CASE STUDY OF GOLDMAN SACHS AND DEUTSCHE BANK

¶A key factor in the recent financial crisis was the role played by complex financial instruments, often referred to as structured finance products, such as residential mortgage backed securities (RMBS), collateralized debt obligations (CDOs), and credit default swaps (CDS), including CDS contracts linked to the ABX Index. These financial products were envisioned, engineered, sold, and traded by major U.S. investment banks.

¶From 2004 to 2008, U.S. financial institutions issued nearly $2.5 trillion in RMBS securities and over $1.4 trillion in CDOs securitizing primarily mortgage related products.1237 Investment banks charged fees ranging from $1 to $8 million to act as the underwriter of an RMBS securitization,1238 and from $5 to $10 million to act as the placement agent for a CDO securitization.1239 Those fees contributed substantial revenues to the investment banks which set up structured finance groups, and a variety of RMBS and CDO origination and trading desks within those groups, to handle mortgage related securitizations. Investment banks placed these securities with investors around the world, and helped develop a secondary market where private RMBS and CDO securities could be bought and sold. The investment banks' trading desks participated in those secondary markets, buying and selling RMBS and CDO securities either for their customers or for themselves.

¶Some of these financial products allowed investors to profit, not only from the success of an RMBS or CDO securitization, but also from its failure. CDS contracts, for example, allowed counterparties to wager on the rise or fall in the value of a specific RMBS security or on a collection of RMBS and other assets contained or referenced in a CDO. Major investment banks also developed standardized CDS contracts that could be traded on a secondary market. In addition, they established the ABX Index which allowed counterparties to wager on the rise or fall in the value of a basket of subprime RMBS securities, and which could be used to reflect the state of the subprime mortgage market as a whole.

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¶Investment banks sometimes matched up parties who wanted to take opposite sides in a structured finance transaction, and other times took one or the other side of a transaction to accommodate a client. At still other times, investment banks used these financial instruments to make their own proprietary wagers. In extreme cases, some investments banks set up structured finance transactions which enabled them to profit at the expense of their clients.

¶Two case studies, involving Goldman Sachs and Deutsche Bank, illustrate a variety of troubling and sometimes abusive practices involving the origination or use of RMBS, CDO, CDS, and ABX financial instruments. Those practices included at times constructing RMBS or CDOs with assets that senior employees within the investment banks knew were of poor quality; underwriting securitizations for lenders known within the industry for issuing high risk, poor quality mortgages or RMBS securities; selling RMBS or CDO securities without full disclosure of the investment bank's own adverse interests; and causing investors to whom they sold the securities to incur substantial losses.

¶In the case of Goldman Sachs, the practices included exploiting conflicts of interest with the firm's clients. For example, Goldman used CDS and ABX contracts to place billions of dollars of bets that specific RMBS securities, baskets of RMBS securities, or collections of assets in CDOs would fall in value, while at the same time convincing customers to invest in new RMBS and CDO securities. In one instance, Goldman took the entire short side of a $2 billion CDO known as Hudson 1, selected assets for the CDO to transfer risk from Goldman's own holdings, allowed investors to buy the CDO securities without fully disclosing its own short position, and when the CDO lost value, made a $1.7 billion gain at the expense of the clients to whom it had sold the securities. While Goldman sometimes told customers that it might take an adverse investment position to the RMBS or CDO securities it was selling them, Goldman did not disclose that, in fact, it already had significant proprietary investments that would pay off if the particular security it was selling or if RMBS and CDO securities in general fell in value. In another instance, Goldman marketed a CDO known as Abacus 2007-AC1 to clients without disclosing that it had allowed the sole short party in the CDO, a hedge fund, to play a major role in selecting the assets. The Abacus securities quickly lost value, and the three long investors together lost $1 billion, while the hedge fund profited by about the same amount. In still other instances, Goldman took on the role of a collateral put provider or liquidation agent in a CDO, and leveraged that role to obtain added financial benefits to the fiscal detriment of the clients to whom it sold the CDO securities.

¶In the case of Deutsche Bank, during 2006 and 2007, the bank's top CDO trader, Greg Lippmann, repeatedly warned and advised his Deutsche Bank colleagues and some of his clients seeking to buy short positions about the poor quality of the RMBS securities underlying many CDOs, describing some of those securities as "crap" and "pigs." At one point, Mr. Lippmann was asked to buy a specific CDO security and responded that it "rarely trades," but he "would take it and try to dupe someone" into buying it. He also disparaged RMBS securities that, at the same time, were being included in Gemstone 7, a CDO being assembled by the bank for sale to investors. Gemstone 7 included or referenced 115 RMBS securities, many of which carried BBB, BBB-, or even BB credit ratings, making them among the highest risk RMBS securities sold to the public, yet received AAA ratings for its top three tranches. Deutsche Bank sold $700 million in Gemstone securities to eight investors who saw their investments rapidly incur delinquencies, rating downgrades, and losses. Mr. Lippmann at times referred to the industry's ongoing CDO marketing efforts as a "CDO machine" or "ponzi scheme," and predicted that the U.S. mortgage market as a whole would eventually plummet in value. Deutsche Bank's senior management disagreed with his negative views, and used the bank's own funds to make large proprietary investments in mortgage related securities that, in 2007, had a notional or face value of $128 billion and a market value of more than $25 billion. At the same time, Deutsche Bank allowed Mr. Lippmann to develop for the bank a $5 billion proprietary short position in the RMBS market, which it later cashed in for a profit of approximately $1.5 billion. Despite that gain, in 2007, due to its substantial long investments, Deutsche Bank incurred an overall loss of about $4.5 billion from its mortgage related proprietary investments.

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¶The two case studies illustrate how investment banks engaged in high intensity sales efforts to market new CDOs in 2007, even as U.S. mortgage delinquencies climbed, RMBS securities incurred losses, the U.S. mortgage market as a whole deteriorated, and investors lost confidence. They demonstrate how these investment banks benefitted from structured finance fees, and had little incentive to stop producing and selling high risk, poor quality structured finance products. They also illustrate how the development of complex structured finance products, such as synthetic CDOs and naked credit default swaps, amplified market risk by allowing investors with no ownership interest in the "reference obligations" to place unlimited side bets on their performance. Finally, the two case histories demonstrate how proprietary trading led to dramatic losses in the case of Deutsche Bank and to conflicts of interest in the case of Goldman Sachs.

¶Investment banks were a major driving force behind the structured finance products that provided a steady stream of funding for lenders to originate high risk, poor quality loans and that magnified risk throughout the U.S. financial system. The investment banks that engineered, sold, traded, and profited from mortgage related structured finance products were a major cause of the financial crisis.

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¶A. Background

¶(1) Investment Banks In General

¶Historically, investment banks helped raise capital for business and other endeavors by helping to design, finance, and sell financial products like stocks or bonds. When a corporation needed capital to fund a large construction project, for example, it often hired an investment bank either to arrange a bank loan or to raise capital by designing, financing, and marketing an issue of shares or corporate bonds for sale to investors. Investment banks performed these services in exchange for fees.

¶Today, investment banks also participate in a wide range of other financial activities, including providing broker-dealer and investment advisory services, and trading commodities and derivatives. Investment banks also often engage in proprietary trading, meaning trading with their own money and not on behalf of a customer. Many investment banks are structured today as affiliates of one or more banks.

¶Under the Glass-Steagall Act of 1933, certain types of financial institutions had been prohibited from commingling their services. For example, with limited exceptions, only broker-dealers could provide brokerage services; only banks could offer banking; and only insurers could offer insurance. Each financial sector had its own primary regulator who was generally prohibited from regulating services outside of its jurisdiction.1240 Glass-Steagall also contained prohibitions against proprietary trading.1241 One reason for keeping the sectors separate was to ensure that banks with federally insured deposits did not engage in the type of high risk activities that might be the bread and butter of a broker-dealer or commodities trader. Another reason was to avoid the conflicts of interest that might arise, for example, from a financial institution pressuring its clients to obtain all of its financial services from the same firm. A third reason was to avoid the conflicts of interest that arise when a financial institution is allowed to act for its own benefit in a proprietary capacity, while at the same time acting on behalf of customers in an agency or fiduciary capacity.

¶Glass-Steagall was repealed in 1999, after which the barriers between banks, broker-dealers, and insurance firms fell. U.S. financial institutions not only began offering a mix of financial services, but also intensified their proprietary trading activities. The resulting changes in the way financial institutions were organized and operated made it more difficult for regulators to distinguish between activities intended to benefit customers versus the financial institution itself. The expanded set of financial services investment banks were allowed to offer also contributed to the multiple and significant conflicts of interest that arose between some investment banks and their clients during the financial crisis.

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(2) Roles and Duties of an Investment Bank: Market Maker, Underwriter, Placement Agent, Broker-Dealer

¶Investment banks typically play a variety of significant roles when dealing with their clients, including that of market maker, underwriter, placement agent, and broker-dealer. Each role brings different legal obligations under federal securities law.

¶Market Maker. A "market maker" is typically a dealer in financial instruments that stands ready to buy and sell for its own account a particular financial instrument on a regular and continuous basis at a publicly quoted price.1242 A major responsibility of a market maker is filling orders on behalf of customers. Market markers do not solicit customers; instead they maintain, buy, and sell quotes in a public setting, demonstrating their readiness to either buy or sell the specified security, and customers come to them. For example, a market maker in a particular stock typically posts the prices at which it is willing to buy or sell that stock, attracting customers based on the competitiveness of its prices. This activity by market makers helps provide liquidity and efficiency in the trading market for the security.1243 It is common for a particular security to have multiple market makers who competitively quote the security.

¶Market makers generally use the same inventory of assets to carry out both their market-making and proprietary trading activities. Market makers are allowed, in certain circumstances specified by the SEC, to sell securities short in situations to satisfy market demand when they do not have the securities in their inventory in order to provide liquidity. Market makers have among the most narrow disclosure obligations under federal securities law, since they do not actively solicit clients or make investment recommendations to them. Their disclosure obligations are generally limited to providing fair and accurate information related to the execution of a particular trade.1244 Market makers are also subject to the securities laws' prohibitions against fraud and market manipulation. In addition, they are subject to legal requirements relating to the handling of customer orders, for example using best execution efforts when placing a client's buy or sell order.1245

¶Underwriter and Placement Agent. If an investment bank agrees to act as an "underwriter" for the issuance of a new security to the public, such as an RMBS, it typically purchases the securities from the issuer, holds them on its books, conducts the public offering, and bears the financial risk until the securities are sold to the public. By law, securities sold to the public must be registered with the SEC. Underwriters help issuers prepare and file the registration statements filed with the SEC, which explain to potential investors the purpose of a proposed public offering, the issuer's operations and management, key financial data, and other important facts. Any offering document, or prospectus, given to the investing public in connection with a registered security must also be filed with the SEC. If a security is not offered to the general public, it can still be offered to investors through a "private placement." Investment banks often act as the "placement agent," performing intermediary services between those seeking to raise money and investors. Placement agents often help issuers design the securities, produce the offering materials, and market the new securities to investors. Offering documents in connection with private placements are exempt from SEC registration and are not filed with the SEC. In the years leading up to the financial crisis, RMBS securities were registered with the SEC, while CDOs were sold to investors through private placements. Both of these securities were also traded in a secondary market by market makers. Investment banks sold both types of securities primarily to large institutional investors, such as other banks, pension funds, insurance companies, municipalities, university endowments, and hedge funds.

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¶Whether acting as an underwriter or placement agent, a major part of the investment bank's responsibility is to solicit customers to buy the new securities being offered. Under the securities laws, investment banks that act as an underwriter or placement agent for new securities are liable for any material misrepresentation or omission of a material fact made in connection with a solicitation or sale of those securities to investors.1246

¶The obligation of an underwriter and placement agent to disclose material facts to every investor it solicits comes from two sources: the duties as an underwriter specifically, and the duties as a broker-dealer generally. With respect to duties relating to being an underwriter, the U.S. Court of Appeals for the First Circuit observed that underwriters have a "unique position" in the securities industry:

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"[T]he relationship between the underwriter and its customer implicitly involves a favorable recommendation of the issued security. … Although the underwriter cannot be a guarantor of the soundness of any issue, he may not give it his implied stamp of approval without having a reasonable basis for concluding that the issue is sound."1247

¶In addition, Section 11 of the Securities Act of 1933 makes underwriters liable to any investor in any registered security if any part of the registration statement "contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading."1248

¶Broker-Dealer. Broker-dealers also have affirmative disclosure obligations to their clients. With respect to the duties of a broker-dealer, the SEC has held:

"[W]hen a securities dealer recommends a stock to a customer, it is not only obligated to avoid affirmative misstatements, but also must disclose material adverse facts to which it is aware. That includes disclosure of 'adverse interests' such as 'economic self interest' that could have influenced its recommendation."1249

¶To help broker-dealers understand when they are obligated to disclose material adverse facts to investors, the Financial Industry Regulatory Authority (FINRA) has further defined the term "recommendation":

"[A] broad range of circumstances may cause a transaction to be considered recommended, and this determination does not depend on the classification of the transaction by a particular member as 'solicited' or 'unsolicited.' In particular a transaction will be considered to be recommended when the member or its associated person brings a specific security to the attention of the customer through any means, including, but not limited to, direct telephone communication, the delivery of promotional material through the mail, or the transmission of electronic messages."1250

¶There is no indication in any law or regulation that the obligation to disclose material adverse facts is diminished or waived in relation to the level of sophistication of the potential investor.1251

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¶(3) Structured Finance Products

¶Over time, investment banks have devised, marketed, and sold increasingly complex financial instruments to investors, often referred to as "structured finance" products. These products include residential mortgage backed securities (RMBS), collateralized debt obligations (CDOs), and credit default swaps (CDS), including CDS contracts linked to the ABX Index, all of which played a central role in the financial crisis.

¶RMBS and CDO Securities. RMBS and CDO securities are two common types of structured finance products. RMBS securities contain pools of mortgage loans, while CDOs contain or reference pools of RMBS securities and other assets. RMBS concentrate risk by including thousands of subprime and other high risk home loans, with similar characteristics and risks, in a single financial instrument. Mortgage related CDOs concentrate risk even more by including hundreds or thousands of RMBS securities, with similar characteristics and risks, in a single financial instrument. In addition, while some CDOs included only AAA rated RMBS securities, others known as "mezzanine" CDOs contained RMBS securities that carried the riskier BBB, BBB-, and even BB credit ratings and were more susceptible to losses if the underlying mortgages began to incur delinquencies or defaults.

¶Some investment banks went a step farther and assembled CDO securities into pools and resecuritized them as so-called "CDO squared" instruments, which further concentrated the risk in the underlying CDOs.1252 Some investment banks also assembled "synthetic CDOs," which did not contain any actual RMBS securities or other assets, but merely referenced them. Some devised "hybrid CDOs," which contained a mix of cash and synthetic assets.

