Authorities look into whether large banks misled investors

Federal prosecutors are working with the Securities and Exchange Commission to look into whether some major banks, including Morgan Stanley, Deutsche Bank, UBS, JPMorgan Chase and Citigroup, might have misled investors regarding their role in collateralized debt obligations, a source said. Prosecutors reportedly are in the early stages of gathering evidence but have not issued subpoenas or started outlining potential cases.

http://online.wsj.com/article/SB10001424052748704247904575240783937399958.html

SEC voiced concern about CDOs as early as 2006, records show

he Securities and Exchange Commission started questioning Wall Street's practice of packaging mortgages into bonds as early as 2006, according to recently released documents. SEC officials wrote that collateralized debt obligations linked to mortgages exposed financial institutions to possible write-downs. "This risk is difficult to measure and hence to manage," according to a memo dated Feb. 1, 2006. The Financial Crisis Inquiry Commission released the document as it looks into Bear Stearns' collapse.

http://www.bloomberg.com/apps/news?pid=20601208&sid=aePB9cb.K2nU

Goldman Sachs CDO Labeled ‘Shi**y Deal’ by Montag in E-Mail

(Bloomberg) -- Thomas Montag, the former head of sales and trading in the Americas at Goldman Sachs Group Inc., called a set of mortgage-linked investments sold by his firm “one shi**y deal,” according to an excerpt from internal e-mails released by Senate lawmakers.

The transaction was Timberwolf Ltd., a $1 billion collateralized debt obligation holding pieces of other CDOs, according to a statement from the Permanent Subcommittee on Investigations. The CDO also included optimistic side-bets on the performance of CDOs, derivatives in which the firm took the opposite pessimistic side in “many” cases, the panel said.

“Boy that timberwo[l]f was one shi**y deal,” Montag, who is now Bank of America Corp.’s president of global banking and markets, said in a June 22, 2007, e-mail to Daniel Sparks, who ran Goldman Sachs’s mortgage business at the time, according to the statement yesterday. Within five months of Timberwolf’s debut, the CDO had lost 80 percent of its value, and it was liquidated in 2008, according to the panel.

The CDO was among securities that Goldman Sachs sold to clients after deciding the New York-based firm needed to reduce its mortgage holdings,Carl Levin, a Michigan Democrat who leads the panel, said in the statement. Chief Executive Officer Lloyd Blankfein and six other current and former executives will testify today in front of the panel about practices in mortgage securities markets before they collapsed.

Truncated Text

The committee, which began to release documents before today’s hearing, didn’t release the full text of the e-mails. A person briefed on the Timberwolf e-mail confirmed that Montag was the author.

Montag, now 53, didn’t respond to a request for comment and Bank of America spokeswoman Jessica Oppenheim had no immediate comment. Blankfein, 55, will tell the panel his firm didn’t wager against clients, according to a prepared text of his remarks.

“We respectfully disagree with Chairman Levin’s statement,” according to an e-mail from Goldman Sachs spokesman Lucas van Praag. “We did not have a big bet against the housing market, as our performance in residential mortgages demonstrates, and we believe we at all times worked appropriately with our clients. We did try to manage our risk, as our shareholders and regulators would expect.”

The Timberwolf CDO was issued in March 2007, following a Goldman Sachs quarter that ended February 2007 in which one department of the bank shifted from $6 billion of bets that mortgage bonds would perform to $10 billion they would default, according to Bloomberg data and information the panel released.

RBS lost £545m in alleged Goldman fraud

Royal Bank of Scotland was the biggest victim of the alleged sub-prime mortgage fraud orchestrated by Goldman Sachs and involving hedge fund Paulson & Co.

In August 2008, the part-nationalised lender paid Goldman $841m (£545m) to close its position on the single trade. According to the US Securities & Exchange Commission, "most of this money was subsequently paid to Paulson". RBS acquired the problem trade in 2007 after buying ABN Amro, the Dutch bank that ultimately proved the cause of its downfall.

RBS went on to post a £24bn loss in 2008, which led to a £45.5bn taxpayer bail-out that has left the state with an 84pc stake in the bank.

Following the SEC's accusations yesterday, RBS's lawyers were examining whether there would be any action to take against Goldman to recover losses.

