Timberwolf I

Timberwolf I

¶Timberwolf I was a $1 billion hybrid CDO2 transaction that Goldman constructed, underwrote, and sold. It contained or referenced A rated CDO securities which, in turn, referenced primarily BBB rated RMBS securities. The assets in Timberwolf were selected by Greywolf Capital Management, a registered investment adviser, with the approval of Goldman. Greywolf served as the collateral manager of the CDO.2355 Goldman effectively served as the collateral put provider.2356 Timberwolf was initiated in the summer of 2006, and closed in March 2007.

¶Partnering with Greywolf. Greywolf Capital Management was founded by a team of former employees of Goldman's fixed income trading division.2357 It had experience in constructing and investing in CDOs. In the summer of 2006, Peter Ostrem, head of Goldman's CDO Origination Desk, approached Greg Mount, a former Goldman trader working for Greywolf, and asked if Greywolf would be interested in managing a CDO2 transaction.2358 Goldman and Greywolf negotiated a risk sharing agreement, and worked through the profitability of the CDO2 under expected market conditions. Greg Mount, as well as Joseph Marconi, another former Goldman trader, obtained approval from Greywolf's Chief Investment Officer to manage the CDO.

¶Greywolf agreed to purchase half of the Timberwolf equity tranche, sharing that risk with Goldman.2359 In addition, Greywolf agreed to share with Goldman the risk of the assets being purchased for the CDO falling in value before the CDO issued its securities. Greywolf also accepted the responsibility of selecting the assets with the approval of Goldman, which would then keep them in a warehouse account for the Timberwolf CDO. Greywolf agreed to provide ongoing surveillance of the performance of the assets in the CDO and liquidate any assets deemed to be impaired.

¶Constructing Timberwolf. In September 2006, Greywolf began identifying, purchasing, and warehousing CDO securities or single name CDS referencing CDO securities for Timberwolf.

542

¶Before selecting an asset for inclusion in Timberwolf, Greywolf did a detailed credit analysis of the relevant CDO security, including examining its underlying mortgage portfolio, the CDO's cashflow structure, and the mortgage servicer.2360 Once Greywolf finished its credit analysis, it submitted its choices to Goldman's CDO Origination Desk for review by Mr. Ostrem and Matthew Bieber, who was assigned to be the Goldman deal captain for Timberwolf. Goldman had the right to approve each asset going into the Timberwolf warehouse account and thus onto Goldman's warehouse balance sheet.

¶Once an asset was approved by both Greywolf and Goldman, it was acquired in one of two ways. In most instances, Greywolf circulated a list of the CDO securities or reference CDO securities that it was interested in buying to the broker-dealer community to get bids. To buy a single name CDS, Goldman wrote the CDS contract, taking the long side on behalf of Greywolf, while the broker-dealer who provided the best bid took the short side. The CDS contract would then be held by Goldman in the Timberwolf warehouse account until the CDO was ready to close.2361 In some instances, after circulating a list for bids, a broker-dealer responded to Greywolf's request with a price for a single name CDS on a similar CDO security, which Greywolf analyzed and sometimes agreed to acquire.2362

¶Timberwolf's single name CDS and CDO securities were acquired from 12 different broker- dealers.2363 Goldman was the single largest source of assets, providing 36% of the assets by value, including $15 million in single name CDS contracts naming Abacus securities.2364 As a result, Goldman held 36% of the short interest in Timberwolf.2365 Altogether, Timberwolf contained 56 different assets, of which 51 were single name CDS contracts referencing CDO securities and five were cash CDO securities.2366 The 51 single name CDS contracts referenced both CDO and CDO2 securities, and each CDO or CDO2 security contained or referenced its own RMBS, CMBS, or CDO securities or other assets. In total, Timberwolf had over 4,500 unique underlying securities and a grand total of almost 7,000 securities.2367 This process was further complicated by the fact that the CDO assets in Timberwolf were privately issued and often had little or no publicly available information on the underlying assets they contained.

543

¶By the time Greywolf and Goldman were nearing completion of the acquisition of the Timberwolf assets in the spring of 2007, Goldman was becoming increasingly concerned about the deteriorating subprime mortgage market and the falling value of the assets in its CDO warehouse accounts. In February 2007, Mr. Sparks, the Mortgage Department head, and Goldman senior executive Thomas Montag exchanged emails about the warehouse risk posed by Timberwolf and another pending CDO2 called Point Pleasant. Mr. Montag asked Mr. Sparks: "cdo squared–how big and how dangerous?"2368 Mr. Sparks responded: "[R]oughly 2bb [billion], and they are the deals to worry about." Mr. Sparks also told Mr. Montag that, due to falling subprime prices, the assets accumulated in the warehouse account for the $1 billion Timberwolf CDO had already incurred significant losses, those losses had eaten through all of Greywolf's portion of the warehouse risk sharing agreement, and any additional drops in value would be Goldman's exclusive obligation.2369

¶In March 2007, due to the falling values of subprime RMBS and CDO securities, Goldman decided against completing several CDOs under construction, and liquidated the assets in their warehouse accounts. Goldman decided, in contrast, to accelerate completion of Timberwolf.2370

¶Timberwolf I closed on March 27, 2007, approximately six weeks ahead of schedule.2371 The final CDO had $1 billion in cash and synthetic assets, including $960 million in single name CDS referencing CDO securities, and $56 million in cash CDO securities.

¶Selling Timberwolf. Selling Timberwolf securities became a high priority for Goldman. Mr. Sparks worked with senior sales managers to review ideas, telling them: "I can't over state the importance to the business of selling these positions and new issues."2372

¶During the spring and summer of 2007, the Goldman Syndicate2373 emailed the CDO sales force a list of "Senior CDO Axes" or sales directives on a weekly and sometimes daily basis, many of which placed a priority on selling Timberwolf securities.2374 As early as February, the Goldman sales force developed "broader lists" of clients to target for Timberwolf sales.2375 After exhausting those initial lists, Goldman sales personnel began to target "non-traditional" buyers2376 as well as clients outside of the United States.2377 The sales force had some early successes. On March 28, 2007, for example, the Syndicate included a note in one of the axe sheets:

544

"Great job Cactus Raazi trading us out of our entire Timberwolf Single-A position – $16mm. Sales – Good job over the last two weeks moving over $66mm of risk off the axe sheet. Please stay focused on trading these axes."2378

¶As sales began to flag in April, Mr. Sparks sent emails reminding Goldman sales personnel that Timberwolf "is our priority."2379 On one occasion, on April 19, 2007, Mr. Sparks suggested to a sales manager offering "ginormous credits" as an incentive to sell Goldman's CDO securities: "for example, let's double the current offering of credits for [T]imberwolf."2380 Mr. Sparks was informed in response: "[W]e have done that with timberwolf already."

¶On March 9, 2007, Harvey Schwartz, a senior executive at Goldman Sachs, expressed concern to Mr. Sparks and others about what Goldman sales personnel were telling clients: "Seems to me ... one of our biggest issues is how we communicate our views of the market – consistently with what the desk wants to execute."2381 Mr. Sparks responded by outlining several concerns and the need for the sales team and traders to work together.2382 He wrote:

"3 things to keep in mind: (1) The market is so volatile and dislocated that priorities and relative value situations change dramatically and constantly. (2) Liquidity is so light that discretion with information is very important to allow execution and avoid getting run over. (3) The team is working incredibly hard and is stretched."

¶He concluded: "Priority 1 – sell our new issues and our cash positions."

¶Pricing Timberwolf Securities. Despite the urgency communicated by Goldman management, Timberwolf sales slowed. By May 11, 2007, only one Timberwolf sale had taken place in the previous several weeks.2383 Goldman personnel also knew that the value of the Timberwolf securities, and the value of their underlying assets, were falling.2384

545

¶On May 11, 2007, Mr. Sparks notified Goldman senior executives that marking down the value of the unsold CDO securities so that, internally, the firm understood their current market value had become a "real issue":

"Cdo positions and market liquidity and transparency have seized. I posted senior guys that I felt there is a real issue. ... We are going to have a very large markdown – multiple hundreds. Not good."2385

¶That same evening, Mr. Lehman sent out a "Gameplan" to colleagues in the Mortgage Department announcing that Goldman was going to undertake a detailed valuation of its CDO2 securities using three different valuation methods, and would also take "a more detailed look" at the values of the assets in the CDO warehouse accounts and in Goldman's own inventory.2386

¶Also on May 11, Chief Credit Officer Craig Broderick sent an email to his team to set up a survey of Goldman clients who might encounter financial difficulty if Goldman lowered the value of the CDO securities they had purchased.2387 As explained earlier, some Goldman clients had purchased their CDO securities with financing supplied by Goldman that required them to post more cash margin if the financed securities lost value. Other clients had invested in the CDO securities by taking the long side of a CDS contract with Goldman and also had to post more cash collateral if the value of the CDO securities declined. All of these clients would also have to record a loss on their books due to the lowered valuations.

¶With respect to the CDO securities that had yet to be sold, Goldman senior executive Harvey Schwartz raised another issue related to lowering the values of the CDO securities Goldman was selling to clients: "[D]on't think we can trade this with our clients andf [sic] then mark them down dramatically the next day. ... Needs to be a discussion if that risk exists."2388 In an email to Mr. Sparks, Mr. Montag, and Mr. Schwartz, Goldman senior executive Donald Mullen acknowledged concerns "about the representations we may be making to clients as well as how we will price assets once we sell them to clients."2389 The executives also agreed, however, not to "slow or delay" efforts to sell Timberwolf securities if they got "strong bids."2390

¶The CDO valuation project generated many comments on how to price the firm's unsold CDO securities, including Timberwolf. One Goldman employee, who was applying Goldman's most common valuation method to Timberwolf, wrote that the price should be dramatically lower:

546

¶"Based on current single-A CDO marks, the A2 tranche of Timberwolf would have a price of 72 cents on the dollar."2391 He also noted:

"Based on a small sample of single-A CDOs for which we have a complete underlier marks, we believe that the risks of the RMBS underliers are frequently not fully reflected in the marks on the CDOs. If the trends in this small sample are extrapolated, the fair spread on the CDOs could even be double where they are marked now; if that were the case, the price of the A2 tranche of Timberwolf would actually be 35-41 cents on the dollar, depending on the correlation."2392

¶Several days later, in preparation for a meeting with senior executives on the valuation issue, the same Goldman employee calculated that, for the A2 tranche of Timberwolf, the "price based on CDO marks" was 66 cents on the dollar, while the "price based on RMBS marks" was 24 cents on the dollar.2393

¶Throughout the valuation process, senior management, including Co-President Gary Cohn, was kept posted on how the Mortgage Department planned to value the firm's CDO assets.2394 On Sunday, May 20, 2007, the Mortgage Department presented its findings in a 9:00 p.m. conference call with CFO David Viniar and others.2395 The presentation's executive summary expressed concern about valuing a range of CDO assets, including unsold securities from Goldman-originated CDOs.2396 The presentation stated: "[T]he desk is most concerned about the CDO^2 positions, comprised of the recent Timberwolf and Point Pleasant transactions. The lack of liquidity in this space and the complexity of the product make these extremely difficult to value."2397

¶The presentation recommended unwinding and selling the assets in the CDO warehouse accounts and using "independent teams" to continue to value the unsold CDO securities from Goldman originations. It also recommended switching to a targeted sales effort for the unsold

547

¶CDO2 securities, focused on four hedge fund clients: Basis Capital, Fortress, Polygon, and Winchester Capital.2398 The Goldman sales force apparently felt those four hedge funds were the clients most likely to buy the CDO2 securities, and two of them, Basis Capital and Polygon, did subsequently purchase Timberwolf securities.2399 An appendix to the presentation identified another 35 clients for targeted sales efforts and provided an assessment of the CDO sales efforts for each.2400 Several of those clients later purchased Timberwolf securities.2401

¶Despite Goldman's internal analysis that the value of the Timberwolf securities was in rapid decline, the firm did not lower the prices at which it marketed the securities to clients. In a May 14 email, Mr. Sparks explained his Timberwolf pricing strategy to Mr. Mullen and Mr. Montag:

"I think we should take the write-down, but market at much higher levels. I'm a little concerned we are overly negative and ahead of the market, and that we could end up leaving some money on the table – but I'm not saying we shouldn't find and hit some bids."2402

¶As a result of the CDO valuation project, Goldman took substantial writedowns on the value of its CDO inventory on May 25, 2007.2403 For example, Goldman marked down the AAA rated Timberwolf A2 securities to a value of $80.2404 At the same time, Goldman continued to market them at inflated prices, selling Timberwolf A2 securities to clients at $87.00 on May 24, at $83.90 on May 30, and at $84.50 on June 11.2405 On May 25, Goldman also marked the AA rated Timberwolf B securities to an internal value of $65.00. Over a month later, Goldman sold $9 million of those AA rated securities to Bank Hapoalim at a price of $78.25, but by then Goldman's internal valuation had fallen to $55, a difference of more than 30% of the market value.2406

548

¶In addition to marketing its CDOs at inflated prices compared to its internal valuations, the Mortgage Department told some clients that the mortgage market was strengthening. On May 14, 2007, for example, Edwin Chin, a trader on the Mortgage Department's ABS Desk, sent this upbeat commentary to both Goldman traders and clients:

"Incredible as it may seem, the subprime mortgage slump is already [a] distant memory for some. It's been two months since the ABX market plunged amid worries about a housing meltdown, and already investors (and some dealers) are beginning to get 'complacent' again. Blame it on the CDO bids, but with subprime production projected down 40-60% from last year's level, appetite for spread products triumphs any risk concern in the marketplace right now. ABX Index is trading higher as dealers short cover their single name positions after a month of range-bound trading. Flows continue to weigh toward better seller of protection – longs outpace shorts by 3 to 1 as CDO demand has been robust the last two weeks. While warehouse activities might be slow, many CDOs are still looking to finish up their ramp post-closing."2407

¶Daniel Sparks responded to Edwin Chin's commentary by asking senior ABS traders, David Lehman, Mike Swenson, and Joshua Birnbaum: "Is this a head fake or does this make you bullish on all spread product?" Mr. Lehman responded: "[G]iven the sizable short interest in ABS/subprime mkt it does not surprise me that short covering is pushing spds [spreads] tighter. Not sure I would enter new longs here." Mr. Swenson responded: "I would characterize this as a great opportunity to be constructive on the market."2408

549

¶A few weeks later, Mr. Lehman forwarded an email to Goldman executives informing them "the market feels that GS is being more aggressive than other dealers moving CDO^2 paper," and marking down clients more than their competitors.2409 Don Mullen responded: "Does this give any one pause about our selling prices?" Mr. Swenson responded to Mr. Mullen: "[N]o pause[.] [E]veryone else is afraid to execute at these levels and they will be wishing for these prices by the end of the summer." Mr. Sparks added: "There is real market meltdown potential (although far from certain)."2410

¶Timberwolf Sales to Basis Capital. At the conclusion of the CDO valuation project, which found that Timberwolf and Goldman's other CDO securities had lost significant value, the Mortgage Department resumed its efforts to push Timberwolf sales.