¶The securitization process generated billions of dollars in funds that allowed investment banks to supply financing to lenders to issue still more high risk mortgages and securities, which investment banks and others then sold or securitized in exchange for still more fees. This cycle was repeated again and again, introducing more and more risk to a wider and wider range of investors.

¶Credit Default Swaps. Some investment banks modified still another structured finance product, a derivative known as a credit default swap (CDS), for use in the mortgage market. Much like an insurance contract, a CDS is a contract between two parties in which one party guarantees payment to the other if the assets referenced in the contract lose value or experience a negative credit event. The party selling the insurance is referred to as the "long" party, since it profits if the referenced asset performs well. The party buying the insurance protection is referred to as the "short" party, because it profits if the referenced asset performs poorly.³³ See U.S. Census Bureau, "Statistical Abstract of the United States 2011," at 735, http://www.census.gov/compendia/statab/2011/tables/11s1175.pdf. (suitability obligation to institutional customers).

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¶The short party, or CDS buyer, typically pays periodic premiums, similar to insurance premiums, to the long party or CDS seller, who has guaranteed the referenced assets against a loss in value or a negative credit event such as a credit rating downgrade, default, or bankruptcy. If the loss or negative credit event occurs, the CDS seller is required to pay an agreed upon amount to the CDS buyer. Many CDS contracts also tracked the changing value of the referenced assets over time, and required the long and short parties to post cash collateral with each other to secure payment of their respective contractual obligations.

¶CDS contracts that reference a single, specific security or bond for protection against a loss in value or negative credit event have become known as "single name" CDS contracts. Other CDS contracts have been designed to protect a broader basket of securities, bonds, or other assets.

¶By 2005, investment banks had standardized CDS contracts that referred to a "single name" RMBS or CDO security. Some investment banks and investors, which held large inventories of RMBS and CDO securities, purchased those single name CDS contracts as a hedge against possible losses in the value of their holdings. Other investors, including investment banks, began to purchase single name CDS contracts, not as a hedge to offset losses from the RMBS or CDO securities they owned, but as a way to profit from particular RMBS or CDO securities they predicted would lose value or fail. CDS contracts that paid off on securities that were not owned by the CDS buyer became known as "naked credit default swaps." Naked CDS contracts enabled investors to bet against mortgage related assets, using the minimal capital needed to make the periodic premium payments and collateral calls required by a CDS contract.

¶The key significance of the CDS product for the mortgage market was that it offered an alternative to investing in RMBS and CDO securities that would perform well. Single name CDS contracts instead enabled investors to place their dollars in financial instruments that would pay off if specific RMBS or CDO securities lost value or failed.

¶ABX Index. In January 2006, a consortium of investment banks, led by Goldman Sachs and Deutsche Bank, launched still another type of structured finance product, linked to a newly created "ABX Index," to enable investors to bet on multiple subprime RMBS securities at once. The ABX Index was administered by a private company called the Markit Group and consisted of five separate indices, each of which tracked the performance of a different basket of 20 designated subprime RMBS securities.1253 The values of the securities in each basket were aggregated into a single composite value that rose and fell over time. Investors could then arrange, through a broker-dealer, to enter into a CDS contract with another party using the ABX basket of subprime RMBS securities as the "reference obligation" and the relevant ABX Index value as the agreed upon value of that basket. For a fee, investors could take either the "long" position, betting on the rise of the index, or the "short" position, betting on the fall of the index, without having to physically purchase or hold any of the referenced securities or raise the capital needed to pay for the full face value of those referenced securities. The index also used standardized CDS contracts that remained in effect for a standard period of time, making it easier for investors to participate in the market, and buy and sell ABX-linked CDS contracts.

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¶The ABX Index allowed investors to place unlimited bets on the performance of one or more of the subprime RMBS baskets. It also made it easier and cheaper for investors, including some investment banks, to short the subprime mortgage market in bulk.1254 Investment banks not only helped establish the ABX Index, they encouraged their clients to enter into CDS contracts based upon the ABX Index, and used it themselves to bet on the mortgage market as a whole. The ABX Index expanded the risks inherent in the subprime mortgage market by providing investors with a way to make unlimited investments in RMBS securities.

¶Synthetic CDOs. By mid-2006, there was a large demand for RMBS and CDO securities as well as a growing demand for CDS contracts to short the mortgage market. To meet this demand, investment banks and others began to make greater use of synthetic CDOs, which could be assembled more quickly, since they did not require the CDO arranger to find and purchase actual RMBS securities or other assets. The increasing use of synthetic CDOs injected even greater risk into the mortgage market by enabling investors to make unlimited wagers on various groups of mortgage related assets and, if those assets performed poorly, expanding the number of investors who would realize losses.

¶Synthetic CDOs did not depend upon actual RMBS securities or other assets to bring in cash to pay investors. Instead, the CDO simply developed a list of existing RMBS or CDO securities or other assets that would be used as its "reference obligations." The parties to the CDO were not required to possess an ownership interest in any of those reference obligations; the CDO simply tracked their performance over time. The performance of the underlying reference obligations, in the aggregate, determined the performance of the synthetic CDO.

¶The synthetic CDO made or lost money for its investors by establishing a contractual agreement that they would make payments to each other, based upon the aggregate performance of the underlying referenced assets, using CDS contracts. The "short" party essentially agreed to make periodic payments, similar to insurance premiums, to the other party in exchange for an agreement that the "long" party would pay the full face value of the synthetic CDO if the underlying assets lost value or experienced a defined credit event such as a ratings downgrade. In essence, then, the synthetic CDO set up a wager in which the short party bet that its underlying assets would perform poorly, while the long party bet that they would perform well.

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¶Synthetic CDOs provided still another vehicle for investors looking to short the mortgage market in bulk. The synthetic CDO typically referenced a variety of RMBS securities. One or more investors could then take the "short" position and wager that the referenced securities as a whole would fall in value or otherwise perform poorly. Synthetic CDOs became a way for investors to short multiple specific RMBS securities that they expected to incur delinquencies, defaults, and losses.

¶Synthetic CDOs magnified the risk in the mortgage market because arrangers had no limit on the number of synthetic CDOs they could create. In addition, multiple synthetic CDOs could reference the same RMBS and CDO securities in various combinations, and sell financial instruments dependent upon the same sets of high risk, poor quality loans over and over again to various investors. Since every synthetic CDO had to have a "short" party betting on the failure of the referenced assets, at least some poor quality RMBS and CDO securities could be included in each transaction to attract those investors. When some of the high risk, poor quality loans later incurred delinquencies or defaults, they caused losses, not in a single RMBS, but in multiple cash, synthetic, and hybrid CDOs whose securities had been sold to a wide circle of investors.1255

¶Conflicts of Interest. Investment banks that designed, obtained credit ratings for, underwrote, sold, managed, and serviced CDO securities, made money from the fees they charged for these and other services. Investment banks reportedly netted from $5 to $10 million in fees per CDO.1256 Some also constructed CDOs to transfer the financial risk of poorly performing RMBS and CDO securities from their own holdings to the investors they were soliciting to buy the CDO securities.1257 By selling the CDO securities to investors, the investment banks profited not only from the CDO sales, but also eliminated possible losses from the assets removed from their warehouse accounts. In some instances, unbeknownst to the customers and investors, the investment banks that sold them CDO securities bet against those instruments by taking short positions through single name CDS contracts. Some even took the short side of the CDO they constructed, and profited when the referenced assets lost value, and the investors to whom they had sold the long side of the CDO were required to make substantial payments to the CDO.

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¶The following two case studies examine how two investment banks active in the U.S. mortgage market constructed, marketed, and sold RMBS and CDO securities; how their activities magnified risk in the mortgage market; and how conflicts of interest negatively impacted investors and contributed to the financial crisis. The Deutsche Bank case history provides an insider's view of what one senior CDO trader described as Wall Street's "CDO machine." It reveals the trader's negative view of the mortgage market in general, the poor quality RMBS assets placed in a CDO that Deutsche Bank marketed to clients, and the fees that made it difficult for investment banks like Deutsche Bank to stop selling CDOs. The Goldman Sachs case history shows how one investment bank was able to profit from the collapse of the mortgage market, and ignored substantial conflicts of interest to profit at the expense of its clients in the sale of RMBS and CDO securities.

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B. Running the CDO Machine: Case Study of Deutsche Bank

¶This case history examines the role of Deutsche Bank USA in the design, marketing, and sale of collateralized debt obligations (CDOs) that incorporated or referenced residential mortgage backed securities (RMBS).

¶From 2004 to 2008, U.S. financial institutions issued over $1.4 trillion worth of CDO securities. At first, this complex structured finance product proved highly profitable for investment banks which established CDO departments and trading desks to create and market the securities. By early 2007, however, due to declining housing prices, accelerating mortgage delinquencies, and RMBS losses, investor interest in CDOs began to drop off sharply. In July 2007, the major credit rating agencies began lowering credit ratings for many CDO securities, at times eliminating the investment grade ratings that had supported CDO sales. Despite waning investor interest, U.S. investment banks continued to issue new mortgage related CDOs throughout 2007, in an apparent effort to sustain their fees and CDO departments. Some investment banks supported the CDO market by purchasing existing CDO securities for inclusion in new, even more complex CDOs, seeking customers in Europe and Asia, or retaining risky CDO securities on their own books.

¶Deutsche Bank was a major player in the CDO market, both in creating new CDO issues and trading these securities in the secondary market. Deutsche Bank's top global CDO trader, Greg Lippmann, began to express concerns that the CDO market was unsustainable. By the middle of 2006, Mr. Lippmann repeatedly warned and advised his Deutsche Bank colleagues and some of his clients seeking to buy short positions about the poor quality of the assets underlying many CDOs. He described some of those assets as "crap" and "pigs," and predicted the assets and the CDO securities would lose value.

¶At one point, Mr. Lippmann was asked to buy a specific CDO security and responded that it "rarely trades," but he "would take it and try to dupe someone" into buying it. He also at times referred to the industry's ongoing CDO marketing efforts as a "CDO machine" or "ponzi scheme." Deutsche Bank's senior management disagreed with his negative views, and used the bank's own funds to make large proprietary investments in mortgage related securities that, in 2007, had a notional or face value of $128 billion and a market value of more than $25 billion.

¶Despite disagreeing with his negative views on the mortgage market, Deutsche Bank allowed Mr. Lippmann, in 2005, to develop a large proprietary short position for the bank in the RMBS market. Since carrying that short position required the bank to pay millions of dollars in premiums, senior management also required Mr. Lippmann to defray or eliminate those costs by convincing others to take short positions in the mortgage market, thereby generating fees for the bank from arranging those shorts. In 2006, Mr. Lippmann generated an estimated $200 million in fees by encouraging his clients, such as hedge funds, to buy short positions. Simultaneously, Mr. Lippmann increased the size of the bank's short position by taking the short side of credit default swaps (CDS) referencing individual RMBS securities, an investment strategy often referred to as investing in "single name CDS" contracts. Over a two-year period from 2005 to 2007, Mr. Lippmann built a massive short position in single name CDS contracts totaling $5 billion. From 2007 to 2008, at the direction of the bank's senior management, he cashed in that position, generating a profit for his trading desk of approximately $1.5 billion, which he claims made more money on a single position than any other trade had ever made for Deutsche Bank in its history. Despite that gain, due to its substantial long investments, Deutsche Bank incurred an overall loss of about $4.5 billion from its mortgage related proprietary investments.¹²⁵⁸¹²⁵⁸ Subcommittee interview of Greg Lippmann (10/18/2010); Net Revenues from ABS Products Backed by U.S. Residential Mortgages, DB_PSI_C00000003.

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¶To understand how Deutsche Bank continued to issue and market CDO securities even as the market for mortgage related securities began collapsing, the Subcommittee examined a specific CDO in detail, called Gemstone CDO VII Ltd. (Gemstone 7). In October 2006, Deutsche Bank began assisting in the gathering of assets for Gemstone 7, which issued its securities in March 2007. It was the last in a series of CDOs sponsored by HBK Capital Management (HBK), a large hedge fund which acted as the collateral manager for the CDO. Deutsche Bank made $4.7 million in fees from the deal, while HBK was slated to receive $3.3 million. It was not the last CDO issued by Deutsche Bank. Even after Gemstone 7 was issued in March of 2007, Deutsche Bank issued 9 additional CDOs.

¶Gemstone 7 was a hybrid CDO containing or referencing a variety of high risk, subprime RMBS securities initially valued at $1.1 billion when issued. Deutsche Bank's head global trader, Mr. Lippmann, recognized that these RMBS securities were high risk and likely to lose value, but did not object to their inclusion in Gemstone 7. Deutsche Bank, the sole placement agent, marketed the initial offering of Gemstone 7 in the first quarter of 2007. Its top tranches received AAA ratings from Standard & Poor's and Moody's, despite signs that the CDO market was failing and the CDO itself contained many poor quality assets.

¶Nearly a third of Gemstone's assets consisted of high risk subprime loans originated by Fremont, Long Beach, and New Century, three lenders known at the time within the financial industry for issuing poor quality loans and RMBS securities. Although HBK directed the selection of assets for Gemstone 7, Mr. Lippmann's CDO Trading Desk was involved in the process and did not object to including certain RMBS securities in Gemstone 7, even though Mr. Lippmann was simultaneously referring to them as "crap" or "pigs." Mr. Lippmann was also at the same time advising some of his clients to short some of those same RMBS securities. In addition, Deutsche Bank sold five RMBS securities directly from its inventory to Gemstone 7, several of which were also contemporaneously disparaged by Mr. Lippmann.

¶The Deutsche Bank sales force aggressively sought purchasers for the CDO securities, while certain executives expressed concerns about the financial risk of retaining Gemstone 7 assets as the market was deteriorating in early 2007. In its struggle to sell Gemstone 7, Deutsche Bank motivated its sales force with special financial incentives, and sought out buyers in Europe and Asia because the U.S. market had dried up. Deutsche Bank also talked of providing HBK's marks, instead of its own, to clients asking about the value of Gemstone 7's assets, since HBK's marks showed the CDO's assets performing better. Deutsche Bank was ultimately unable to sell $400 million, or 36%, of the Gemstone 7 securities, and agreed with HBK to split the unsold securities, each taking $200 million onto its own books. Deutsche Bank did not disclose to the eight investors whom it had solicited and convinced to buy Gemstone 7, that its global head trader of CDOs had an extremely negative view of a third of the assets in the CDO or that the bank's internal valuations showed that the assets had lost over $19 million in value since purchased.¹²⁵⁹¹²⁵⁹ See Sections 11 and 12 of Securities Act of 1933. See also Rule 10b-5 of the Securities Exchange Act of 1934. For a more detailed discussion of the legal obligations of underwriters, placement agents, and broker-dealers, see Section C(6) on conflicts of interest analysis, below.

