Traders for Morgan Stanley gnashed their teeth for weeks in early 2008, watching helplessly as their $1.2 billion investment in an exotic offshore deal, which was marketed by Wall Street rival Goldman Sachs, began to shrivel.
With the housing market deteriorating rapidly, Morgan Stanley traders wanted to sell off hundreds of millions of dollars in securities positions that had been downgraded by credit ratings agencies and recover what money they could. But as the deal's liquidation manager, Goldman Sachs held sole control over the disposal of any of the securities contracts, and Goldman Sachs was resisting.
On Feb. 6, 2008, Morgan Stanley trader John Pearce wrote a colleague that he got so exasperated with a Goldman representative that "I broke my phone." A day later, he wrote to a Goldman Sachs counterpart: "One day I hope I get the real reason why you are doing this to me."
It turns out, Senate investigators revealed this week, that Goldman Sachs had plenty of reasons to delay a selloff. The investment banking giant had secretly wagered on the default of the securities around which the $2 billion deal was structured. The farther their value dropped, the bigger Goldman Sachs' profits.
Ultimately, a Morgan Stanley lawyer lodged a formal protest, charging that Goldman Sachs had breached its contractual duty to sell off downgraded securities, and that the delays had already cost Morgan Stanley $150 million.
Known as Hudson-Mezzanine-2006-1, the deal totally collapsed in November 2008, barely more than two years after its creation. Goldman Sachs reaped $1.35 billion. Morgan Stanley lost $930 million.
The story of the deal, which drew outrage from Democratic Sen. Carl Levin of Michigan at a news conference Wednesday, is unveiled among hundreds of newly disclosed documents released by his Senate Permanent Investigations Committee, culminating a two-year inquiry into the financial crisis.
It provides another close-up glimpse of how Goldman Sachs deftly scaled back its risks as the housing market crested in late 2006 and then, at the expense of its investor clients, earned billions of dollars from a full-scale blitz of secret bets that the value of home mortgage securities would crash. Goldman Sachs was the only major Wall Street firm to escape relatively unscathed from the nation's economic meltdown.
The subcommittee reported that Goldman Sachs packaged at least four offshore deals with total value of $4.5 billion that were rife with conflicts of interest, including one for which the firm paid $550 million in fines to Securities and Exchange Commission last summer to settle a civil fraud suit.
Levin charged that Goldman Sachs deceived investors on the Hudson deal by failing to disclose that it was betting the other way. And, he alleged, the company misled the subcommittee during a marathon hearing last year in which he repeatedly pressed Chief Executive Lloyd Blankfein and a half-dozen other current and former Goldman Sachs execs to acknowledge the firm bet massively on a housing downturn in 2006 and 2007.
A spokesman for Goldman Sachs, which says its executives testified truthfully, declined to comment on the Hudson deal.
Internal Goldman Sachs documents show that the firm's mortgage department came up with the idea for the Hudson deal to offset $1.2 billion in positive bets on dicey mortgage securities on a London-based exchange, known as the ABX Index. By late 2006, it grew hard to find buyers willing to pay good prices to bet that baskets of subprime loans to marginal homebuyers would perform well.
To "transfer the risks" of its ABX holdings to investors, Goldman Sachs traders and structured products specialists came up with the idea on Sept. 19, 2006, of creating a series of new bets, known as credit-default swaps, on 80 of the mortgage securities listed on the ABX, most barely investment grade or below. They even offered investors a discount to cover the $1.2 billion in risks. The firm also added $800 million in bets on other subprime securities.
Top-level executives, including Blankfein and Chief Operating Officer Gary Cohn, were apprised on Oct. 26, 2006, that the deal would reduce the mortgage department's housing risks, an internal document said.
The pressure was intense enough that marketing of another deal was bumped in favor of Hudson, and Goldman Sachs traders sent congratulatory messages when they'd peddled most of the deal to investors over the next month.
In their marketing booklet, the Goldman Sachs traders stated that the securities selected for the deal were "sourced from the street" and that Hudson "is not a balance sheet" deal. In Wall Street parlance, that meant that the securities were purchased from Wall Street dealers and that Goldman Sachs wasn't taking the "short" position, or wagering that the securities would default.
Neither was true, the investigators said, and Goldman Sachs was making "a proprietary investment ... in a direct, adverse position to the investors" - a position it declined to divulge even when a representative of another investor, National Australia Bank, directly asked.
Goldman Sachs also stressed to investors that it was investing in an equity piece, or one of the riskiest slices of the deal.
The committee found that Goldman Sachs invested $6 million in the equity slice. Meanwhile, Levin said, it bet "more than 300 times more" - $2 billion - against the deal.
Sylvain Raynes, an expert in structured products, said the Hudson deal was "full of conflicts of interest," including Goldman's dual role as liquidation agent.
"This deal should never have gone to market, due to the lack of transparency and the fact that Goldman was holding both ends of the deal," he said.
However, Goldman Sachs could mitigate liability due to standard language in the contract documents informing investors that it may initially take the short position and that it may have conflicts of interest.
For its role as liquidation agent, the subcommittee said, Goldman Sachs collected an additional $3.1 million in fees.