¶On Sunday, May 20, 2007, the same day the Mortgage Department made its valuation presentation to Mr. Viniar and recommended targeting Basis Capital for CDO sales, George Maltezos, the Goldman sales representative responsible for Basis Capital, emailed Mr. Lehman saying he would contact the Basis Capital principals immediately upon their return from a business trip the following day.2411

¶Mr. Maltezos began pressing Basis Capital to buy the securities. On May 22, Mr. Maltezos urged Basis Capital to consider buying the securities before the end of the quarter:

"I appreciate you are flat chat [busy] at the moment, but pls [please] keep in mind GS is an aggressive seller of risk for QTR [quarter] end purposes (last day of quarter is this Friday). We would certainly appreciate your support, and equally help create something where the return on invested capital for Basis is over 60%."2412

¶At the same time Mr. Maltezos was claiming that a Timberwolf investment could provide over a 60% return on invested capital, Goldman's internal marks were showing that Timberwolf was continuing to fall in value.

¶Basis Capital indicated that it was interested in the Timberwolf securities, but had several issues it needed to work through. First, Basis Capital indicated that Goldman would have to help it find financing for the purchase price.2413 Second, Basis Capital was concerned about the value of its existing CDO2 investment with Goldman. On April 19, 2007, Basis Capital had purchased BBB rated Point Pleasant securities at a price of $81.72.2414 Goldman had provided the financing for this purchase. Two weeks later, Goldman had marked down the value of the securities to $76.72, and asked Basis Capital to post additional cash collateral totaling $700,000.2415 When Basis Capital asked how the value of the security had fallen $5 in just two weeks, Goldman responded that the price had gone back up to $81.72, and no additional cash was required.2416

550

¶In May and June 2007, Mr. Maltezos worked to convince Basis Capital to purchase $100 million in Timberwolf securities. At one point Basis Capital pressed for a lower sales price, but was told by Mr. Maltezos: "I don't think the trading desk shares the sentiment with regard to such spread levels [lower prices]."2417 During the negotiations over the Timberwolf sale, on June 12, 2007, Goldman again marked down the value of the Point Pleasant securities to $75, and again asked Basis to post more cash collateral.2418 When Basis Capital asked Mr. Maltezos to justify the lower value, Mr. Maltezos wrote:

"[T]here has been further softening in the market since the Point Pleasant trade was put on 8 weeks ago. We have infact [sic] traded some Point Pleasant BBBs at this level in the last 2 weeks."2419

551

¶In fact, no such sales had taken place, and the lower value could not be justified by any sales transactions.2420 The lower mark was instead related to Goldman's CDO valuation project in May, which had concluded that its CDO2 securities had lost significant value.2421

¶Stuart Fowler at Basis Capital brought up the valuation issue in the context of the Timberwolf securities, and asked Mr. Maltezos: "I need to be very clear on this and are we going to see a similar problem on [T]imberwolf?"2422 Mr. Maltezos responded: "Stuart – I assure you no foul here," and offered to set up some "1-on-1 time with the trading desk" to discuss pricing.2423

¶Mr. Sparks was closely monitoring Mr. Maltezos' ongoing effort to sell the Timberwolf securities to Basis Capital and, on June 13, 2007, sent this email to Mr. Maltezos:

"Let me know if you need help tonight - or feel free to wake up [Mr. Lehman and Mr. Egol] in [S]pain. I'd love to tell the senior guys on 30 at risk comm[ittee] Wednesday morning that you moved 100mm [$100 million]."2424

¶In response, Mr. Maltezos coordinated a call between Basis Capital and Mr. Lehman to "clarify any and all questions you have on the marking policy of Goldman, the actual marking of Point Pleasant, and the overall trading that has been seen by the [Goldman] desk in the last 1-6 months."2425 In that telephone call with Basis Capital, Mr. Lehman apparently corrected Mr. Maltezos' misstatement about recent Timberwolf sales, and Mr. Maltezos followed up with an email to Basis Capital:

"[P]lease accept my sincerest apologies for the mis-information below. As David mentioned, the 75 mark on Pt Pleasant BBB was more reflective of an interpretation of softer AAA-AA rated CDO-sqd paper translating to BBB part of the curve."2426

¶Later that same day, June 13, 2007, Mr. Lehman reported that Goldman had reached agreement on $100 million in Timberwolf sales to Basis Capital. The sale consisted of the hedge fund taking the long side of a CDS contract with Goldman, referencing $50 million in AAA rated

552

¶Timberwolf securities and $50 million in AA rated Timberwolf securities.2427 Mr. Lehman told Mr. Montag that the CDS premiums that Basis Capital had agreed to accept implied a cash price of $84 for the AAA securities and $76 for the AA securities. Mr. Montag asked what Goldman's internal mark was for the Timberwolf AA securities, and Mr. Lehman responded: "$65."2428

¶The Timberwolf sale to Basis Capital was finalized on June 18, 2007.2429 Goldman provided the financing. Just two weeks later, Goldman informed Basis Capital that the Timberwolf securities had lost value and required the hedge fund to post additional cash collateral.2430 Basis Capital immediately questioned the new value and asked to see a "comparable market data point for the Timberwolf marks."2431 In response, Mr. Lehman complained internally: "I would like to know what the precedent there is here – does GS need (outside of the client issue) to provide the below info to justify our prices???"2432 After Goldman provided additional information, Basis Capital appeared to agree to post the additional collateral.

¶Eight days later, on July 12, Goldman again marked down the value of the Timberwolf securities to prices of $65 and $60, after having sold them to Basis Capital one month earlier at $84 and $76.2433 This repricing resulted in a $37.5 million movement in the value of the securities, and required Basis Capital to post substantially more cash collateral with the firm.2434 On July 13, 2007, Basis Capital told Goldman that one of its funds was "in real trouble."2435 On July 16, Goldman again marked down Basis Capital's securities to prices of $55 for AAA and $45 for AA.2436 These prices matched Goldman's internal valuations.2437 By the end of July, Basis Capital was forced to liquidate its hedge fund.2438 Goldman bought back the Timberwolf securities from Basis Capital on July 31, at prices of $30 and $25.2439

¶Other Timberwolf Sales. Basis Capital was only one of several clients that Goldman contacted in connection with Timberwolf. On May 24, 2007, a Goldman sales associate told Mr. Lehman and Mr. Sparks that he wanted more information to send to a European hedge fund that was "not experts in the space at all but [I] made them a lot of money in correlation dislocation and will do as I suggest. Would like to show stuff today if possible."2440 Mr. Lehman told the sales associate that he was available to get on the telephone with the clients, and forwarded him the Timberwolf offering circular and marketing materials.2441

553

¶On June 5, 2007, Goldman trader Benjamin Case emailed Mr. Lehman with a "[g]ameplan for distribution" or sales of Goldman's remaining CDO2 securities.2442 The plan was to target "institutional buyers that can take larger bite size than traditional CDO buyers ... for example Asian banks and insurance companies."2443 Mr. Case also noted that Goldman was shorting "51 CDO names in the two portfolios [Timberwolf and Point Pleasant] and we have been aggressively sourcing further protection in the CDS market on names in the two portfolios recently."2444

¶In early June, Goldman targeted a Korean insurance company called Hungkuk Life for Timberwolf sales. According to a Goldman employee in the Japan sales office, Jay Lee, "the largest hurdle from the client perspective is whether or not they can get the mandate to buy something backed by synthetically sourced CDO's [sic], as they have never bought CDO^2 before."2445 Mr. Lee was also concerned that the value of the securities would drop soon after the office sold the Timberwolf securities to the insurance company. Mr. Lee stated:

"[T]he largest hurdle from a sales' perspective is MTM [mark to market]. It is an important client, and if the mark widens out more than 1pt immediately after selling the asset to them, sales cannot sell it. Understanding that it is a volatile asset, sales wants to know that where we sell it to the client will not be more than 1pt less than where the mark would be, provided no new market information."2446

¶It is unclear how his valuation concern was addressed. Later the same day, on June 1, Mr. Lee reported that Hungkuk Life had purchased $36 million in AAA rated Timberwolf securities. Mr. Sparks responded "good job – keep going."2447

¶Six days later, on June 7, 2007, the head of the Goldman Japan sales office, Omar Chaudhary, contacted Mr. Sparks and Mr. Lehman about a possible additional sale of Timberwolf securities to Hungkuk Life. Mr. Chaudhary wrote that the head of Goldman's Korean sales office was "pushing on our personal relationships" to make the sale and wanted to be assured he'd be paid more if he "got it done":

554

"Jay and I spoke to the head of Korea Sales today. He said that he feels we can push for H[ungkuk] Life to increase their size from the 36mm of AAA's and wanted to see if we would pay more GC's [sales credits] if he got it done. Told him that if we sell ~45-50mm+ [$45-50 million more] that we would honor the 7.0% even if we trade at the 84.5 dollar px [expected price]. Trust you will support this as we are pushing on our personal relationships to get this done."2448

¶Mr. Lehman and Mr. Sparks told Mr. Chaudhary to "go for it" and "[g]et 'er done."2449 The Korean office did get it done, and Goldman sold another $56 million in Timberwolf securities to Hungkuk Life at a price of $84.50.2450 The sales representative was awarded the 7% sales credit.2451 Mr. Sparks wrote to the sales office: "you boys are awesome and many people are noticing."2452 Mr. Montag, a senior Goldman executive monitoring the Timberwolf sales, told the mortgage team it had done an "incredible job – just incredible."2453

¶On June 11, 2007, Mr. Lehman received an email from the Goldman Syndicate asking whether the CDO axe sheet, which included directives to sell Timberwolf securities, could be sent to the Japan sales office for re-distribution to sales representatives across Asia. Mr. Lehman agreed: "let's send to all Japan sales."2454 Two days later, on June 13, 2007, the Japan sales office reported over $250 million in new sales of Goldman's CDO securities, including Timberwolf.2455

¶Mr. Montag continued to monitor the sales of Timberwolf as well as other CDO securities in Goldman's inventory and warehouse accounts. On June 22, 2007, Mr. Sparks reported to him on the completion of a number of sales of CDO and RMBS securities that Goldman had purchased from the two failed Bear Stearns hedge funds. Mr. Montag asked Mr. Sparks to provide him with a "complete rundown" on "what[']s left."2456 Mr. Sparks responded that the "main thing left" was $300 million in Timberwolf securities. Mr. Montag responded: "boy that timeberwo[l]f was one shitty deal."2457

¶Despite Mr. Montag's assessment of Timberwolf, he continued to press for the sale of Timberwolf securities to Goldman clients. On June 25, 2007, Mr. Sparks emailed Mr. Montag and others with another update on selling Goldman's remaining CDO assets.2458 Mr. Sparks informed the group that Goldman would probably have to lower the values of the CDO assets over the next few days, but that the net effect for Goldman would be positive, since its short position was larger than its long. In fact, the Mortgage Department made $42.5 million that day.2459 Mr. Montag remained focused on Timberwolf, responding: "[h]ow are twolf sales doing?"2460

555

¶On July 12, 2007, another Goldman sales representative, Leor Ceder, reported selling $9 million in Timberwolf securities to Bank Hapoalim at a price of $78.25.2461 Goldman trader Mitchell Resnick asked Mr. Lehman "to pay him well on this."2462 Mr. Ceder was paid an 8% sales credit.2463 That was Goldman's last Timberwolf sale, even though its Syndicate continued to list the CDO as a top sales priority for months afterward.

¶Goldman ultimately sold about $853 million of the $1 billion in Timberwolf securities to about 12 investors. The unsold securities, with a face value of about $150 million, remained on Goldman's books.

¶Limited Disclosures. Despite their aggressive sales efforts, Goldman sales personnel typically did not help potential investors analyze the Timberwolf securities and the 4,500 unique assets underlying the CDO. One Goldman employee told his colleagues: "In terms of telling customers. I prefer to give them the general idea of the trade. Then give them the excel spread sheet with our info on ref obs [reference obligations] and let them draw their own conclusions."2464 Another Goldman employee, discussing a potential buyer of Timberwolf, warned:

"[H]e is going to want to look at the TWOLF trade on a fundamental basis with a lot of supporting runs to back up any additional mark downs we have – telling him we are busy when it comes to month end and we can't run that analysis because we are resource- constrained will not be good enough."2465

556

¶Still another Goldman employee stated with respect to Timberwolf and Point Pleasant: "The trickiest part about sharing this [pricing] analysis with custies [customers] is that it shows just how rudimentary our own understanding of these positions actually is."2466

¶Goldman also in many instances refused to provide investors with its pricing methodology or specific prices or values for the CDO securities it was selling. After its securities began to lose value, Basis Capital emailed George Maltezos, David Lehman, and others asking: "How many times do we have to request data points and scenarios by email. These were read out to us on the call and it was agreed that GS would send them through. I am getting weary of continually hearing about transparency and yet an obvious avoidance of 'putting things to paper.'"2467

¶Similarly, when Hungkuk Life requested additional information about the underlying Timberwolf assets, Goldman sent an asset report, but only after removing all of its pricing and valuing information related to those assets.2468 In August 2007, Jay Lee from Goldman's Japan sales office told a sales associate who was seeking information about Goldman's marks for Tokyo Star Bank:

"[U]nder no circumstances are we going to be able to provide materials specific to Timberwolf ... or even use the word 'mark' in written materials. ... Everything will be described in general terms, and if what we provide is too vague or general, the medium for further clarification must be oral, not written."2469

¶Mr. Lehman added: "[W]e should be clear that the information we are providing is not our pricing methodology but rather some tho[ugh]ts on the current market."2470

¶In an interview with the Subcommittee, Mr. Lehman defended Goldman's aggressive markdowns by noting that Goldman would buy or sell at the prices it quoted to a customer. He explained that if a client thought Goldman's mark was too low, the client could buy more of the securities from Goldman at the low price, then resell them for a profit. Since Goldman's internal valuations were much lower than the price quoted to clients, however, such sales would still produce a profit for the firm.2471 Furthermore, as Goldman marked down the values in the summer of 2007, it began to decrease the volume of the securities it was willing to buy or sell at the prices it quoted to clients. Goldman was initially willing to buy or sell CDO securities in blocks of $10 million, but by July, it lowered the maximum size to $3 million for some securities and $1 million for others: "Given current market environment, we would like our bid for size for CDO valuations to be MAX $3mm for AAA to AA and $1mm for A and below. No valuations should go out with a bid for $10mm."2472

557

¶"A Day That Will Live In Infamy." The Timberwolf securities issued by Goldman steadily lost money from the day they were issued. Less than four months after they were issued, on July 16, 2007, Mr. Lehman instructed the Timberwolf deal captain, Mr. Bieber, to "create an 'unwind' spreadsheet ... where we can input CDS spds [spreads]/prices and liability prices so we can determine if unwinding these deals makes sense."2473 The analysis appeared to show that it would cost Goldman $140 million to unwind Timberwolf, and the conclusion was to "Hold Off."2474 Instead of unwinding, Goldman continued its sales push.