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¶Gemstone 7 also demonstrated how CDOs magnified risk by including or referencing within itself 115 different RMBS securities containing thousands of high risk, poor quality subprime loans. Many of those RMBS securities carried BB ratings, which are non-investment grade credit ratings and were among the highest risk securities in the CDO. Gemstone 7 also included CDO securities that, in themselves, concentrated the risk of their underlying assets. Over 75% of Gemstone's assets consisted of RMBS securities with ratings of BBB or lower, including approximately 33% with non-investment grade ratings, yet Gemstone's top three tranches were given AAA ratings by the credit rating agencies. The next three tranches were given investment grade ratings as well. Those investment grade ratings enabled investors like pension funds, insurance companies, university endowments, and municipalities, some of which were required by law, regulation, or their investment plans to put their funds in safe investments, to consider buying Gemstone securities. Eight investors actually purchased them. Within eight months, the Gemstone securities began incurring rating downgrades. By July 2008, all seven tranches in the CDO had been downgraded to junk status, and the long investors were almost completely wiped out. Today, the Gemstone 7 securities are nearly worthless.

¶Deutsche Bank was, in Mr. Lippmann's words, part of a "CDO machine" run by investment banks that produced hundreds of billions of high risk CDO securities. Because the fees to design and market CDOs ranged from $5 to $10 million per CDO, investment bankers had a strong financial incentive to continue issuing them, even in the face of waning investor interest and poor quality assets, since reduced CDO activity would have led to less income for structured finance units, smaller bonuses for executives, and even the disappearance of CDO departments, which is eventually what occurred. The Deutsche Bank case history provides a cautionary tale for both market participants and regulators about how complex structured finance products gain advocates within an organization committed to pushing the products through the pipeline to maintain revenues and jobs, regardless of the financial risks or possible impact on the marketplace.

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¶(1) Subcommittee Investigation and Findings of Fact

¶As part of its investigation into the CDO market and the Deutsche Bank case study, the Subcommittee collected and reviewed hundreds of thousands of Deutsche Bank documents including reports, analyses, memoranda, correspondence, transcripts, spreadsheets, and email. The Subcommittee also collected and reviewed documents from HBK Capital Management, several financial institutions that purchased Deutsche Bank CDO securities, and the Securities and Exchange Commission (SEC). In addition, the Subcommittee conducted 14 interviews, including interviews with current and former Deutsche Bank and HBK executives, managers, sales representatives, and traders; spoke with personnel from the financial institutions that invested in Gemstone 7; and consulted with a number of experts from the SEC, academia, and industry.

¶Based upon the Subcommittee's review, the Report makes the following findings of fact.

CDO Machine. From late 2006 through 2007, despite increasing mortgage delinquencies, RMBS losses, and investor flight from the U.S. mortgage market, U.S. investment banks continued to issue new CDOs, including Deutsche Bank which issued 15 new CDOs securitizing nearly $11.5 billion of primarily mortgage related assets from December 2006 to December 2007.

Fee Incentives. Because the fees charged to design and market CDOs were in the range of $5 to $10 million per CDO, investment banks had strong incentives to continue issuing CDOs despite increasing risks and waning investor interest, since reduced CDO activity meant less revenues for structured finance units and even the disappearance of CDO departments and trading desks, which is eventually what occurred.

Deutsche Bank's $5 Billion Short. Although Deutsche Bank as a whole and through an affiliated hedge fund, Winchester Capital, made proprietary investments in long mortgage related assets, the bank also permitted its head CDO trader to make a $5 billion short investment that bet against the mortgage market and produced bank profits totaling approximately $1.5 billion.

Proprietary Loss. By 2007, Deutsche Bank, through its mortgage department and an affiliated hedge fund, had substantial proprietary holdings in the mortgage market, including more than $25 billion in long investments and a $5 billion short position, which together resulted in 2007 losses to the bank of about $4.5 billion.

Gemstone 7. In the face of a deteriorating market, Deutsche Bank aggressively sold a $1.1 billion CDO, Gemstone 7, which included RMBS securities that the bank's top CDO trader had disparaged as "crap" and "pigs," and which produced $1.1 billion of high risk, poor quality securities that are now virtually worthless.

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¶(2) Deutsche Bank Background

¶CDOs In General. According to the Securities Industry and Financial Markets Association, $1.4 trillion worth of CDOs were issued in the United States from 2004 through the end of 2007.¹²⁶⁰¹²⁶⁰ 10/15/2010 "Global CDO Issuance," Securities Industry and Financial Markets Association, http://www.sifma.org/research/statistics.aspx. The following chart depicts the dramatic rise and fall of the U.S. CDO market over the last ten years, with total CDO issuance reaching its peak in 2006 at $520 billion, and then falling to a low of $4 billion in 2009.¹²⁶¹¹²⁶¹ Chart prepared by the Subcommittee using data from 10/15/2010 "Global CDO Issuance," Securities Industry and Financial Markets Association, http://www.sifma.org/research/statistics.aspx. 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).

Total Annual CDO Issuance 2000-2009 Total CDO Issuance Year ($ in billions)²⁰⁰⁰²⁰⁰⁰ 4/7/2010 Blankfein & Cohn, Letter to Shareholders (quoted in Hearing Exhibit 4/27-161 at 12). 67.99 2001 78.45 2002 83.07 2003 86.63 2004 157.82 2005 251.27 2006 520.64 2007 481.60 2008 61.89 2009 4.34

¶In 2006 and 2007, investment banks created around half a trillion dollars in CDO securities each year, even as U.S. housing prices began to stagnate and decline, subprime mortgages began to default at record rates, and RMBS securities began to incur dramatic losses. By the middle of 2007, due to the increasing risks, U.S. institutional investors like pension funds, hedge funds, and others began to purchase fewer CDO securities, and investment banks turned their attention increasingly to European and Asian investors as well as the issuers of new CDOs who became the primary buyers of CDO securities.¹²⁶²¹²⁶² See 7/12/2007 email from Michael Lamont to Boaz Weinstein at Deutsche Bank, DBSI_01201843; "Banks' Self-Dealing Super Charged Financial Crisis," ProPublica (8/26/2010), http://www.propublica.org/article/banks- self-dealing-super-charged-financial-crisis; and "Mortgage-Bond Pioneer Dislikes What He Sees," Wall Street Journal (2/24/2007). In 2007, U.S. investment banks kept issuing and selling CDOs despite slowed sales, which meant that investment banks had to retain an increasing portion of the unsold assets on their own balance sheets.¹²⁶³¹²⁶³ "Banks' Self-Dealing Super Charged Financial Crisis," ProPublica (8/26/2010).

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¶The credit rating agencies marked a "sea change" in the CDO market in 2007, in which investment banks issued CDOs at near record levels in the first half of the year, but then sharply reined in their efforts after the mass rating downgrades of RMBS and CDO securities began in July 2007:

"[The CDO] market in the U.S. was very active in terms of issuance throughout the first half of 2007. … The year 2007 saw a sea change for the CDO market. Moody's rated more than 100 SF [structured finance] CDO transactions in each of the first two quarters, but the number fell sharply to 40 in the third quarter and to just eight in the fourth quarter as the sheer speed and magnitude of the subprime mortgage fallout significantly weakened investors' confidence."¹²⁶⁴¹²⁶⁴ Moody's 2008 Global CDO Review (3/3/2008).

¶In the years leading up to the financial crisis, the typical size of a CDO deal was between $1 and $1.5 billion,¹²⁶⁵¹²⁶⁵ "Wall Street's money machine breaks down," CNNMoney.com (11/12/2007), http://money.cnn.com/magazines/fortune/fortune_archive/2007/11/26/101232838/index.htm. and generated large fees for investment banks in the range of $5 to $10 million per CDO.¹²⁶⁶¹²⁶⁶ See "Banks' Self-Dealing Super-Charged Financial Crisis," ProPublica (8/26/2010), http://www.propublica.org/article/banks-self-dealing-super-charged-financial-crisis ("A typical CDO could net the bank that created it between $5 million and $10 million – about half of which usually ended up as employee bonuses. Indeed, Wall Street awarded record bonuses in 2006, a hefty chunk of which came from the CDO business."). Fee information obtained by the Subcommittee is consistent with this range of CDO fees. For example, Deutsche Bank received nearly $5 million in fees for Gemstone 7, and the head of its CDO Group said that Deutsche Bank received typically between $5 and 10 million in fees per CDO, while Goldman Sachs charged a range of $5 to $30 million in fees for its Camber 7, Fort Denison, and Hudson Mezzanine 1 and 2 CDOs. 12/20/2006 Gemstone 7 Securitization Credit Report, DB_PSI_00237655-71; undated Gemstone 7 Securitization Credit Report, MTSS000011-13; 3/15/2007 Gemstone CDO VII Ltd. Closing Memorandum, DB_PSI_00133536-41; Subcommittee interview of Michael Lamont (Deutsche Bank) (9/29/2010); 3/21/2011 letter from Deutsche Bank's counsel to the Subcommittee, PSI-Deutsche_Bank-0001-04; Goldman Sachs response to Subcommittee QFRs at PSI-QFR-GS0249.Show full note To handle these transactions, a number of large investment banks established CDO departments and trading desks charged with designing, underwriting, selling, or trading CDO securities. The CDO origination desks typically worked with the investment banks' structured finance sales force to sell the resulting CDO securities. This structure meant that stopping the issuance of CDO securities would require the investment banks to lose out on the fees, prestige, and market share tied to CDO sales. In addition, whole CDO departments, with their dedicated bankers, traders, and supervisors, would have to disappear, which is eventually what happened after the CDO market crashed.

¶CDOs at Deutsche Bank. From 2004 to 2008, Deutsche Bank issued 47 asset backed CDOs for a total securitization of $32.2 billion.1267 According to analysts, in both 2006 and 2007, Deutsche Bank ranked fourth globally in issuing asset backed CDOs, behind Merrill Lynch, JPMorgan Chase, and Citigroup.¹²⁶⁸¹²⁶⁸ See "Global ABS CDO Issuance" chart, Reuters (4/20/2010), http://graphics.thomsonreuters.com/10/04/GLB_GCDOV0410.gif; "Banks in Talks to End Bond Probe," Wall Street Journal (12/2/2010), http://online.wsj.com/article/SB10001424052748704594804575649170454587534.html?KEYWORDS=Banks+in+ Talks+to+End+Bond+Probe. See also 10/2006, "CDO Primary Update Progress Report," prepared by Deutsche Bank, DBSI_PSI_EMAIL03970167-72, at 68 (ranking Deutsche Bank as third in CDO issuances as of October 2006).Show full note

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¶At Deutsche Bank, five different parts of the Securitized Product Group played key roles in its CDO business. They were the CDO Group (North America); the CDO sales force, formally called Securitized Products; the CDO Syndication Desk which helped promote and track CDO sales; the mortgage department; and the CDO Trading Desk, formally called ABS (Asset Backed Security) Trading, CDO Trading, and ABS Correlation Trading.

¶The CDO Group had two co-heads, Michael Lamont and Michael Herzig, and approximately 20 employees. The heads of the group reported to Richard D'Albert, Global Head of Deutsche Bank's Securitized Product Group. The CDO Group designed and structured the bank's CDOs, analyzed the assets that went into the CDOs, monitored the purchasing and warehousing of those assets, obtained CDO credit ratings, prepared CDO legal documentation, acted as the CDO underwriter or placement agent on behalf of Deutsche Bank, and oversaw the issuance of the CDO securities.¹²⁶⁹¹²⁶⁹ Subcommittee interview of Michael Lamont (9/29/2010).

¶The CDO sales force sold the resulting CDO securities for Deutsche Bank. It received assistance from the CDO Syndication, sometimes called the "syndicate," which helped promote the deals with investors and tracked CDO sales. The CDO sales force was headed by Sean Whelan and Michael Jones. They reported to Munir D'auhajre, overall head of sales, who reported, in turn, to Fred Brettschneider, the head of the Institutional Client Group of Deutsche Bank Americas. The CDO sales force had approximately 20 employees. In the United States, the CDO Syndication had about seven employees, and was headed by Anthony Pawlowski, who reported to Mr. Lamont and Mr. Herzig, who headed the CDO Group.

¶The Deutsche Bank mortgage department was responsible for purchasing residential mortgages from a variety of sources, warehousing those mortgages, and securitizing the mortgages into RMBS securities for which Deutsche Bank acted as the underwriter or placement agent. Some of those RMBS securities were later included or referenced in CDOs issued by the bank.

¶The CDO Trading Desk was headed by Greg Lippmann, who served as global head of Deutsche Bank's CDO, ABS, and ABS Correlation Trading Desks.¹²⁷⁰¹²⁷⁰ Organizational Chart for Deutsche Bank Global CDO Group, DB_PSI_C00000001. Those desks were responsible for trading a variety of RMBS, CDO, and other asset backed securities on the secondary market. Mr. Lippmann had a staff of approximately 30 employees,²⁰²⁰ To develop FICO scores, Fair Isaac uses proprietary mathematical models that draw upon databases of actual credit information to identify factors that can reliably be used to predict whether an individual will repay outstanding debt. Key factors in the FICO score include an individual's overall level of debt, payment history, types of credit extensions, and use of available credit lines. See "What's in Your FICO Score," Fair Isaac Corporation, http://www.myfico.com/CreditEducation/WhatsInYourScore.aspx. Other types of credit scores have also been developed, including the VantageScore developed jointly by the three major credit bureaus, Equifax Inc., Experian Group Ltd., and TransUnion LLC, but the FICO score remains the most widely used credit score in U.S. financial markets.Show full note in the United States and 10 in London. Like the head of the CDO Group, Mr. Lippmann reported to Mr. D'Albert, the head of the bank's Securitized Product Group. Mr. Lippmann was also the head of risk management for all new issue CDOs and described himself as "involved in underwriting, structuring, marketing and hedging our warehouse risk for new issue cdos."¹²⁷¹¹²⁷¹ 7/14/2006 email from Greg Lippmann to Melissa Goldsmith at Deutsche Bank, DBSI_PSI_EMAIL01400135- 37.

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¶The CDO Trading Desk conducted trades for both clients and other Deutsche Bank entities. It was further divided into three trading desks, designated the CDO, ABS, and ABS Correlation Desks. Each traded certain structured finance products, tracked relevant market news and developed expertise in its assigned products, and served as a source of asset and market information for other branches of Deutsche Bank. The CDO Desk focused on buying and selling CDO securities; the ABS Desk concentrated on trading RMBS and other asset backed securities as well as short trading strategies involving credit default swap (CDS) contracts in single name RMBS; and the ABS Correlation Desk acted primarily in a market making capacity for Deutsche Bank clients, trading both long and short RMBS and CDO securities and CDS contracts with the objective of taking offsetting positions that minimized the bank's risk.¹²⁷²¹²⁷² Subcommittee interview of Greg Lippmann (10/18/2010).