RBS found itself bearing the bulk of the losses because ABN had written insurance against the "synthetic collateralised debt obligation (CDO)" at the centre of the alleged fraud.

However, according to the SEC, Goldman convinced investors to buy a poor quality CDO in the full expectation that it would collapse. Paulson, which was shorting the product, is alleged to have selected the sub-prime mortgage assets to be referenced by the "synthetic CDO" that were most likely to default.

Goldman then sold the CDO to investors to put someone on the other side of the trade without revealing Paulson's involvement. Investors would have believed the sub-prime assets to be high quality.

Goldman Sachs’s ‘Fabulous Fab’ Tourre Loses ‘Survivor’ Bet

(Bloomberg) -- Goldman Sachs Group Inc.’s “Fabulous Fab” saw himself as the “only potential survivor” when the housing market began to collapse in 2007. Instead he became the only person named when regulators sued the firm for fraud.

Fabrice Pierre Tourre, the 31-year-old French trader accused by the U.S. Securities and Exchange Commission yesterday of misleading investors in selling securities linked to mortgages, saw the wreckage coming early on.

“The whole building is about to collapse anytime now,” Tourre, an executive director at Goldman Sachs in London, wrote to a friend in a January 2007 e-mail, according to the SEC’s complaint. “Only potential survivor, the fabulous Fab... standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities!!!”

Tourre was a vice president on the structured product correlation trading desk in New York at Goldman Sachs’s headquarters when the SEC claims he packaged mortgage bonds he knew were toxic into securities he sold to unwitting clients.

Tourre, who joined Goldman Sachs in July 2001, according to his LinkedIn profile, was “principally responsible” for creating and marketing a collateralized debt obligation known as Abacus 2007-AC1, the SEC said.

Paulson & Co.

According to the complaint, he knew hedge fund Paulson & Co. had played a “significant role” in selecting many of the securities used to create the CDOs and was betting against them. Tourre and Goldman didn’t tell Abacus investors about Paulson’s role, the SEC said. New York-based Paulson wasn’t accused of wrongdoing.

Goldman Sachs said in a statement that it lost more than $90 million because it had an investment in the deal, overwhelming the $15 million it made in fees. The firm said it provided “extensive disclosure” about the risk of the underlying mortgage securities.

Tourre received a bachelor’s degree in mathematics at Ecole Centrale Paris, one of France’s top engineering schools, in 2000, according to his LinkedIn profile. He graduated the next year from Stanford University in California with a master’s degree in operations research.

Before college, Tourre studied three years at Lycee Marie Curie, a French high school, according to JournalduNet, a professional networking Web site. Tourre spent two years at Lycee Henri IV and Lycee Louis Le Grand, two prep schools known for getting students into France’s top universities.

Tourre’s registration with the U.K.’s Financial Services Authority began in November 2008.

The SEC complaint described Tourre thusly:

Fabrice Tourre, age 31, is a registered representative with GS&Co. Tourre was the GS&Co employee principally responsible for the structuring and marketing of ABACUS 2007-AC1. Tourre worked as a Vice President on the structured product correlation trading desk at GS&Co headquarters in New York City during the relevant period. Tourre presently works in London as an Executive Director of Goldman Sachs International.

Tourre was principally responsible for ABACUS 2007-AC1. Tourre devised the transaction, prepared the marketing materials and communicated directly with investors. Tourre knew of Paulson’s undisclosed short interest and its role in the collateral selection process. Tourre also misled ACA into believing that Paulson invested approximately $200 million in the equity of ABACUS 2007-AC1 (a long position) and, accordingly, that Paulson’s interests in the collateral section process were aligned with ACA’s when in reality Paulson’s interests were sharply conflicting.

Later, the complaint describes the marketing challenges in selling the security:

At the same time, GS&Co recognized that market conditions were presenting challenges to the successful marketing of CDO transactions backed by mortgage-related securities. For example, portions of an email in French and English sent by Tourre to a friend on January 23, 2007 stated, in English translation where applicable: “More and more leverage in the system, The whole building is about to collapse anytime now…Only potential survivor, the fabulous Fab[rice Tourre]…standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities!!!” Similarly, an email on February 11, 2007 to Tourre from the head of the GS&Co structured product correlation trading desk stated in part, “the cdo biz is dead we don’t have a lot of time left.”