¶In September 2007, Mr. Montag asked for data tracking the drop in prices for a Goldman CDO that experienced a dramatic fall in value, such as Timberwolf.2475 In response, a Goldman employee provided prices for the A2 tranche of the Timberwolf securities using a combination of Goldman's internal marks and the bids provided to investors, from the issuance of the CDO on March 27,^20072007 "Home Loans Product Strategy," WaMu presentation at JPM_WM03097203, Hearing Exhibit 4/13-60a (only Countrywide ranked higher). WaMu Home Loans Product Strategy, "Strategy and Business Initiatives Update," JPM_WM03097217, Hearing Exhibit 4/13-60a [emphasis in original]. Performance Evaluation for Peter D'Erchia, S&P SEN-PSI 0007442; See also April 23, 2010 Subcommittee Hearing at 74-75. annual report filed with the SEC, in particular the Executive Summary of Deutsche Bank's Annual Report and the letter from the Chairman of the Board. See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0252, at 0262. through September. The data showed that, in six months, prices for Timberwolf's AAA rated A2 security had fallen from $94 per security to $15, a drop of almost 80%:

"3/31/07 94-12 4/30/07 87-25 5/31/07 83-16 6/29/07 75-00 7/31/07 30-00 8/31/07 15-00 Current 15-00."2476

¶After receiving this pricing history, Mr. Bieber, the Timberwolf deal captain, described March 27, the Timberwolf issuance date, as "a day that will live in infamy."2477

¶The chart on the next page shows how, between mid-June 2007 and early August 2007, the value of Timberwolf securities dropped precipitously, and that Goldman personnel were aware of its falling value while selling the securities to clients.

[SEE CHART NEXT PAGE: Timberwolf Marks, Axes, and Sales, prepared by the Permanent Subcommittee on Investigations.]

Timberwolf Marks, Axes, and Sales 3/1/2007 3/31/2007 4/30/2007 5/30/2007 6/29/2007 7/29/2007 8/28/2007 9/27/2007 10/27/2007 11/26/2007 12/26/2007 140

Sales of 120 TWOLF‐ 3/13/07: A1A‐ $99.45 Axes (Sales A1B‐ $100 A1C‐ $99.71 Directives) A1D‐ $100 INC‐ $100

¶Price

¶Sales Marks

0 3/1/2007 3/31/2007 4/30/2007 5/30/2007 6/29/2007 7/29/2007 8/28/2007 9/27/2007 10/27/2007 11/26/2007 12/26/2007

¶Prepared by the U.S. Senate Permanent Subcommittee on Investigations, February 2011. Derived from Goldman Sachs document, GS MBS-E-000779366.

559

¶Goldman profited in part from Timberwolf's decline in value due to its 36% short interest in the CDO. In addition, June was the month that Goldman built its $13.9 billion big short, which meant that the decline in most mortgage related assets translated into increasing profits for Goldman.2478

¶Timberwolf experienced its first credit rating downgrades in November 2007, just eight months after the CDO closed and issued its securities. The downgrades included the AAA rated securities. In March 2008, one year after Timberwolf was issued, its AAA securities were downgraded to junk status. In June 2008, a controlling class of debt investors voted to liquidate Timberwolf, and the deal was terminated in October 2008.2479

¶Goldman's 36% short position in Timberwolf produced about $330 million in revenues at the direct expense of the clients to whom Goldman had sold the Timberwolf securities. Goldman also made $3 million in interest while the Timberwolf assets were in Goldman's warehouse account. At the same time, because Goldman was unable to sell about a third of the Timberwolf securities and had to keep the unsold securities on its books, it ended up losing $562 million from them. Goldman also lost $226 million from the decline in the value of the collateral securities securing the CDO. When offset by the profits from its Timberwolf short, Goldman ended up with a total loss of about $455 million.2480

¶Timberwolf's investors lost virtually their entire investments. Basis Capital ended up declaring bankruptcy and has filed suit against Goldman.2481

¶Analysis. Goldman constructed Timberwolf using CDO assets that began to fall in value almost as soon as the Timberwolf securities were issued, yet solicited clients to buy the securities. Timberwolf contained or referenced CDO assets with more than 4,500 unique mortgage related securities, but Goldman offered potential investors little help in understanding those securities, and targeted clients with limited or no experience in CDO investments. When marketing Timberwolf, Goldman withheld its internal marks showing the securities losing value and did not mention its short position. Senior Goldman executives knew the firm was selling poor quality assets at inflated prices. Within six months of issuance, AAA Timberwolf securities lost almost 80% of their value. Due to its short position, Goldman profited at the expense of the clients to whom it sold the Timberwolf securities, but it lost money overall because Goldman was forced to retain so many of the unsold Timberwolf securities on its books.

560

¶DD. Abacus 2007-AC1

¶Abacus 2007-AC1 was a $2 billion synthetic CDO whose reference obligations were BBB rated mid and subprime RMBS securities issued in 2006 and early 2007.2482 It was a static CDO, meaning once selected, its reference obligations did not change.2483 It was the last in a series of 16 Abacus CDOs referencing RMBS securities designed by Goldman. Goldman served as the underwriter or placement agent,2484 the lead manager,2485 and the protection buyer,2486 and also acted in other roles related to the CDO.2487 Unlike previous Abacus CDOs, Abacus 2007-AC1 used a third party to select its assets, referring to it as the portfolio selection agent.2488

¶Designing Single Tranche CDOs. Abacus CDOs were known as single tranche CDOs, a structure pioneered by Goldman through its Abacus platform.2489 Goldman used this structure to design customized CDOs for clients interested in assuming a specific type and amount of investment risk. An Abacus CDO could be issued with a single tranche, designed in coordination with a client who could select the assets the client wished to reference, the size of the investment, and the amount of subordination or cushion before the single tranche of securities would be exposed to loss.2490 Abacus also enabled investors to short a selected group of RMBS or CDO securities at the same time. Goldman used the Abacus CDOs not only to sell short positions to investors, but also to carry out its own shorts. As summarized in one Goldman Mortgage Capital Committee Memorandum, the Abacus design allowed "Goldman to short spreads in our core structured products business in large size."2491 Between 2004 and 2007, Goldman issued 16 Abacus deals referencing RMBS securities, including Abacus 2007-AC1, which together had an aggregate value of $13 billion.2492

561

¶Responding to Paulson Inquiry. In mid to late 2006, Goldman was approached by the hedge fund Paulson & Co. Inc. (Paulson), and asked to structure a transaction that would enable the hedge fund to short multiple RMBS securities.2493 Goldman had previously worked with Paulson and was aware that Paulson held strong negative views of the residential mortgage market and was making investments based on that view. The Goldman Mortgage Capital Committee Memorandum seeking approval of Abacus 2007-AC1, for example, stated:

"Paulson is a macro hedge fund that has taken directional views on the subprime RMBS market for the past few months. In 2006 the Desk worked an order for Paulson to buy protection on a supersenior tranche off a portfolio similar to the Reference Portfolio selected by ACA, and the AC1 Transaction is another means for Paulson to accomplish their trading objective: buying protection in tranched format on the subprime RMBS market."2494

¶An email sent to Daniel Sparks, head of the Mortgage Department, by Fabrice Tourre, a Correlation Trading Desk employee who led the effort on the Abacus CDO for Paulson, was even more blunt:

562

"Gerstie and I are finishing up engagement letters ... for the large RMBS CDO Abacus trade that will help Paulson short senior tranches off a reference portfolio of Baa2 subprime RMBS risk selected by ACA."2495

¶These documents make it clear that Goldman knew Paulson's investment strategy was to identify a reference portfolio of assets for the Abacus CDO that Paulson believed would perform poorly or fail, so that its short position would profit at the expense of the long investors.2496 In addition, during his Subcommittee interview, Mr. Tourre made it clear that he was aware of the Paulson investment strategy.2497

¶In response to the inquiry from Paulson, Goldman proposed structuring an Abacus CDO.2498 Fabrice Tourre was given lead responsibility for organizing and structuring the Abacus transaction. Goldman's primary role was to act as an agent and administrator of the CDO, obtaining its profit from the fees it charged for the services rendered, rather than from any investment in the CDO itself. In effect, Goldman "rented" the Abacus platform to the Paulson hedge fund and served as Paulson's agent in carrying out the hedge fund's investment objectives. Mr. Tourre had been suggesting that Goldman employ such an approach and supported the arrangement.2499

¶Finding a Portfolio Selection Agent. According to Mr. Tourre, Paulson suggested that Goldman employ an outside portfolio selection agent for the CDO.2500 However, Paolo Pellegrini, Paulson's Managing Director who led Paulson's selection of the reference assets for the Abacus 2007-AC1 transaction, told the SEC that it was Goldman's idea to have a portfolio selection agent.2501 At the same time, Goldman internal communications made it clear that the objective was to select a portfolio selection agent that would comply with Paulson's suggestions for the assets to be referenced in the CDO. In an email to colleagues discussing the matter, Mr. Tourre suggested finding a manager that:

563

"will be flexible w.r.t. [with respect to] portfolio selection (i.e. ideally we will send them a list of 200 Baa2-rated 2006-vintage RMBS bonds that fit certain criteria, and the portfolio selection agent will select 100 out of the 200 bonds)."2502

¶In the early part of January 2007, Mr. Tourre sent an email to prospective selection agents describing their anticipated role in the CDO. One of his points was the following:

"Reference Portfolio: static, fully identified upfront, and consisting of approx 100 equally- sized mezzanine subprime RMBS names issued between Q4 [the fourth quarter of] 2005 and today. Starting portfolio would be ideally what the Transaction Sponsor shared, but there is flexibility around the names."2503

¶Goldman's internal communications also suggest that Goldman was, in fact, more interested in identifying cooperative portfolio selection agents for its own transactions, rather than locating one for the Paulson CDO. In an email chain discussing a portfolio selection agent for Abacus 2007- AC1, a Goldman employee wrote to a colleague that Mr. Tourre "suggested Faxtor was a potential portfolio selection agent [for Paulson] since they are relatively inexpensive and easy to work with." The colleague responded: "We already have a portfolio in front of Faxtor; they probably will be willing to structure a short that I believe we would want to keep for ourselves ... not sure if this is the best fit."2504

¶Jonathan Egol, chief architect of the Abacus structure and head of the Correlation Trading Desk, suggested that Goldman approach GSC Partners, a New York hedge fund that Goldman had worked with on other CDOs, including Anderson. Mr. Tourre sent an email to colleagues asking:

"Do you think gsc is easier to work with than faxtor? They will never agree to the type of names paulson wants to use, I don't think steffelin [a senior trader at GSC] will be willing to put gsc's name at risk for small economics on a weak quality portfolio whose bonds are distributed globally."2505

¶A colleague replied:

"There are more managers out there than just GSC / Faxtor. The way I look at it, the easiest managers to work with should be used for our own axes. Managers that are a bit more

564

difficult should be used for trades like Paulson given how axed Paulson seems to be (i.e. I'm betting they can give on certain terms and overall portfolio increase)."2506

¶On January 4, 2007, on behalf of Paulson, Goldman approached GSC Partners as well as two other companies to act as the portfolio selection agent for the Abacus CDO.2507 Following a meeting among representatives of Goldman, Paulson, and GSC, Mr. Tourre sent an email to his colleagues summarizing the meeting and indicating that Paulson was also looking for a portfolio selection agent that would be willing to accept many of the reference assets it identified:

"At the end of the meeting, the Paulson team told us that they were happy to have met GSC and assuming that (1) GSC could get comfortable with a sufficient number of obligations that Paulson is looking to buy protection on in ABACUS format, (2) GSC could get comfortable being in the market as early as end of January with a transaction under which Gsc is disclosed as Portfolio Selection Agent (without any credit risk removal rights), and (3) Paulson, Goldman, and GSC agree[] on GSC's required compensation for a transaction like this, then Paulson will want to proceed with gsc as soon as possible and be in the market as soon as possible."2508

¶Subsequently, Mr. Tourre reported to his colleagues that GSC had declined the offer to act as the Abacus portfolio selection agent due to its negative views of the assets Paulson wanted to include in the CDO:

"As you know, a couple of weeks ago we had approached GSC to ask them to act as portfolio selection agent for that Paulson-sponsored trade, and GSC declined given their negative views on most of the credits that Paulson had selected."2509

¶Later, when Goldman began to market Abacus 2007-AC1 securities, Edward Steffelin, a senior trader at GSC, sent an email to Peter Ostrem, head of Goldman's CDO Origination Desk saying: "I do not have to say how bad it is that you guys are pushing this thing."2510 When asked by the Subcommittee what he meant, Mr. Steffelin responded that he believed that particular Abacus CDO created "reputational risk" for GSC as the collateral manager and for the whole market.2511

¶Goldman and Paulson eventually settled on ACA Capital Management, LLC, a company with experience in selecting assets for CDOs. Goldman employees expressed the hope that ACA's involvement would improve the sales of the Abacus securities. In an internal memorandum seeking approval of the CDO, for example, Goldman personnel wrote: "We expect to leverage ACA's credibility and franchise to help distribute this Transaction."2512

565

¶Selecting Assets. During January, February, and March 2007, the Abacus reference assets were selected. The Paulson hedge fund initiated the asset selection process by providing Goldman with criteria for choosing RMBS securities for the CDO.2513 According to Mr. Tourre, Goldman's subsequent identification of candidate assets was essentially ministerial, as Paulson's specified criteria had restricted the scope of the RMBS securities that could be proposed.2514 For example, Paulson wanted RMBS securities that had adjustable rate mortgages, low borrower FICO scores, and mortgages in states with slowing home price appreciation, like Arizona, California, Florida, and Nevada.2515 Paulson specifically required 2006-vintage or 2007-vintage subprime RMBS that were rated BBB by S&P or Baa2 by Moody's.2516 Goldman sent Paulson a database and spreadsheet listing the securities that met Paulson's criteria.2517 Paulson used that database to select 123 securities, and Goldman forwarded the resulting list to ACA.2518 Over the next two months, a series of negotiations and meetings took place to finalize selection of the reference assets and the structure of the CDO.