¶Mr. Lippmann was well known in the CDO marketplace as a trader. He had joined Deutsche Bank in 2000, after a stint at Credit Suisse trading bonds. One publication noted that Mr. Lippmann "made his name with big bets on a housing bust," continuing: "Mr. Lippmann emerged as a Cassandra of the financial crisis, spotting cracks in the mortgage market as early as 2006. His warnings helped Deutsche brace for the crisis. He also helped investors – and himself – land huge profits as big bets that the housing market would collapse materialized."¹²⁷³¹²⁷³ "Lippmann, Deutsche Trader, Steps Down," New York Times (4/21/2010), http://dealbook.nytimes.com/2010/04/21/lippmann-deutsche-trader-steps-down/. See also Michael Lewis, The Big Short (2010), at 64.

¶(3) Deutsche Bank's $5 Billion Short

¶In 2006 and 2007, Deutsche Bank's top CDO trader, Greg Lippmann, repeatedly warned his Deutsche Bank colleagues and some clients outside of the bank about the poor quality of the assets underlying many RMBS and CDO securities. Although senior management within the bank did not agree with his views, they allowed Mr. Lippmann, in 2005, to establish a large short position on behalf of the bank, essentially betting that mortgage related securities would fall in value. From 2005 to 2007, Mr. Lippmann built that position into a $5 billion short.

¶(a) Lippmann's Negative Views of Mortgage Related Assets

¶Emails produced to the Subcommittee provide repeated examples of Mr. Lippmann's negative views of mortgage related assets, particularly those involving subprime mortgages. At times, he expressed his views to colleagues within the bank; at other times he expressed them in connection with advising a client to bet against an RMBS security by taking a short position. At times, Mr. Lippmann recommended that his clients short poor quality RMBS assets, even while his trading desk was participating in a selection process that included those same assets in Gemstone 7. The following emails by Mr. Lippmann, written during 2006 and 2007, provide examples of his negative views.

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Emails regarding LBMLT 2004-3 M8, a subprime RMBS security issued by Long Beach: "[T]his bond blows."¹²⁷⁴¹²⁷⁴ 2/24/2006 emails between Greg Lippmann and Rocky Kurita at Deutsche Bank, DBSI_PSI_EMAIL00966290. Mr. Lippmann's negative comments did not begin in 2006; as early as May 2005, he wrote that the "real money flows are buying protection." 5/11/2005 email from Greg Lippmann to Rocky Kurita at Deutsche Bank, DBSI_PSI_EMAIL00048683. (2/24/2006)

Email providing Deutsche Bank trader his opinion regarding RMBS shelves: ["[Y]ikes didn't see that[.] … [H]alf of these are crap and rest are ok[.] …[C]rap-heat pchlt sail tmts."¹²⁷⁵¹²⁷⁵ 4/5/2006 email from Greg Lippmann to Deutsche Bank employee, DBSI_PSI_EMAIL01073270. The acronyms in the email refer to the following lenders: Home Equity Asset Trust ("heat"), People's Choice Home Loan Securities Trust ("pchlt"), Structured Asset Investment Loan ("sail"), and Terwin Mortgage Trust ("tmts"). (4/5/2006)

Email advising an investment banker at JPMorgan Chase regarding subprime RMBS securities issued by Aegis Asset Backed Securities Trust ("aabst"), Bay View Financial Acquisition Trust ("bayv"), Home Equity Mortgage Loan Asset Based Trust ("inabs"), Park Place Securities Inc. ("ppsi"), and Structured Asset Investment Loan ("sail"): "This is a good pool for you because it has a fair number of weak names but not so many that investors should balk (I wouldn't add more of these) and also has only a few names that are very good."¹²⁷⁶¹²⁷⁶ 6/23/2006 email from Greg Lippmann to Derek Kaufman at JPMorgan, DBSI_PSI_EMAIL01344930-33. (6/23/2006)

Email advising an investment banker at Oppenheimer Funds: "[Y]ou can certainly build a portfolio by picking only bad names and you have largely done that as Rasc ahl is considered bad as is Fremont (bsabs fr, fhlt, jpmac fre, sabr fr, nheli fm deals) ace, arsi and lbmlt."¹²⁷⁷¹²⁷⁷ 8/4/2006 email from Greg Lippmann to Michelle Borre at Oppenheimer Funds, DBSI_PSI_EMAIL01528941- 43. The acronyms in the email refer to the following lenders: Residential Asset Securities Corp. ("Rasc"), American Home Loans ("ahl"), Fremont ("fr," "fre," "fm," and "fhlt"), Bear Stearns Asset Backed Securities (bsabs), JPMorgan Acquisition Trust ("jpmac"), Securitized Asset Backed Receivables Trust ("sabr"), Nomura Home Equity Loan, Inc. ("nheli"), ACE Securities Corp. ("ace"), Argent Securities Inc. ("arsi"), and Long Beach Mortgage Trust ("lbmlt").Show full note Mr. Lippmann listed ACE Securities Corp. as a "bad name" even though it was created by and associated with Deutsche Bank itself.¹²⁷⁸¹²⁷⁸ Subcommittee interview of Greg Lippmann (10/18/2010); Subcommittee interview with Deutsche Bank's counsel (3/7/2011); 3/21/2011 letter from Deutsche Bank's counsel to the Subcommittee (ACE is one of "Deutsche Bank's own shelf offerings."), PSI-Deutsche_Bank-32-0001-04. See also 3/2/2011 letter from Deutsche Bank's counsel to the Subcommittee ("Deutsche Bank has no ownership interest in ACE Securities Corp. ('ACE'). All shares of ACE are held by Altamont Holdings Corp, a Delaware corporation. Deutsche Bank Securities, Inc. ('DBSI'), however, is an administrative agent for ACE and in that role has authority to act on behalf of ACE in connection with offerings of asset-backed securities, including RMBS offerings. … Deutsche Bank hired the AMACAR Group, LLC ('AMACAR') to assist in the creation of ACE to act as a registrant and depositor in connection with RMBS offerings sponsored and/or underwritten by Deutsche Bank."), PSI-DeutscheBank-31-0004- 06.Show full note (8/4/2006)

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Email to co-head of the Deutsche Bank CDO Group and to Global Head of Deutsche Bank's Securitized Product Group: "I was going to reject this [long purchase of a synthetic CDO] because it seems to be a pig cdo position dump 60^ but then I noticed winchester [Deutsche Bank affiliated hedge fund] is the portfolio selector……any idea???"1279 (8/4/2006)

Email responding to a hedge fund trader at Spinnaker Capital asking about a subprime RMBS security issued by Credit Based Asset Servicing and Securitization, LLC ("cbass"): "That said I can probably short this name to some CDO fool."¹²⁸⁰¹²⁸⁰ 8/30/2006 email from Greg Lippmann to Bradley Wickens at Spinnaker Capital, DBSI_PSI_EMAIL01634802. (8/30/2006)

Email responding to a hedge fund trader at Spinnaker Capital asking about MABS 2006-FRE1, a subprime RMBS security that contained Fremont loans and was issued by Mortgage Asset Securitization Transactions Asset-Backed Securities Trust: "This kind of stuff rarely trades in the synthetic market and will be tough for us to cover i.e. short to a CDO fool. That said if u gave us an order at 260 we would take it and try to dupe someone."¹²⁸¹¹²⁸¹ 9/1/2006 email from Greg Lippmann to Bradley Wickens at Spinnaker Capital, DBSI_PSI_EMAIL02228884. (9/1/2006)

Email describing MABS 2006-FRE1, a subprime RMBS security that contained Fremont loans and was issued by Mortgage Asset Securitization Transactions Asset- Backed Securities Trust, as a "crap bond."¹²⁸²¹²⁸² 9/1/2006 email from Greg Lippmann to Bradley Wickens at Spinnaker Capital, DBSI_PSI_EMAIL01645016. (9/01/2006)

Email describing MSHEL 2006-1 B3, an RMBS security issued by Morgan Stanley as "crap we shorted"; referring to GSAMP 2006-HE3 M9, an RMBS security issued by Goldman Sachs, as "this bond sucks but we are short 20MM"; and noting with regard to ACE, which was created by and associated with Deutsche Bank, that "ace is generally horrible."¹²⁸³¹²⁸³ 9/21/2006 email from Greg Lippmann to Deutsche Bank employee, DBSI_PSI_EMAIL01689001-02. In an October 2006 email, a Deutsche Bank employee wrote to Mr. Lippmann and others that a number of RMBS such as LBMLT, HEAT, INABS, AMSI/ARSI, RAMP/RASC, and CWL "would be impossible to sell to the public" due to their poor quality. 10/2/2006 email from Axel Kunde at Deutsche Bank to Sean Whelan with copy to Mr. Lippmann, DBSI_PSI_EMAIL02255361.Show full note (9/21/2006)

Email responding to a hedge fund trader at Mast Capital: "Long Beach is one of the weakest names in the market."¹²⁸⁴¹²⁸⁴ 10/20/2006 email from Greg Lippmann to Craig Carlozzi at Mast Capital, DBSI_PSI_EMAIL01774820-21. (10/20/2006)

Email to a client selecting bonds to short: "u have picked some crap right away so u have figured it out."¹²⁸⁵¹²⁸⁵ 12/4/2006 email from Greg Lippmann to Mark Lee at Contrarian Capital, DBSI_PSI_EMAIL01866336. The acronyms in the email refer to the following lenders: Bear Stearns Asset Backed Securities ("bsabs"), Option One Mortgage Loan Trust ("omlt"), and Ameriquest Mortgage Securities, Inc. ("amsi"). (12/04/2006)

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Email regarding GSAMP 06-NC2 M8, an RMBS security that contained New Century loans and was issued by Goldman Sachs: "[T]his is an absolute pig."¹²⁸⁶¹²⁸⁶ 12/8/2006 email from Greg Lippmann to Peter Faulkner at PSAM LLC, DBSI_PSI_EMAIL01882188. (12/8/2006)

Email describing ABSHE 2006-HE1 M7, a subprime RMBS security issued by Asset Backed Securities Corporation Home Equity Loan Trust, as a "crap deal"; and describing ACE 2006 HE2 M7, a subprime RMBS securitization issued by ACE Securities Corp., as: "[D]eal is a pig!"¹²⁸⁷¹²⁸⁷ 3/1/2007 email from Greg Lippmann to Joris Hoedemaekers at Oasis Capital UK, DBSI_PSI_EMAIL02033845. (3/1/2007)

¶When asked about these emails, Mr. Lippmann told the Subcommittee that he generally thought all assets in CDOs were weak, and that his descriptions were often a form of posturing while negotiating prices with his clients. In a number of cases, however, Mr. Lippmann was assisting his clients in devising short strategies or communicating with Deutsche Bank colleagues, rather than negotiating with clients over prices. As will be seen later in this Report, some of the RMBS securities he criticized were, at virtually the same time, being included by his trading desk in Gemstone 7, which was later sold by Deutsche Bank's CDO Group.

¶In addition to disparaging individual RMBS securities, Mr. Lippmann expressed repeated negative views about the CDO market as a whole. At times during 2006 and 2007, he referred to CDO underwriting activity by investment banks as the workings of a "CDO machine" or "ponzi scheme."¹²⁸⁸¹²⁸⁸ In the 1920s, Charles Ponzi defrauded thousands of investors in a speculation scheme that "involves the payment of purported returns to existing investors from funds contributed by new investors." "Ponzi Schemes – Frequently Asked Questions," SEC, http://www.sec.gov/answers/ponzi.htm. In June 2006, for example, a year before CDO credit ratings began to be downgraded en masse, Mr. Lippmann sent an email to a hedge fund trader warning about the state of the CDO market: "[S]tuff is flat b/c [because] the cdo machine has not slowed but I am fielding 2-4 new guys a day that are kicking the tires so we probably don't go tighter."¹²⁸⁹¹²⁸⁹ 6/8/2006 email from Greg Lippmann to Bradley Wickens at Spinnaker Capital, DBSI_PSI_EMAIL01282551. A few months later, in August 2006, Mr. Lippmann wrote about the coming market crash: "I don't care what some trained seal bull market research person says this stuff has a real chance of massively blowing up."¹²⁹⁰¹²⁹⁰ 8/29/2006 email from Greg Lippmann to Bradley Wickens at Spinnaker Capital, DBSI_PSI_EMAIL01628496.

¶When asked about his comments, Mr. Lippmann told the Subcommittee that the CDO market was not really a ponzi scheme, because people did receive an investment return, and asserted that he had used the term because he was "grasping at things" to prove he was right in his short position.1291 Mr. Lippmann also told the Subcommittee that while he knew that the major credit rating agencies had given AAA ratings to an unusually large number of RMBS and CDO securities and most people believed in the ratings, he did not. He also told the

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¶Subcommittee that he "told his views to anyone who would listen" but most CDO investors disagreed with him.¹²⁹²¹²⁹² Subcommittee interview of Greg Lippmann (10/18/2010).

¶In March 2007, Mr. Lippmann again expressed his view that mortgage related assets were "blowing up":

"I remain firm in my belief that these are blowing up whether people like it or not and that hpa [housing price appreciation] is far less relevant than these bulls think. Can't blame them because if this blows up lots of people lose their jobs so they must deny in hope that that will help prevent the collapse. At this price I'm nearly just as short as I've ever been."¹²⁹³¹²⁹³ 3/4/2007 email from Greg Lippmann to Harvey Allon at Braddock Financial, DBSI_PSI_EMAIL02041351-53. On June 23, 2007, Mr. Lippmann wrote to a Deutsche Bank colleague, "Yup this is the beginning of phase 2 (the bulls still can't see it), sales by the longs and how do you think the foreign banks will feel when they see that the true mark for what they have is … this could be the end of the cdo biz." 6/23/2007 email from Greg Lippmann to Michael George, DBSI_PSI_EMAIL02584591.Show full note

¶(b) Building and Cashing in the $5 Billion Short

¶Mr. Lippmann did not just express negative views of RMBS and CDO securities to his colleagues and clients, he also acquired a significant short position on those assets on behalf of Deutsche Bank. Despite the views of virtually all other senior executives at the bank that RMBS and CDO securities would gain in value over time, Mr. Lippmann convinced the bank to allow him to initiate and build a substantial proprietary short position that would pay off only if mortgage related securities lost value.

