Inside Job

by Charles Ferguson

  Rajan’s paper was titled “Has Financial Development Made the World Riskier?” And his answer was yes. After some introductory comments, Rajan said: “My main concern has to do with incentives.” Rajan discussed the new compensation structures that dominated the financial system, making risk taking so deliciously profitable: “These developments may create more financial-sector-induced procyclicality than the past. They also may create a greater (albeit still small) probability of a catastrophic meltdown” (page 6).

  On page 25, he describes a scenario nearly identical to the destruction of AIG by Joseph Cassano’s unit: “A number of insurance companies and pension funds have entered the credit derivatives market to sell guarantees against a company defaulting. . . . These strategies have the appearance of producing very high alphas (high returns for low risk), so managers have an incentive to load up on them. Every once in a while, however, they will blow up. Since true performance can be estimated only over a long period, far exceeding the horizon set by the average manager’s incentives, managers will take these risks if they can.”

  And then, on page 31: “Because they [banks] typically can sell much of the risk off their balance sheets, they have an incentive to originate the assets that are in high demand and, thus, feed the frenzy. If it is housing, banks have an incentive to provide whatever mortgages are demanded, even if they are risky ‘interest-only’ mortgages. In the midst of a frenzy, banks are unlikely to maintain much spare risk-bearing capacity.”

  Three pages later: “Linkages between markets, and between markets and institutions, are now more pronounced. While this helps the system diversify across small shocks, it also exposes the system to large systemic shocks.”

  Starting on page 44, Rajan discusses how to curtail the dangers posed by the new system: “Perhaps the focus should shift to ensuring investment managers have the right incentives” . . . “Industry groups could urge all managers to vest some fixed portion of their pay . . . in the funds they manage” . . . “In order that incentives be to invest for the long term, the norm could be that the manager’s holdings in the fund would be retained for several years.”

  When Rajan finished delivering his paper, Greenspan and most of the audience reacted with sullen, defensive silence. But not so Larry Summers. At the time, Summers was president of Harvard University, while also consulting to a hedge fund, Taconic Capital Advisors. One year later, after being forced to resign, he became a consultant to D. E. Shaw, a $30 billion hedge fund, which, in 2008, paid Summers $5.2 million for one day per week of work. Both hedge funds used precisely the incentives that Rajan was warning about in his paper—managers kept 20 percent of annual profits but had no liability for losses.

  With his trademark casual arrogance, Summers stood up to put Rajan in his place. If you want to read all of his response, it’s on the website of the Kansas City Federal Reserve Bank. Some quotes from Summers’s remarks:

  “I speak as . . . someone who has learned a great deal about the subject . . . from Alan Greenspan, and someone who finds the basic, slightly Luddite premise of this paper to be largely misguided.

  “We all would say almost certainly that something . . . overwhelmingly positive has taken place through this process [of financial innovation].

  “While I think the paper is right to warn us of the possibility of positive feedback and the dangers that it can bring about in financial markets, the tendency toward restriction that runs through the tone of the presentation seems to me to be quite problematic. It seems to me to support a wide variety of misguided policy impulses in many countries.”

  But Wall Street insiders already understood what Summers seemed to say he didn’t. When did they know there was a really serious bubble, and that they could game it? Many of the clever ones knew it by about 2004, when, for example, Howie Hubler at Morgan Stanley first started to bet against the worst subprime mortgage securities with the knowledge and approval of his management. But you can only make money betting against a bubble as it unravels. As long as there was room for the bubble to grow, Wall Street’s overwhelming incentive was to keep it going. But when they saw that the bubble was ending, their incentives changed. And we therefore know that many on Wall Street realized there was a huge bubble by late 2006, because that’s when they started massively betting on its collapse.

  Here, I must briefly mention a problem with Michael Lewis’s generally superb financial journalism. In his highly entertaining and in many ways informative book The Big Short, Lewis leaves the impression that Wall Street was blindly running itself off a cliff, whereas a few wild and crazy, off-the-beaten-track, adorably weird loners figured out how to short the mortgage market and beat the system. With all due respect to Mr Lewis, it didn’t happen like that. The Big Short was seriously big business, and much of Wall Street was ruthlessly good at it.

