Money and Power

by William D. Cohan

  So Friedman took a new tack: he started to urge pairs of partners to work together on various projects to see if any two of them could gel the way he and Rubin had. He pushed Paulson together with Corzine to work on various projects, and he pushed Winkelman to work with Roy Zuckerberg, the head of equities. This felt a bit awkward to Paulson. “I would come to New York, work, and then get out of New York,” he said. “I didn’t go out to dinner with other people on the Management Committee. I didn’t socialize. I didn’t politic.” Friedman kept urging Paulson to be more sociable. “He started saying to me, ‘Well, I’d like you to get to know Jon Corzine better,’ ” Paulson recalled. “ ‘I’d like you to know Jon Corzine. Spend time with Jon Corzine.’ And I was little thick. And then finally he said, ‘You like Asia. He likes Asia. Why don’t you two take a trip together through Asia?’ ” Paulson and Corzine traveled to Asia together to wave the Goldman flag. Paulson went alone; Corzine traveled with an entourage.

  Paulson missed this message, too. “We were both interested in Asia,” he said of his trips with Corzine, “and with his understanding of the trading and the sales side, I took it as the two of us going around and sending the right signal to people there. Not that ‘We should be cooperating better or working better together when we made these business decisions in Asia.’ It hadn’t occurred to me that we were going to be joined in some way to help run the firm.”

  ——

  BUT MUCH OF this social calculus quickly got pushed to the back burner as the firm’s traders started to stumble—badly—racking up huge losses during 1994 of as much as $100 million, or more, a month. “I don’t like the feel of this,” Friedman remembered thinking. “Our trading is not right and they think they’re better than they are. They did real well in 1992 and 1993 but I think they were shooting fish in a barrel.” Especially on the heels of the huge profits the year before, these ongoing losses rattled the firm and raised the question for the first time about how the loss of Rubin was affecting Goldman. “They were a great pair,” one partner said of Rubin and Friedman. “They trusted each other, liked each other, collaborated. They complemented each other. Bob understood the sales and trading much better than Steve. It didn’t seem that disruptive when Bob left, because the firm went on to have these fabulous years. But the thing that disrupted the transition was when we had the significant trading losses.” By the early 1990s, Goldman “hardly lived up to its century-old image as a staid investment bank making money through old-line relationships,” Steven Drobny observed in Inside the House of Money, his 2006 book about how hedge-fund traders make money. “Rather, it turned into one of the biggest proprietary risk-takers among investment banks, with its traders making huge bets with the firm capital in global fixed-income, foreign exchange, commodities and derivatives.”

  What tripped up Goldman’s traders was a massive wrong-way bet on interest rates. “Credit spreads just blew out,” Paulson explained. Recalled another Goldman partner, “In December 1993, the Fed raised interest rates, and it just completely fucked up the firm’s trading position. And the firm didn’t really know what the risks were.” Goldman’s biggest losses were in the fixed-income arbitrage “book” of Michael O’Brien, who was running trading in London. He was heading up a firm of proprietary traders composed, in large part, of people who came from J. Aron. Christian Siva-Jothy worked for O’Brien as a proprietary trader in London at the time, having joined Goldman from Citibank in March 1992. He found the trading culture at Goldman diametrically opposed to that of Citibank. During his first week at Goldman, he placed a $50 million bet involving deutsche marks and Swiss francs. It was Siva-Jothy’s largest trade ever. That first week, O’Brien came by and asked him how things were going. “I’m short 50 mark Swiss,” he told O’Brien.

  “I like a guy who averages into his positions,” O’Brien deadpanned before turning and walking off.