¶Initiating the Short Position. In 2005, Deutsche Bank was heavily invested in the U.S. mortgage market and, by 2007, had accumulated a long position in mortgage related assets that, according to Deutsche Bank, had a notional or face value of $128 billion and a market value of more than $25 billion.¹²⁹⁴¹²⁹⁴ According to Deutsche Bank, as of March 31, 2007, it held a total long position in mortgage related securities whose notional or face value totaled $127.8 billion, including $4.3 billion at "ABS Correlation London"; $5 billion at "CDO Primary Issue/New York"; $102 billion at "RMBS/New York"; $7.6 billion at "SPG-Asset Finance/New York"; and $8.9 billion at "Winchester Capital/London." 3/2/2011 letter from Deutsche Bank's counsel to the Subcommittee, PSI-DeutscheBank-31-0004-06. The market value of those positions was substantially lower. For example, according to Deutsche Bank, the $102 billion long investment held by its RMBS/New York office had a market value of about $24 billion. 3/21/2011 letter from Deutsche Bank's counsel to the Subcommittee, PSI- Deutsche_Bank-32-0001-04.Show full note These positions had been accumulated and were held primarily by the Deutsche Bank mortgage department, the ABS Trading Desk, and a Deutsche Bank affiliated hedge fund, Winchester Capital, which was based in London.¹²⁹⁵¹²⁹⁵ Id.

¶Mr. Lippmann told the Subcommittee that, despite the bank's positive view of the mortgage market, in the fall of 2005, he requested permission to establish a proprietary trading position that would short RMBS securities.¹²⁹⁶¹²⁹⁶ Subcommittee interview of Greg Lippmann (10/18/2010). When asked if the position was a proprietary investment by the bank, Mr. Lippmann told the Subcommittee that it was. Id. Deutsche Bank acknowledges in a 20-F filing with the U.S. Securities and Exchange Commission that it conducts proprietary trading, in addition to trading activity that facilitates customer business. Deutsche Bank stated that it trades for its own account (i.e., uses its capital) to exploit market opportunities. See Deutsche Bank Aktiengesellschaft's Form 20-F filed with the Securities and Exchange Commission on March 26, 2008, at 24.Show full note He explained that he made this request after reviewing data he received from a Deutsche Bank quantitative analyst, Eugene Xu. He said that this data showed that, in regions of the United States where housing prices had increased by 13%, the default rates for subprime mortgages had increased to 7%.¹²⁹⁷¹²⁹⁷ Subcommittee interview of Greg Lippmann (10/18/2010). At the same time, he said, in other regions where housing prices had increased only 4%, the subprime mortgage default rates had quadrupled to 28%.¹²⁹⁸¹²⁹⁸ Id. Mr. Lippmann explained that he had concluded that even a moderate slow down in rising housing prices would result in significant subprime mortgage defaults, that there was considerable correlation among these subprime mortgages, and that the defaults would affect BBB rated RMBS securities. Mr. Lippmann stressed that his negative view of RMBS securities was based primarily on his view that moderating home prices would cause subprime mortgage defaults and was not dependent upon the quality of the subprime loans.¹²⁹⁹¹²⁹⁹ Id.

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¶In the fall of 2005, Mr. Lippmann said that he approached his supervisor Richard D'Albert, Global Head of the Structured Products Group, for permission to enter into CDS agreements to short RMBS securities totaling $1 billion.1300 He said that he explained at the time that a cost benefit analysis favored a short RMBS position, because the bank would pay a relatively small amount of CDS premiums per year in exchange for a potentially huge payout. Mr. Lippmann said that he estimated at the time that, when the costs were compared to the potential payout if the BBB securities defaulted, the proposed short position offered a potential payout ratio of 8 to 1.

¶Mr. Lippmann also developed a presentation supporting his position entitled, "Shorting Home Equity Mezzanine Tranches." It made the following points:

"Over 50% of outstanding subprime mortgages are located in MSAs [metropolitan statistical areas] with double digit 5 year average of annual home price growth rates.

There is a strong negative correlation between home price appreciation and loss severity.

Default of subprime mortgages are also strongly negatively correlated with home price growth rates.

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Nearly $440 billion subprime mortgages will experience payment shocks in the next 3 years.

Products that may be riskier than traditional home equity/subprime mortgages have become popular."¹³⁰¹¹³⁰¹ 9/2005 "Shorting Home Equity Mezzanine Tranches, A Strategy to Cash in on a Slowing Housing Market," DBSI_PSI_EMAIL00502892-29.

¶Mr. Lippmann told the Subcommittee that Mr. D'Albert approved his taking the short position in or around November 2005, but said the trade was so big and controversial that Mr. Lippmann also had to get the approval of Rajeev Misra, Global Head of Credit Trading, Securitization and Commodities, who was based in London.¹³⁰²¹³⁰² Subcommittee interview of Greg Lippmann (10/18/2010). Mr. Lippmann said that, in or around November 2005, Mr. Misra reluctantly gave his approval for the short position, even though Mr. Misra believed mortgage related securities would continue to increase in value over time.

¶Building the Short Position. Mr. Lippmann told the Subcommittee that he used some existing short positions that had been undertaken as hedges to begin building his position.¹³⁰³¹³⁰³ Id. He said that, throughout 2006, he gradually accumulated a larger short position, which eventually reached $2 billion. According to Mr. Lippmann, Deutsche Bank senior management reluctantly went along.¹³⁰⁴¹³⁰⁴ Id. He told the Subcommittee that, at one point in 2006, Boaz Weinstein, who reported to Mr. Misra, told him that the carrying costs of his position, which required the bank to pay insurance-like premiums to support the $2 billion short position, had become so large that he had to find a way to pay for them. According to Mr. Lippmann, the bank's senior management asked him to persuade them that he was right by demonstrating that others were willing to "short" the market as well. Mr. Lippmann told the Subcommittee he was then motivated to convince his clients that they ought to short the mortgage market, arrange the shorts for them, and make enough in fees from those transactions to pay for the costs of his multi-billion-dollar short.¹³⁰⁵¹³⁰⁵ Id.

¶Mr. Lippmann told the Subcommittee that he spent much of 2006 pitching his clients to short the mortgage market. He said that he often made presentations to prospective clients sharing with them his "strategy on how to cash in on a slowing housing market."¹³⁰⁶¹³⁰⁶ Id. He said that, in early 2006, he expended approximately 200 hours trying to convince AIG to short single name RMBS, but was unsuccessful. He told the Subcommittee that he also believed that his presentations helped convince AIG to stop buying RMBS and CDO securities and stop selling CDS protection for those deals. In an August 2006 email, Mr. Lippmann wrote: "In 05 for a time, we sold EVERY single one to AIG. They stepped out of the market in March of 06 after speaking with me and our research people (and I don't doubt other dealers)."¹³⁰⁷¹³⁰⁷ 8/26/2006 email from Greg Lippmann to Richard Axilrod at Moore Capital, DBSI_PSI_EMAIL01618236. Mr. Lippmann told the Subcommittee that Mr. Lamont, who co-led Deutsche Bank's CDO Group, was not pleased that Mr. Lippmann had convinced AIG, a very large purchaser of long interest in RMBS and CDO securities, to stop buying them.

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¶The documents indicate that Mr. Lippmann and his trading team were aware at the time that the CDO Trading Desk was expected to promote rather than discourage client interest in purchasing Deutsche Bank's CDO securities. One of Mr. Lippmann's top traders, Rocky Kurita, put it this way in mid-2005: "[W]e have to make money. Customer happiness is a secondary goal but we cannot lose sight of the trading desk[']s other role of supporting new issue and the customer franchise."¹³⁰⁸¹³⁰⁸ 5/12/2005 email from Rocky Kurita to Greg Lippmann, DBSI_PSI_EMAIL00054826. In a 2007 email to a client, Mr. Lippmann wrote: "[P]lease please do not forward these emails outside of your firm. … I do not want to be blamed by the new issue people for destroying their business."¹³⁰⁹¹³⁰⁹ 2/1/2007 email from Greg Lippmann to Wyck Brown at Braddock Financial, DBSI_PSI_EMAIL01969867.

¶Although Mr. Lippmann was unsuccessful in convincing AIG to short RMBS and CDO securities, he did convince some of his other clients, usually hedge funds, to undertake such shorts, primarily by purchasing single name CDS contracts referencing specific RMBS securities. Those trades generated substantial sums for the ABS Correlation Trading Desk which acted as a market maker in the CDS market for those clients. Mr. Lippmann told the Subcommittee that the shorts executed by his clients ultimately generated about $200 million in revenues for his desk in 2006.¹³¹⁰¹³¹⁰ Subcommittee interview of Greg Lippmann (10/18/2010).

¶Defending the Short. According to Mr. Lippmann, in December 2006, he met in London with a senior bank official, Anshu Jain, Head of Global Markets at Deutsche Bank, and suggested that Deutsche Bank's long positions in mortgage related securities created too much exposure for the bank and should be reduced.¹³¹¹¹³¹¹ Id. Mr. Lippmann recommended that the bank hedge its risk using his short strategy. His suggestion was not acted upon, but as the market grew more volatile in late 2006 and early 2007, Mr. Lippmann's short position began to gain in value and caught the attention of senior management at the bank.

¶Mr. Lippmann told the Subcommittee that, in January 2007, he met with Mr. Jain, Mr. Misra, and Mr. D'Albert at a hotel in Lisbon, where all three again challenged him to defend his short position by noting that it had required him to pay out $20 million in CDS premiums during 2006.¹³¹²¹³¹² Id. Mr. Lippmann told the Subcommittee that he countered by pointing out, while he had paid out $20 million, his desk made $200 million from trading in RMBS and CDO shorts for his clients. He said that the three concluded he could keep his short position.¹³¹³¹³¹³ Id. According to Mr. Lippmann, in February 2007, Mr. Jain met with him again to discuss whether or not to keep his short position, because it had gained in value and Deutsche Bank could cash in the position and take the profits at that time. Mr. Lippmann said that the result of the meeting was that, once again, his position was left in place.

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¶While defending his position within the bank, Mr. Lippmann continued to speak with his outside clients about his negative views of the market, continued to make presentations to potential clients about shorting the market,¹³¹⁴¹³¹⁴ See, e.g., 2/2007 presentation, "Shorting Home Equity Mezzanine Tranches," prepared by Mr. Lippmann, DBSI_PSI_EMAIL01988773-845. and continued to execute shorts for them, while building his desk's proprietary short position.

¶According to Mr. Lippmann, in late February or early March 2007, as the ABX Index showed subprime RMBS securities losing value and subprime mortgages continued incurring delinquencies at record rates, an ad hoc meeting of Deutsche Bank's executive committee took place in London to discuss the bank's risk exposure in mortgage related securities. According to Mr. Lippmann, he happened to be in London at the time and was invited to attend. He estimated that ten to twelve persons were at the meeting in person, and another two to four persons participated by telephone. He said that, at the meeting, Deutsche Bank executives discussed whether the recent market volatility reflected short term or longer term trends and whether the bank should make any changes in its holdings.¹³¹⁵¹³¹⁵ Subcommittee interview of Greg Lippmann (10/18/2010). At that time, Mr. Lippmann held the only large short position on behalf of the bank, then about $4 to 5 billion in size.1316 In contrast, the Deutsche Bank mortgage group held $102 billion in long RMBS and CDO securities, and Winchester Capital, Deutsche Bank's hedge fund affiliate, held a net long position of $8.9 billion.1317 Mr. Lippmann told the Subcommittee that he was the only person at the meeting who argued for the bank to increase its short position.¹³¹⁸¹³¹⁸ Subcommittee interview of Greg Lippmann (10/18/2010).

¶At the time of the London meeting, Mr. Lippmann's position was showing a significant profit. Mr. Misra brought up the alternative of cashing in his position while RMBS prices were down, because he thought prices were in a short term dip and the profits might disappear later on. Mr. Lippmann contended that the bank should not only keep his short position, but increase it, but more senior voices disagreed with him. He told the Subcommittee that the decision at the end of the meeting was for all parties to keep their positions unchanged, including Mr. Lippmann.¹³¹⁹¹³¹⁹ Id.

¶Cashing In the Short. In July 2007, the major credit rating agencies began issuing downgrades of RMBS and CDO securities, in particular those that incorporated or referenced subprime mortgages. The value of those securities began to plummet. By the end of the summer of 2007, Deutsche Bank initiated efforts to sell off the long positions held by Winchester Capital and other Deutsche Bank entities, reflecting a shift in the bank's strategy, but its sales force had difficulty due to the lack of customers willing to buy long.¹³²⁰¹³²⁰ Subcommittee interview of Jordan Milman (10/22/2010). Mr. Milman, one of Mr. Lippmann's top traders, stated that the market first weakened in February 2007, stabilized until June or July 2007, and then it was a "one way train" down from then through 2008. Id. During 2007 and 2008, at the direction of senior management, Mr. Lippmann gradually cashed in his short position, obtaining a total return of about $1.5 billion, which Mr. Lippmann told the Subcommittee he believes was the largest profit obtained from a single position in Deutsche Bank history.¹³²¹¹³²¹ Subcommittee interview of Greg Lippmann (10/18/2010). See Net Revenues from ABS Products Backed by U.S. Residential Mortgages, DB_PSI_C00000003.

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¶Despite the gain from Mr. Lippmann's short position, Deutsche Bank told the Subcommittee that, overall in 2007, it had a long position in mortgage related holdings, with a face value of about $128 billion and a market value of more than $25 billion. Deutsche Bank told the Subcommittee that, despite the size of these holdings and their declining value, it lost only about $4.5 billion on those mortgage related holdings for the year.¹³²²¹³²² According to a chart prepared by Deutsche Bank for the Subcommittee, in 2007 and 2008, its RMBS holdings lost about $3.4 billion; the CDO Group lost about $1.0 billion; Winchester Capital lost about $1.1 billion; and two other trading desks lost nearly $650 million. These losses were offset by the $1.5 billion gain from the bank's short position, for total mortgage related losses of about $4.5 billion. Net Revenues from ABS Products Backed by U.S. Residential Mortgages, DB_PSI_C00000003.Show full note Deutsche Bank also filed a 2007 annual report with the SEC claiming a 2007 profit of €7.2 billion.¹³²³¹³²³ Deutsche Bank stated in its annual report filed with the SEC that it ended 2007 in the black, due to gains in other areas of the bank, including its Corporate and Investment Bank which reported a pre-tax profit of €5.1 billion and its Private Clients and Asset Management division which reported a pre-tax profit of €2.1 billion. See Deutsche Bank's 2007 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.Show full note When asked why its large long position in mortgage holdings did not lose more value, Deutsche Bank told the Subcommittee that it had placed large hedges, using U.S. Treasury bonds, which reduced its losses.¹³²⁴¹³²⁴ Subcommittee interview with Deutsche Bank's counsel (3/7/2011). See also 3/21/2011 letter and accompanying chart from Deutsche Bank's counsel to the Subcommittee, PSI-Deutsche_Bank-32-0001-04.