  To begin with, a number of big hedge funds figured it out. Unlike investment banks, however, they couldn’t make serious money by securitizing loans and selling CDOs, so they had to wait until the bubble was about to burst and make their money from the collapse. And this they did. In addition to Bill Ackman, already mentioned, other major hedge funds including Magnetar, Tricadia, Harbinger Capital, George Soros, and John Paulson made billions of dollars each by betting against mortgage securities as the bubble ended. It appears that just those five hedge funds made well over $25 billion, and possibly over $50 billion, shorting the mortgage bubble, and all of them worked closely with Wall Street in order to do so. In fact, as we shall soon see, their bets against the bubble appear to have been extremely helpful in allowing Wall Street to perpetuate the bubble.

  And as we’ve just seen, many people on Wall Street had huge financial incentives to keep creating and selling junk until the very end, even if it meant knowingly destroying their employers. Without question, thousands of Wall Street loan buyers, securitizers, traders, salespeople, and executives knew perfectly well that it would end in tears, but they were making a fortune while it lasted, with no individual ability to stop the bubble and very little to lose when it ended.

  In fairness to Mr Lewis, it is true that in several major cases—most notably Citigroup, Merrill Lynch, Lehman, and Bear Stearns—senior management was indeed disconnected and thus clueless, allowed their employees to take advantage too long, and therefore destroyed their own firms. Unquestionably, the general atmosphere of adrenaline, testosterone, and money also played a role, infecting many in the banks who should have known better. But even within these firms, there were groups that started dumping bad assets on unsuspecting customers and profiting by betting against their own securities. In 2011 the SEC tried to settle a case against Citigroup in which senior CDO traders profited by holding the “short side” of bad securities. A US federal judge rejected the SEC’s proposed settlement on the grounds that it was too lenient.2

  Moreover, cluelessness was most definitely not an issue with the senior managements of Goldman Sachs, JPMorgan Chase, and Morgan Stanley. As we saw, Morgan Stanley started betting against the bubble as early as 2004 but made a tactical error in doing so, one that cost them $9 billion. The fact that they underestimated the scale of the collapse does not excuse them, nor does it mean that they didn’t realize there was a bubble. They realized it very clearly, and ruthlessly tried to exploit it.

  Conversely, JPMorgan Chase just stayed away; they sold some toxic stuff, but mostly just remained prudently above the junk mortgage fray. JPMorgan Chase’s senior management sometimes countenanced extremely unethical, even illegal behaviour, but they weren’t stupid or complacent, and they kept their employees firmly under control. It probably also helped that Jamie Dimon only became CEO of JPMorgan Chase in 2005, and that he had just come from a troubled bank in Chicago that he had needed to rescue.

  But it was also clear that Dimon was paying attention. In May 2007 Bill Ackman, the hedge fund manager who was shorting MBIA, delivered a presentation to an investment conference, bluntly entitled “Who’s Holding the Bag?” It dissected the
bubble and its imminent collapse with devastating thoroughness. I have read it; the presentation was sixty-three pages long and left absolutely nothing to the imagination. It ranged from high-level questions of corporate governance and incentive structures to the conflicts of interest at the rating agencies, to the very fine-grained details of how many hundreds of billions of dollars of adjustable-rate mortgages would reset at higher interest rates in the coming year, with an inevitable wave of defaults to follow. Ackman’s presentation was widely circulated among the investment banks. A few months afterwards, Ackman encountered Jamie Dimon at the US Open tennis tournament. Ackman said to Dimon, “You should read my presentation,” to which Dimon replied, “I already have.”

  Goldman Sachs, though, was in a class by itself. They made billions of dollars by betting against the very same stuff that they had been making billions selling only a year or two before, profiting from the foolishness of AIG, Morgan Stanley, and, allegedly, Lehman Brothers. We consider them next; but first, a brief digression.

