Goldman Prepares Its Defense To Market Timing & Subprime Risk Charges

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Goldman Readies Reply To Claims It Misled Clients

Goldman Sachs is preparing its most detailed defense yet to allegations that it misled clients in its mortgage securities business, arguing that the firm was unsure whether housing prices would rise or fall and did not take any action at odds with the interests of its clients.

An internal Goldman document, prepared for senior executives and obtained by The Washington Post, addresses the criticism that the bank invested its own money betting against the housing market while simultaneously urging clients to invest in securities that would increase in value only if the housing market did.

Those concerns over possible double-dealing spiked a week ago as the Securities and Exchange Commission filed a fraud suit against Goldman, alleging that it misled clients by selling them mortgage-related securities secretly designed to fail.

Goldman prepared the 11-page document to serve as the basis for testimony that chief executive Lloyd Blankfein is scheduled to deliver Tuesday before the Senate Permanent Subcommittee on Investigations.

The Goldman paper describes debates among top executives in 2006 and 2007 over whether the firm should make investment decisions based on the belief that the mortgage market would continue to prosper. The document details meetings and e-mails that ultimately resulted in a decision to reduce the company's exposure to the mortgage market, especially subprime loans, by making new investments that would pay off if housing prices fell.

Subprime Risk

Over the past few years, other financial firms and some in the media have complained that Goldman recognized the risks of the subprime mortgage market early on and, without telling clients, developed financial products that would allow the bank to bet against mortgages with its own money. At the same time, Goldman continued to sell mortgage-related investments to clients who expected the subprime loan business to remain vibrant, critics have alleged.

While the firm moved to significantly reduce its losses when the housing market cratered, the impression conveyed by the document is that Goldman was confused, like many other financial firms, over how bad the collapse would be and suffered losses as a result.

The document also reprises Goldman's frequent explanation that it was not investing its own money in financial transactions to make a trading profit but to help investors who wanted to do a deal and could not easily find someone else to trade with. That role, commonly played by investment banks, is known as being a market maker.

A spokesman for the Senate subcommittee declined Friday evening to comment on Goldman's defense.

"Our investigation has found that investment banks such as Goldman Sachs were not market makers helping clients," Sen. Carl M. Levin (D-Mich.), who heads the panel, said Friday. "They were self-interested promoters of risky and complicated financial schemes that were a major part of the 2008 crisis."

In the paper, Goldman argues that it was a relatively small player in the mortgage market, bringing in only $500 million from its residential mortgage business in 2007, less than 1 percent of the firm's overall revenues.

Still, the bank's mortgage investments were large enough that executives began to worry in 2006 that it was betting too heavily on the health of the housing market.

According to the document, the concerns arose in late 2006, when Dan Sparks, the head of the mortgage unit, wrote to top executives that the "subprime market [was] getting hit hard," with the firm losing $20 million in one day.

On Dec. 14, 2006, financial officer David Viniar called Goldman's mortgage traders and risk managers into a meeting to discuss investing strategy. They concluded that they would reduce the firm's overall exposure to the subprime mortgage market.

But the prevailing view of executives, as described in the paper, was not that the housing market was headed into a prolonged decline. They were not looking to short the market overall. That would have entailed making such large bets against mortgage securities that the firm would turn a profit if the market as a whole collapsed, which in fact it did.

The document acknowledges that Goldman at times shorted the overall market but describes those periods as temporary while the firm was rebalancing its portfolio to limit losses if mortgage securities were to lose more value.

At some moments, executives were actually considering making new bets, buying potentially undervalued securities that could pay off when the mortgage market turned around. A day after Viniar met with traders and risk managers, he wrote to Tom Montan, co-head of the securities division, saying, "There will be very good opportunities as the markets goes into what is likely to be even greater distress and we want to be in position to take advantage of them."

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Market Timing

The back-and-forth over which way the market would go, and how to invest in it, continued into 2007.

On March 14, Goldman co-president Jon Winkelried e-mailed Sparks and others asking what the bank was doing to protect itself from a decline in prices of not just subprime loans but also of other loans traditionally considered less risky. Sparks replied that the firm was trying to have "smaller" exposure to those loans also.

But managing director Richard Ruzika took issue with that answer a few days later, saying that Goldman might be overestimating the decline in housing. "It does feel to me like the market in general underestimated how bad it could get. And now could be overestimating where we are heading," he wrote in an e-mail. "While undoubtedly there will be some continued spillover, I'm not so convinced this is a total death spiral. In fact, we may have terrific opportunities."

Sparks later endorsed that optimistic view, suggesting as late as August 2007 that Goldman begin buying more mortgage securities.

The bank did not immediately follow that path, and by Nov. 30, 2007, Goldman had largely canceled out its exposure to subprime mortgages by increasing its bets that the market would continue to slide, according to the document.

But by that account, Goldman also continued to have $13.5 billion in exposure to safer, prime mortgages. That cost the bank. In 2008, the firm lost $1.7 billion on investments in residential mortgages.


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Sources: CNBC, MSNBC, Washington Post, Google Maps