¶(4) The "CDO Machine"

¶From 2006 to 2007, Mr. Lippmann repeatedly cautioned his colleagues and clients that the mortgage market was headed for a downfall, convinced a number of his clients to short RMBS and CDO securities, and built his $5 billion short position on behalf of Deutsche Bank. Meanwhile, the "CDO machine," as he described it, continued issuing new CDO securities through the end of 2007. The reasons for this continuing CDO activity, despite a deteriorating mortgage market and waning investor interest, are key to understanding how these complex, high risk, structured finance products ended up in multiple financial portfolios throughout the U.S. financial system.

¶Mr. Lippmann was frequently asked why, given his negative views, the CDO market was continuing to operate. He pointed to investment bank fees, prestige, and pressure to preserve the CDO jobs involved. In August 2006, for example, Mr. Lippmann wrote:

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"Why have we done this? It is not without reluctance and we are looking for ways to get out of this risk, but for now the view has been, we like the fees and the league table credit (and dammit we have a budget to make)."¹³²⁵¹³²⁵ 8/26/2006 email from Greg Lippmann to Richard Axilrod at Moore Capital, DBSI_PSI_EMAIL01618236-42. On August 1, 2006, Mr. Lippmann wrote to Mr. Milman, "who has all this crap and let me know which ones to look at looks like a lot of crappy deals." 8/1/2006 email from Greg Lippmann to Jordan Milman, DBSI_PSI_EMAIL01510643. Mr. Lippmann's negative views were shared by his traders. In an email originally sent by one of the traders on his desk, Rocky Kurita, the CDO business is set to a song, "CDO Oh Baby," by Vanilla Ice with the following lyrics: "Yo vip let's kick it! CDO oh baby, CDO oh baby. All right, stop, collaborate and listen. Spreads are wide with a technical invasion. Home Eq Subs were trading so tightly. Until Hedge Funds Bot Protection daily and nightly. Will they stop? Yo I don't know. Turn up the Arb and let's go. To the extreme Macro Funds do damage like a vandal. Now, BBs are trading with a new handle. Print, even if the housing bubble looms. There are never ends to real estate booms. If there is a problem, yo, we'll solve it. Check out the spreads while my structurer revolves it. CDO oh baby, CDO oh baby." 11/8/2005 email from Jordan Milman to Greg Lippmann, DBSI_PSI_EMAIL00686597-601 (forwarding an 11/8/2005 email from Rocky Kurita at Deutsche Bank).Show full note

¶In January 2007, after a trader asked Mr. Lippmann why the CDO market hadn't imploded, Mr. Lippmann responded: "league table, fees, never has one blown up yet."¹³²⁶¹³²⁶ 1/5/2007 email from Greg Lippmann to Chris Madison at Mast Capital, DBSI_PSI_EMAIL02333467-68. The reference to "league table credit" indicates that investment banks considered it prestigious to be listed as the leading producer of a complex structured finance product like CDOs, and used their standing in the tables that tracked total origination numbers as a way of burnishing their reputations, attracting top talent, and generating new business. An October 2006 "Progress Report" on its CDO business, for example, which was prepared internally by the bank, included a slide entitled, "CDO Primary Revenue Forecast and League Tables," in which a chart ranked Deutsche Bank third in CDO issuance, behind Merrill Lynch and Citigroup.¹³²⁷¹³²⁷ 10/2006, "CDO Primary Update Progress Report," DBSI_PSI_EMAIL03970167-72, at 68. The slide indicated that Deutsche Bank had completed 38 CDOs to date, had a 7% share of the CDO market, and "expected to close 50 deals by year end," with the "pipeline for Q1 and Q2 2007 building." The final page of the presentation, providing a chart listing the top 20 Deutsche Bank CDO salespersons by region, together with their individual sales credits, identifies some of the bank personnel invested in the continuation of the CDO business.

¶On the issue of fees, the head of Deutsche Bank's CDO Group Michael Lamont told the Subcommittee that he estimated the bank received 40-200 basis points for each CDO created, depending upon the complexity of the CDO.¹³²⁸¹³²⁸ Subcommittee interview of Michael Lamont (9/29/2010). He indicated those fees translated into about $5 to $10 million per CDO.¹³²⁹¹³²⁹ Id. When asked what he meant by saying "we have a budget to make," Mr. Lippmann explained that new CDO deals had to be completed continuously to produce the revenues needed to support the budgets of the CDO desks and departments involved with their creation.¹³³⁰¹³³⁰ Subcommittee interview of Greg Lippmann (10/18/2010).

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¶A similar view as to why the CDO business continued to operate despite increasing market risk was expressed by a former executive at the hedge fund Paulson & Co. in a January 2007 email exchange with another investor. The Paulson executive wrote:

"It is true that the market is not pricing the subprime RMBS wipeout scenario. In my opinion this situation is due to the fact that rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while 'real money' investors have neither the analytic tools nor the institutional framework to take action before the losses that one could anticipate based [on] the 'news' available everywhere are actually realized."¹³³¹¹³³¹ 1/14/2007 email from Paolo Pellegrini at Paulson to Ananth Krishnamurthy at 3a Investors, PAULSON ABACUS 0234459.

¶At the end of September 2006, the head of Deutsche Bank's sales force, Sean Whelan, wrote to Mr. Lippmann expressing concern that some CDO tranches were getting increasingly difficult to sell: "[T]he equity and the AAA were the parts we found difficult to place."¹³³²¹³³² 9/27/2006 email from Sean Whelan to Greg Lippmann, DBSI_PSI_EMAIL02255361-63. Mr. Lippmann told the Subcommittee that once firms could not sell an entire CDO to investors, it was a warning that the market was waning, and the investment banks should have stopped structuring new ones.¹³³³¹³³³ Subcommittee interview of Greg Lippmann (10/18/2010). Mr. Lippmann told the Subcommittee that he thought Mr. Lamont's CDO Group at Deutsche Bank had too many CDOs in the pipeline in the spring of 2007, when it could not sell all of its CDO securities. He reported that he told Mr. Lamont that defaults would increase. Instead of getting out of the CDO business, however, he said, a new source of CDO demand was found – when new CDOs started buying old CDO securities to include in their assets. One media report explained how this worked:

"As the housing boom began to slow in mid-2006, investors became skittish about the riskier parts of those investments. So the banks created – and ultimately provided most of the money for – new CDOs. Those new CDOs bought the hard-to-sell pieces of the original CDOs. The result was a daisy chain that solved one problem but created another: Each new CDO had its own risky pieces. Banks created yet other CDOs to buy those."¹³³⁴¹³³⁴ "Banks' Self-Dealing Super Charged Financial Crisis," ProPublica, (8/26/2010), http://www.propublica.org/article/banks-self-dealing-super-charged-financial-crisis.

¶Research conducted by Thetica Systems, at the request of ProPublica, found that in the last years before the financial crisis, CDOs had become the dominant purchaser of high risk CDO securities, largely replacing real money investors like pension funds, insurance companies, and hedge funds. The CDO market analysis found that, by 2007, 67% of the high risk mezzanine CDO securities had been purchased by other CDOs, up from 36% in 2004.¹³³⁵¹³³⁵ Id. ProPublica even found that, from 2006 to 2007, nearly half of all the CDOs sponsored by Merrill Lynch bought significant portions of other Merrill CDOs.

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¶Mr. Lippmann told the Subcommittee that he considered it a "shady" practice when, in 2006, difficult-to-sell BBB CDO tranches began to be placed in new CDOs.¹³³⁶¹³³⁶ Subcommittee interview of Greg Lippmann (10/18/2010). In a June 2007 email to Mr. Lippmann, Richard Kim, a Deutsche Bank Managing Director, described placing unsold CDO tranches into a new CDO to be sold to investors as a "CDO2 balance sheet dump."¹³³⁷¹³³⁷ 6/14/2007 email from Richard Kim at Deutsche Bank to Greg Lippmann, DBSI_PSI_EMAIL02202920.

¶In addition to placing unsold CDO securities in newly issued CDOs, investment banks turned increasingly to non-U.S. investors to keep the CDO machine going. In August 2006, Mr. Lippmann noted that European and Asian banks were being targeted to buy CDOs:

"Hear what you are saying and in a normal market your logic would be inarguable, but the demand for this crap is virtually entirely technically driven, all cdos. And each person at the cdo table thinks someone else is the fool- cdo equity, ostensibly only two buyers one mutual fund in Australia, and one hedge fund in Chicago, who is actually putting on a bearish correlation trade: bbb sold mostly ponzi-like to other cdos with limited distribution in Europe. AA and Junior AAA sold mostly to high grade cdos and to a certain extent European and Asian banks and lastly the senior AAA, this may ultimately break the cdo market."¹³³⁸¹³³⁸ 8/26/2006 email from Greg Lippmann to Richard Axilrod at Moore Capital, DBSI_PSI_EMAIL01618236.

¶In a December 2006 email, Mr. Lippmann wrote to a client: "[W]ho owns the cdos…insurance company and german and asian banks…and high grade cdos (can you say ponzi scheme)[?]"¹³³⁹¹³³⁹ 12/4/2006 email from Greg Lippmann to Deutsche Bank employee, DBSI_PSI_EMAIL01867147-49. In early 2007, he wrote:

"[T]he other side is all cdos..so it is the cdo investors who r on the other side who buys cdos: aaa-reinsurance, ws [Wall Street] conduits, European and Asian banks, aa-high grade cdos, European and Asian banks and insurers..some US insurers, bbb other mezz [mezzanine] abs [asset-backed security] cdos (i.e. ponzi scheme), European banks and insurers, equity some US hedge funds, Asian insurance companies, Australian and Japanese retail investors through mutual funds."¹³⁴⁰¹³⁴⁰ 2/27/2007 email from Greg Lippmann to Fabrizio Wittenburg at Deutsche Bank, DBSI_PSI_EMAIL02027053- 55.

¶In February 2007, when an investor wrote to Mr. Lippmann inquiring about the status of the "CDO machine," Mr. Lippmann responded: "[G]etting slower but not dead yet[.] … 2-5 ramping a day instead of 10-15[.] … [H]earing of many investors in [A]sia especially shutting down … but the window is not completely shut yet."¹³⁴¹¹³⁴¹ 2/20/2007 email from Greg Lippmann to David Homan at Moore Capital, DBSI_PSI_EMAIL02006853-54. Deutsche Bank emails demonstrate that, in 2007, like other investment banks, it was actively trying to sell CDOs in Asia.¹³⁴²¹³⁴² See, e.g., "I would like these guys to push Asia sales on this…, but also as Ilinca said, the question arises why weren't they working on this thus far?" 2/21/2007 email from Abhayad Kamat at Deutsche Bank to Michael Lamont and others at Deutsche Bank, DBSI_PSI_EMAIL04056326-36.

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¶Mr. Lippmann had an unrelentingly negative view of the RMBS and CDO securities he traded. He believed the securities would ultimately lose value, but he also believed investment banks would do all they could to sustain the CDO market for as long as possible due to the CDO fees, prestige, market share, and jobs at stake.

¶(5) Gemstone

¶To understand how one investment bank, Deutsche Bank, continued to develop and aggressively solicit its clients to purchase CDO securities even as mortgage related securities lost value and the CDO market began collapsing, the Subcommittee examined in detail Gemstone 7, a $1.1 billion CDO. Gemstone 7 was assembled and marketed by Deutsche Bank, as sole placement agent, from October 2006 to March 2007.¹³⁴³¹³⁴³ In the Gemstone 7 offering circular, Deutsche Bank is described as the placement agent: "The Notes purchased by the Initial Purchaser, if any, will be privately placed with eligible investors by the Initial Purchaser" where the Initial Purchaser was Deutsche Bank. Gemstone 7 Offering Circular, GEM7-00000427-816 at GEM7-00000640. In contrast, other documents produced by Deutsche Bank indicate that the bank was acting as an underwriter in the Gemstone 7 transaction. See, e.g., 12/20/2006 Gemstone 7 Securitization Credit Report, DB_PSI_00237655-71 and undated Gemstone 7 Securitization Credit Report, MTSS000011-13. For ease of reference but without making a judgment on the matter, this Report uses the term "placement agent" when describing Deutsche Bank's role in Gemstone 7.Show full note Gemstone 7 was the last in a series of CDOs sponsored by HBK Capital Management (HBK), a large hedge fund.¹³⁴⁴¹³⁴⁴ Subcommittee interview of HBK Managing Director Jamiel Akhtar (9/15/2010).

¶Deutsche Bank issued the Gemstone 7 securities in March 2007. Six out of Gemstone's seven tranches received investment grade ratings, including AAA ratings for the top three tranches. Two months later, in July 2007, the major credit rating agencies issued mass rating downgrades of RMBS and CDO securities, including 19 of the 115 RMBS securities included or referenced in Gemstone 7. In November 2007, the credit rating agencies began to downgrade the Gemstone 7 securities. Today, all seven tranches have been downgraded to junk status, and the Gemstone 7 securities are nearly worthless.

¶(a) Background on Gemstone

¶Gemstone 7 was a $1.1 billion hybrid CDO whose assets consisted predominantly of high risk subprime RMBS securities. Nearly 90% of its assets were mid and subprime RMBS securities with 33% carrying non-investment grade ratings.¹³⁴⁵¹³⁴⁵ The intended portfolio composition of Gemstone 7 was disclosed to investors in a Debt Investor Presentation. See 2/2007 Gemstone 7 Debt Investor Presentation, GEM7-00001687-1747 at 1695. Of the remaining assets, 4.5% were CDO securities; 3.3% were commercial mortgage backed securities; and 3.5% were securities backed by pools of student loans.¹³⁴⁶¹³⁴⁶ Id. at 1691. When the deal closed in March 2007, Gemstone 7 had about $476 million in cash RMBS assets as well as $625 million in synthetic assets.¹³⁴⁷¹³⁴⁷ 9/14/2010 Gemstone 7 Asset Chart, PSI-Deutsche Bank-17-Gemstone7-0001-03. Gemstone 7 was constructed as a "partially static" CDO, meaning that while some of its assets were set and could not change, others could be replaced by the collateral manager, HBK.

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¶HBK is a Dallas based hedge fund that was founded in October 1991, and by 2007, managed approximately $12 billion in capital.¹³⁴⁸¹³⁴⁸ 1/2007 Gemstone 7 Debt Investor Presentation, at 17, DBSI_PSI_EMAIL01980000-60. According to HBK, its Structured Products Group, one of its 21 business units, was "one of the leading purchasers and long-term investors in credit sensitive mortgages … including RMBS and ABS, a component in HBK's overall strategy since 2002."¹³⁴⁹¹³⁴⁹ Id. Deutsche Bank told the Subcommittee that HBK had a reputation as a competent manager of mortgage related assets.¹³⁵⁰¹³⁵⁰ Subcommittee interview of Sean Whelan, co-head of Deutsche Bank sales force (9/22/2010). HBK had acted as the collateral manager for seven previous CDO deals (six named Gemstone), choosing to alternate the mandate for the deals between Lehman Brothers and Deutsche Bank.

