Inside Job (21 page)

Before moving on to Goldman’s really serious bets with AIG, we should note briefly that, disgraceful as Goldman’s and Paulson’s behaviour was, they were far from alone.
Deutsche Bank and several other major investment banks worked with Paulson, as well as with several other large hedge funds, to construct similar deals with similar results. However, it would be
surprising to see the SEC go after Deutsche Bank, because since the Obama administration took office, the SEC’s director of enforcement has been Robert Khuzami, who was general counsel to
Deutsche Bank for the Americas throughout the bubble. (In a way, though, it could be tidy—he could depose himself, subpoena himself, prosecute himself, and settle with himself.)

As for the other hedge funds that behaved like Paulson, the two best known are Magnetar and Tricadia.

MAGNETAR IS A
Chicago hedge fund that developed a strategy similar to Paulson’s. The brief discussion here is based on an excellent
investigative series by the not-for-profit ProPublica news organization, and a more technical analysis in Yves Smith’s book
Econned
.
²⁹

In the Goldman Sachs ABACUS deal just discussed, Paulson did not make any long investments; he merely bought the short side, which sufficed for him to make gallons of money when the securities
defaulted. But Magnetar, and sometimes Paulson too in his deals with Deutsche Bank, did something even more clever. They would find, or help construct, really bad deals, and buy the short side of
nearly all of them. But then, seemingly paradoxically, they also bought the
long
side of the so-called equity piece—the lowest-quality part of the whole deal, and the first to fail.
Why would they do that?

Because they were handling, in a far more intelligent way, the same problem that poor Howie Hubler had faced at Morgan Stanley. Until the securities actually fail, the guy holding the short side
of a synthetic CDO has to keep making those payments to the long investor. That could get expensive. Magnetar (and sometimes Paulson) covered these payments through the extremely high interest
rates (often 20 percent per year, sometimes even more) paid by the equity piece. What Paulson and Magnetar realized, and Morgan Stanley didn’t, was that bubbles often last for a long time,
but the collapse is usually fast and complete. So the equity piece would keep paying interest, and covering the cost of Paulson’s and Magnetar’s massive short position, until the
collapse came. Then, yes, the equity piece would fail first, but everything else would probably fail soon afterwards. This strategy had the additional benefit of disguising their real intentions,
at least to naive investors.

Their returns were huge; this was not a small business. An executive from a European bank that managed some of Magnetar’s deals said:

In a rare error for Jamie Dimon, JPMorgan Chase was heavily involved in structuring one of these deals, called Squared, and lost money as a result. Magnetar’s
behaviour was very similar to Paulson’s with ABACUS. Magnetar helped select the assets that went into Squared, with the intent of betting against it. JPMorgan Chase structured the deal, and
then sold off pieces of it without telling its customers that the package had been designed to fail, or that Magnetar was involved. But JPMorgan Chase didn’t sell off enough of the deal, and
lost $880 million as a result.

Magnetar pumped out thirty deals, in the $1 billion to $1.5 billion range
each
. Very rough estimates suggest that this one hedge fund’s short payments may have funded a quarter of
the 2006 subprime mortgage securities market. Investment bankers (of the Fabulous Fab sort) collected major fees for helping to structure the deals and matching Magnetar with the fools it bet
against. Magnetar was a few clever guys who found a way to turn financial muck and the fools owning it into billions for themselves. If they happened to facilitate another $100 billion to $200
billion of stupid lending and investing, well, that was not their problem.
⁴
Tricadia’s story is very similar.

But now, back to Goldman Sachs, because their best trick was yet to come.

AFTER GOLDMAN HAD
sold off its lumps of coal to various fools, they knowingly put the global financial system at risk. They had played AIG for such a
massive sucker while shorting the mortgage market that by 2008 they
knew
that their shorts alone could precipitate AIG’s collapse. And what did Goldman do about
that
? Push even
harder,
while
shorting AIG
, of course. And while doing this, did they call up their pal and former CEO, Henry Paulson aka the Treasury secretary, to warn him that the
shit was about to hit the fan?No, it seems that they neglected to do that.