566

¶On March 22, 2007, ACA and Paulson agreed on the final $2 billion reference portfolio for Abacus 2007-AC1.2519 The assets consisted of 90 Baa2 rated mid and subprime RMBS securities issued after January 1, 2006.2520 The RMBS securities were "equally-sized," each with a $22.22 million notional value.2521 Each asset in the final reference portfolio was approved by both Paulson and ACA. Of the final 90 RMBS securities,⁴⁹⁴⁹ "Revenue of the Three Credit Rating Agencies: 2002-2007," chart prepared by the Subcommittee using data from http://thismatter.com/money, Hearing Exhibit 4/23-1g. had been initially proposed by Paulson, and 41 had been initially proposed by ACA.2522

¶Goldman Sachs (September 25, 2009), at 3,⁴⁴ 1/3/2011 chart, "Insurance Fund Ten-Year Trends," supplied by the National Credit Union Administration (showing that, as of 12/31/1993, the United States had 12,317 federal and state credit unions). N%20FGCAnnouncesDefaultNoticewithRRELoanTransactions.pdf. See also "CapitalSource to Acquire Fremont's Retail Arm," New York Times (4/14/2008). Q07 Fact Sheet prepared for David Viniar, GS MBS-E-009724276, Hearing Exhibit 4/27-159. (hereinafter "Goldman Supp. Submission"). A January 3,^20072007 "Home Loans Product Strategy," WaMu presentation at JPM_WM03097203, Hearing Exhibit 4/13-60a (only Countrywide ranked higher). WaMu Home Loans Product Strategy, "Strategy and Business Initiatives Update," JPM_WM03097217, Hearing Exhibit 4/13-60a [emphasis in original]. Performance Evaluation for Peter D'Erchia, S&P SEN-PSI 0007442; See also April 23, 2010 Subcommittee Hearing at 74-75. annual report filed with the SEC, in particular the Executive Summary of Deutsche Bank's Annual Report and the letter from the Chairman of the Board. See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0252, at 0262. draft engagement letter listed the following portfolio selection criteria: Baa2 ratings; RM BS issued after March 1, 2006; weighted average FICO scores between 600 and 675; and at least 80% adjustable rate mortgages underlying the RM BS. 1/3/2007 draft engagement letter, PAULSON-ABACUS 0252736, at 40. See also 1/6/2007 email from Fabrice Tourre to Ed Steffelin and others, GS MBS-E-002754054 (listing criteria for the Abacus portfolio as 2006 vintage bonds underwritten after March 1, 2006; Baa2 rated bonds; average FICO score between 600 and 675; RMBS transaction size greater than $500 million; and percentage of adjustable rate mortgages greater than 80%).

567

¶Goldman characterized Paulson's participation in the asset selection process as one in which the hedge fund merely "express[ed] [its] views" about the reference portfolio,2523 which often happens in synthetic CDO transactions.2524 The evidence indicates, however, that Paulson did more than express its views; it played an active and determinative role in the asset selection process. Paulson established the criteria used to identify the initial list of RMBS securities, proposed a majority of the reference assets in the final portfolio, and approved 100% of the reference assets. Moreover, the "views" expressed by Paulson directly conflicted with the interests of the investors to whom Goldman was marketing the Abacus 2007-AC1 deal. Mr. Pellegrini was quite clear about Paulson's intentions in a deposition with the SEC:

Question: Your portfolio analysis was designed in large part to identify bonds that weren't going to perform, right?

¶Answer: Right.

¶Question: Because you wanted to short those bonds?

¶Answer: Right.2525

¶Goldman documents reviewed by the Subcommittee contain conflicting information on exactly who was involved in the asset selection process. Goldman's Mortgage Capital Committee Memorandum on the Abacus CDO, the key internal Goldman document describing the new CDO, stated: "The Reference portfolio has been selected and mutually agreed upon by ACA and Goldman."2526 In an email to a colleague, however, Mr. Tourre wrote that the portfolio had been selected by "ACA/Paulson."2527 The Abacus Marketing book identified ACA as the portfolio selection agent for the CDO, and stated that the portfolio selection agent had selected the reference assets.2528 The Abacus Offering Memorandum stated: "The Initial Reference Portfolio will be selected by ACA Management, L.L.C."2529

¶Another email exchange, between Mr. Tourre and his colleague Mr. Egol, demonstrates the strong influence Paulson had in the selection process. IKB, a German bank that was a frequent investor in past Abacus CDOs and was considering purchasing securities issued by Abacus 2007- AC1, apparently asked to have certain RMBS securities removed from the portfolio and sent the following email to a Goldman sales representative:

568

"[D]id you hear something on my request to remove Fremont and New Century serviced bonds? I would like to try to [sic] the advisory com[m]it[t]ee this week and would need consent on it."2530

¶The IKB email was forwarded to Mr. Tourre, who sent it to Mr. Egol with the following message: "Paulson will likely not agree to this unless we tell them that nobody will buy these bonds if we don't make that change."2531 Mr. Tourre expressed concern, not about what ACA, the portfolio selection agent, might or might not agree to, but only about what the Paulson hedge fund might agree to.

¶Failing to Disclose Key Information. Evidence obtained by the Subcommittee indicates that Paulson's role in the Abacus asset selection process and its investment objectives for the CDO were not fully or accurately disclosed to key parties or investors at the time the CDO was being structured and sold.

¶Moody's, one of the credit rating agencies asked to rate the Abacus securities, was not informed of Paulson's role or investment objectives. At a Subcommittee hearing on the role of the credit rating agencies in the financial crisis, Eric Kolchinsky, a former Moody's managing director who oversaw its CDO ratings and was familiar with Abacus 2007-AC1, provided sworn testimony that he had not known of Paulson's involvement with the CDO at the time it was rated, did not know of Paulson's role in selecting the referenced assets, and believed his staff did not know either. He testified that allowing an entity that wants a CDO to "blow up" to pick its assets "changes the whole dynamic," and was information that he would have wanted to know when rating the securities:

Senator Levin: And were you or your staff aware at the time that Moody's was working on the ABACUS rating that Paulson was shorting the assets in ABACUS and playing a role in selecting referenced assets expected to perform poorly?

Mr. Kolchinsky: I did not know, and I suspect, I am fairly sure, that my staff did not know either.

Senator Levin: And are these facts that you or your staff would have wanted to know before rating ABACUS?

Mr. Kolchinsky: From my personal perspective, it is something that I would have wanted to know because it is more of a qualitative not a quantitative assessment if someone who intends the deal to blow up is picking the portfolio. But, yes, that is something that I would have personally wanted to know. It changes the incentives in the structure.

569

Senator Levin: Are people usually putting deals together that want the deal to succeed? Isn't that the usual assumption?

¶Mr. Kolchinsky: That is the basic assumption, yes.

Senator Levin: And if the person wanting the deal to blow up is picking the assets, that would run counter to what the usual assumption is?

Mr. Kolchinsky: It just changes the whole dynamic of the structure where the person who is putting it together, choosing it, wants it to blow up.2532

¶Moody's assigned AAA ratings to two tranches of the Abacus CDO.2533

¶ACA told the Subcommittee that, throughout the asset selection process, it was not informed and remained unaware of Paulson's true investment objective, which was to identify and short a set of assets that it believed would not perform and would lose value.2534 According to ACA, it believed that Paulson was going to be a long investor in the CDO through its purchase of the equity share that would incur the first losses in the CDO. Contemporaneous ACA documents support that position. An internal ACA Commitments Committee Memorandum on Abacus 2007-AC1 dated February 12, 2007, for example, stated: "The hedge fund is taking the 0-9% equity tranche."2535 Ten days later, on February 23, 2007, the ACA Managing Director who worked on the Abacus transaction spoke with a Goldman representative, and took notes of the conversation which stated in part: "Paulson taking 0-10%."2536 In April 2007, the same ACA Managing Director sent an email to the CEO and President of ACA's parent company, ACA Capital Holdings Inc., which was considering buying Abacus securities for itself. Her email stated: "We did price $192 million in total of Class A1 and A2 today to settle April 26th. Paulson took down a proportionate amount of equity (0-10% tranche)."2537

¶In addition, on January 10, 2007, a few days after ACA was first approached by Goldman about working on the Abacus CDO, Mr. Tourre sent ACA a "Transaction Summary" describing the proposed transaction. The Transaction Summary identified the Paulson hedge fund as the "Transaction Sponsor," described the "Contemplated Capital Structure" of the CDO, and indicated that the lowest tranche, "[0]%-[9]%," was "pre-committed first loss."2538 The ACA Managing Director told the Subcommittee that the "[0]%-[9]%" tranche identified in the Transaction

570

¶Summary matched the general description of an equity tranche, and the wording suggested that someone had already committed to buy it.2539 She explained that it was typical for a CDO sponsor to purchase the equity tranche, and she believed that Paulson, as the Abacus "sponsor," had committed to buy that tranche.2540 The Abacus Marketing book also specified that the "First Loss" tranche of the CDO, of a "[+10%]" size, was "Not Offered" for sale.2541 The ACA Managing Director declared in a statement to the SEC that she had interpreted the phrase, "Not Offered," to indicate the equity tranche had been "pre-placed" and "ha[d] already been committed to purchase by an investor and [would] not be marketed."2542 She thought that investor was the Paulson hedge fund.

¶When asked about the Transaction Summary description of the lowest tranche in the Abacus CDO, Mr. Tourre told the Subcommittee that the phrase "pre-committed first loss" normally indicated that the tranche had been sold. He stated that he actually meant to communicate that the tranche had not been sold, and that portion of the Transaction Summary was poorly worded.2543

¶In his prepared statement at the Subcommittee hearing, Mr. Tourre testified that he never told ACA that the Paulson hedge fund would be a long investor in the Abacus CDO:

"I never told ACA, the portfolio selection agent, that Paulson and Company would be an equity investor in the AC-1 transaction or would take any long position in the deal. Although I don't recall the exact words that I used, I recall informing ACA that Paulson's fund was expected to buy credit protection on some of the senior tranches in this deal. This necessarily meant that Paulson was expected to take some short position in the transaction."2544

¶In addition, Mr. Tourre testified that he informed ACA that the Paulson hedge fund was going to invest only on the short side of the transaction:

Senator Levin: You did not disclose to ACA that Paulson was on the short side of this deal. Is that correct?

Mr. Tourre: I did mention to ACA that the expectation was that Paulson was going to buy protection on senior layers of risk in the transaction.

¶Senator Levin: That they were going to be only on the short side.

571

¶Mr. Tourre: Yes.2545

¶ACA has since filed a civil lawsuit against Goldman asserting that Goldman did not inform ACA that "Paulson intended to take an enormous short position" in Abacus and is seeking to recover $30 million in compensatory damages and $90 million in punitive damages for fraudulent inducement, fraudulent concealment, and unjust enrichment.2546

¶Regardless of the communications between Goldman and ACA, it is clear that the Abacus marketing material and offering documents provided by Goldman to investors contained no mention of Paulson's short position in the CDO nor the significant role it played in the selection of the CDO's reference assets. This was confirmed by Mr. Tourre at the Subcommittee hearing:

Senator Levin: And was it reflected in the Goldman Sachs security offering to investors that Paulson had been part of the selection process? Was that represented in that document?

¶Mr. Tourre: Paulson was not disclosed in the Abacus 07 AC-1 transaction, Mr. Chairman.

¶Senator Levin: It was not?

¶Mr. Tourre: No, it was not.2547

¶Still another troubling omission was Goldman's failure to advise potential Abacus investors that the firm's own economic interests were aligned with those of the Paulson hedge fund. As part of the Abacus CDO arrangement, Paulson agreed to pay Goldman a higher fee if Goldman could provide Paulson with CDS contracts containing premium payments below a certain level.2548 The problem with the fee incentive offer was that, while lower premiums would result in lower costs to Paulson, it would also result in lower premium payments to the CDO, directly reducing the amount of cash available to the long investors. The Paulson-Goldman compensation arrangement, thus, created a direct conflict of interest between Goldman and the investors to whom it was selling the Abacus securities.

572

¶Selling Abacus Securities. Abacus 2007-AC1 closed, and its securities were issued on April 26, 2007. They were issued later than the securities from the Hudson, Anderson, and Timberwolf CDOs and hit the market as subprime mortgages were hitting record delinquency and default rates. Goldman sold the Abacus 2007-AC1 securities to just three investors: IKB, the German bank; ACA, the portfolio selection agent; and ACA Financial Guaranty Corp., the owner of ACA and a wholly owned subsidiary of ACA Capital Holdings Inc.2549 IKB bought $150 million of the AAA rated Abacus securities. ACA bought about $42 million in the AAA securities for placement in another CDO it was managing.^25502550 See Goldman trading datasheet, GS MBS 0000004276 (showing closing dates and details on various deals, including Abacus). ACA Financial Guaranty Corp. was by far the largest investor, taking the long side of a $909 million CDS contract referencing the super senior portion of the CDO.2551 Goldman took the short side of the CDS contract, which it then transferred to Paulson.2552

¶"comfortable buying protection only to the extent that the spreads they were paying were less than a certain level." SEC deposition of Fabrice Tourre (3/3/2009), GS MBS 0000022785, at 899-900.