  “It was a bit of a free for all at [Goldman] in the early 1990s,” Siva-Jothy explained, “but the opportunities were there. There were no limit structures per se, no value-at-risk system. It was just kind of get on and do it and hope for the best.” He described the attitude at the time among Goldman’s proprietary traders as “suck it and see,” which translated into English roughly as “if you want to try a big position, try it” and “make mistakes but learn from them.” He recalled a moment during Goldman’s 1993 bonanza when one trader went on the internal squawk box and said, “Buy Bunds,” a reference to German federal government bonds. When a broker wanted to know how many Bunds he should be buying, the reply came: “I said buy Bunds. I’ll tell you when to stop.”

  Another time, Goldman’s chief economist in London, Gavyn Davies, came by the proprietary trading desk to offer his macroeconomic view of the world. One trader cut Davies off and “with his boots up on the desk,” told him, “With all due respect, Gavyn, I do my own research. I was in quite a few bars in Spain last weekend and let me tell you something—they were empty.” He followed this bit of trenchant analysis with another: “I’ve got another rule that I live by: ‘If you can’t drink the water, sell the currency.’ ”

  Siva-Jothy said he found the Goldman approach “incredibly powerful” and a “wonderful environment in which to work” but also “it was to have its downside as we discovered in 1994.” Siva-Jothy realized that at some point in 1993, it seemed like every trader at Goldman in London had become a proprietary trader. “There were 500-plus prop traders at Goldman Sachs then and they all had the same position,” he said. He made “well over $100 million” in profits that year “and I was a bit full of myself.”

  The dynamic began to change in December 1993. Siva-Jothy had made a massive bet that the British pound would rise against the yen. “It was over £1 billion, which was the biggest position I’d ever run,” he said. The bet paid off in December and January as the pound rose in value. He was up about $30 million on the trade. “People were starting to say, ‘Christian is going to do it again,’ ” he recalled. He was so confident, he even added to his position by selling puts.

  In February, disaster struck. Not only were the monthly British inflation numbers terrible but also President Clinton had blasted the Japanese on their trading policies, threatening tariffs and quotas. “Sterling went into a free fall,” he observed. “It was classic—the market found me.” During the course of fifteen trading days in February, the pound lost 10 percent of its value against the yen. “I was selling out of the position as fast as I could but I was selling just to stand still because I was short these puts,” he said. “It was a disaster. Markets have a great way of taking it out of you.” At one point during the trade’s collapse, Siva-Jothy remembered being overcome by a desire to stand up and walk out. But he stayed and took the pain. By the time the final accounting was in, Siva-Jothy had lost somewhere between $100 million and $200 million—and he was just one trader making one bet.

  Another trader, Lawrence Becerra, had joined Goldman in London in 1992 as a senior proprietary trader. “Becerra was probably the trader with the highest appetite for risk of all of those people,” remembered David Schwartz. Becerra had put on a large trade involving the Italian Treasury market. “They kept on piling on the position,” Schwartz said, “and it kept on going against him. And the culture at the time—and this was throughout the trading culture—was that you don’t tell a trader what to do. And O’Brien obviously understood that they were losing money and losing a lot of it, but Becerra believed in the trade and, I guess, Mike did as well. But the trade just never worked out. Eventually, they had to cut it, and in cutting it, they lost even more money.”

  Before long, the losses in London had spiraled so far out of control, Corzine and Winkelman flew to London to see if anything could be salvaged from the trading positions. Winkelman met with Siva-Jothy. “Christian, sit down, what’s this all about?” Winkelman asked him.

  “I’ve lost [more than $100 million],” he said. “I’ve liquidated everything. What do you want me to do?”

  “If
you hadn’t liquidated and come in here, you wouldn’t be working at Goldman Sachs anymore,” Winkelman told him. “What I want you to do now is go out and make it back, with lower risk limits.” Siva-Jothy was surprised—and impressed—that he hadn’t been fired. (He actually was promoted to run the entire revamped proprietary trading desk in Europe.) He then established a new trade betting that fixed-income securities would fall in value. When the Fed started tightening the money supply and interest rates rose, bond prices fell, and his short bet began paying off. He made back about 35 percent of what he had lost.

