GOLDMAN AND THE FINANCIAL CRISIS
When the housing bust began to take its toll on Wall Street, Goldman seemed to be the firm best positioned to weather the storm. In 2007, a year when Citigroup and Merrill Lynch cast out their chief executives, Goldman booked record revenue and earnings and paid its chief, Lloyd C. Blankfein, $68.7 million — the most ever for a Wall Street C.E.O.
And as 2008 progressed, Goldman appeared to persevere through deepening economic crisis that consumed rivals Lehman Brothers and Merrill. In September, the company reported modest, though diminished, profits for the third quarter, beating expectations.
But the company was not invincible, as the credit crisis escalated later that month. American International Group, an insurance giant facing collapse due to its exposure to the mortgage crisis, was Goldman's largest trading partner. When A.I.G. received an emergency $85 billion bailout from the federal government, jittery investors and clients pulled out of Goldman, nervous that stand-alone investment banks — even one as esteemed as Goldman — might not survive. Company shares went into a free fall.
On Sept. 21, in a move that fundamentally changed the shape of Wall Street, Goldman and Morgan Stanley, the last major American investment banks, asked the Federal Reserve to change their status to bank holding companies. Goldman would now look much like a commercial bank, with significantly tighter regulations and much closer supervision by bank examiners from several government agencies.
The radical shift represented an assault on Goldman's culture and the core of its astounding returns of recent years.
Goldman received $10 billion from the federal government as part the Bush administration's $700 billion rescue of the financial industry. Goldman also benefitted from an indirect subsidy adopted by the federal government that allows them to issue their debt cheaply with the backing of the Federal Deposit Insurance Corporation. It was the first bank to take advantage of the debt program when it was introduced in November, when the financial crisis made it nearly impossible for companies to raise cash. The program will continue to bolster scores of banks through at least the middle of 2012.
In recent months, Goldman has repeatedly defended its actions in the mortgage market, including its own bets against it. In a letter published last week in Goldman's annual report, the bank rebutted criticism that it had created, and sold to its clients, mortgage-linked securities that it had little confidence in.
"We certainly did not know the future of the residential housing market in the first half of 2007 anymore than we can predict the future of markets today," Goldman wrote. "We also did not know whether the value of the instruments we sold would increase or decrease."
The letter continued: "Although Goldman Sachs held various positions in residential mortgage-related products in 2007, our short positions were not a ‘bet against our clients.' " Instead, the trades were used to hedge other trading positions, the bank said.
RETURN TO PROFITABILITY
On April 13, 2009, Goldman announced strong quarterly earnings and said that it would seek to raise money in the capital markets to repay the government the $10 billion it received in 2008. Goldman's chief financial officer, David A. Viniar, said that it was able to generate much of its revenue by trading "plain vanilla" investments. Margins were higher than usual, he said, in part because of the disappearance of some of Goldman's former competitors, like Bear Stearns and Lehman Brothers.
In June, the federal government allowed Goldman to return its share of the federal aid.
In July, it announced that it had earned second-quarter net profits of $3.44 billion, and on Oct. 15, it announced $3.19 billion more. on Jan. 22, 2010, the bank reported bumper 2009 earnings: a profit of $13.4 billion on revenue of $45.2 billion. For the fourth quarter, Goldman earned $4.95 billion on $9.6 billion in revenue. But in reaction to the public outcry over executive compensation, the bank reduced the share of revenue going to bonuses. on average, each Goldman employee received about $498,000 in bonus and compensation for 2009, an amount that still incensed the bank's critics, given the economic pain elsewhere in the country.
Wall Street Tactics and a Battered Euro
The role of banks like Goldman became the focus of criticism in February 2010 as Greece, Spain and other southern European countries found themselves facing a debt crisis. Over the last decade, Goldman and others helped the Greek government legally mask its debts so the nation appeared to comply with budget rules governing its membership in the euro, Europe's common currency. In that role, Goldman advised Greece and, in return, collected hundreds of millions of dollars in fees from Athens.
But, just as the true extent of Greece debts began to worry investors, Goldman put on another hat. In July 2009, it sent clients a 48-page primer on credit-default swaps entitled "C.D.S. 101." The report said that credit-default swaps enabled investors "to short credit easily" — that is, to bet against certain borrowers. The report made no mention of Greece. But its disclosure in March 2010 fueled the suspicions of European officials who have called for investigations into the role swaps have played in the current crisis.
With Wall Street — and Goldman in particular — still in the public's cross hairs, the entire financial industry is grappling with how to remake itself. A poll offered Goldman evidence about the challenge it faces in battling widespread public resentment (and regulatory scrutiny) over the bailout of Wall Street and subsequent huge profits. Roughly half (49 percent) of respondents had a negative view of the firm.
In its annual letter on April 7, Goldman denied the charge that it "bet against" its own clients at the height of the subprime mortgage crisis and addressed claims that the bank benefited from the housing disaster and the collapse of the insurer American International Group.
The report was the clearest defense yet of Goldman's actions during the crisis and suggests a break from their more tested strategy of shrugging off media criticism of the bank's actions.
The Abacus Case
The instrument at issue in the lawsuit filed by the S.E.C. on April 16, 2010, called Abacus 2007-AC1, was one of 25 deals that Goldman created so the bank and select clients could bet against the housing market. Those deals, which were the subject of an article in The New York Times in December 2009, initially protected Goldman from losses when the mortgage market disintegrated and later yielded profits for the bank.
Goldman was one of many Wall Street firms that created complex mortgage securities — known as synthetic collateralized debt obligations — as the housing wave was cresting. At the time, traders like Mr. Paulson, as well as those within Goldman, were looking for ways to short the overheated market.
Such investments consisted of insurance-like policies written on mortgage bonds. If the mortgage market held up and those bonds did well, investors who bought Abacus notes would have made money from the insurance premiums paid by investors like Mr. Paulson, who were negative on housing and had bought insurance on mortgage bonds. Instead, defaults spread and the bonds plunged, generating billion of dollars in losses for Abacus investors and billions in profits for Mr. Paulson. Goldman structured the Abacus deals with a sharp eye on the credit ratings assigned to the mortgage bonds associated with the instrument, the S.E.C. said. In the Abacus deal in the S.E.C. complaint, Mr. Paulson pinpointed those mortgage bonds that he believed carried higher ratings than the underlying loans deserved. Goldman placed insurance on those bonds — called credit-default swaps — inside Abacus, allowing Mr. Paulson to short them while clients on the other side of the trade wagered that they would not fail.
But when Goldman sold shares in Abacus to investors, the bank only disclosed the ratings of those bonds and did not disclose that Mr. Paulson was on other side, betting those ratings were wrong.
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