573

¶Within months, the high risk subprime mortgages underlying the RMBS securities referenced in the Abacus portfolio incurred steep rates of default, and the Abacus securities began to lose value. According to the SEC, by October 2007, six months after the securities were issued, 83% of the underlying assets had received a credit rating downgrade and 17% of the underlying assets had been placed on a negative credit watch.2553 On October 26, 2007, a Goldman employee sent an email about Abacus 2007-AC1 with an assessment even more negative than that of the SEC:

"This deal was number 1 in the universe of CDO's that were downgraded by Moody's and S&P. 99.89% of the underlying assets were downgraded."2554

¶The three long investors in Abacus 2007-AC1 together lost more than $1 billion. As the sole short investor, Paulson recorded a corresponding profit of about $1 billion.2555

¶On April 16, 2010, the SEC filed a complaint against Goldman and Mr. Tourre, alleging their actions constituted securities fraud.2556 The SEC specifically alleged violations of Section 17(a) of the Securities Act of 1933, as well as Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934.2557 The SEC contended that Goldman had failed to disclose to potential investors materially adverse information, that the party shorting the reference assets was the same party that had played a significant role in selecting those assets.2558 On July 14, 2010, Goldman reached a $550 million settlement with the SEC.2559 In connection with the settlement, Goldman acknowledged:

"[T]he marketing materials for the ABACUS 2007-AC1 transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state

574

that the reference portfolio was 'selected by' ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson's economic interests were adverse to CDO investors."2560

¶Analysis. Goldman constructed Abacus 2007-AC1 to help a hedge fund short multiple RMBS securities. Goldman allowed the hedge fund to play a significant role in the selection of the CDO's referenced assets, while employing an outside portfolio agent to give the impression that the CDO assets were selected by a disinterested third party. Goldman failed to disclose the hedge fund's investment objective and asset selection role to a credit rating agency that assigned AAA ratings to two tranches of the Abacus securities. Goldman also failed to provide full disclosure to the long investors to whom it sold the Abacus securities. In addition, Goldman failed to disclose to the investors a compensation arrangement that provided incentives for Goldman to minimize the premium payments into the CDO. Within six months, the Abacus securities began incurring losses and ratings downgrades. Goldman watched the long investors to whom it had sold the securities lose virtually all the funds they had invested, while the hedge fund it had assisted walked away with a profit of approximately $1 billion.

¶(iii) Additional CDO Conflicts of Interest

¶In addition to creating and failing to manage conflicts of interest arising from its design and sale of CDO securities, Goldman at times allowed conflicts of interest to affect how it carried out key roles in the administration of its CDOs.2561 Two examples, in which Goldman acted as the liquidation agent in Hudson 1 and the collateral put provider in Timberwolf, illustrate the problems. In both cases, Goldman used its administrative roles to promote and enhance its own financial interests at the expense of the clients to whom it had sold the CDO securities.

¶AA. Liquidation Agent in Hudson 1

¶In 2006 and 2007, several Goldman CDOs included provisions establishing a "liquidation agent" to sell any poorly performing assets in the CDO. This feature appeared in Hudson Mezzanine 2006-1, which is examined in this Report, as well as Hout Bay 2006-1, Hudson High

575

¶Grade 2006-1, Hudson Mezzanine 2006-2, and Anderson Mezzanine 2007-1.2562 In each instance, Goldman served as the initial liquidation agent, although in several CDOs, it later transferred the role to a third party. In Hudson 1, Goldman's dual roles as liquidation agent and sole short party in the CDO created a direct conflict of interest between Goldman and the clients to whom it sold the Hudson securities, which Goldman exploited by placing its own financial interests ahead of those of its clients.

¶Designing the Liquidation Agent Role. According to Goldman, appointing a CDO liquidation agent was a "fairly novel idea" that was first implemented in the 2006 Hout Bay CDO.2563 Peter Ostrem, then head of the CDO Origination Desk, oversaw the drafting of the liquidation agent feature.2564 He told the Subcommittee that Goldman wanted to issue static portfolio CDOs, meaning CDOs whose assets did not change over time, but also wanted to protect investors from poorly performing assets. He explained that the liquidation agent feature was intended to be triggered by a specified event and provided the liquidation agent with "no discretion" other than to sell the poorly performing asset, which was referred to as a "Credit Risk Asset." He explained that, without such a feature, poorly performing assets would "just stay there" in a CDO, further harming investors.2565 The CDO Origination Desk also favored the approach, because it could be performed by Goldman itself at a lower cost than retaining a traditional collateral manager.2566

¶The liquidation agent provisions established criteria for identifying "Credit Risk Assets" and removing them from the CDO. In a July 2006 memorandum to the Goldman Mortgage Capital Committee, the CDO Origination Desk described the liquidation agent role as follows:

"As Liquidation Agent, Goldman will liquidate assets determined by the Trustee to be 'Credit Risk Assets' based on specific guidelines. Goldman will have 12 months to sell these assets. Sales will be made under a competitive bidding process, whereby we will solicit three outside bids and select the highest. Prior to executing Hout Bay 1, in which we also played the Liquidation Agent role, we spoke to multiple counterparties as to our role as Liquidation Agent. We received approval for our role in this transaction from legal and accounting. ... Finally, we spoke with outside counsel, Wilmer Cutler, about potential issues related to the Investment Advisor Act. They are of the opinion that our role of Liquidation Agent does not cause us to be deemed an Investment Advisor based on the exception to the Advisors Act for a 'limited grant of discretion.'"2567

576

¶One key issue discussed in the memorandum was whether, by assuming the role of liquidation agent, Goldman would trigger registration and disclosure obligations under the Investment Advisers Act of 1940. The CDO Origination Desk wrote:

"We have discussed Goldman's role as Liquidation Agent internally with Tim Saunders [counsel in Goldman's legal department] and externally with outside counsel, Wilmer Cutler. One concern about that role was whether Goldman would be viewed as an Investment Advisor. We specifically crafted Goldman's role in Hout Bay 1 and in this case to eliminate both internal and external counsel's concern about Goldman being treated as an Investment Advisor. The main factors that made Tim Saunders and Wilmer Cutler comfortable that Goldman will not be treated as an Investment Advisor were:

• Goldman's role is Liquidation Agent and not Collateral Manager. Goldman is engaged by the CDO to liquidate Credit Risk Assets and will receive an ongoing Liquidation Agent Fee for such services;

• Goldman does not determine whether an asset is a Credit Risk Asset. Such determination is made by the CDO based on specific rules . . . ;

• Goldman must liquidate such Credit Risk Assets within 12 months of such determination and the price received on such liquidation must be in the context of a three-bid process;

• Goldman does not receive additional compensation and or control of the CDO for acting as a Liquidation Agent. ...

We will build a provision in the deal documents to allow Goldman to resign as Liquidation Agent if appropriate notice is given and a replacement Liquidation Agent is in place."2568

¶This memorandum indicates that, from its inception, the liquidation agent function was designed as a narrow, ministerial role, in part to avoid the legal obligations applicable under federal law to investment advisers.

¶The memorandum also indicated that "Credit Risk Assets" would be identified through objective criteria. For example, in the CDO under review, the memorandum stated that Credit Risk Assets would be defined as "[a]ny asset that is downgraded by Moody's or S&P below Ba2" and "[a]ny asset that is defaulted."2569

¶Credit Rating Downgrades. One year later, on July 19, 2007, after Mr. Ostrem had left Goldman and Mr. Lehman had assumed responsibility for all Goldman-originated CDOs, he held a conference call with members of the CDO team and Goldman in-house legal counsel Tim Saunders, to discuss how to carry out Goldman's CDO liquidation agent responsibilities. The prior week, Moody's and S&P had suddenly downgraded hundreds of RMBS and CDO securities in the first of many mass downgrades. Those downgrades suddenly caused a number of assets in Goldman's CDOs to qualify as Credit Risk Assets that had to be liquidated.

577

¶In advance of the conference call, Mr. Lehman's staff prepared a two-page summary of Goldman's liquidation agent duties, the liquidation procedures specified in the CDO documents, the CDOs affected, and the assets that Goldman anticipated would be affected by the downgrades.2570

¶Four days after the conference call, on July 23, 2007, Benjamin Case, who had been assigned lead responsibility for carrying out Goldman's liquidation agent functions, circulated a draft document describing Goldman's role. It stated that Goldman's goal as liquidation agent was:

"to attempt to maximize proceeds on the unwind of credit risk assets pursuant to the liquidation process governed by the CDO documents, rather than to liquidate at an arbitrary pre-specified time without regard to market conditions."2571

¶It identified the assets that had been classified as Credit Risk Assets and provided Goldman's "Current Strategy" for handling them:

"– wait and continue to evaluate market conditions, rather than liquidating now. - upside is that continued short-covering by hedge funds anxious to monetize profits could cause minor rally (5-10 points)[.] - downside is that speed up of foreclosure process vs. current timeline expected by market could decrease IO value, or significant forced selling of similar names by CDO vehicles could push levels wider [lower prices]."

¶Hudson Liquidation Agent. Although the liquidation agent role was originally designed for use in Goldman's "high grade" CDOs, where "there is substantially less credit risk in the assets vs. a mezzanine structured product CDO portfolio," the feature was also added to some of its riskier mezzanine CDOs, including Hudson Mezzanine 2007-1 (Hudson 1).2572 Hudson 1 was a synthetic CDO whose assets consisted entirely of CDS contracts referencing subprime RMBS or ABX assets with BBB or BBB- ratings. Goldman had selected 100% of the reference assets and held 100% of the short side of the CDO.

¶Hudson 1's marketing materials outlined Goldman's liquidation agent role. The Hudson marketing booklet, for example, told potential investors:

578

"Hudson CDOs are non-managed and static in nature and provide term non-recourse funding where Goldman Sachs acts as Liquidation Agent on an ongoing basis. The Liquidation Agent will be responsible for efficiently selling credit risk assets."2573

¶The Hudson term sheet provided additional information about the liquidation agent role and the "Credit Risk Assets" that would have to be liquidated:

"Goldman as Liquidation Agent, will liquidate any asset determined to be a 'credit risk' within 12 months of said determination. Credit Risk assets will include: any asset downgraded by Moody's or S&P below Ba3 or BB-, any asset that is defaulted or would be experiencing a credit event as defined by the PAUG [Pay As You Go] confirm. There will be no reinvestment, substitution, discretionary trading or discretionary sales. After closing, assets that are determined to be 'credit risk' securities will be sold by the Liquidation Agent within one year of such determination."2574

¶The Hudson Offering Circular repeated that information and added:

"The Liquidation Agent will not have the right, or the obligation, to exercise any discretion with respect to the method or the price of any assignment, termination or disposition of a CDS Transaction; the sole obligation of the Liquidation Agent will be to execute such assignment or termination of a CDS Transaction in accordance with the terms of the Liquidation Agency Agreement. ... [T]he Liquidation Agent shall have no responsibility for, or liability relating to, the performance of the Issuer or any CDS Transaction, Reference Obligation, Collateral Security or Eligible Investment."2575

¶Goldman charged a 10 basis point ongoing fee for serving as the Hudson Liquidation Agent,2576 which resulted in its being paid a total fee of approximately $3.1 million.2577

¶While Goldman was marketing Hudson in 2007, a client asked why the liquidation agent was "afforded up to 12 months to sell a credit risk asset."2578 The Subcommittee was unable to find Goldman's contemporaneous response, but when asked the same question, Darryl Herrick, the Hudson deal captain, told the Subcommittee that there was "headline risk" associated with the downgrade of an asset, and twelve months gave Goldman "flexibility to try to get a better price later."2579 When asked whether the "flexibility" to delay a sale violated Hudson's prohibition against discretionary trading by the liquidation agent, Mr. Herrick said that Goldman had

579

¶"discretion based on a rule," and that the liquidation agent provisions had been vetted with the credit rating agencies which "probably wanted the deal to avoid forced sales."2580

¶Failure to Liquidate. In July 2007, after the credit rating agencies began the mass downgrades of RMBS securities, the first RMBS securities underlying the Hudson CDO lost their investment grade ratings, and the CDS contracts referencing those assets qualified as Credit Risk Assets requiring liquidation.2581 Within three months, by October 15, 2007, over 28% of the Hudson assets qualified as Credit Risk Assets.2582 As liquidation agent, Goldman should have begun issuing bids to sell the assets at the best possible price and remove them from the Hudson CDO, but it did not.

¶In October 2007, Goldman began to contact Hudson investors to discuss transferring its liquidation agent responsibilities to a third party. That transfer required investor consent. Benjamin Case took notes of two telephone conversations he had with a Hudson investor, National Australia Bank (NAB), discussing the issues.2583 In the calls, Mr. Case explained why Goldman had yet to liquidate any of the Credit Risk Assets, explaining that Goldman was waiting for asset prices to improve.2584 He also reported that Goldman was considering an amendment to the Hudson transaction that would extend the maximum liquidation period, as well as make other structural changes to the Hudson deal.2585

¶According to his notes, Mr. Case informed NAB that Goldman was seeking to transfer its liquidation role to a third party with more liquidation experience, because that change:

"will be in the best interest of investors – the credit obligation term was originally written with the expectation that was unlikely to happen. ... Good for several reasons: 1. Large institutional assets manager will be able to access more liquidity b/c [because] they can access other broker dealers and get good pricing[.]

580

2. Even keeping the deal the way it is, the decision of when in the 12 month period to liquidate could be better handled by an experienced manager[.] 3. Potential amendment could be made to benefit the deal by giving more flexibility to agent."2586

¶These notes indicate that, although Goldman was the architect of the Hudson CDO and selected itself to serve as liquidation agent at a fee of $3.1 million, when Goldman was called upon to execute its role, it believed the decision of when to liquidate the impaired assets "could be better handled by an experienced manager."

¶According to Mr. Case's notes, NAB sent Mr. Case an email asking if Goldman held any of the Hudson investments: "does GS hold any of this?" Mr. Case responded:

"def own equity and different pieces of various tranches no [sic] exactly, but decent size and numbers of cl[a]sses on our books."2587

¶Mr. Case apparently did not disclose that, in addition to its $6 million equity tranche, Goldman also held 100% of the short position in the $2 billion CDO, and that its short investment would increase in value as the Hudson assets lost value.