  Back in New York, though, the losses were still resonating. “When the market went against us, the lesson I took away was the lack of discipline in that department,” Paulson said. “And a real lack of rigor. And there was an arrogance: ‘We know that the market’s going to be like this … and we like it better every month. Because we just think the markets are going to come back.’ Of course, Goldman Sachs wasn’t a hedge fund. And we just couldn’t afford to do that. There wasn’t the level of scrutiny we should have had at the Management Committee level.”

  One of the problems, it turned out, was that Corzine was wearing two hats at once. He was both co-CFO and co-head of fixed-income. “He wasn’t independent,” explained one partner, from the investment banking side of Goldman. “You just really need independent control functions and it just is critical that you have that to run any kind of trading business. You need to have people on the control side and the compliance side to independently mark the books, to go head to head with the traders, to have a totally independent career track. And you need to look at everything in terms of the size. You know Bob Rubin always talked about small but deep holes. You can’t afford to lose a lot of money even if the odds are very low. You just have to protect yourself.”

  One of the ways Friedman sought to protect the firm from the growing monthly losses was by cutting expenses, which on Wall Street means cutting people, since by far the largest single cost at a Wall Street firm was—and is—compensation. But Friedman was hesitant to unilaterally make the decision to cut people as the year unfolded, in part because he had already decided to retire and didn’t think it would be fair to his partners to saddle them with the lower growth prospects that having fewer traders might cause. He also knew that it was possible that the trading environment could improve suddenly, and without traders in the seats, money could be left on the table. He put the question of cutting people to a vote, but he and the financial types were the only ones who thought the firm should do it. As the losses continued, Friedman broached the subject again, and again he got shot down. “I was always very, very careful with my management clout,” he said. “When you are the senior partner at Goldman Sachs, you have more power than you needed. Your job was to make sure that people felt included and free and empowered and obliged to tell you stuff you didn’t want to hear. I would always lean over backward to get people involved in the decisions.”

  But by the summer, as the trading losses mounted, Friedman was increasingly frazzled. Bob Hurst remembered seeing Friedman in Jackson Hole, Wyoming, and thinking that the senior partner was hurting. “ ‘Your job’s impossible,’ ” Hurst remembered telling Friedman. “ ‘I have no interest in it.’ I said it from a perspective of I thought he had a couple of years to go and not that he was quitting that fall.” Another partner put it more bluntly: “Steve hated his job as CEO. He hated it because he felt he had lost control of his life.”

  Hurst remembered hearing about a telephone call between Friedman and Corzine where Corzine told Friedman that another $50 million had been lost in London that week. Friedman was trying to get Corzine to cut back the trading positions. “He just won’t do it,” Friedman told Hurst. “He says it’s a great trade.” Part of the problem for Friedman was that, without Rubin, he was not expert enough in fixed-income to know for sure whether to overrule Corzine. The other part of the problem was that 1992 and 1993 had been such amazingly profitable years in fixed-income that Corzine would have been difficult to overrule under any circumstances.

  While Friedman couldn’t stop the trade, he did start insisting that personnel cuts be made. “But people weren’t as worried as I was,” he said. Friedman started to micromanage. “I spent a lot of time with the traders,” he said. “I was not really happy with how a lot of that was going. We were in an industry-wide bear market and our traders were out of sync. I really made them contract a lot of their positions. I’d see guys who hadn’t made any money in their positions for whatever the hell it was, nine out of ten months.… So, we reduced our positions sharply and maintained a lot of liquidity. I did feel our traders had been much too confident about their abilities.”

