Question: During the depths of the subprime lending

During the depths of the subprime lending crisis in 2008, a major U.S. investment banking firm, Goldman Sachs, required a $10 billion bailout from the U.S. government’s Troubled Asset Relief Pro- gram (TARP) to stay afloat. But in 2009, Goldman’s fortunes reversed as the firm earned $13.4 billion profit, repaid the $10 billion to TARP, and paid its employees over $16 billion.1
The firm’s nickname, “Golden Socks,” appears to be well earned. But is this spectacular reversal just too good to be true—or at least the result of unethical, if not illegal, practices? Did Goldman profit unfairly by somehow taking advantage of unsuspecting clients or by undermining a floundering United States or even world economy? In fact, serious allegations have been raised about Goldman’s role in the financial crisis, including the following:
1. Duping American International Group, Inc. (AIG) into insuring poor-quality mortgage securities and then
a. triggering insurance payments to Goldman by setting artificially low securities valuations, thereby
b. precipitating a $130 billion–plus bailout of AIG and a transfer of 79.9% equity ownership to the U.S. Federal Reserve Bank and
c. causing the U.S. government to pay $52.5 million to Goldman in settlement of credit default swaps in which AIG had insured mortgage securities.2
2. Betting against clients by taking “short positions on collateralized debt obligations [CDOs] that it had created and sold to clients.”3
3. Stuffing “these CDOs with inferior mortgage assets that ensured their collapse.”4
The ABACUS Deal: Goldman Engineered, Paulson & Co. Influenced
The spotlight fell on one of Goldman’s transactions, known as ABACUS 2007- AC1, when the SEC filed securities fraud charges on April 16, 2010, against Goldman and one of its employees, Fabrice Tourre, who vainly dubbed himself the “fabulous Fab” for creating the deal.5 According to the SEC’s allegations, Goldman created and marketed a synthetic CDO to customers without disclosing to investors that the underlying subprime residential mortgage-backed securities (RMBS) had been selected, in part, by a hedge fund, Paulson & Co. Inc.,6 which immediately bet that ABACUS 207-AC1 would fail by buying CDSs from Goldman (GS&Co) that effectively insured against losses related to that failure.7 According to the SEC,
The deal closed on April 26, 2007. Paulson paid GS&Co approximately $15 million for structuring and marketing ABACUS 2007-AC1. By October 24, 2007, 83% of the RMBS in the ABACUS 2007-AC1 portfolio had been downgraded and 17% was on negative watch. By January 29, 2008, 99% of the portfolio had allegedly been downgraded. Investors in the liabilities of ABACUS 2007- AC1 are alleged to have lost over $1 billion. Paulson’s opposite CDS positions yielded a profit of approximately $1 billion.8
On July 15, 2010, the SEC announced that Goldman had paid $550 million, the highest penalty ever paid to settle the case, and agreed to remedial actions but did not admit or deny the allegations. Two hundred and fifty million was to be returned to investors, and $300 million was paid to the U.S. Treasury. In court papers filed,
Goldman acknowledged that the marketing materials for the ABACUS 2007-AC1 transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state that the reference portfolio was “selected by” ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson’s economic interests were adverse to CDO investors. Goldman regrets that the marketing materials did not contain that disclosure.9
Deals with AIG
AIG, once the world’s largest insurer, began to insure portions of subprime mortgage deals in 2003.10 Many observers came to believe that the company “was reck- less during the mortgage mania,” and as it turned out, AIG “had written far more insurance than it could possibly have paid off if a national mortgage debacle occurred—as, in fact, it did.”11 This was the underlying reason why the federal government had to step in September 2008 and ultimately bail out AIG by providing $180 billion and taking over the company.12 Reports have indicated that Goldman received $7 billion from AIG before the rescue and $12.9 billion after the rescue, plus “a portion of $11 billion in taxpayer money that went to Société Générale, a French bank that traded with AIG, was subsequently transferred to Goldman under a deal the two banks had struck.”13 Since Goldman knew that AIG was insuring other companies’ deals as well, should Goldman not have known that AIG was being stretched, in a risk of default sense, to or beyond that company’s reasonable limit?