How Goldman profited from subprime meltdown

By The Wall Street Journal
The subprime-mortgage crisis has been a financial catastrophe for much of Wall Street. But at Goldman Sachs, thanks to a tiny group of traders, it has generated one of the biggest windfalls the securities industry has seen in years.

The group's big bet that securities backed by risky home loans would fall in value generated nearly $4 billion of profits during the year that ended Nov. 30, according to sources familiar with the firm's finances. Those gains erased $1.5 billion to $2 billion of mortgage-related losses elsewhere in the firm.

On Tuesday, despite a terrible November and some of the worst market conditions in decades, analysts expect Goldman Sachs (GS) to report a record net annual income of more than $11 billion.

Goldman's trading home run was blasted from an obscure corner of the firm's mortgage department -- the structured-products trading group, which now numbers about 16 traders.

Two of them, Michael Swenson, 40, and Josh Birnbaum, 35, pushed Goldman to wager that the subprime market was heading for trouble. Their boss, mortgage-department head Dan Sparks, 40, backed them during heated debates about how much money the firm should risk.

This year, the three men are expected to be paid between $5 million and $15 million apiece, people familiar with the matter say.

Under Chief Executive Lloyd Blankfein, Goldman has stood out on Wall Street for its penchant for rolling the dice with its own money. The upside of that approach was obvious in the third quarter: Despite credit-market turmoil, Goldman earned $2.9 billion, its second-best three-month period ever. Blankfein is set to be paid close to $70 million this year, according to one person familiar with the matter.

Goldman's success at wringing profits out of the subprime fiasco, however, raises questions about how the firm balances its responsibilities to its shareholders and to its clients.

Making a market
Goldman's mortgage department underwrote collateralized debt obligations, or CDOs, complex securities created from pools of subprime mortgages and other debt. When those securities plunged in value this year, Goldman's customers suffered major losses, as did units within Goldman itself, due to their CDO holdings.

The question now being raised: Why did Goldman continue to peddle CDOs to customers early this year while its own traders were betting that CDO values would fall? A spokesman for Goldman Sachs declined to comment on the issue.

The structured-products trading group that executed the winning trades isn't involved in selling CDOs minted by Goldman, a task handled by others. Its principal job is to "make a market" for Goldman clients trading various financial instruments tied to mortgage-backed securities. That is, the group handles clients' buy and sell orders, often stepping in on the other side of trades if no other buyer or seller is available.

The group also has another mission: If it spots opportunity, it can trade Goldman's own capital to make a profit. And when it does, it doesn't necessarily have to share such information with clients, who may be making opposite bets. This year, Goldman's traders did a brisk business handling trades for clients who were bullish on the subprime-mortgage-securities market. At the same time, they used Goldman's money to bet that market would fall.

Financial firms have good reason to keep a tight leash on proprietary traders. In 1995, bad bets by Nicholas Leeson, a young trader, led to $1.4 billion in losses and the collapse of Barings. Last year, the hedge fund Amaranth Advisors shut down after a young Canadian trader lost more than $6 billion on natural-gas trades. But big trading wins such as George Soros' 1992 bet against the British pound, which netted more than $1 billion for his hedge fund, tend to be talked about for years.

The subprime trading gains notched by Birnbaum and Swenson and their Goldman associates are large by recent Wall Street standards. Traders at Deutsche Bank (DB) and Morgan Stanley (MS) also bet against the subprime-mortgage market this year, but in each case, their gains were essentially wiped out because their firms underestimated how far the markets would fall.

New York hedge-fund company Paulson also turned a considerable profit on the subprime meltdown this year, as did Hayman Capital Partners, a Dallas hedge-fund firm, say people familiar with the matter.

As recently as a year ago, few on Wall Street thought that the market for home loans made to risky borrowers, known as subprime mortgages, was heading for disaster. At that point, Goldman was bullish on bonds backed by such loans.