¶According to Mr. Case's notes, NAB replied by asking Goldman to provide more specific information about Goldman's holdings in the transaction: "Could you please follow up with what Goldman holds?"2588 When Mr. Case asked why NAB wanted that information, NAB responded: "Want to make sure you [Goldman] are making restructuring decisions for the right reasons – make sure serving the right interests." According to his notes, Mr. Case replied: "Our intended goal of liquidation agent is to serve the best interests of the CDO – that is the duty of the liquidation agent – it is a policy and process."2589

¶In November 2007, Goldman took initial steps to transfer its liquidation agent responsibilities to a third party.2590 At that point, Goldman had yet to liquidate any of the Hudson Credit Risk Assets.2591 The nine assets that had become Credit Risks in July had already dropped significantly in value. One asset which, on July 16, had a value of 61% of its face (par) value, had fallen by November 1 to 16% of par.2592 Another asset that, on July 16, had a value of 43% of par, had fallen in value by November 1 to 7% of par.2593

581

¶At the end of November, Goldman reached an agreement with Trust Company of the West (TCW), subject to investor approval, in which Goldman would assign its liquidation agent duties to TCW, and TCW would "share back" 30% of the fees with Goldman.2594 Mr. Lehman told the Subcommittee that Goldman's decision to assign the liquidation agent rights to a third party was because liquidation was a non core business for Goldman, and TCW was better suited to liquidate the Credit Risk Assets.2595 On December 18, 2007, while Goldman was still seeking investor approval to assign the liquidation agent role to TCW, a Goldman representative explained to an investor the firm's thinking:

"GS [Goldman Sachs] is soliciting consent to assign GS role as liquidation agent to TCW bec[ause] when liquidation agent role was designed, it was very 'out of the money'; now when the risk is very real, it is much more efficient to have a sophisticated collateral manager bec[ause] (i) TCW can access better liquidity than GS, ie get bids from the entire street (ii) real asset manager can pursue further amendments to the doc to make liquidation more efficient bec[ause] is not an asset [manager] under the investment act in 1940 and cannot act [sic] investment advisory services and can't act with optimal discretion."2596

¶On December 19, 2007, Morgan Stanley, the largest Hudson long investor with a $1.2 billion interest encompassing the entire super-senior tranche,2597 was presented with a consent form to assign the liquidation agent rights to TCW.2598 Morgan Stanley told the Subcommittee that it had declined to consent to the transfer, because the liquidation agent role was ministerial, had no discretionary authority, and could quickly and easily be accomplished by Goldman.2599 Morgan Stanley told the Subcommittee that it instead asked Goldman to begin liquidating the $596.5 million in Credit Risk Assets immediately, some of which had been designated as Credit Risks for five months, and all of which had declined in value.2600

¶On January 3, 2008, Daniel Sparks, the Mortgage Department head, was given a spreadsheet listing the Credit Risk Assets in each of the CDOs in which Goldman was serving as the liquidation agent, including Hudson 1. The spreadsheet showed that, in Hudson,⁴⁴⁴⁴ 3/11/2008 compliance letter from Moody's to SEC, SEC_OCIE_CRA_011212 and SEC_OCIE_CRA_011214. These numbers represent the RMBS or CDO pools that were presented to Moody's which then issued ratings for multiple tranches per RMBS or CDO pool. The data Moody's provided to the SEC on CDOs represented ABS CDOs, some of which may not be mortgage related. However, by 2004, most, but not all, CDOs relied primarily on mortgage related assets such as RMBS securities. Subcommittee interview of Gary Witt, former Managing Director of Moody's RMBS Group (10/29/2009). (See Chapter V below.) assets were Credit Risks with a face value of $635 million, totaling about 30% of the asset pool.2601

[SEE CHART NEXT PAGE: Credit Risk Assets, prepared by Goldman Sachs.]

¶Credit Risk Assets (%)

¶35.00%

¶30.00% G) (,J

¶I Anderson c: nI 25.00% • Hout Bay

• nI In II Hudson High Grade G) 20.00% II Hudson Mezz 1 I/) I/)

• <C c: 15.00% e ...

¶II Hudson Mezz 2

¶:::l

¶... ()

¶10.00%

¶~ 0 5.00%

0.00% 7/1/2007 7/31/2007 8/30/2007 9/29/2007 10/29/2007 11/28/2007 12/28/2007 Date

583

¶The spreadsheet also showed that the weighted average values of the Hudson assets had fallen dramatically, causing losses that could have been avoided had Goldman liquidated them sooner. The weighted average values had fallen from 45% of face (par) value in July, to a low of 15% on November 1, 2007, and were about 20% of par value on January 2, 2008.2602

[SEE CHART NEXT PAGE: Weighted Average Levels, prepared by Goldman Sachs.]

¶Hudson Conflict of Interest. Despite the falling values and Morgan Stanley's ongoing request to initiate liquidation of the Credit Risk Assets as set out in the Hudson 1 agreement, Goldman still did not begin liquidating.

¶During January and February 2008, Morgan Stanley engaged in frequent communications with Goldman personnel, including Mr. Lehman who oversaw Goldman's CDOs, and Mr. Case who oversaw the liquidation agent function, to initiate liquidation of the Hudson assets.2603 The falling value of the Hudson assets caused sharp losses in Morgan Stanley's $1.2 billion investment, leading Morgan Stanley to press for the Credit Risk Assets to be liquidated and removed from the CDO as soon as possible. In contrast, as the Hudson assets fell in value, Goldman, as the CDO's sole short party, saw its short position become increasingly profitable. Goldman had little financial incentive to liquidate the Credit Risk Assets, because the more they fell in value, the more Goldman was able to maximize the profits from its short position in the CDO. Goldman's dual roles as liquidation agent and short party, thus, created a conflict of interest that disadvantaged the long investors in the Hudson CDO, such as Morgan Stanley.2604

¶Weighted Average Levels

¶60.00%

¶50.00%

¶40.00%

¶~ 30.00% oJ

I Anderson 20.00% • Houl Bay o Hudson High Grade 10.00% II Hudson Mezz 1 II Hudson Mezz 2

0.00% 7/16/2007 8/15/2007 9/14/2007 10/14/2007 11/13/2007 12/13/2007 Date

585

¶Morgan Stanley personnel expressed increasing frustration with Goldman's failure to liquidate the Hudson Credit Risk Assets, in both internal communications and with Goldman representatives. On January 16, 2008, for example, the key trader on Morgan Stanley's Proprietary Trading Desk dealing with Hudson wrote to a colleague: "Had another call with [Goldman's] sr. trader about GS's liquidation agent role in the $1.2bn HUDSON deal. They insist they are NOT acting as a fiduciary per the docs in this deal."2605 On February 5, he sent Mr. Lehman an email: "[P]lease call when possible – $969mm now eligible to be liquidated post S&P do[w]ngrades."2606

¶On February 6, the Morgan Stanley trader wrote to a colleague:

"[W]ent down the road with Goldman on liquidation agent assets (now ~$1bb of eligible assets post downgrades). They told me they will 'continue to take my opinion under advisement' but provided no course of action. I broke my phone. Will talk to [Morgan Stanley legal counsel] tomorrow but don't think there is any probable way for us to force them to liquidate assets."2607

¶On February 7, the Morgan Stanley trader sent another email to Mr. Lehman:

"Spoke with Ben [Case] re: Hudson today. Goes without saying I remain very frustrated by the way GS is handling the liquidation agent role. There is almost $1bb of eligible assets in that deal now, every one of which has lost value since it was downgraded. No good reason to wait other th[a]n to devalue our position. It's a shame .... [O]ne day I hope I get the real reason why you are doing this to me."2608

¶According to Morgan Stanley, Goldman continued to explain its seven-month delay in liquidating the Credit Risk Assets by asserting that the market would rebound during a rally to cover shorts, and it should wait to liquidate until asset prices rose. In a February 13,^20082008 SEC Examination Report for Moody's Investor Services Inc., PSI-SEC (Moodys Exam Report)-14-0001- 16, at 4. SEC Examination Report for Standard and Poor's Ratings Services, Inc., PSI-SEC (S&P Exam Report)- 14-0001-24, at 3. For a detailed discussion of these obligations under federal securities laws, see Section (6)(a), below. telephone call between Morgan Stanley and Goldman, for example, which was recorded and transcribed, Mr. Case stated:

"So I think, as we see the short covering wave kind of continue to proceed ... it's gonna get to the point where it's in the best interest of the deal to start liquidating then. ... I know we've talked about this twelve month period ... it doesn't seem like it's gonna take till late in the twelve month process for the majority of these assets to get to that point."2609

¶Morgan Stanley asked if there was anything beyond the "technical nature of the markets," such as government intervention, to produce "any kind of real pop" that would improve the underlying fundamentals in the mortgage market. Mr. Case responded: "The chance that it could move in that direction, at least in the next few months . . . is de minimis I'd say."2610 During the call, Morgan Stanley's representative again urged Goldman to begin the liquidation process: "Just so you know, my opinion stays the same, I'd like to see a bid list before three o'clock today."2611

586

¶Morgan Stanley told the Subcommittee that the Hudson assets had been in near continuous decline, and Goldman's refusal to liquidate assets shortly after they became Credit Risk Assets allowed them to decline further, rather than limiting losses for bondholders. By February 21, 2008, Morgan Stanley had calculated that the liquidation delay had cost it $130.5 million; the next week it calculated the losses had increased to $150 million.2612

¶Morgan Stanley told Goldman that by delaying the liquidation of the Credit Risk Assets, Goldman was in violation of the terms in the Hudson 1 offering circular, in particular the provision: "The Liquidation Agent will not have the right, or the obligation, to exercise any discretion with respect to the method or the price of any assignment, termination or disposition of a ... Credit Risk Obligation."2613 On February 29, 2008, Morgan Stanley sent Goldman a letter demanding that it immediately initiate liquidation of $1 billion in Hudson Credit Risk Assets:

"As Liquidation Agent, [Goldman] is currently responsible for liquidating approximately $1,000,000,000 of Credit Risk Obligations. The transaction documents clearly state that [Goldman] would not exercise investment discretion in its role as Liquidation Agent. [Goldman] has not yet liquidated a single Credit Risk Obligation, notwithstanding that some date back to August of 2007. The [Goldman] employee handling the liquidation has explained this by stating that he believes the price for these obligations will increase in the future and it is better for the deal to liquidate these obligations at a later date. ...

The Liquidation Agency Agreement states that "the Liquidation Agent ... shall not provide investment advisory services to the Issuer or act as the "collateral manager" for the Pledged Assets. ...

While the Liquidation Agency Agreement provides that the Liquidation Agent must complete the process of liquidating the relevant assets within twelve months, it does not provide the Liquidation Agent with any right to delay the liquidation process based on the exercise of Investment discretion. To the contrary, the Liquidation Agency Agreement and the [Offering Circular] clearly state that no discretion or investment advisory services are ever to be provided by the Liquidation Agent."2614

587

¶Morgan Stanley concluded by "demanding only that [Goldman] fulfill its contractual duties as required by the Liquidation Agency Agreement and assign, terminate or otherwise dispose of the relevant CDS transaction forthwith."

¶On March 10, 2008, Goldman responded:

"[Y]our letter is entirely mistaken in its suggestion that Goldman Sachs has somehow breached its obligations under the Liquidation Agency Agreement. As [Morgan Stanley's] letter recognizes, Section 2(b) of the Liquidation Agency Agreement specifically provides that Goldman, acting as Liquidation Agent, has up to twelve months in which to assign, terminate or otherwise dispose of Credit Risk Obligations assigned to it for that purpose. Obviously, establishment of a liquidation period of that duration contemplates – and, indeed, embodies Hudson's informed consent – that the Liquidation Agent will necessarily exercise judgement in determining when and how to dispose of Credit Risk Obligations assigned to it for that purpose. ...

Nor does this expressly intended contractual latitude transform Goldman Sachs into a de facto 'investment adviser' to Hudson, as you suggest. The Agreement ... in fact categorically disclaims that Goldman Sachs or its affiliates will be providing investment advisory services or otherwise acting as an adviser or fiduciary to Hudson by virtue of its liquidation services. That disclaimer is perfectly consistent with discretion routinely accorded to securities brokers in seeking to fulfill their obligation to obtain the best execution possible for their clients without making them 'investment advisors.'"2615

¶Several days before Goldman's response letter was sent to Morgan Stanley, however, Goldman began liquidating the Credit Risk Assets in Hudson 1. On March 7, 2008, Goldman liquidated eight assets, followed by more on March 20 and 28, liquidating nearly one third of the eligible assets over the course of the month.2616 In its role as liquidation agent, Goldman was required to solicit bids from at least three independent dealers for the Credit Risk Assets, and Morgan Stanley was given an opportunity to bid on many of the liquidated assets.2617 Liquidation proceeded over the next two months, from April through June.2618 On July 22, 2008, Hudson's realized losses exceeded $800 million, and Hudson 1 went into default. Hudson's remaining assets were liquidated in November 2008. Morgan Stanley's losses from its Hudson investment exceeded $930 million.2619

588

¶Analysis. In several of the CDOs it constructed, Goldman established a new position of liquidation agent and appointed itself to play that role for a substantial fee. In the case of Hudson 1, by taking on the role of liquidation agent at the same time it was the sole short party in the CDO, Goldman created a conflict of interest. When the Hudson 1 assets began falling in value, the long investors wanted the poorly performing assets liquidated as soon as possible; Goldman, on the other hand, benefitted financially the farther the assets fell in value since that allowed Goldman to maximize the value of its short position.

¶Goldman delayed liquidating the Credit Risk Assets, despite urgent requests from the largest Hudson investor, Morgan Stanley, placing its own financial interests ahead of the client to whom it had sold a $1.2 billion Hudson investment.

¶BB. Collateral Put Provider in Timberwolf

¶The second example of a conflict of interest affecting how Goldman carried out a CDO administrative function involves Goldman's role as the collateral put provider in Timberwolf I. Synthetic CDOs like Timberwolf collected cash from the long investors that purchased its securities as well as from the short parties that paid CDS premiums to the CDO. A portion of the cash collected from the long investors was placed by the CDO into a "default swap collateral account" to be used if the CDO performed poorly and payments had to be made to the short parties.2620 At one time, many CDOs used the cash in the default swap collateral account to purchase Guaranteed Investment Contracts (GICs), which guaranteed repayment of the principal and a fixed or floating interest rate for a fixed period of time. But in the years leading up to the financial crisis, CDO issuers sought to use the cash in the default swap collateral account to make investments that generated higher returns, in order to improve financial performance, obtain better credit ratings, and attract investors. To obtain those higher returns, CDO issuers began to invest the incoming cash in "default swap collateral securities."