It is possible that the black swan14 phenomenon was at work. AIG and many other insurers and investors put such a low probability on a national mortgage default that they discounted the overall impact far too much and did not have a clear view of the risk limits of AIG and other market participants. But it has been reported that Goldman was betting significant capital that the mortgage market would decline or crash as early as 2006.15 Moreover, Goldman was pressing AIG to recognize Goldman’s abnormally low market valuations on the mortgages insured so that AIG would have to pay off on their insurance. These valuations were so low that AIG objected strenuously, but Goldman would not submit them to outside adjudication.16
Betting against the Market and Clients: A Shift in Focus and Culture
Goldman’s significant bets in 2006 and later against the stability of the national mort- gage raise other concerns. Throughout this period, Goldman was actively structuring deals like ABACUS and marketing these to their investor clients. But Goldman was being disingenuous. They were marketing mortgage-backed securities to their clients while at the same time investing Goldman’s own resources in ways that would pay off if mortgage securities sank in value (e.g., short positions). In addition, Goldman’s proprietary trading would be undermining the market price of the mortgage-backed securities being sold to others. It is worth noting that the financial market reforms introduced in September 2010 crystallized the so-called Volker Rule,17 which placed restrictions on proprietary trading by investment banks based on conflict-of- interest concerns.18
Goldman’s culture and revenue had changed significantly since the 1990s toward a heavy reliance on proprietary trading and special situation investing and away from the traditional investment bank services of “getting to know companies and their executives inside out, while advising them on mergers, acquisitions, and stock offerings.”19 Once the dominant activity, traditional investment banking services were increasingly dwarfed by proprietary trading until in 2009 proprietary trading “accounted for three-quarters of the firm’s $45 billion (U.S.) in revenues,”20 whereas investment banking accounted for only a tenth.
Although both activities are intended to generate profit, the “time frame and approach—executives wooed over years of lunches and dinners, not rapid-fire trades during the course of a day—are poles apart.”21 “On the investment banking side, you protected your clients and your market share,”22 both of which involved long-term thinking and stewardship. “On the trading side, it was all about making money.”23
This shift in thinking was articulated in what has become known as the “fork in the road speech” given in 2005 by Lloyd Blankfein, who was then the chief operating officer. “He argued Goldman had to com- bine its roles as an adviser, financier, and investor, or risk irrelevance. By focusing more on putting its own money to work, new conflicts would arise, but Goldman was skilled at managing them, he said.”24
Goldman Sachs’s Response:
“… Not Guilty. Not One Little Bit.” According to Goldman’s senior executives, as might be expected, the firm is “not guilty. Not one little bit.”25 In the firm’s Letter to Shareholders26 accompanying its 2009 Annual Report, these executives provide Goldman’s official response, as follows:
Our Relationship with AIG
Over the last year, there has been a lot of focus on Goldman Sachs’ relationship with AIG, particularly our credit exposure to the company and the direct effect the U.S. government’s decision to support AIG had or didn’t have on our firm. Here are the facts:
Since the mid-1990s, Goldman Sachs has had a trading relationship with AIG. Our business with them spanned a number of their entities, including many of their insurance subsidiaries. And it included multiple activities, such as stock lending, foreign exchange, fixed income, futures and mortgage trading.
AIG was a AAA-rated company, one of the largest and considered one of the most sophisticated trading counterparts in the world. We established credit terms with them commensurate with those extended to other major counterparts, including a willingness to do substantial trading volumes but subject to collateral arrangements that were tightly managed.
As we do with most other counterparty relationships, we limited our overall credit exposure to AIG through a combination of collateral and market hedges in order to protect ourselves against the potential inability of AIG to make good on its commitments.
We established a pre-determined hedging program, which provided that if aggregate exposure moved above a certain threshold, credit default swaps (CDS) and other credit hedges would be obtained. This hedging was designed to keep our overall risk to manageable levels.
As part of our trading with AIG, we purchased from them protection on super- senior collateralized debt obligation (CDO) risk. This protection was designed to hedge equivalent transactions executed with clients taking the other side of the same trades. In so doing, we served as an intermediary in assisting our clients to express a defined view on the market. The net risk we were exposed to was consistent with our role as a market intermediary rather than a proprietary market participant.
In July 2007, as the market deteriorated, we began to significantly mark down the value of our super-senior CDO positions. Our rigorous commitment to fair value accounting, coupled with our daily transactions as a market maker in these securities, prompted us to reduce our valuations on a real-time basis which we believe we did earlier than other institutions. This resulted in collateral disputes with AIG. We believe that subsequent events in the housing market proved our marks to be correct—they reflected the realistic values markets were placing on these securities.