Last December, Sparks, a longtime trader of bond-related products, was named head of Goldman's 400-person mortgage department. That gave him a seat on the firm's risk committee, which numbers about 30 and meets weekly to hash out the firm's risk profile. It also gave him authority over the structured-products trading group, which then had just eight traders and was run jointly by Swenson and David Lehman, 30, a former Deutsche Bank trader.

Swenson, known as Swenny on the trading desk, is a former Williams College hockey player with four children and an acid wit. A veteran trader of asset-backed securities, he joined Goldman in 2000. In late 2005, he helped persuade Birnbaum, a Goldman veteran, to join the group. Birnbaum had developed and traded a new security tied to mortgage rates.

Swenson and Sparks, then No. 2 in the mortgage department, wanted Birnbaum to try his hand at trading related to the first ABX index, which was scheduled to launch in January 2006. Because securities backed by subprime mortgages trade privately and infrequently, their values are hard to determine. The ABX family of indexes was designed to reflect their values based on instruments called credit-default swaps.

A more bearish posture
These swaps, in essence, are insurance contracts that pay out if the securities backed by subprime mortgages decline in value. Such swaps trade more actively, with their values rising and falling based on market sentiments about subprime default risk.

Swenson and Sparks told Birnbaum the ABX was going to be a hot product, according to people with knowledge of their pitch.

They were right. On the first day of trading, Goldman netted $1 million in trading profits. But the index was tough to trade. In comparison to huge markets like Treasury bonds, there wasn't much buying and selling. That meant that Swenson's team nearly always had to use Goldman's capital to complete trades for clients looking to buy or sell.

Last December, David Viniar, Goldman's chief financial officer, gave the group a big push, suggesting that it adopt a more bearish posture on the subprime market, according to people familiar with his instructions.

During a discussion with Sparks and others, Viniar noted that Goldman had big exposure to the subprime mortgage market because of CDOs and other complex securities it was holding. Emerging signs of weakness in the market meant that Goldman needed to hedge its bets, the group concluded.

Swenson and his traders began shorting certain slices of the ABX, or betting against them, by buying credit-default swaps. At that time, new subprime mortgages still were being pumped out at a rapid clip, and gloom hadn't yet descended on the market. As a result, the swaps were relatively cheap.

Still, trading volume was thin, so it took months for the group to accumulate enough swaps to fully hedge Goldman's exposure to the subprime market. By February, Goldman had built up a sizable short position and was poised to profit from the subprime meltdown.

The timing was nearly perfect. Goldman's bets were focused on an ABX index that reflects the value of a basket of securities that came to market in early 2006, known as the 06-2 index. Goldman bet that the riskiest portion of that index -- a subindex that reflects the value of the slices of the securities with the lowest credit ratings -- would plunge in value.

This January, as concerns about subprime mortgages grew, that subindex dropped from about 95 to below 90. The traders handling the ABX trades were sitting on big profits.

Like other Wall Street firms, Goldman weighs its financial risk by calculating its average daily "value at risk," or VaR. It's meant to be a measure of how much money the firm could lose under adverse market conditions. Because the ABX had become so volatile, the VaR connected to the trades was soaring.

Goldman's co-president, Gary Cohn, who oversees the firm's trading business, became a frequent visitor, as did the firm's risk managers. More than once, Sparks was summoned to Blankfein's office to discuss the market. Goldman's top executives understood the group's strategy, say people with knowledge of the matter, but were uncompromising about the VaR. They demanded that risk be cut by as much as 50%.

Swenson and Birnbaum, however, argued that the mortgage market was heading down, and Goldman should take full advantage by maintaining large short positions, people familiar with the matter say.

Leaving money on the table
One day in late February, with the riskiest portion of the 06-2 index heading toward 60, the discussion about what to do grew heated. Birnbaum argued that Goldman would be leaving money on the table by unwinding some of the trades his group had used to bet on the mortgage market's decline.

"This is the wrong price" to close out the positions, Birnbaum snapped at a colleague assigned to help reduce risk, slamming down his phone receiver, these people say. He was overruled.

In March and April, the risky portion of the 06-2 index, which had taken a beating in February, bounced back from near 60 into the mid-70s. By then, the CDO underwriting business, which had been lucrative for Goldman, Merrill Lynch (MER) and other Wall Street firms, was slowing dramatically. Potential buyers had grown worried about the market.

