Bad Debt, Bet Against It and Won
In late October
2007, as the financial markets were starting to come unglued, a Goldman Sachs
trader, Jonathan M. Egol, received very good news. At 37, he was named a managing
director at the firm.
Mr. Egol, a
Princeton graduate, had risen to prominence inside the bank by creating mortgage-related
securities, named Abacus, that were at first intended to protect Goldman from
investment losses if the housing market collapsed. As the market soured, Goldman
created even more of these securities, enabling it to pocket huge profits.
own clients who bought them, however, were less fortunate.
and insurance companies lost billions of dollars on securities that they believed
were solid investments, according to former Goldman employees with direct
knowledge of the deals who asked not to be identified because they have confidentiality
agreements with the firm.
not the only firm that peddled these complex securities known as synthetic
collateralized debt obligations, or C.D.O.s and then made financial
bets against them, called selling short in Wall Street parlance. Others that
created similar securities and then bet they would fail, according to Wall
Street traders, include Deutsche Bank and Morgan Stanley, as well as smaller
firms like Tricadia Inc., an investment company whose parent firm was overseen
by Lewis A. Sachs, who this year became a special counselor to Treasury Secretary
Timothy F. Geithner.
How these disastrously
performing securities were devised is now the subject of scrutiny by investigators
in Congress, at the Securities and Exchange Commission and at the Financial
Industry Regulatory Authority, Wall Streets self-regulatory organization,
according to people briefed on the investigations. Those involved with the
inquiries declined to comment.
While the investigations
are in the early phases, authorities appear to be looking at whether securities
laws or rules of fair dealing were violated by firms that created and sold
these mortgage-linked debt instruments and then bet against the clients who
purchased them, people briefed on the matter say.
One focus of
the inquiry is whether the firms creating the securities purposely helped
to select especially risky mortgage-linked assets that would be most likely
to crater, setting their clients up to lose billions of dollars if the housing
packaged by Goldman and Tricadia ended up being so vulnerable that they soured
within months of being created.
other Wall Street firms maintain there is nothing improper about synthetic
C.D.O.s, saying that they typically employ many trading techniques to
hedge investments and protect against losses. They add that many prudent investors
often do the same. Goldman used these securities initially to offset any potential
losses stemming from its positive bets on mortgage securities.
and other firms eventually used the C.D.O.s to place unusually large
negative bets that were not mainly for hedging purposes, and investors and
industry experts say that put the firms at odds with their own clients
selling of securities to customers and shorting them because they believed
they were going to default is the most cynical use of credit information that
I have ever seen, said Sylvain R. Raynes, an expert in structured finance
at R & R Consulting in New York. When you buy protection against
an event that you have a hand in causing, you are buying fire insurance on
someone elses house and then committing arson.
were not alone in reaping rich rewards by placing trades against synthetic
C.D.O.s. Some hedge funds also benefited, including Paulson & Company,
according to former Goldman workers and people at other banks familiar with
that firms trading.
a Goldman Sachs spokesman, declined to make Mr. Egol available for comment.
But Mr. DuVally said many of the C.D.O.s created by Wall Street were
made to satisfy client demand for such products, which the clients thought
would produce profits because they had an optimistic view of the housing market.
In addition, he said that clients knew Goldman might be betting against mortgages
linked to the securities, and that the buyers of synthetic mortgage C.D.O.s
were large, sophisticated investors, he said.
and sale of synthetic C.D.O.s helped make the financial crisis worse
than it might otherwise have been, effectively multiplying losses by providing
more securities to bet against. Some $8 billion in these securities remain
on the books at American International Group, the giant insurer rescued by
the government in September 2008.
From 2005 through
2007, at least $108 billion in these securities was issued, according to Dealogic,
a financial data firm. And the actual volume was much higher because synthetic
C.D.O.s and other customized trades are unregulated and often not reported
to any financial exchange or market.
Before the financial
crisis, many investors large American and European banks, pension funds,
insurance companies and even some hedge funds failed to recognize that
overextended borrowers would default on their mortgages, and they kept increasing
their investments in mortgage-related securities. As the mortgage market collapsed,
they suffered steep losses.
A handful of
investors and Wall Street traders, however, anticipated the crisis. In 2006,
Wall Street had introduced a new index, called the ABX, that became a way
to invest in the direction of mortgage securities. The index allowed traders
to bet on or against pools of mortgages with different risk characteristics,
just as stock indexes enable traders to bet on whether the overall stock market,
or technology stocks or bank stocks, will go up or down.
others on Wall Street, has said since the collapse that it made big money
by using the ABX to bet against the housing market. Worried about a housing
bubble, top Goldman executives decided in December 2006 to change the firms
overall stance on the mortgage market, from positive to negative, though it
did not disclose that publicly.
then, however, pockets of the investment bank had also started using C.D.O.s
to place bets against mortgage securities, in some cases to hedge the firms
mortgage investments, as protection against a fall in housing prices and an
increase in defaults.