Although no single firm or government agency knew the entire extent of the market’s exposures, or even AIG’s, Goldman was much better positioned than most, for several reasons.
First, Goldman had sold $17 billion of the $62 billion in mortgage CDOs that AIG had insured through its London-based credit default swap (CDS) business, AIG Financial Products.
³¹
In some cases, Goldman had helpfully referred investors to AIGFP, so that CDS insurance could help reassure potential investors that Goldman’s CDOs were
essentially riskless. In some cases Goldman even had the right to change the mortgages underlying these securities after their sale, and there have been allegations that Goldman deliberately used
this capability to off-load even more of its toxic assets. This capability gave Goldman even more information and control over the performance of its CDOs, and therefore also of AIGFP’s CDSs.
But second, Goldman was also a huge direct buyer of CDS protection from AIG, in some cases on the very same securities that it had earlier sold. (Some of Goldman’s CDOs turned out to be the
worst in AIG’s CDS portfolio.) Third, Goldman had also created and sold some of the $75 billion in mortgage CDOs that another part of AIG, its securities investment and lending business, had
foolishly purchased, and that had started to decline sharply in value. Fourth, as the bubble unravelled, Goldman knew that AIG was being rapidly weakened by cash demands from the holders of the
insurer’s CDSs. Goldman knew this better than anyone, because as we saw earlier, Goldman was the most aggressive firm on Wall Street in marking down its toxic assets. Because it marked them
down earlier than others, it was therefore the earliest and most aggressive in demanding money from AIG based on those markdowns. Goldman knew that its own demands alone could soon reach tens of
billions of dollars. And finally, Goldman’s equity research organization also covered AIG and regularly provided research reports on AIG’s financial condition.

Starting in 2007, when Goldman was implementing its massive short, it quickly purchased over $20 billion in CDS protection on mortgage securities and related indexes from
AIGFP. The protection was cheap to buy, because the securities were still highly rated and marked at or near full value, both by the wider market and on Goldman’s own books. Soon afterwards,
however, having locked in the CDS protection, Goldman began aggressive markdowns of the securities’ value—and with every markdown, it demanded immediate corresponding cash payments from
AIG. In February 2008, partly as a result of Goldman’s demands, AIG was forced by its increasingly panicked external auditor to announce losses and also a “material weakness” in
its accounting, pertaining to the valuation of its CDS portfolio. Throughout 2008, Goldman radically accelerated its demands, leading to fierce disputes between Goldman and AIG over the
securities’ value and, therefore, the size of the required payments.

By mid-2008 and perhaps even earlier, Goldman knew that its CDS payment demands alone could easily cause AIG to collapse. Added to this would be further losses from other securities owned by AIG
and/or insured via AIG’s CDS business. Goldman possessed far more detailed knowledge of many of these securities, and the likelihood of their failure, than AIG did, because Goldman had
created and sold them. With this combined knowledge, Goldman unquestionably knew that AIG was in dire straits. Goldman did not warn any regulators, much less its customers or AIG, but it
did
take action. First, it became ever more aggressive in demanding payment on its CDSs, so that it could get its money out ahead of others and before AIG’s failure. And second, it spent about
$150 million buying $2.5 billion in CDS protection
on AIG
, which it would collect in the event of an AIG default or bankruptcy. At a minimum, this insulated Goldman from risk; and depending
upon precise contract terms and events, it could even have given Goldman an affirmative incentive to
cause
AIG’s collapse. If, for example, Goldman could get paid fully for its
mortgage CDSs just before AIG went bankrupt, it would actually make more money from AIG’s actual or feared bankruptcy
than from its continued health. And, in the end,
this was very close to what happened, although Goldman could not have predicted that in advance.

It was only on 18 August 2008, that a Goldman Sachs research analyst issued the first public comment by Goldman on the catastrophic nature of AIG’s condition. The report said that AIG was
a major credit risk, likely to be downgraded, and in dire need of raising additional capital. Well, Goldman would have known. By 12 September 2008, shortly before AIG’s collapse, AIG had
already
been forced to pay out $18.9 billion on its mortgage CDSs—of which $7.6 billion, over 40 percent, had gone directly to Goldman, which was demanding even more. Then, a few days
later, after paying Goldman several hundred million dollars more, AIG ran out of money and collapsed. It was bailed out through $85 billion in “loans” that gave the US government 79.9
percent ownership of AIG.
³²

Shortly afterwards, under directions from the US Treasury Department and the New York Federal Reserve, AIG used over $60 billion of the bailout money to pay the holders of its mortgage CDSs in
full, via contracts that also barred AIG from later suing anyone for fraud. Goldman received $14 billion. Ever since, the New York Federal Reserve and the Treasury Department, under
both
the
Bush and Obama administrations, have fiercely resisted providing information about these payments and their contractual terms. Ironically, it was AIG’s new management that pressed for
disclosure.

It is not publicly known what Goldman did with its $2.5 billion of CDS protection on AIG, but it almost certainly sold it at a significant profit, probably over $1 billion, sometime in late 2008
or early 2009.

In April 2010, after both the SEC lawsuit and a Senate investigation, US Senator from Michigan Carl Levin’s Permanent Subcommittee on Investigations held hearings on Goldman’s
conduct, focusing on Goldman’s shorting strategy of 2006–2007. Here are some excerpts, beginning with testimony by head mortgage trader Dan Sparks. They speak for themselves; as several
of the senators noted, the witnesses proved to be stunningly confused and ill-informed, with very poor
memories about the business they had been running so well, and about
which they had been so focused and ruthlessly clear in their internal communications.