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Goldman shocks

The SEC has alleged that Goldman Sachs sold mortgaged derivatives it knew were doomed and then made a killing when they went bust.

india Updated: Apr 19, 2010 23:42 IST

Tensions were rising inside Goldman Sachs.

It was late 2006, and an argument had broken out inside the Wall Street bank’s prized mortgage unit — a dispute that would reach all the way up to the executive suite. One camp of traders was insisting that the American housing market was safe. Another thought it was poised for collapse.

Among those who saw disaster looming were an effusive young Frenchman, Fabrice P. Tourre, and his quiet colleague, Jonathan M. Egol, the mastermind behind a series of mortgage deals known as the Abacus investments.

Their elite mortgage unit is now at the centre of allegations that Goldman and Tourre, 31, defrauded investors with one of
those complex deals.

The Securities and Exchange Commission (SEC), the stock market watchdog in the US, filed a civil fraud suit on Friday that says that Goldman built the financial equivalent of a time bomb and then sold it to unwitting investors. Egol, 40, was not named in SEC’s suit.

This spooked investors worldwide. All Asian stock markets tanked — the Nikkei and Hang Seng fell 1.74 per cent and 2.1 per cent, respectively. In India the BSE Sensex and NSE Nifty fell 190 points and 62 points, respectively.

Goldman has vowed to fight the SEC. But the allegations have left many on Wall Street wondering how far the investigation might spread inside Goldman and perhaps beyond.

Tourre was the only person named in the SEC suit. But according to interviews with former Goldman employees, senior bank executives played a pivotal role in overseeing the mortgage unit just as the housing market began to go south.

According to these people, executives up to and including Lloyd C. Blankfein, chairman and chief executive, took an active role in overseeing the mortgage unit as the tremors in the housing market began to reverberate through the nation’s
economy. It was Goldman’s top brass, they say, that finally ended the dispute on the mortgage desk by siding with those who, like Tourre and Egol, believed home prices would decline.

Lucas van Praag, a Goldman spokesman, said that senior executives were not involved in approving the Abacus deals. He said that the executives had sought to balance Goldman’s positive bets on the mortgage market, rather than take an overall negative view.

Mortgage specialists like those at Goldman were, in a sense, the mad scientists of the sub-prime era. They devised investments by bundling together bonds backed by home loans, a process that enabled mortgage lenders to make even more loans.

While this sort of financing helped make loans available, the most exotic creations spread the growing risks inside the American housing market throughout the financial world. When the boom went bust, the results were disastrous.

By early 2007, Goldman’s mortgage unit had become a hive of intense activity. The business had captured the attention of senior management. In addition to Blankfein, Gary D. Cohn, Goldman’s president, and David A. Viniar, the chief financial officer, visited the mortgage unit frequently, often for hours at a time.

The decision to get rid of positive bets on mortgages turned out to be prescient. Unlike most other Wall Street banks, Goldman profited from its mortgage business as the housing bubble was inflating and then when the bubble burst.

During the boom, Goldman’s mortgage unit was a leader on Wall Street. In 2006 alone, the bank underwrote $26 billion of collateralised debt obligations (securities whose value is based on underlying assets), according to Dealogic, a financial
data provider.

But a few desks away, Tourre and Egol were working on the Abacus deals. Their Abacus deals included insurance-like protection that would pay out if certain mortgage bonds soured.

Unlike many of their colleagues at Goldman and other banks, they argued that the nation’s mortgage market was far more interconnected than believed, former Goldman employees said.

Tourre and Egol made way for a hedge fund manager, John A. Paulson, to bet against risky mortgages.

With Paulson’s help, Goldman created an Abacus investment that, the SEC now says, was devised to fall apart. By betting against that Abacus investment, Mr. Paulson reaped $1 billion in profit, according to the SEC. Paulson was not named in the SEC complaint.

Goldman’s top ranks changed its stance on housing in December 2006. In a meeting in a windowless conference room on the executive floor, Viniar and Cohn gathered about 10 executives for a briefing. Daniel L. Sparks, the head of the mortgage unit, walked them through the numbers. The group was unanimous: Goldman had to reduce its exposure to the increasingly troubled mortgage market.

In February 2007, senior executives began turning up on the trading floor. The message, one former employee said, was clear: management was watching.

The executives told Sparks to tell his traders to sell Goldman’s positive bets on housing. The traders’ short positions — that is, negative bets, mostly used to hedge other investments — were placed in a central trading account.

By the third quarter of 2007, the mortgage unit was minting money, while Goldman’s rivals were losing big.

Viniar told analysts that the mortgage unit was posting record profits because of its short bets that mortgage investments would lose value.

“Our risk bias in that market was to be short, and that net short position was profitable,” Viniar said.

First Published: Apr 19, 2010 23:40 IST