Mr. Egol was
a prime mover behind these securities. Beginning in 2004, with housing prices
soaring and the mortgage mania in full swing, Mr. Egol began creating the
deals known as Abacus. From 2004 to 2008, Goldman issued 25 Abacus deals,
according to Bloomberg, with a total value of $10.9 billion.
investors to bet for or against the mortgage securities that were linked to
the deal. The C.D.O.s didnt contain actual mortgages. Instead,
they consisted of credit-default swaps, a type of insurance that pays out
when a borrower defaults. These swaps made it much easier to place large bets
on mortgage failures.
persuading his customers to make negative bets on Abacus, Mr. Egol kept most
of these wagers for his firm, said five former Goldman employees who spoke
on the condition of anonymity. On occasion, he allowed some hedge funds to
take some of the short trades.
Mr. Egol and
Fabrice Tourre, a French trader at Goldman, were aggressive from the start
in trying to make the assets in Abacus deals look better than they were, according
to notes taken by a Wall Street investor during a phone call with Mr. Tourre
and another Goldman employee in May 2005.
On the call,
the two traders noted that they were trying to persuade analysts at Moodys
Investors Service, a credit rating agency, to assign a higher rating to one
part of an Abacus C.D.O. but were having trouble, according to the investors
notes, which were provided by a colleague who asked for anonymity because
he was not authorized to release them. Goldman declined to discuss the selection
of the assets in the C.D.O.s, but a spokesman said investors could have
rejected the C.D.O. if they did not like the assets.
bets against the performances of the Abacus C.D.O.s were not worth much
in 2005 and 2006, but they soared in value in 2007 and 2008 when the mortgage
market collapsed. The trades gave Mr. Egol a higher profile at the bank, and
he was among a group promoted to managing director on Oct. 24, 2007.
Fabrice were way ahead of their time, said one of the former Goldman
workers. They saw the writing on the wall in this market as early as
2005. By creating the Abacus C.D.O.s, they helped protect Goldman
against losses that others would suffer.
As early as
the summer of 2006, Goldmans sales desk began marketing short bets using
the ABX index to hedge funds like Paulson & Company, Magnetar and Soros
Fund Management, which invests for the billionaire George Soros. John Paulson,
the founder of Paulson & Company, also would later take some of the shorts
from the Abacus deals, helping him profit when mortgage bonds collapsed. He
declined to comment.
A Deal Gone
Bad, for Some
The woeful performance
of some C.D.O.s issued by Goldman made them ideal for betting against.
As of September 2007, for example, just five months after Goldman had sold
a new Abacus C.D.O., the ratings on 84 percent of the mortgages underlying
it had been downgraded, indicating growing concerns about borrowers
ability to repay the loans, according to research from UBS, the big Swiss
bank. Of more than 500 C.D.O.s analyzed by UBS, only two were worse
than the Abacus deal.
other mortgage-linked C.D.O.s that performed poorly, too. One, in October
2006, was a $800 million C.D.O. known as Hudson Mezzanine. It included credit
insurance on mortgage and subprime mortgage bonds that were in the ABX index;
Hudson buyers would make money if the housing market stayed healthy
but lose money if it collapsed. Goldman kept a significant amount of the financial
bets against securities in Hudson, so it would profit if they failed, according
to three of the former Goldman employees.
A Goldman salesman
involved in Hudson said the deal was one of the earliest in which outside
investors raised questions about Goldmans incentives. Here we
are selling this, but we think the market is going the other way, he
A hedge fund
investor in Hudson, who spoke on the condition of anonymity, said that because
Goldman was betting against the deal, he wondered whether the bank built Hudson
with bonds they really think are going to get into trouble.
investors suffered large losses. In March 2008, just 18 months after Goldman
created that C.D.O., so many borrowers had defaulted that holders of the security
paid out about $310 million to Goldman and others who had bet against it,
according to correspondence sent to Hudson investors.
salesman said that C.D.O. buyers were not misled because they were advised
that Goldman was placing large bets against the securities. We were
very open with all the risks that we thought we sold. When youre facing
a tidal wave of people who want to invest, its hard to stop them,
he said. The salesman added that investors could have placed bets against
Abacus and similar C.D.O.s if they had wanted to.