¶Goldman's synthetic CDOs generally invested in default swap collateral securities, and its CDO agreements typically set out parameters for the types of default swap collateral securities that could be purchased with investor funds, often requiring them to be high quality, low risk, liquid investments.2621 If the CDO had a collateral manager, the manager often selected the CDO's default swap collateral securities. The returns earned by the default swap collateral securities often became an important component of the CDO's income. The principal proceeds of the default swap collateral securities were typically re-invested in similar securities until the CDO matured or the proceeds were needed to make payments to short parties.

589

¶Goldman's Dual Roles. In its synthetic CDOs, Goldman often took on two roles that affected the default swap collateral securities, acting as both the CDO's primary CDS counterparty2622 and its collateral put provider. Goldman's synthetic CDOs typically followed industry practice by making one entity the sole counterparty for all of the CDS contracts issued by the CDO. In Goldman CDOs, that party was generally Goldman Sachs International (GSI), a United Kingdom subsidiary that was wholly owned by Goldman. Typically, GSI was the sole party that entered into a CDS contract directly with the domestic and offshore companies that served as the issuers of the CDO's securities (hereinafter collectively referred to as the "Issuer").2623 GSI then acted as an intermediary for the Issuer by entering into a corresponding CDS contract with each party seeking to take a short position in the CDO. By inserting itself into the middle of the CDS transactions, GSI put Goldman's financial standing behind the CDS contracts issued by the Issuer and improved the credit ratings assigned to and investor confidence in the CDO. If a credit event later took place, the Issuer was responsible for making payments to GSI, and GSI, whether or not it received sufficient payments from the Issuer, was responsible for making the payments owed to the short parties in the corresponding CDS contracts. Sometimes, instead of contracting with a third party, GSI kept some or all of the short positions in the CDO on behalf of Goldman itself.

¶By acting as the primary CDS counterparty, GSI necessarily took the short side of each CDS contract it entered into with the Issuer. Those CDS contracts typically provided that, in the event of a specified credit event that required payment to GSI, GSI could collect a specified amount of funds from the Issuer. The Issuer paid its obligations to GSI by first drawing down any available cash in the default swap collateral account. If that cash was insufficient, GSI also had the right to identify one or more of the default swap collateral securities that together had a face (par) value equal to the amount owed to GSI. Those securities could then be sold and the sale proceeds used to satisfy the amount owed to GSI under the CDS contracts.2624 GSI would then use the cash it received from the sale proceeds to pay off the short parties in the corresponding CDS contracts. Since GSI's financial obligations under the CDS contracts were dependent in part upon the quality of the default swap collateral securities, Goldman provided in the CDO agreement that those securities could be purchased only with the prior "consent" of GSI. This arrangement enabled Goldman to exert control over the selection of the default swap collateral securities.

590

¶In addition to acting as the primary CDS counterparty in the CDOs it constructed, Goldman often acted as the CDO's default swap collateral put provider (hereinafter "collateral put provider"). The collateral put provider essentially guarantees the face (par) value of the CDO's default swap collateral securities.2625

¶Since GSI was already acting as the primary CDS counterparty, the CDO indenture agreement typically provided that, if the market value of any default collateral security selected by GSI to satisfy an amount owed to GSI fell below its face (par) value, then GSI suffered the market risk, and could not recover additional funds from the Issuer to make up for the security's loss in value. GSI was still responsible, however, for making full payments to the short parties in the corresponding CDS contracts. This arrangement functioned effectively as a "put" agreement that guaranteed the face (par) value of the default swap collateral securities, and Goldman treated the arrangement as a put agreement.

¶Due to the dual roles played by GSI in its CDOs, many of Goldman's CDO indenture agreements did not contain an explicit put agreement, but simply constructed GSI's CDS contracts to include the provisions that achieved the same result. For example, the Timberwolf Indenture agreement specified that the primary CDS counterparty in its CDS contract – GSI – bore the market risk associated with any default swap collateral sold to satisfy an obligation to that counterparty.2626 In exchange for bearing the risk of not receiving the full payment owed to it from the sale of the default swap collateral securities, GSI received a discount – typically equal to 5 basis points – on the premiums GSI paid to the Issuer under the primary CDS contract. In a CDO deal of $1 billion, the premium discount would yield a "fee" of approximately $500,000.2627 In most cases, however, the CDO indenture agreements did not specifically cite the connection between GSI's bearing the market risk of the default swap collateral sales and receiving a CDS premium discount. The CDO agreements simply included a reduced premium payment by GSI under the primary CDS contract with the Issuer.2628

591

¶Timberwolf Conflict of Interest. In the Timberwolf CDO, GSI acted as both the primary CDS counterparty and the collateral put provider. Documents provided to the Subcommittee show how these dual roles created a conflict between Goldman and the Timberwolf long investors, and how Goldman reacted by placing its interests before those of the clients to whom it had sold the Timberwolf securities.

¶In 2007, as the mortgage market deteriorated, the value of many types of default swap collateral securities also declined. Goldman became concerned that if the market value of the securities fell below par and a credit event occurred, those securities would provide insufficient funds to pay the amounts owed to GSI under its primary CDS contract with the Issuer. In addition, Goldman knew that the more the default swap collateral securities fell in value, the more of a shortfall Goldman would have to make up if GSI had to make payments to other short parties. Goldman wanted to maximize the value of the default swap collateral and what would be available

¶Subcommittee QFR at PSI_QFR_GS0249. For another CDO, Broadwick, Goldman also projected that the premium discount would yield a profit of more than $1 million, less any costs it might have to absorb in its role as put provider. See 4/12/2006 email from Peter Ostrem to John Little and Robert Leventhal, GS MBS-E-010808964 at 66-67 ("Can we agree on how we want to treat P&L [profit and loss] on Peloton relative to the put swap? W e expect P&L of over $1mm [million] for the 5bp [basis point] reduction in the CDS premiums. ... I propose we separately book the put swap at close to zero (contingent MTM risk on 2 yr AAA diversified portfolio where Goldman retains selection optionality seems low), but we are open to booking 1bp in negative put cost (i.e., -$200k)."). In some other CDOs, the projected put fee was about $500,000.

592

¶to make all of the payments needed pursuant to Goldman's own short positions as well as any payments it would need to make to other short parties.

¶In the late spring of 2007, Goldman began to closely monitor the value of the default swap collateral securities in its synthetic CDOs.2629 On June 20, 2007, Matthew Bieber, a Goldman employee on the CDO Origination Desk and the deal captain of the Timberwolf CDO, sent an email to his colleagues requesting information on CDOs that Goldman had "significant exposure to in terms of default swap collateral."2630 Mr. Bieber identified 17 possible CDOs where the default swap collateral securities may have lost value and stated: "we need to get Dan [Sparks, the Mortgage Department head,] a list this morning."2631 When asked about this email, Mr. Bieber told the Subcommittee that he did not recall why he had sent it or why he had to deliver the list to Mr. Sparks that same day, but he said he did recall that the decline in the value of the default swap securities was an issue.2632 In response to the email, Goldman employees associated with the various CDOs submitted lists of the existing default swap collateral securities with their par and market values.

¶As the mortgage market worsened, Goldman's attention to the value of the default collateral securities increased. On July 18, 2007, the Goldman Credit Department sent an email to Mr. Bieber indicating that Goldman had large, valuable short positions in six of the CDOs it had originated, but that the department needed to monitor the value of the default swap collateral securities in each CDO to understand Goldman's "exposure" under the CDS contracts:

"From our discussion earlier today, we were able to verify the MTM [mark to market] exposures on the below CDOs against what we have in our credit systems (they are in fact as large as we mentioned). Our next step is understanding how the collateral pools are performing in each of the deals. Would you be able to give us a summary of the current marks and default writedowns for the below deals? This would help us in monitoring the collateralization in relation to our exposure from CDS."2633

¶The next day, July 19, 2007, Mr. Bieber informed David Lehman, who then oversaw Goldman's CDOs, that the Credit Department had asked the ABS Desk in the Mortgage Department to "mark" the value of all of the default swap collateral securities in the Goldman-originated CDOs to "get a sense of the MV [market value] supporting the deals['] obligation to pay us, if necessary."2634

593

¶Later that same day, another Credit Department official sent an email message to Mr. Lehman similar to the one that had been sent to Mr. Bieber:

"We understand that you are responsible for marking the collateral in relation to the below CDOs. Is that true? If so, can you please put us on your distribution list for these. We have some sizeable in the money swap positions (i.e. cdo owes GS) and Credit needs to monitor these positions vs. collateral market value."2635

¶With respect to Timberwolf, on July 25, 2007, Fabrice Tourre, a Goldman employee on the Mortgage Department's Correlation Trading Desk, circulated an internal Goldman analysis showing that the weighted average value or "mark" of Timberwolf's default swap collateral securities had declined over 3%.2636 During the same period, the value of Goldman's short position had increased. Mr. Tourre suggested to his colleagues that as Timberwolf's default swap collateral securities matured, the resulting cash proceeds should not be re-invested in new securities, but instead be retained as cash:

"We need to start monitoring MtM [mark to market value] of the CDS collateral for the Wolf, given how much in the money the CDS are - right now, average bid side for the AAA cash bonds is approx 96.89 - per Mahesh analysis below. Matt/Mehesh - maybe we should look at the collateral reinvestment provisions in this deal - ideally principal proceeds on the CDS collateral should not be reinvested but I guess Greywolfe [sic] has discretion on this, right?"2637

¶In response, Mr. Bieber noted that the same situation applied to all of Goldman's CDOs; the declining value of the default swap collateral securities was increasing Goldman's exposure, and a weekly monitoring program was being set up. He also noted that it would be difficult for Goldman to oppose re-investment of the cash proceeds from maturing securities across the board:

"CDS across all of our transactions are in the money. We've had conversations at length with credit regarding our exposure to the default swap collateral and are setting ourselves up for weekly monitoring/pricing of the default swap collateral across the cdo business.

"We have discretionary approval over default swap collateral, however, it will be difficult for us to take the non-reinvestment approach."2638

594

¶The next day, on July 26, 2007, the collateral manager of one of Goldman's CDOs sought approval to purchase some new default swap collateral securities. A Goldman employee responded: "We are going to pass on this bond. Given current market conditions, we'd like to keep some cash in the default swap collateral."2639 A few days later, after receiving more requests to approve the purchase of new default swap collateral securities, Mr. Bieber asked Mr. Lehman for a meeting to discuss how to proceed:

"Have gotten several requests today for reinvestment (Greywolf on TWOLF and TCW on DS7 [Davis Square 7]). Would like to sit down this evening to discuss how we're going to respond as this comes up."2640

¶In early August, Goldman conducted an internal analysis to assess the decrease in the return to the CDOs if the default swap collateral was kept in cash rather than re-invested in securities.2641 As expected, that analysis showed that using the cash in the default swap collateral account to buy new securities would yield a larger return and more money for the CDO investors.2642 But buying new securities also meant that Goldman, as the primary CDS counterparty and collateral put provider, would bear the risk if those securities later declined in market value. If the securities' market value fell below their par value, but had to be sold to make payments to the CDOs' short parties, Goldman would have to absorb any shortfall in the course of making the required payments to the short parties. Goldman's risk would be mitigated, however, if the default swap collateral was kept in cash, since cash is not subject to the same market fluctuation. The result was that Goldman benefitted more if the CDO default swap collateral was kept in cash, but the CDO investors benefitted more if the collateral was kept in securities. In short, what was best for Goldman clashed with what was best for the investors to whom Goldman had sold the Timberwolf securities.

¶Subsequent documents show that Goldman placed its financial interests before those of the CDO investors by taking actions to keep the CDO default swap collateral in cash, rather than securities. On August 21, 2007, Mr. Bieber sent an email to Mr. Lehman asking about what Goldman had decided regarding re-investment of the cash collateral: "Was there any further discussion over the past few days on what were going to be doing? With the 25th coming up, I suspect a bunch of managers are going to be looking to put cash to work."2643 Mr. Lehman responded: "Nothing further – I think our gameplan remains to build cash for now." Mr. Bieber replied: "Ok. I think we should be proactive in letting managers know, then, rather than waiting for them to come to us for approval and then denying." Mr. Lehman agreed.

595

¶Greywolf Objections. Over the next three or four weeks, Goldman continued to refuse to consent to the purchase of new default swap collateral securities by the collateral managers of its CDOs.2644

¶At first, Goldman delayed telling Greywolf, Timberwolf's collateral manager, what it had decided. In late August and early September, Joseph Marconi, a Greywolf executive, former Goldman employee, and key member of the Greywolf team managing Timberwolf, sent Goldman several requests to buy new default swap collateral securities, without receiving a response. On September 6, 2007, a Goldman employee on the CDO Origination Desk forwarded one of the requests to Mr. Bieber with the comment: "Guess we can't delay talking to him anymore."2645 Mr. Bieber informed Mr. Marconi that Goldman would no longer approve the purchase of additional default swap collateral securities for Timberwolf. When informed of Goldman's decision, Mr. Marconi protested in an email to Mr. Lehman, who was Mr. Bieber's supervisor:

"David: I would like to have a call with you to discuss the purchase of Default Swap Collateral into Timberwolf. I understand you are traveling this week. Let me know when you will have some time to talk. In response to the attached message, Matt [Bieber] told me that GS will not approve the purchase of any additional Default Swap Collateral into Timberwolf. While GS does have consent rights regarding the purchase of Default Swap Collateral, a blanket refusal to approve any assets is inappropriate, inconsistent with the parties' original expectations and will negatively impact the performance of both the debt and equity issued by Timberwolf. Give me a call when you can."2646

¶When asked by Subcommittee what he meant when he wrote that "a blanket refusal to approve any assets is inappropriate, inconsistent with the parties' original expectations and will negatively impact the performance of both the debt and equity issued by Timberwolf," Mr. Marconi explained that if Goldman wouldn't approve any new purchases as the default swap collateral securities matured, the CDO would have an increasing amount of cash on hand that would produce less income for Timberwolf than if that cash were invested in new securities.2647

¶Later on September 6, 2007, Mr. Lehman telephoned and spoke with Mr. Marconi. Neither he nor Mr. Marconi recalled exactly what was discussed, but the following day Mr. Marconi sent Mr. Lehman an email that repeated Greywolf's objections to Goldman's decision not to consent to the purchase of new default swap collateral securities:

596

"David: As we discussed yesterday, I believe that your refusal to approve the purchase of any additional Default Swap Collateral into Timberwolf is unreasonable and inconsistent with the way the transaction structure was originally presented to us. We were told that the purpose of the approval rights was to permit GS to review specific assets and approve or disapprove specific assets based on their relative credit merits. If we thought for a second that you had the right to prohibit all new purchases indefinitely, we would have implemented the much simpler GIC [Guaranteed Investment Contract] structure that is used in most other synthetic CDOs and CDO^2 transactions and thereby locked in a fixed spread to LlBOR for the term of our transaction. Also, the Timberwolf CDS economics include an ongoing fee to GS for the put swap component of the trade; we would not have agreed to those terms if we thought you had this option. Finally, I believe that if anyone on the deal team thought you had this option, it would have been clearly disclosed in the OM [Offering Memorandum]. Especially given current market conditions, I am surprised that you are taking a position that will directly result in less cash flow being available to debt and equity investors. As I said yesterday, we recognize the impact of current market conditions and, even before I spoke with Matt, I was suggesting we collectively focus on shorter average life AAA RMBS for the deal and I specifically solicited feedback on securities where GS would be comfortable. I continue to be surprised by your response."2648

¶When asked by the Subcommittee why he sent such a strongly worded email to Goldman regarding its refusal to approve the reinvestment of Timberwolf's cash collateral, Mr. Marconi responded: "We felt strongly about this. We had an obligation to investors to do the right thing."2649

¶Mr. Marconi told the Subcommittee that Goldman had rationalized its decision by contending that it was less risky to have more cash and fewer securities. Mr. Marconi also told the Subcommittee that Greywolf felt Goldman's blanket refusal to approve the purchase of additional securities was inconsistent with the terms of the CDO, and if anyone at Greywolf had believed that Goldman possessed that authority, Greywolf would have structured the deal differently.2650 In addition, Mr. Marconi's September 6 email pointed out that Goldman was receiving an "ongoing fee" to serve as the collateral put provider and undertake the risk of guaranteeing the par value of the default swap collateral securities. The email stated that Greywolf would not have agreed to pay that fee to Goldman if it had thought Goldman could use its approval authority to stop the purchase of all default swap collateral securities and mitigate the risk it was being paid to bear.