  As the year dragged on, the pain across the Goldman partnership became more acute. “Every month, Corzine and Winkelman would stand up and say, ‘I’m sorry, guys, we’ve lost another hundred and fifty million bucks,’ ” remembered one partner from the banking side of Goldman. “My capital account in 1993 was like seven million dollars, something like that. And it went down to four million dollars. Every month, it went down three hundred thousand, four hundred thousand dollars. And you’re just saying like, ‘What the fuck? This is unbelievable.’ It was pretty out of control, but no one knew. People were just completely off the reservation.” There was also a growing concern among the partners that because their liability was not limited, their entire net worth was on the line as the losses mounted. Some partners were beginning to think that everything they had built up for so long at Goldman might be at serious risk of being lost, since their capital remained at the firm and their annual cash compensation was limited to an 8 percent dividend on their capital account. “Partners are seen outside as mega-rich, but that is not the case at all,” Mike O’Brien told The Independent, a U.K. newspaper, in September 1992. “Their capital stays with the firm. My C-registration Ford Granada is testament to that.” (On the other hand, one of O’Brien’s London partners, David Morrison, drove a Ferrari around town.) For the banking partner who started 1994 with a $7 million capital account and ended with a $4 million capital account, after absorbing the trading losses, his cash compensation for the year decreased to $320,000, from $560,000. Suddenly, some serious sand had been tossed into the gravy train’s engine.

  Toward the end of the August, while his concern for both his own and the firm’s health continued to increase, Friedman’s hints about his future were becoming less opaque. “We had a really bad dynamic in the firm,” Corzine recalled. “It was made all the worse almost every other day by something coming out about Maxwell. Pretty tense period of time.” Finally, a decision was made to cut the losses on the bad trades. “It didn’t matter how intelligent the trades were …,” Corzine said, but a change had to be made. “I didn’t think it was existential. But you have to stay calm or you can’t make good decisions. Otherwise, you end up making an emotional decision as opposed to a calculated, probability-based decision.”

  Corzine also remembered a conversation he had with Friedman in the late summer that left him “with the idea” that the senior partner was getting ready to retire. “We had an indirect conversation that led me to believe my promotion was what would take place,” Corzine said. He could tell something was not right with Friedman. “He did not feel well,” he continued. “You could see it on his face as we were trying to get our world squared. As for Steve, it wasn’t obvious that it was only a health issue that was troubling him. This was another one of those times when people who run firms that take on risk—they may earn a lot of money, but they earn their keep.” Other partners were aware of Friedman’s health problems, too. “He had things where his heart, when he traveled—it’s just the rigors of the job—and his heartbeat would speed way up,” one of them said. “And it scared him.”

  ——

  THROUGHOUT 1994, Friedman and Katz had had a number of dinners to discuss how the succession plan at the firm would unfold. They intentionally chose to meet in offbeat neighborhoods around New York w
here they assumed few Goldman partners would be hanging out. At the first dinner, they chose an Italian restaurant on West Seventeenth Street, far from the usual haunts of the Upper East Side, but were interrupted by a partner who was dining there.

  By discussing repeatedly how the announcement should be made and how the new senior partner should be selected, Friedman and Katz were hoping to avoid the internecine political warfare that generally accompanies Wall Street succession. “I wanted to avoid anything that was political, and I wanted to give myself and other management committee members the opportunity to continue to evaluate how different people worked together,” Friedman explained in October 1994. “We had seen numerous firms in which the succession dragged on and had been the subject of rumors and, thus, divisions, or where they had a long, drawn-out transition with too many hands on the steering wheel. We were convinced our firm could avoid that.”

  Friedman had wanted to “drop his bombshell” in August, but after more conversations with Katz and Rubin, he decided that the Management Committee’s schedules would be easier to coordinate after Labor Day, when everyone was back in New York after the summer holidays. On Tuesday, September 6, the calls went out to the Management Committee to make sure they were in New York the next day. “I had no special call from him,” Paulson said. “No warning. We were told we were supposed to be there. He wanted us all there.” Usually, Paulson would join the Management Committee meetings from Chicago by videoconference and would often forget that he was on camera and start reading the newspaper. Someone in New York would step out of the meeting and call him and tell him, “Don’t forget you’re on the screen. Stop picking your nose.”