns before launching his own hedge fund Paulson & Co. in 1994.
William Cohan, who wrote “Money and Power” about Goldman, told The Guardian on April 29 this year that Paulson had initiated the idea of massively betting against the housing market. Cohan also said in an article to The Irish Times on May 27 this year that Paulson had been one of Goldman’s hedge fund clients until in the summer of 2006, when a star Goldman trader, Josh Birnbaum, met Paulson and convinced Goldman executives of the imminent collapse of the mortgage market.
The SEC, however, has not brought any charges against Paulson. “It was Goldman that made the representations to investors,” SEC enforcement director Robert Khuzami said after the SEC complaint against Goldman last year. “Paulson did not.”
Paulson & Co. also issued a statement and said, “Paulson is not the subject of this complaint, made no misrepresentations and is not the subject of any charges.”
One of Goldman’s controversial business practices was aggressively selling clients lousy financial products in spite of its allegedly full awareness of their doomed fate.
E-mails exchanged between Goldman traders showed that the investment bank with 14,000 employees -- including economic analysts trained to detect the market risk around the clock -- in the United States knew well about the forthcoming market collapse and prepared well for it. The bank has 32,500 employees worldwide.
An e-mail sent by Daniel Sparks, then head of the Mortgage Department, to Goldman executives hours after the crucial December 14 meeting in 2006, details actions to take in line with the bank’s forecast of a market meltdown. The electronic message is one of hundreds of e-mails disclosed by the Senate report.
Sparks said, “Followups: 1. Reduce exposure … 7. Be ready for the good opportunities that are coming (keep powder dry and look around the market hard).”
Another e-mail, whose photocopy carried a note “Confidential Treatment Requested by Goldman Sachs” at the top, showed that Fabrice Tourre, then executive director of the structured products group trading at Goldman, knew about the imminent collapse of the mortgage market. The BlackBerry e-mail has not been included in the Senate report, but the e-mail can be found easily with a Google search.
In the e-mail to his “Darling” Marine Serres on Jan. 23, 2007, Tourre, a Frenchman who graduated from Stanford University in 2001 before joining Goldman, said, “More and more leverage in the system, L’edifice entire entire risqué de s’effondrer a tout moment… Seul survivant potential, the fabulous Fab,” The French part was officially translated as: “The entire system is about to crumble at any moment… The only potential survivor, the fabulous Fab.” Fab is Tourre’s nickname.
The SEC has filed a separate complaint against Tourre, a vice president at Goldman, for not telling investors about Paulson &Co, which had picked and bet against subprime mortgage-backed securities underlying the Abacus deal.
Goldman first reacted angrily to the SEC complaint against the bank for fraud. But Goldman’s reaction was gradually being toned down after reaching the $550-million pre-trial settlement with the SEC.
“The SEC’s charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation,” Goldman said in its first statement in response to the SEC complaint on April 16, 2010.
Agreeing on July 15, 2010, to pay the record penalty of $550 million in a settlement with the SEC, Goldman issued a watered-down statement. “The firm entered into the settlement without admitting or denying the SEC’s allegations,” the bank said in the statement. It also admitted to having made “a mistake” not to state Paulson’s role in the Abacus portfolio in its marketing materials. “Goldman regrets that the marketing materials did not contain disclosure,” it added.
Professor Filler of New York Law School said firms would settle regulatory actions for a variety of reasons. “You do not have to spend lots of legal and other fees to contest the charges,” Filler said. “You also know the amount of the fine.”
Goldman denies having defrauded its clients in the run up to the crisis, but evidences of Goldman traders duping its clients were found extensively in the Senate report.
Edwin Chin, a trader of Goldman’s mortgage department, spread out an upbeat commentary to his customers in the run-up to the crisis, according to the Senate report. Chin, on May 14, 2007, said, “Incredible as it may seem, the subprime mortgage slump is already [a] distant memory for some. It’s been two months…amid worries about a housing meltdown, and already investors (and some dealers) are beginning to get ‘complacent’ again.”
Goldman, however, was then frantically acting to bet on the market collapse. For the first two months until February 2007, Goldman had swung from a $6 billion net long position to a $10 billion net short position in the mortgage market. In June 2007, Goldman’s net short position peaked at $13.9 billion. Goldman constantly had to raise its internal limit on the usually risky short positions, according to Goldman’s internal memos and data submitted to the Senate hearing.
In a latest lawsuit against Goldman, Basis Yield Alpha Fund, a Sydney-based Australian hedge fund, in October this year sued the bank for $1.07 billion -- $67 million to recoup its losses and $1 billion in punitive damages.
The complaint, filed on Oct. 27, 2011, in New York State Supreme Court, focused on Goldman’s CDO deal, called Timberwolf. The Austrian hedge fund accused Goldman of “knowingly making materially false and misleading statements” in the sales.
Thomas Montag, a former co-head of Goldman’s global securities for the Americas before and during the crisis, described Timberwolf “one shitty deal” in an email to his colleague, according to the Senate report.
South Korea’s Heungkuk Life Insurance Co. and its sister firm also sued Goldman and three affiliates for fraud over Timberwolf. Heungkuk said in a 53-page complaint filed in New York State Supreme Court on April 13, 2011, that Goldman misled it to buy $47.32 million of subprime mortgage-backed securities in 2007. The Goldman-designed financial product quickly soured amid crumbling housing markets. Heungkuk sad Goldman had earned $3.7 billion in profit from taking its short positions in subprime mortgages -- a bet against Heungkuk’s investment. The South Korean insurer wants to recoup its total investment loss in Timberwolf.
Denying any fraudulence in trade, Goldman wants to settle the case with Heungkuk outside the courtroom, a Heungkuk attorney said.
“The case is still pending before the New York Supreme Court,” Andrew Corkhill, one of Heungkuk’s attorneys at Quinn Emanuel Urquhart & Sullivan LLP. “Goldman filed a motion to compel arbitration and to dismiss the complaint.” He would not elaborate further and stopped responding to follow-up e-mails.
Goldman’s attorneys at Sullivan & Cromwell LLP. and Boies, Schiller & Flexner LLP. did not respond to multiple e-mail requests for comment.
“Goldman defrauded Heungkuk by misrepresenting Timberwolf as a highly rated, secure and profitable long-term investment in which Heungkuk’s interests would be aligned with Goldman’s,” Heungkuk said in the court document. “The truth, however, was that Goldman had utilized its specialized knowledge of the subprime mortgage market to make a massive, concealed bet against the very CDO that it sold to Heungkuk.”
Goldman denied Heungkuk’s claims. “Defendants owed no duty to disclose their motives and opinions, which were immaterial as a matter of law,” Goldman said in its reply brief. “As an initial matter, failure to disclose a prediction of future economic events—such as the unprecedented collapse of U.S. housing markets—does not misrepresent any existing fact, the essential ingredient of fraud.”
Senator Levin has dismissed Goldman’s argument. “In my judgment, Goldman clearly misled their clients and they misled the Congress,” Levin said on April 13, 2011. “Our investigation found a financial snake pit rife with greed, conflicts of interest, and wrongdoing.”
Meanwhile, Goldman Chairman Blankfein has hired Reid Weingarten, one of America’s top criminal defense lawyers, ahead of a Department of Justice investigation of claims that his bank defrauded clients in the run-up to the financial crisis.
The Seoul-based Korea Herald newspaper said in July this year that Heungkuk filed a separate criminal complaint against nine former and incumbent Goldman employees with South Korea’s state prosecutors on June 28, 2011.
This year, Goldman has published a new code of business practices. “Our clients’ interests always come first,” the revised 67-page code said in the very first line.
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