¶The exchanges between Greywolf and Goldman brought into question the proper interpretation of Section 12.5 of the Timberwolf Indenture agreement which required the CDO to purchase default swap collateral which satisfied certain criteria and which received the "consent" of and was not "objected to" by Goldman as the "Synthetic Security Counterparty."2651 The issue was whether that authority allowed Goldman to block the purchase of all default swap collateral securities and essentially limit the default swap collateral to cash. In a July 2007 email, Mr. Bieber wrote: "We have discretionary approval over default swap collateral, however, it will be difficult for us to take the non-reinvestment approach."2652 But when the Subcommittee asked about the matter, Goldman's legal counsel sent a written statement indicating the Indenture agreement authorized Goldman's actions:

597

"Section 12.5 of the Indenture for the Timberwolf CDO confers on the Secured Party the right to consent to the selection and reinvestment of default swap collateral. It is the position of Goldman Sachs that neither Section 12.5 of the Indenture nor any other relevant deal documents impose any obligation on the Secured Party to consent to reinvestment of default swap collateral, either on a case-by-case basis or generally."2653

¶Goldman's internal documents show that on September 7, 2007, the day after the email exchange between Mr. Marconi and Mr. Lehman, Mr. Bieber scheduled a meeting with Goldman's legal counsel and a key compliance officer to discuss the issue. His email stated:

"Pls see email we received below – wanted to get your take on what response (if any) we should craft. This is related to the default swap collateral account in Timberwolf used to collateralize the exposure we have to the CDO on the CDS contracts that are the assets in TWOLF."2654

¶The meeting was scheduled for 1:15 p.m. that same day,2655 and one of the counsels requested a copy of the Offering Memorandum and "the operative documents that contain our rights/obligations with respect to the Collateral."2656

¶The Subcommittee did not locate any documents recounting exactly what was discussed at the meeting. The default swap collateral issue involved a significant number of Goldman CDOs, affected Goldman's relationships with investors and other financial firms serving as collateral managers of its CDOs, and entailed substantial financial risk for Goldman. Yet, when asked about

¶Eligibility Criteria set forth in the related Synthetic Security and the inclusion of which has been consented to by the Synthetic Security Counterparty in the amount required to secure the obligations of the Issuer in accordance with the terms of the related Synthetic Security which shall be in at least an amount equal to the Aggregate Reference Obligation Notional Amount. The Synthetic Security Counterparty shall have consent rights with respect to the Default Swap Collateral and no Default Swap Collateral objected to by the Synthetic Security Counterparty may be purchased by the Issuer. Default Swap Collateral shall be credited to the Default Swap Collateral Account. The amount payable by the Issuer to the Synthetic Security Counterparty under a Synthetic Security shall not exceed the Default Swap Collateral." 3/27/2007 Timberwolf I, LTD. Indenture Agreement, GS MBS-E-021825583 at 711.

598

¶it, the key participants said they could not recall whether the meeting took place, what was discussed at the meeting if it did take place, or what determinations were reached regarding Goldman's authority or actions. The participants who could not recall the meeting included Mr. Bieber, the Timberwolf deal captain; Tim Saunders, counsel from Goldman's legal department; Susan Helfrick, another legal counsel; and Jordan Horvath, the compliance officer. Mr. Saunders, the lead Goldman legal counsel on the matter, informed the Subcommittee that he had "no present recollection of the circumstances surrounding any disagreement between Goldman Sachs and Greywolf Capital Management LP regarding Goldman Sachs' right to consent to reinvestment of default swap collateral in Timberwolf."2657 Mr. Bieber, the Timberwolf deal captain, told the Subcommittee that he did not recall whether Goldman developed any specific strategy limiting the type of default swap collateral securities that could be purchased for its CDOs.2658

¶However, documents obtained by the Subcommittee indicate that the meeting did take place, and Goldman did develop a strategy to respond to Greywolf's concerns. On September 7, 2007, the same day as the meeting, Mr. Lehman sent a email to Mr. Bieber stating:

"U spoke w[ith] [Jonathan] egol? What ab[ou]t legal/compliance[?] Just make sure Dan [Sparks] is ok w[ith] it[.] Also I do th[in]k we sh[oul]d be consistent across deals . . . so if slmas and credit cards are 'ok' I th[in]k we tell our mgrs [managers] that . . . maybe 2 y[ea]rs and shorter."2659

¶Mr. Bieber responded: "Spoke with legal/compliance. Not doing anything w/o [without] discussing with dan [Sparks] first. Agree with the point on consistency."2660

¶Also on September 7, 2007, Jonathan Egol, head of the Mortgage Department's Correlation Trading Desk, sent an email to Mr. Lehman and others suggesting that Goldman identify a narrow set of very safe asset backed securities that it could propose to Greywolf as possible default swap collateral securities, such as AAA rated securities backed by credit card receivables or student loans.2661 Mr. Bieber sent an email the same day indicating he supported that approach, but wanted to speak first with Mr. Sparks, head of the Mortgage Department.2662

599

¶Subsequent documents indicate that Goldman reversed its initial position and decided to consent to the purchase of more default swap collateral securities. However, Goldman appeared to narrow the class of asset backed securities that it would consent to be acquired as default swap collateral. On September 10, 2007, Mr. Bieber sent an email to Mr. Lehman reporting:

"Managed to catch up with Dan [Sparks] just now ... we're going to put together a list of SLMA floaters in our inventory to show Joe [Marconi at Greywolf]. Going over w/ Dan tomorrow before sending anything externally."2663

¶Goldman also sent a short list of commercial mortgage backed securities (CMBS) in its inventory that it would consent to be acquired for Timberwolf.2664

¶Over the next two weeks, Goldman sent a list of acceptable securities to two more collateral managers of its CDOs.2665 On October 15, 2007, Mr. Bieber provided virtually the same list to a Goldman colleague together with a short explanation of some of the criteria used to identify the securities:

600

"Here are the shelves we'd like to use for default swap collateral reinvestment. RMBS: CBASS, GSAA, GSAMP, JPMAC, WFHET CARDS: AMXCA, BACCT, BOIT, MBNAS, CCCIT,CHAIT, DCMT AUTOS: COPAR, DCMOT, FORDO, HAROT, HDMOT, NALT, USAOT STUDENT LOANS: ACCSS, GCOE, KSLT, NCSLT, SLMA (FFELP)

In addition to the default swap collateral constraints in the docs for each transaction, also looking to securities that are (a) floating rate (b) monthly pay (c) senior-most bond in capital structure (d) avg life of less than or equal to 2 years (e) currently amortizing. Please let me know if you have any questions."2666

¶All of the listed securities consisted of AAA rated securities backed by residential mortgages, credit card receivables, automobile loans, or student loans, and had an expected maturity of two years or less. It appears as if Goldman was restricting the selection of default swap collateral securities to a limited list of assets that it believed were likely to maintain their par value in order to minimize its financial exposure.

¶After indicating it would allow these new purchases, Goldman maintained tight control over the actual purchases made by the collateral managers. A September 27,^20072007 "Home Loans Product Strategy," WaMu presentation at JPM_WM03097203, Hearing Exhibit 4/13-60a (only Countrywide ranked higher). WaMu Home Loans Product Strategy, "Strategy and Business Initiatives Update," JPM_WM03097217, Hearing Exhibit 4/13-60a [emphasis in original]. Performance Evaluation for Peter D'Erchia, S&P SEN-PSI 0007442; See also April 23, 2010 Subcommittee Hearing at 74-75. annual report filed with the SEC, in particular the Executive Summary of Deutsche Bank's Annual Report and the letter from the Chairman of the Board. See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0252, at 0262. email exchange between Mr. Marconi of Greywolf and Mr. Bieber of Goldman, for example, demonstrates Goldman's intense monitoring effort:

Mr. Marconi: "Matt: I am seeing this list from another dealer. Can I assume that I can buy any name on your approved list?" ... Mr. Bieber: "No-we need to give approval on a security by security basis."2667

¶When asked about these matters, both Mr. Sparks and Mr. Lehman characterized the default swap collateral securities issue as a minor issue. Mr. Lehman informed the Subcommittee that he did not recall significant debate with collateral managers on the matter.2668 Mr. Sparks said the yield difference between keeping the collateral in cash and investing in securities was minimal and characterized the whole issue as "structured finance gymnastics."2669 But information supplied by Goldman to the Subcommittee on seven Goldman-originated CDOs shows that, due to its duties as collateral put provider and the declining value of the CDOs' default swap collateral securities, Goldman eventually lost over $1 billion.2670

601

¶Analysis. In its synthetic CDOs, Goldman arranged for its subsidiary, GSI, to act as both the primary CDS counterparty and the collateral put provider. Goldman also arranged for GSI to receive a fee for serving as the collateral put provider, through paying reduced premiums in connection with the CDS contracts it entered into with the CDOs. Despite this fee, Goldman took actions to evade its responsibilities as the collateral put provider, including by refusing to approve the purchase of new default swap collateral securities whose values might decline below par value. Instead, Goldman tried to force the CDOs to keep their collateral in cash. While this effort provided more protection for Goldman's financial interest as the short party, it worked to the disadvantage of the CDO investors because it produced lower returns for the CDOs than the purchase of default swap collateral securities.

¶When the Timberwolf collateral manager objected, Goldman backed down and allowed the purchase of a narrow range of very safe, short term asset backed securities as collateral for Timberwolf and other CDOs. Goldman's conduct in the Timberwolf CDO demonstrates how a financial institution that plays multiple roles in a CDO can develop conflicts of interest and attempt to manipulate the CDO to place its own financial interests before those of the investors to whom it sold the CDO securities.

602

¶(6) Analysis of Goldman's Conflicts of Interest

¶The Goldman Sachs case study identifies a number of practices that raise conflict of interest concerns. Those practices include the following.

Shorting Its Own Securities. In Hudson, Anderson, and Timberwolf, Goldman

marketed CDO securities to clients, took a substantial portion of the short side of the CDO, bet the CDO would fall in value, and profited from its short position at the expense of the clients to whom it sold the securities.

Failing to Disclose Key Information to Investors. In Hudson, Anderson, and

Timberwolf, Goldman represented to potential investors that its interests "were aligned" with theirs or advertised its retention of a portion of the CDO's equity tranche, without disclosing that it had an even larger short position in the CDO and held a financial interest directly adverse to the investors to whom it was selling the CDO securities.

Misrepresenting Source of Assets. In Hudson, Goldman provided 100% of the

CDO assets using CDS contracts it controlled and priced, transferred $1.2 billion of risk from its own inventory to the CDO, and told investors the assets had been "sourced from the Street," when they had been supplied solely by Goldman and not priced from transactions with third parties.

Failing to Disclose Client Involvement. In Abacus, Goldman enabled a client

who was shorting the CDO to help select the CDO's assets, solicited investors to buy the Abacus securities without disclosing the short party's asset selection role or investment objective, and helped the client gain a $1 billion profit at the expense of the investors to whom Goldman sold the securities.

5. Minimizing Premiums. In Abacus, Goldman entered into an undisclosed agreement with the sole short party to accept a fee for arranging low premium payments by the short party to the CDO, even though low premium payments meant less money for the long investors to whom Goldman had sold the Abacus securities.

Selling Securities Designed to Fail. Goldman sold Hudson and Abacus securities

to clients knowing the securities were designed to fall in value and benefit the short party, which was a client in the case of Abacus and itself in the case of Hudson.

7. Delaying Liquidation. In Hudson, Goldman was paid a fee to serve as the liquidation agent, but delayed liquidating assets that were losing value for eight months, enhancing its financial gain as the CDO's short party at the expense of the long parties whose losses would have been staunched if the assets had been liquidated.

603

8. Misrepresenting Assets. In Anderson, when clients asked how Goldman got "comfortable" with poor quality New Century loans in the CDO, Goldman worked to dispel those concerns and failed to disclose its own discomfort with New Century loans and that it held 40% of the short side of the CDO, betting its assets would lose value.

Taking Immediate Post-Sale Markdowns. In Timberwolf, Goldman knowingly

sold Timberwolf securities to clients at prices above its own book values and then, often within days or weeks of a sale, marked down the value of the sold securities, causing clients to incur quick losses and requiring some to post higher margin or cash collateral.

10. Evading Put Obligation. In Timberwolf, Goldman was paid a fee to serve as the collateral put provider, but refused for two months to allow the purchase of default swap collateral securities, even though they meant better returns for long investors, because Goldman did not want to assume the risk that the collateral securities might lose value.