A Goldman spokesman
said the firms negative bets didnt keep it from suffering losses
on its mortgage assets, taking $1.7 billion in write-downs on them in 2008;
but he would not say how much the bank had since earned on its short positions,
which former Goldman workers say will be far more lucrative over time. For
instance, Goldman profited to the tune of $1.5 billion from one series of
mortgage-related trades by Mr. Egol with Wall Street rival Morgan Stanley,
which had to book a steep loss, according to people at both firms.
a salesman on several Abacus and Hudson deals, left Goldman and later published
a novel, How I Caused the Credit Crunch. In it, he wrote that
bankers deserted their clients who had bought mortgage bonds when that market
collapsed: We had moved on to hurting others in our quest for self-preservation.
Mr. Ishikawa, who now works for another financial firm in London, declined
to comment on his work at Goldman.
Just as synthetic
C.D.O.s began growing rapidly, some Wall Street banks pushed for technical
modifications governing how they worked in ways that made it possible for
C.D.O.s to expand even faster, and also tilted the playing field in
favor of banks and hedge funds that bet against C.D.O.s, according to
In early 2005,
a group of prominent traders met at Deutsche Banks office in New York
and drew up a new system, called Pay as You Go. This meant the insurance for
those betting against mortgages would pay out more quickly. The traders then
went to the International Swaps and Derivatives Association, the group that
governs trading in derivatives like C.D.O.s. The new system was presented
as a fait accompli, and adopted.
also increased the likelihood that investors would suffer losses if the mortgage
market tanked. Previously, investors took losses only in certain dire credit
events, as when the mortgages associated with the C.D.O. defaulted or
their issuers went bankrupt.
But the new
rules meant that C.D.O. holders would have to make payments to short sellers
under less onerous outcomes, or triggers, like a ratings downgrade
on a bond. This meant that anyone who bet against a C.D.O. could collect on
the bet more easily.
early deals you see none of these triggers, said one investor who asked
for anonymity to preserve relationships. These things were built in
to provide the dealers with a big payoff when something bad happened.
Banks also set
up ever more complex deals that favored those betting against C.D.O.s.
Morgan Stanley established a series of C.D.O.s named after United States
presidents (Buchanan and Jackson) with an unusual feature: short-sellers could
lock in very cheap bets against mortgages, even beyond the life of the mortgage
bonds. It was akin to allowing someone paying a low insurance premium for
coverage on one automobile to pay the same on another one even if premiums
over all had increased because of high accident rates.
Mr. Egol structured some Abacus deals in a way that enabled those betting
on a mortgage-market collapse to multiply the value of their bets, to as much
as six or seven times the face value of those C.D.O.s. When the mortgage
market tumbled, this meant bigger profits for Goldman and other short sellers
and bigger losses for other investors.
Other Wall Street
firms also created risky mortgage-related securities that they bet against.
Bank, the point man on betting against the mortgage market was Greg Lippmann,
a trader. Mr. Lippmann made his pitch to select hedge fund clients, arguing
they should short the mortgage market. He sometimes distributed a T-shirt
that read Im Short Your House!!! in black and red letters.
declined to comment, at the same time was selling synthetic C.D.O.s
to its clients, and those deals created more short-selling opportunities for
traders like Mr. Lippmann.
Among the most
aggressive C.D.O. creators was Tricadia, a management company that was a unit
of Mariner Investment Group. Until he became a senior adviser to the Treasury
secretary early this year, Lewis Sachs was Mariners vice chairman. Mr.
Sachs oversaw about 20 portfolios there, including Tricadia, and its documents
also show that Mr. Sachs sat atop the firms C.D.O. management committee.
From 2003 to
2007, Tricadia issued 14 mortgage-linked C.D.O.s, which it called TABS.
Even when the market was starting to implode, Tricadia continued to create
TABS deals in early 2007 to sell to investors. The deal documents referring
to conflicts of interest stated that affiliates and clients of Tricadia might
place bets against the types of securities in the TABS deal.
Even so, the
sales material also boasted that the mortgages linked to C.D.O.s had
historically low default rates, citing a recently completed study
by Standard & Poors ratings agency though fine print indicated
that the date of the study was September 2002, almost five years earlier.
At a financial
symposium in New York in September 2006, Michael Barnes, the co-head of Tricadia,
described how a hedge fund could put on a negative mortgage bet by shorting
assets to C.D.O. investors, according to his presentation, which was reviewed
by The New York Times.
Mr. Barnes declined
to comment. James E. McKee, general counsel at Tricadia, said, Tricadia
has never shorted assets into the TABS deals, and Tricadia has always acted
in the best interests of its clients and investors.
Mr. Sachs, through
a spokesman at the Treasury Department, declined to comment.
in some of Goldmans Abacus deals, buyers of some TABS experienced heavy
losses. By the end of 2007, UBS research showed that two TABS deals were the
eighth- and ninth-worst performing C.D.O.s. Both had been downgraded
on at least 75 percent of their associated assets within a year of being issued.
hedge fund did far better, earning roughly a 50 percent return in 2007 and
similar profits in 2008, in part from the short bets.