Over the ensuing weeks and months, we continued to make collateral calls, which were based on market values, consistent with our agreements with AIG. While we collected collateral, there still remained gaps between what we received and what we believed we were owed. These gaps were hedged in full by the purchase of CDS and other risk mitigants from third parties, such that we had no material residual risk if AIG defaulted on its obligations to us.
In mid-September 2008, prior to the government’s action to save AIG, a majority of Goldman Sachs’ exposure to AIG was collateralized and the rest was covered through various risk mitigants. Our total exposure on the securities on which we bought protection was roughly $10 billion. Against this, we held roughly $7.5 billion in collateral. The remainder was fully covered through hedges we purchased, primarily through CDS for which we received collateral from our market counterparties. Thus, if AIG had failed, we would have had the collateral from AIG and the proceeds from the CDS protection we purchased and, therefore, would not have incurred any material economic loss.
In this regard, a list of AIG’s cash flows to counterparties indicates little about each bank’s credit exposure to the company. The figure of $12.9 billion that AIG paid to Goldman Sachs post the government’s decision to support AIG is made up as follows:
$4.8 billion for highly marketable U.S. Government Agency securities that AIG had pledged to us in return for a loan of $4.8 billion. They gave us the cash, we gave them back the securities. If AIG hadn’t repaid the loan, we would simply have sold the securities and received the $4.8 billion of value in that way.
An additional $2.5 billion that AIG owed us in collateral from September 16, 2008 (just after the government’s action) through December 31, 2008. This represented the additional col- lateral that was called as markets continued to deteriorate and was consistent with the existing agreements that we had with AIG.
$5.6 billion associated with a financing entity called Maiden Lane III, which was established in mid-November 2008 by the Federal Reserve to purchase the securities underlying certain CDS contracts and to cancel those contracts between AIG and its counterparties. The Federal Reserve required that the counterparties deliver the cash bonds to Maiden Lane III in order to settle the CDS contracts and avoid any further collateral calls. Consequently, the cash flow of $5.6 billion between Maiden Lane III and Goldman Sachs reflected the Federal Reserve paying Goldman Sachs the face value of the securities (approximately $14 billion) less the collateral (approximately $8.4 billion) we already held on those securities. Goldman Sachs then spent the vast majority of the money we received to buy the cash bonds from our counterparties in order to complete the settlement as required by the Federal Reserve.
While our direct economic exposure to AIG was minimal, the financial markets, and, as a result, Goldman Sachs and every other financial institution and company, benefited from the continued viability of AIG. Although it is difficult to determine what the exact systemic implications would have been had AIG failed, it would have been extremely disruptive to the world’s already turbulent financial markets.
Our Activities in the Mortgage Securitization Market
Another issue that has attracted attention and speculation has been how we managed the risk we assumed as a market maker and underwriter in the mortgage securitization market. Again, we want to provide you with the facts.
As a market maker, we execute a variety of transactions each day with clients and other market participants, buying and selling financial instruments, which may result in long or short risk exposures to thousands of different instruments at any given time. This does not mean that we know or even think that prices will fall every time we sell or are short, or rise when we buy or are long.
In these cases, we are executing transactions in connection with our role of providing liquidity to markets. Clients come to us as a market maker because of our willing- ness and ability to commit our capital and to assume market risk. We are responding to our clients’ desire either to establish, or to increase or decrease, their exposure to a position on their own investment views. We are not “betting against” them.
As a market maker, we assume risk created through client purchases and sales. This is fundamental to our role as a financial intermediary. As part of facilitating client transactions, we generally carry an “inventory” of securities. This inventory comprises long and short positions. Its composition reflects the accumulation of customer trades and our judgments about supply and demand or market direction. If a client asks us to transact in an instrument we hold in inventory, we may be able to give the client a better price than it could find elsewhere in the market and to execute the order without potential delay and price movement. This inventory represents a risk position that we manage continuously.
In so doing, we must also manage the size of our inventory and keep exposures in line with risk limits. We believe that risk limits are an important tool in managing our firm. They are established by senior management, and scaled to be in line with our financial resources (capital, liquidity, etc.). They help ensure that regardless of the opinions of an individual or busi- ness unit about market direction, our risk must remain within prescribed levels. In addition to selling positions, we use other techniques to manage risk. These include establishing offsetting positions (“hedges”) through the same or other instruments, which serve to reduce the firm’s overall exposure.