  The coming end of the bubble produced one final, wonderfully poisonous financial innovation, whose invention and widening use proves that many people on Wall Street knew exactly what was going on.

  Creating Something Special Just for the Innocents and Fools

  BY LATE 2005 and certainly by 2006, even the most fraudulent subprime mortgages were becoming harder to find. Borrowers had all the financing they could take, and even the most crooked mortgage broker would soon have been reduced to making loans to dead people, pets, and aliens. But there were still so many naively greedy investors out there who were willing to buy toxic securities. What to do? Wall Street came up with something brilliant. Once again, derivatives came to the rescue. The bankers’ insight was to realize that many investment managers in the world were so innocent, avaricious, and/or foolish that they would buy mortgage securities even when they knew that their interest payments came not from real mortgages, but rather from clever people betting that their securities would collapse.

  Enter a new product, the synthetic CDO. (We encountered it earlier, briefly, as the way Morgan Stanley ripped off the pension fund of the Virgin Islands.) Synthetic CDOs permitted banks to generate hundreds of billions in new high-risk paper, out of thin air, when they could no longer find subprime mortgages to buy. All it took was a computer, a flair for math, and complete amorality.

  Instead of going to all the trouble of defrauding borrowers, you simply used existing mortgage-backed securities as a reference or index. You then created a two-sided wager. On one side, an investor purchased the “long side” of the synthetic CDO, receiving payments that mimicked the performance of some “real” CDO (or an index of CDO prices). But the payments to the investor didn’t come from real mortgages; rather, they came from the opposite side of the bet—someone willing to pay an interest rate, often a surprisingly low rate, in return for the right to collect money if the referenced securities failed. So a synthetic CDO basically turned an “investor” into a seller of CDS insurance, on whatever stuff had been used as the reference or index. The investors’ “interest payments” were actually the bets being placed by the other side on the reference securities’ failure.

  What is interesting—and very dangerous—about this is that even as the housing bubble ended and the flow of real mortgages dried up, the investment banks were able to prolong the financial bubble (and worsen the eventual crisis) by selling synthetic CDOs. They used them to bet against the very securities they had created and sold, as Morgan Stanley did with Libertas and Goldman Sachs did repeatedly; to bet against the market generally; and to collect transaction fees by matching fools with sharks (e.g., hedge funds), structuring and selling both sides of the deal. Since synthetic CDOs can exist only if someone is willing to bet against the “long side”, their sharp rise was a clear indication that Wall Street knew not only that there was a bubble, but also that its end was imminent. It was no coincidence that synthetics grew strongly after home price increases levelled out in 2006.

  And this was most emphatically not a small business catering to a few adorably cranky contrarian individuals. A reasonable estimate is that by the end of 2006, the volume of synthetic, or primarily synthetic, CDOs was approaching $100 billion, while about a quarter of the assets in “conventional” CDOs were also synthetic. By the first half of 2007, just before the market collapsed, synthetic CDOs were almost certainly the majority of the total CDO market.

  And nobody knew more about this business than Goldman Sachs, John Paulson, Magnetar, and Tricadia.

  Goldman Sachs, the Really Big Short, Gaming the Crisis, Lying to Congress

  THE NINE-HUNDRED–PLUS PAGES of documents and e-mails gathered by the US Senate Permanent Subcommittee on Investigations, supplemented by the Levin hearings of April 2010 and other records, lay out a remarkable narrative of how Goldman Sachs profited from the collapse. Two conclusions dominate.

  The first is that Goldman’s management was tough and competent. In contrast to Jimmy Cayne, Stan O’Neal, and Chuck Prince (CEO of Citigroup), who had no clue or apparent concern about what their traders were doing, Goldman’s executives closely monitored and understood both the wider market and their own position. Helicopter golf and bridge tournaments did not take precedence. They called the end of the bubble accurately, shifted their strategy to betting against it, and implemented their decision with great discipline, speed, and foresight.