Thanks to the wager that the ABX index would fall, Goldman's mortgage department earned several hundred million dollars during the first quarter, say people familiar with the matter. But the traders had unwound that bet in the weeks that followed. That left Goldman unhedged against further carnage, a worrisome situation for the second quarter.

In late April, Sparks, the mortgage-department chief, met with Cohn, the trading head, Viniar, the chief financial officer and a couple of other senior executives. "We've got a big problem," Sparks told them as they paged through a handout listing the declining values of Goldman's CDO portfolio, according to people with knowledge of the meeting. Prices were heading straight down, he told them. He suggested that Goldman cancel a number of pending CDO deals and sell whatever it could of the firm's roughly $10 billion in CDOs and related securities -- probably at a loss.

Led by Lehman, the co-head of the structured-products trading group, Goldman began selling off the majority of its CDO holdings. The losses pushed the mortgage group into the red for the second quarter.

By then, the subprime-mortgage market was cratering.

Dozens of lenders had filed for bankruptcy protection, and legions of subprime borrowers were losing their homes. At Bear Stearns (BSC, news, msgs), two internal hedge funds that had invested in risky portions of CDOs and other securities were struggling. Merrill and Citigroup, among others, were sitting on billions of dollars in depreciating mortgage holdings.

Although it had become more expensive to wager against the ABX index, Swenson and Birnbaum got a green light to once again ratchet up the firm's bet that securities backed by subprime mortgages would fall further. In July, the riskiest portion of the index plunged.

The structured-products traders were working long hours. Swenson would leave his home in northern New Jersey in time to hit the gym and be at his desk by 7:30 a.m. When Birnbaum arrived from his Manhattan loft, they'd begin executing large trades on behalf of clients. There was no time for breaks. They took breakfast and lunch at their desks.

Sparks, the mortgage chief, climbed into his car at 5:30 each morning for the drive in from New Canaan, Conn. To calm his nerves, he'd stop by the gym in Goldman's downtown building to briefly jump rope and lift weights.

Sometimes he worked past midnight. He canceled a family ski trip to Wyoming. Although he loves to attend Texas A&M football games, is a major donor to the university's athletic program and owns a second home near the university, Sparks decided not to join his wife and two children on more than one trip.

Raking in profits
By late July, the Bear Stearns funds had collapsed and rumors were circulating of multibillion-dollar CDO losses at Merrill. Goldman was raking in profits.

But once again, concern was growing about VaR, the all-important measure of risk. At one point in July, senior executives called another meeting to demand the mortgage traders pull back, according to people familiar with the matter. The traders agreed.

Around Labor Day, Birnbaum was asked to ratchet back one of his short positions by $250 million, according to Hayman Capital's Kyle Bass, a client who had similar positions at the time. Bass says he made $100 million by relieving Goldman of that particular short bet. "It appeared to me that (the traders) constantly fought a VaR battle with the firm once the market started to break," says Bass.

In the first three quarters of its fiscal year, Goldman's VaR rose 38%, ending that period at $139 million per day, an all-time high, regulatory filings indicate.

During the third quarter ended Aug. 30, the structured-products trading group made more than $1 billion, say people knowledgeable about its performance. That helped the mortgage department notch record quarterly earnings of $800 million, these people say.

The subprime market continued to deteriorate through the fall. Both Merrill and Citigroup announced massive write-downs connected to the subprime mess, and their chief executive officers resigned.

Goldman pressed forward with its bearish bets on the ABX index, people familiar with its strategy say. In October, Goldman's mortgage unit moved from one downtown Manhattan office building to another. Despite their stellar year, traders were crowded into a low-ceiling floor where 150 employees shared one small men's room.

In late November, Sparks summoned Birnbaum and Swenson to his office for separate visits. He thanked each trader for what he had done for the firm.

But there has been no time to relax. Two weeks into Goldman's new fiscal year, credit markets are looking bleaker than ever. Already, analysts are trimming their estimates of how much Goldman and other Wall Street firms will make in the coming year.

This article was reported and written by Kate Kelly for The Wall Street Journal.