In this way, we are able to serve our clients and to maintain a robust client franchise while prudently limiting overall risk consistent with our financial resources.
Through the end of 2006, Goldman Sachs generally was long in exposure to residential mortgages and mortgage- related products, such as residential mortgage-backed securities (RMBS), CDOs backed by residential mortgages and credit default swaps referencing residential mort- gage products. In late 2006, we began to experience losses in our daily residential mortgage-related products P&L as we marked down the value of our inventory of various residential mortgage-related products to reflect lower market prices.
In response to those losses, we decided to reduce our overall exposure to the residential housing market, consistent with our risk protocols—given the uncertainty of the future direction of prices in the housing market and the increased market volatility. The firm did not generate enormous net revenues or profits by betting against residential mortgage-related products, as some have speculated; rather, our relatively early risk reduction resulted in our losing less money than we otherwise would have when the residential housing market began to deteriorate rapidly.
The markets for residential mortgage- related products, and subprime mortgage securities in particular, were volatile and unpredictable in the first half of 2007. Investors in these markets held very different views of the future direction of the
U.S. housing market based on their out- look on factors that were equally avail- able to all market participants, including housing prices, interest rates and personal income and indebtedness data. Some investors developed aggressively negative views on the residential mortgage market. Others believed that any weakness in the residential housing markets would be relatively mild and temporary. Investors with both sets of views came to Goldman Sachs and other financial intermediaries to establish long and short exposures to the residential housing market through RMBS, CDOs, CDS and other types of instruments or transactions.
The investors who transacted with Goldman Sachs in CDOs in 2007, as in prior years, were primarily large, global financial institutions, insurance companies and hedge funds (no pension funds invested in these products, with one exception: a corporate-related pension fund that had long been active in this area made a purchase of less than $5 million). These investors had significant resources, relationships with multiple financial intermediaries and access to extensive information and research flow, performed their own analysis of the data, formed their own views about trends, and many actively negotiated at arm’s length the structure and terms of transactions.
We certainly did not know the future of the residential housing market in the first half of 2007 any more than we can predict the future of markets today. We also did not know whether the value of the instruments we sold would increase or decrease. It was well known that housing prices were weakening in early 2007, but no one— including Goldman Sachs—knew whether they would continue to fall or to stabilize at levels where purchasers of residential mortgage-related securities would have received their full interest and principal payments.
Although Goldman Sachs held various positions in residential mortgage-related products in 2007, our short positions were not a “bet against our clients.” Rather, they served to offset our long positions. Our goal was, and is, to be in a position to make markets for our clients while managing our risk within prescribed limits.27
In their Bloomberg Businessweek article on April 12, 2010, Robert Farzad and Paula Dwyer28 investigated the positions taken by Goldman’s senior executives. In conclusion, the authors state, Business is booming, but Goldman, which once prided itself on avoiding the ostentations and on making money for the long haul, is a different firm, with a perception problem that mere explanation can’t solve. In committing to market-making at all costs, the firm has opened itself up to forces beyond its control. The Question is: Has Goldman Sachs shorted itself?29
Questions
1. Based on the conflicts of interest raised in the case, has Goldman Sachs, in effect, shorted itself? Explain why and why not.
2. How should Goldman Sachs have handled each conflict of interest?
3. If Goldman Sachs really is innocent of all conflicts, why has the firm’s reputation suffered?
4. Referring to the outrage over the apparent abuse of AIG, Farzad and Dwyer ask the question, “If the firm could just write a multibillion-dollar check to erase the outrage—deserved or not—over the AIG payout and be done with the public agony, wouldn’t it just do it?”30 What would your answer be? Provide your reasoning for and against.
5. Is it appropriate for Goldman Sachs to “bet against their clients” through their investment activities?
6. One of Goldman’s main arguments in their defense is that their intentions were good—they did what they did in response to client requests, thus facilitating markets and making the world a better place.
a. Is the “good intention” argument sufficient to claim actions following from it are ethical? Why and why not? Remember the saying, “The road to hell is paved with good intentions.”
b. Is there something in addition to good intentions that Goldman Sachs would have been wise to consider in its decision making?
7. How would you have advised Goldman Sachs’s executives to have handled this crisis better?
8. What would an appropriate level of bonus payments be for Goldman Sachs as a whole?
9. Would bonuses paid in Goldman Sachs stock be more appropriate than those paid in cash?