¶In October 2006, HBK retained Deutsche Bank to act as the placement agent for Gemstone 7. Under the agreement, HBK was to receive 30 basis points, or 0.3%, per year of the notional amount of Gemstone 7 (approximately $3.3 million) in return for serving as the collateral manager. Deutsche Bank was slated to receive $6.79 million in "underwriting fees," but because the deal did not sell completely, Deutsche Bank ultimately received a lesser amount of $4.7 million.¹³⁵¹¹³⁵¹ See 12/20/2006 Gemstone 7 Securitization Credit Report, DB_PSI_00237655-71; undated Gemstone 7 Securitization Credit Report, MTSS000011-13; 3/15/2007 Gemstone CDO VII Ltd. Closing Memorandum, DB_PSI_00133536-41. According to the Gemstone Offering Circular, HBK was to receive "0.30% per annum on the Quarterly Amount payable in arrears on each distribution date." 3/15/2007 Offering Circular for Gemstone CDO VII, Ltd., GEM7-00000427-816, "The Management Agreement," at 168. As opposed to an upfront fee, which Deutsche Bank received, the fee to HBK was paid quarterly. Thus, 0.30% of $1.1 billion translates to a fee of approximately $3.3 million for HBK. See 7/11/2007 email from Chehao Lu at Deutsche Bank to Marco Lukesch at HBK, GEM7-00003568. See also email noting HBK's quarterly collateral management fee of $826,067.88 as of September 11, 2007. 9/11/2007 email from Eric Martel at HBK to Jamiel Akhtar at HBK, GEM7-00006900.Show full note

¶On October 25, 2006, HBK and Deutsche Bank signed an agreement outlining the terms of Gemstone 7. HBK told the Subcommittee:

"The collateral purchased under the warehouse arrangement was selected by HBK and subject to Deutsche Bank's right of approval. The warehouse documents originally contemplated a total collateral pool of $750 million, which was increased to $1.1 billion in late December 2006."¹³⁵²¹³⁵² 8/20/2010 letter from HBK's counsel to the Subcommittee, at 2.

¶On October 24, 2006, Deutsche Bank opened a warehouse account to store the assets that would serve as the collateral for the CDO when it closed.¹³⁵³¹³⁵³ See chart, "Assets Purchased by Gemstone VII CDO during Warehouse Period," GEM7-00001831-33 (showing assets purchased during the warehouse period). According to Credit magazine, "The financial press will often make its first mention of a 'new' CDO on or around the time of its closing – with the closing date generally the day on which the CDO issues tranches of debt and equity to investors. Prior to that day, however, there will have been a so- called pre-closing or 'warehousing' period, typically lasting between three and six months. During that period the asset manager will have acquired (or 'warehoused') assets to act as collateral for the securities to be issued by the CDO … on the closing day." See "CDO Guide: recovery rates," Credit magazine (May 2004), http://db.riskwaters.com/public/showPage.html?page=133193.Show full note Deutsche Bank and HBK shared the risk for any change in value of the warehoused assets if the deal failed to close. Pursuant to the risk sharing agreement, if the deal failed to close, HBK would incur the risk for the first $80 million in losses, and Deutsche Bank would bear the remaining risk.¹³⁵⁴¹³⁵⁴ 12/20/2006 Gemstone 7 Securitization Credit Report, DB_PSI_00237655-71.

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¶Deutsche Bank CDO Group. Several departments and desks at Deutsche Bank were involved in designing, marketing, and selling the Gemstone 7 securities. The CDO Group, co-headed by Michael Lamont and Michael Herzig, was responsible for designing its structure, monitoring the purchasing and warehousing of its assets, obtaining its credit ratings, preparing the legal documentation, establishing its administrative structure, obtaining underwriting approval of the deal, designing the marketing materials, and overseeing the issuance of the CDO securities.¹³⁵⁵¹³⁵⁵ Subcommittee interview of Michael Lamont (9/29/2010). Abhayad Kamat within the CDO Group was assigned lead responsibility for structuring Gemstone 7.¹³⁵⁶¹³⁵⁶ Subcommittee interview of Abhayad Kamat (10/8/2010). The CDO Trading Desk, headed by Greg Lippmann, participated in the CDO approval process once HBK selected assets. The CDO sales force, headed by Sean Whelan and Michael Jones, was responsible for selling the Gemstone 7 CDO securities.

¶To issue the CDO securities, Deutsche Bank established an offshore corporation in the Cayman Islands called Gemstone CDO VII, Ltd.¹³⁵⁷¹³⁵⁷ Gemstone CDO VII Ltd. Certificate of Incorporation and Memorandum and Articles of Association of Gemstone CDO VII Ltd., DB_PSI_00236844. To administer the corporation, Deutsche Bank appointed its Cayman Island affiliate, Deutsche Bank Cayman, which is a licensed trust company.¹³⁵⁸¹³⁵⁸ Deutsche Bank International Limited is a wholly owned subsidiary of Deutsche Bank AG. It currently has several offices around the world, including one in the Cayman Islands, Deutsche Bank (Cayman) Limited ("DB Cayman"), that was opened in 1983. "Deutsche Bank International Ltd.," Bloomberg Businessweek, http://investing.businessweek.com/research/stocks/private/snapshot.asp?privcapId=884191; "Deutsche Bank in the Cayman Islands," Deutsche Bank, http://www.dboffshore.com/page.php?title=cayman_islands. DB Cayman is a licensed trust company incorporated in the Cayman Islands. Preference Share Paying Agency Agreement, GEM7- 00001089-1030, at 1092.Show full note As administrator, Deutsche Bank Cayman provided Gemstone 7 with the administrative services needed to operate the CDO securitization, including but not limited to, providing office facilities and secretarial staff, maintaining the books and records required by Cayman law, naming at least two Cayman directors, and acting as the Share Registrar for Gemstone shares.¹³⁵⁹¹³⁵⁹ Amended and Restated Administrative Agreement, GEM7-00001223-31; Preference Share Paying Agency Agreement, GEM7-00001089-1130 at 1095-96.

¶HBK's Long Investment in Gemstone. HBK routinely purchased the equity tranche,¹³⁶⁰¹³⁶⁰ An equity tranche is the tranche in an RMBS or CDO structure that is designed to be the first to incur any losses from the securitization. Since it is expected to incur at least some level of losses, the equity tranche is usually not given a credit rating and is often retained by the originator of the securitization. See American Banker definition, http://www.americanbanker.com/glossary/e.html. also known as the residual interest, in all of its Gemstone deals, including Gemstone 7.¹³⁶¹¹³⁶¹ According to HBK, "HBK's investment process integrates expertise in capital markets, structural analysis, collateral and loan level analysis, due diligence, and in house surveillance. HBK is seen as not as a trader but as a vigilant investor that maximizes value through intensive analysis and surveillance." 1/2007 Gemstone 7 Debt Investor Presentation, DBSI_PSI_EMAIL01980000-60 at 23. HBK told investors in its sales presentation that "HBK has retained 100% of the equity from CDO transactions resulting in strong alignment of interests between HBK and investors."¹³⁶²¹³⁶² Id. According to Kevin Jenks, HBK's collateral manager, HBK had a "buy and hold" approach to all of its Gemstone CDOs.¹³⁶³¹³⁶³ Subcommittee interview of Kevin Jenks (10/13/2010). Also see 1/2007 Gemstone 7 Debt Investor Presentation, DBSI_PSI_EMAIL01980000-60 at 25. HBK also told the Subcommittee that it participated in Gemstone 7 with "the objective of obtaining long exposure to the CDO's collateral, on a leveraged basis, through ownership of the Residual interest."¹³⁶⁴¹³⁶⁴ 8/20/2010 letter from HBK's counsel to the Subcommittee.

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¶HBK deals were known for containing above average concentrations of BB or lower rated assets, but HBK prided itself on its ability to run in-depth analysis and accurate stress tests on assets it selected for its CDOs.¹³⁶⁵¹³⁶⁵ Subcommittee interview of Abhayad Kamat (10/8/2010). Mr. Kamat was the individual at Deutsche Bank who was primarily responsible for structuring Gemstone 7. HBK expected to receive a 15% return on its investment in the equity tranche.¹³⁶⁶¹³⁶⁶ Subcommittee interview of Jamiel Akhtar (9/15/2010). In its investor presentation, HBK stated: "The firm strives to provide superior risk-adjusted rates of return with relatively low volatility and relatively low correlation to most major market indices."¹³⁶⁷¹³⁶⁷ 1/2007 Gemstone 7 Debt Investor Presentation, DBSI_PSI_EMAIL01980000-60 at 17. HBK's presentation also claimed that, as of January 2007, it had only three downgrades in its asset backed security portfolio, and that its upgrade to downgrade ratio was 23 to 3.¹³⁶⁸¹³⁶⁸ Id. at 25. Investor M&T Bank, who later purchased Gemstone 7 securities, told the Subcommittee that it had relied on HBK's assertions when choosing what it thought was an investment with "minimal risk."¹³⁶⁹¹³⁶⁹ Subcommittee interview of M&T (9/20/2010).

¶HBK informed the Subcommittee that it had never shorted any of the assets in its seven Gemstone CDOs, that its CDO trade book was evenly matched with long and short CDO assets during the 2006-2007 period,¹³⁷⁰¹³⁷⁰ According to HBK, "HBK never had a short position in any securities issued by the Gemstone 7 CDO." HBK also told the Subcommittee staff that it had approximately $350 million of long exposure in Gemstone 7 and another $800 million of "additional long exposure to the same assets underlying collateral outside the CDO." 8/20/2010 letter from HBK's counsel to the Subcommittee. HBK told the Subcommittee that it did at times take short positions in certain mortgage backed securities unrelated to the Gemstone transactions.Show full note and that it lost over $700 million in its Structured Credit business unit during 2007.¹³⁷¹¹³⁷¹ 8/20/2010 letter from HBK's counsel to the Subcommittee, and exhibit to letter, HBK's exposure to Gemstone VII Notes, GEM7-00000001-10.

¶(b) Gemstone Asset Selection

¶As the collateral manager, HBK selected the assets for Gemstone 7, subject to approval by Deutsche Bank's structuring and trading groups before each asset could be placed in the Deutsche Bank warehouse account for the CDO.¹³⁷²¹³⁷² Subcommittee interview of Abhayad Kamat (10/8/2010). According to HBK and Deutsche Bank personnel, the approval process worked in the following manner. First, HBK identified the RMBS, CDO, and other securities it wanted to include or reference in the CDO. HBK then sent an email to Mr. Lippmann or his traders at Deutsche Bank requesting that the identified assets be placed in the warehouse account for Gemstone 7. Deutsche Bank traders, sometimes in consultation with Mr. Lamont's structuring group, would then either approve or voice concerns regarding the proposed assets. If they had concerns, the traders would work with HBK personnel to resolve them. For example, on January 9, 2007, HBK's Jason Lowry sent an email to Mr. Lippmann and his trader, Jordan Milman, with a list of RMBS securities proposed for inclusion in Gemstone 7, and asked: "This is the last BB list for approval. Could you take a look?" On the same day, Mr. Milman wrote back: "approved contingent upon first pay defaults getting bought back on the 2 heat bonds."¹³⁷³¹³⁷³ See, e.g., 1/9/2007 email from Jason Lowry to Greg Lippmann, GEM7-00002154; and 12/11/2006 email from Greg Lippmann to Kevin Jenks, GEM7-00002805. The term "heat" refers to an RMBS security issued by Home Equity Asset Trust.

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¶Although the Gemstone 7 offering circular did not describe Deutsche Bank's role in the asset selection process, the private engagement agreement between HBK and Deutsche Bank did.¹³⁷⁴¹³⁷⁴ The Gemstone 7 offering circular states that with regard to the purchase of underlying assets: "The Issuer [Gemstone 7] will acquire Underlying Assets from a warehouse facility (the 'Warehouse Facility') provided by an affiliate of DBSI [Deutsche Bank Securities, Inc.], which provides for the purchase of Asset-Backed Securities at the direction of the Collateral Manager [HBK] on behalf of the Issuer prior to the Closing Date." Gemstone 7 Offering Circular, GEM7-00000427-816 at 494.Show full note According to the terms of the engagement agreement, Deutsche Bank agreed to provide, among other items, the following service: "advising the Issuer [Gemstone 7] and the Company [HBK] on the selection and acquisition of the Underlying Assets" and "the scope of due diligence for the Underlying Assets."¹³⁷⁵¹³⁷⁵ 10/25/2006 signed letter agreement between HBK and Deutsche Bank, GEM7-00000071-89 at 72. Under both the engagement agreement and a separate risk sharing agreement, Deutsche Bank also had the right to reject assets selected by HBK for the Gemstone warehouse account.¹³⁷⁶¹³⁷⁶ Id.; 10/24/2006 Risk Sharing Agreement, GEM7-00000090-99 at 91. When asked about Deutsche Bank's obligations under these agreements, Mr. Lippmann told the Subcommittee that he viewed Deutsche Bank as having an obligation to the entity, Gemstone 7, to price the assets accurately as they were purchased, which included comparing the price of each security or CDS contract on the date it went into the warehouse account to its market price and ensuring that the CDO did not overpay for the assets it purchased.¹³⁷⁷¹³⁷⁷ Subcommittee interview of Greg Lippmann (10/18/2010). Mr. Lippmann's trader, Mr. Milman, and Mr. Kamat, of Mr. Lamont's CDO Group, agreed with that assessment.¹³⁷⁸¹³⁷⁸ Subcommittee interview of Jordan Milman (10/22/2010) and Abhayad Kamat (10/8/2010). All three also stated that the engagement agreement did not require Deutsche Bank to analyze the quality of the assets being purchased or how those assets were expected to perform.