  The second clear lesson, from the way they dumped their “shitty” assets, gamed the industry, failed to warn regulators of impending crisis, and later misrepresented their behaviour, is that they could be utterly cold-blooded bastards. We’ll look first at their trading and asset-shedding strategies in 2006–2007, then their brilliant, ruthless manipulation of the industry in 2007–2008, and finally, their not-so-honest Senate testimony in 2010.

  E-mail records reveal Goldman’s strategic shift. The first step was a full-scale “drilldown” on the company’s entire mortgage portfolio, conducted in mid-December 2006. The working group produced a listing of all its mortgage positions and hedges, and a position-by-position list of loss exposures that added up to $807 million in potential losses.

  David Viniar, the Goldman CFO, sat down with the entire mortgage team on 14 December and decided on an approach. The objective was to “reduce exposure . . . distribute [sell] as much as possible on bonds created from new loan securitizations and clean previous positions.”

  Just four days later, Fabrice Tourre, a thirty-one-year-old senior account manager based in London, made a special inquiry about buying some selected bonds because he was aware that “we have a big short on” [italics mine].3 Goldman reduced its bids on new loans, loaded up on mortgage index shorts, and bought credit default protection on individual bonds. To avoid revealing its strategy, Goldman continued to be active in buy-side markets but deliberately lowered its bids in order to win as few auctions as possible.

  Almost immediately afterwards, the mortgage market started deteriorating badly. A medium-sized subprime lender, Ownit, filed for bankruptcy in late December, and two big originators admitted to major problems in the first week of February 2007. HSBC announced large subprime losses, while New Century, one of the most important subprime originators, announced it would restate its 2006 earnings—what had appeared to be large profits became substantial losses. New Century’s stock went off a cliff, and it filed for bankruptcy soon afterwards. The spread, or risk premium, on a widely used subprime mortgage index jumped from 3 percent to 15 percent.

  By that time, however, Dan Sparks, the head mortgage trader, could advise his bosses that his “trading position has basically squared”—in other words, the $807 million exposure was almost gone, although “credit issues are worsening on deals and pain is broad (including investors in certain GS-issued deals).” He also advised his management that his group’s estimates of the real value of Goldman’s holdings was dropping even faster than market prices.

  The main reason for this is that most
of the other investment banks didn’t react the same way; virtually all of them kept their marks (i.e., valuations) much higher than Goldman’s, which made Goldman’s market exit all the easier.4 This difference between the behaviour of Goldman Sachs and the other banks was the combined result of three forces we have discussed previously. The first was that many traders were gaming the system, keeping the bubble going as long as they could for their own personal benefit. The second was the compartmentalization of information. And the third force, of course, was the obliviousness of the senior management of some of the large banks, which allowed their employees to keep going too long.

  Sparks continued his shorting and said that his group had continued to make aggressive markdowns, which were “good for us position-wise, bad for accounts who wrote that [CDS] protection.”5 It appears that Goldman had bought all the CDS protection it could while protection was still cheap, and then, as soon as it had protected itself, wrote the securities down and demanded payment from its protection suppliers. (We will see this again, on steroids, when we come to AIG.) A week later, with the market collapsing, Sparks ordered the team to “monetize” their positions. This meant that they locked in a limited but guaranteed profit, which they could start booking immediately for that year’s earnings, rather than waiting until their protection contracts ended. “This is the time to just do it, show respect for risk, and show the ability to listen and execute firm directives. . . . You guys are doing very well.”6

  Sparks told his bosses, “We are net short,”7 but that he was still worried. He needn’t have been. Mortgage trading had a record first quarter in 2007, booking $266 million in revenues, at the same time that it accomplished major position reductions. The overall mortgage inventory was down from $11 billion to $7 billion, with the subprime component down by a net $4.8 billion. From that point onward, Goldman was safe—unless the whole financial system melted down, a contingency for which, we shall see, they started to prepare. In late July 2007, after two Bear Stearns mortgage hedge funds had blown up, Goldman Sachs’s copresident Gary Cohn commented to David Viniar, Goldman’s CFO, on the sudden carnage. Viniar replied, “Tells you what might be happening to people who don’t have the big short.”8