¶On the other hand, documents reviewed by the Subcommittee indicate, in at least a few instances, that Deutsche Bank personnel voiced concerns about an RMBS security being placed in the deal due to performance concerns in addition to price. For example, Mr. Kamat, who also assisted Mr. Lippmann's trading desks, wrote to Mr. Jenks about the quality of an asset being considered for Gemstone 7. Mr. Kamat wrote: "MLMI 2005-HE1 B3 [is] on credit watch – do you want to move this out of the portfolio – investors might question/resist[.]" Mr. Jenks responded: "[N]o let's leave it in[.]"1379

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¶On another occasion, Mr. Jenks from HBK exchanged several emails with Mr. Lippmann about several RMBS securities that Mr. Jenks wanted to include in the Gemstone 7 warehouse account. Mr. Jenks sent the list to Mr. Lippmann and wrote: "please approve." Mr. Lippmann responded: "ok approved but would like to lower these 2 pts each given recent press on fhlt and significant widening in the baa3 cds. Is that cool?" The term "fhlt" referred to RMBS securities issued by Fremont; by saying he wanted to "lower these 2 pts," Mr. Lippman indicated he wanted to assign them a lower value for warehouse purposes. Mr. Jenks replied: "Greg, Fremont overall is really not trading badly just the ones on downgrade watch," to which Mr. Lippmann responded: "we have seen the fhlt 05-d bbb-trade wide …. please work with me on this. … I am trying to work with you." Mr. Jenks replied:

"Greg, I have been trying to work with you. Doing trades just with you and not on bid lists. But we play in the higher quality part of the market, I really expected you to approve the list as is. We still have several hundred million of bonds to do in cds form to do [sic]."1380

¶This exchange shows that Mr. Lippmann was cognizant of the quality of the assets being included in the CDO, and pushed for lower prices when he thought the assets were of poor quality.

¶HBK told the Subcommittee that it selected good quality bonds using a very complex model to analyze them.¹³⁸¹¹³⁸¹ See 1/2007 Gemstone 7 Debt Investor Presentation, DBSI_PSI_EMAIL01980000-60 ("HBK's investment model utilizes proprietary default, prepay and severity loan level models to make investments in the residential market. ... Transaction performance is tracked monthly via trustee surveillance reports and ongoing loan level information to monitor and analyze parameters such as collateral yields, delinquency and default trends, recoveries, prepayments, and available credit enhancement.").Show full note It told investors that it "analyze[d] every bond in the market, providing for a vast range of data …. [F]rom this data, trends can be observed early regarding the bonds themselves as well as the general economy and the implications on future issuance."¹³⁸²¹³⁸² Id. at 42. HBK provided this description for the Subcommittee regarding the tools it used in the asset selection process:

"HBK used a statistically driven mortgage behavior model to help make trading decisions and select assets for inclusion in the Gemstone VII CDO. Three separate database tools were utilized in this process. First, HBK licensed a commercial database called LP Database, which contained detailed information and performance history for millions of non-agency mortgages. The LP Database was a robust dataset comprising close to 80% of the market, back to the 1996 vintage. Utilizing the data acquired from the LP

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Database, HBK then developed a proprietary system called the Loss Model that forecasted the likelihood of default, prepayment, delinquency, or timely payment for an individual mortgage monthly over a ten-year time horizon. The Loss Model made these forecasts based on a series of 50 loan characteristics, including whether the mortgage was a first or second lien mortgage, the type of mortgage (e.g., fixed or ARM), its geographic location, FICO score, loan-to-value ratio, and level of documentation, and projections of home price appreciation and unemployment rates.

Finally, HBK merged the information from the Loss Model into a Bond Evaluation Engine, which was based on software licensed from Intex Solutions. The Bond Evaluation Engine provided information that assisted HBK traders in pricing mortgage bonds and evaluating how the bonds might perform under certain stresses. … This portion of the analysis focused on the structure and enhancements of the RMBS and how those structures would contribute to bond performance."¹³⁸³¹³⁸³ 10/12/2010 letter from HBK's counsel to the Subcommittee.

¶Mr. Jenks of HBK told the Subcommittee that HBK "never had a bond that we thought was bad that was put in a CDO."¹³⁸⁴¹³⁸⁴ Subcommittee interview of Kevin Jenks (10/13/2010). Mr. Jenks also told the Subcommittee that he had frequent conversations with Mr. Lippmann, was aware of his "negative housing view," but disagreed with the magnitude of Mr. Lippmann's negative views.¹³⁸⁵¹³⁸⁵ Id. Mr. Lippmann told the Subcommittee that although he occasionally suggested bonds to Mr. Jenks for Gemstone 7, and Mr. Jenks at times purchased them, Mr. Jenks had strong views on the assets that should be included in the CDO and was not required to listen to him. HBK and Deutsche Bank emails confirm that Mr. Lippmann or his traders offered at times to sell certain bonds to HBK, which occasionally purchased them.¹³⁸⁶¹³⁸⁶ See, e.g., 12/8/2006 email from Greg Lippmann to Kevin Jenks, DBSI_PSI_EMAIL01883072 (discussing trade they agreed to). See also 2/23/2007 email from Jordan Milman to Greg Lippmann, DBSI_PSI_EMAIL02022054 ("I'd rather just have Ilinca show hbk, he loves bonds like this."). Deutsche Bank sold five bonds from its inventory, with a value of more than $27 million, to HBK for inclusion in Gemstone 7.¹³⁸⁷¹³⁸⁷ Assets Purchased by Gemstone VII CDO during Warehouse Period, GEM7-00001831-33. According to Mr. Lamont, his CDO Group was "agnostic" towards the quality of the assets that HBK purchased for Gemstone 7, and told the Subcommittee that investors had relied on HBK, the collateral manager, to analyze their quality.¹³⁸⁸¹³⁸⁸ Subcommittee interview of Michael Lamont (9/29/2010). Mr. Kamat also agreed that Deutsche Bank was agnostic with regard to the quality of the assets. Subcommittee interview of Abhayad Kamat (10/8/2010). Mr. Lamont said that the role of the CDO Group was, not to select the CDO's assets, but to structure the deal and then use models to conduct stress tests on it.¹³⁸⁹¹³⁸⁹ Subcommittee interview of Michael Lamont (9/29/2010).

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¶(c) Gemstone Risks and Poor Quality Assets

¶Gemstone 7's assets were assembled in late 2006 and early 2007, when the mortgage market was deteriorating and subprime mortgages were experiencing record delinquency rates. The CDO posed a host of risks due to both the state of the market and the poor quality of many of its underlying assets.

¶Credit Report. In December 2006, Mr. Lamont's CDO Group prepared a Credit Report for Deutsche Bank's credit risk management group to obtain internal approval for the securitization of Gemstone 7.¹³⁹⁰¹³⁹⁰ Id. See undated Gemstone 7 Securitization Credit Report, MTSS000011-13 and 12/20/2006 Gemstone 7 Securitization Credit Report, DB_PSI_00237655-71. The 12/20/2006 Credit Report appears to be an earlier version of the document. The Credit Report noted the following business risks for Deutsche Bank regarding Gemstone 7, including the possibility that the bank would be unable to sell $400 million of the Gemstone securities, which carried "significant" risk:

"The portfolio is concentrated on RMBS obligations, with 67.6%, 20.2% and 1.9% of the RMBS exposure represented by 2005, 2006, and 2007 vintages, respectively, which results in significant vintage risk."

"RMBS accounts for ~90.0% of the initial collateral portfolio."

"All unsold tranches have been taken back by HBK except for the Class A-1B ($400mm). Currently, we are working with [redacted] to see if they will be interested in taking the tranche. The plan for distribution if [redacted] decides not to take the tranche, will be a senior sequential repack. The Class A-1B will be broken into two tranches. DB will take the senior part (Class A-1B(i) $200mm) and HBK will take the bottom part (Class A-1B(i) $200mm). Once the repack is setup, then DB will try to syndicate the Class A-1B(i)."¹³⁹¹¹³⁹¹ Gemstone 7 Securitization Credit Report, MTSS000011-13.

¶The business risks described in the internal Deutsche Bank credit report relating to "significant vintage risk" for the 2005, 2006, and 2007 vintage RMBS securities 1392were not disclosed in the Gemstone 7 offering materials given to investors. Although the March 15, 2007 Offering Circular contained a "Risk Factor" section describing multiple risks associated with an investment in Gemstone 7, including those associated with residential asset backed securities, the Offering Circular was silent with respect to the above risks identified in the Credit Report, which were highlighted for Deutsche Bank management.

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¶The Offering Circular did, however, describe in detail a number of significant risks associated with RMBS securities. For example, it stated:

"The risk of losses on residential mortgage loans is particularly relevant now. While there is always a risk of defaults or delinquencies in payment, recently losses on residential mortgage loans have been increasing and may continue to increase in the future. The losses have been most significant in respect of subprime mortgage loans but all are affected.

A number of factors are contributing to the increase in losses. Residential property values that increased for many years are now declining. … Declining property values also exacerbate the losses due to a failure to apply adequate standards to potential borrowers. Failures to properly screen borrowers may include failures to do adequate due diligence on a borrower (including employment and income history) or the relevant property (including valuation) or failures to follow predatory lending and the other borrower-protection statutes. Increases in interest rates may also contribute to higher rates of loss. ...

The increase in delinquencies and defaults has contributed to a declining market for mortgage loans. The declining market has, in turn, seriously impacted mortgage originators and servicers. … The financial difficulties of servicers in particular are likely to result in losses in respect of securities backed by residential mortgage loans. … At any one time, the portfolio of Residential ABS Securities may be backed by residential loans with disproportionately large aggregate principal amounts secured by properties in only a few states or regions."¹³⁹³¹³⁹³ 3/15/2007 Offering Circular for Gemstone CDO VII, Ltd., GEM7-00000427-816 at 483-84. While an earlier offering circular for Gemstone 7, dated February 14, 2007, identifies some risks associated with the CDO, the March offering circular contains additional language, quoted above, on the risks associated with the deteriorating mortgage market. 2/14/2007 Offering Circular for Gemstone CDO VII, Ltd., PSI-M&T_Bank-02-0001-370.Show full note

¶These disclosures demonstrate that both HBK and Deutsche Bank were well aware of the deteriorating mortgage market and increased risks associated with RMBS and CDO securities, even as they were marketing the Gemstone 7 securities and claiming HBK had applied careful analysis in the asset selection process to ensure good quality CDO securities.

¶Long Beach-Fremont-New Century Bonds. A substantial portion of the cash and synthetic assets included in Gemstone 7, 30% in all, involved subprime residential mortgages issued by three subprime lenders, Long Beach, Fremont, and New Century, all known for issuing poor quality loans and securities.¹³⁹⁴¹³⁹⁴ For more information on these three lenders, see sections D(3)(d) and E(2)(c)-(d) of Chapter IV. Mr. Jenks of HBK told the Subcommittee that he saw data showing that Long Beach and Fremont were poor performers, but he thought the performance varied depending upon the tranche, and he believed he could pick the better tranches. He thought he could buy low, structure the deal well, and make money. Subcommittee interview of Kevin Jenks (10/13/2010).Show full note Loans by these lenders were among the first to collapse. According to Moody's, these three originators, plus WMC Corporation, accounted for 31% of the subprime RMBS securities issued in 2006, but 63% of the rating downgrades issued in the second week of July 2007, when the mass rating downgrades began.¹³⁹⁵¹³⁹⁵ 7/12/2007 Moody's Structured Finance Teleconference and Web Cast: RMBS and CDO Rating Actions, at Moody's SI 2010-0046902, Hearing Exhibit 4/23-106.

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¶During the period when securities were being assembled for the Gemstone 7 warehouse in late 2006 and early 2007, Mr. Lippmann frequently disparaged many of the same assets he and his traders allowed to be included in Gemstone 7. About $27 million of these assets came from Deutsche Bank's own inventory. In emails to colleagues and his clients, Mr. Lippmann used words like "crap" and "pig" to describe the assets. Mr. Lippmann brought some of the assets of Gemstone 7 to the attention of some of his clients that shorted these assets.¹³⁹⁶¹³⁹⁶ Subcommittee interview of counsel for Deutsche Bank (2/1/2011).

¶On October 20, 2006, for example, one of Mr. Lippmann's clients sent him an email seeking advice about certain subprime bonds issued by Long Beach Mortgage Loan and Trust (LBMLT) and other originators. Mr. Lippmann responded:

"LBMLT-06-5 M9-375. Long Beach is one of the weakest names in the market. We shorted this bond to a CDO in the mid-300s on October 13[.] Deal was done before S&P changed their criteria on July 1. Lots of 40 year mortgages …. Less than half the loans have full documentation and 10% are investor properties. This is a real pig.

LBMLT -06-2 M9 350. See above on Long Beach. This one is already performing poorly with substantial delinquencies .… Further the FICO is less than the 06-05 and there are fewer full doc loans. This seems a better short than the 06-5. Only reason I can think for my guys showing you a tighter level is that we are short this one and that the June 06 deals have a taint that earlier months don[']t due to the theory that late June deals were crammed with bad stuff in order to beat the S & P revisions."¹³⁹⁷¹³⁹⁷ 10/20/2006 email from Greg Lippmann to Craig Carlozzi at Mast Capital, DBSI_PSI_EMAIL01774820-21.

¶Despite these negative views of Long Beach, Mr. Lippmann's group raised no concerns when $25 million in LBMLT 2006-5 M9 securities was purchased by HBK for Gemstone 7's warehouse account, $20 million of which was purchased on October 24, 2006, four days after Mr. Lippmann's email. Altogether, a total of $79.5 million in Long Beach bonds went into Gemstone 7.¹³⁹⁸¹³⁹⁸ 9/14/2010 Gemstone 7 Asset Chart, PSI-DeutscheBank-17-Gemstone7-0001-03.

¶Mr. Lippmann had similar negative views of RMBS securities containing subprime loans originated by Fremont, yet his group did not object to including Fremont securities in Gemstone 7. For instance, on December 6, 2006, Mr. Lippmann's traders did not object to including $20 million of an RMBS known as SABR 2005-FR4 B3, which contained Fremont loans, in Gemstone 7.¹³⁹⁹¹³⁹⁹ Id. In addition, on November 29, 2006, Mr. Lippmann called still another RMBS security with Fremont loans, FHLT 2005-A M9, a "pig." 1402 Yet a month earlier, on October 30, 2006, approximately $1 million of FHLT 2005-A M9 had been purchased for Gemstone 7, with no objection from Mr. Lippmann's trading desk. 1403 Mr. Lippmann made similar negative remarks about RMBS securities containing subprime loans originated by New Century. On November 28, 2006, Mr. Lippmann wrote: "MABS 2005-NC2 M9 … huge payment shock coming." 1404 Yet six weeks later, on January 17, 2007, $10 million of this exact asset, MABS 2005-NC2 M9, was purchased by Gemstone 7, without objection from Mr. Lippmann's traders. 1405 On December 8, 2006, Mr. Lippmann wrote about another New Century security underwritten by Goldman Sachs: "GSAMP 06-nc2 m8 this is an absolute pig." 1406 Although Gemstone 7 did not purchase the M8 securities, it did purchase a total of $30 million in GSAMP 2006-NC2 M9 securities – from a lower tranche in the same securitization with less subordination. It purchased those securities over a month-long period, with $10 million of the securities on November 13, 2006; another $10 million on December 8, 2006; and still another $10 million on December 21, 2006. 1407 In addition, on December 18, 2006, Gemstone 7 purchased $8.8 million worth of a similar security, GSAMP 2006-NC2 B2. 1408 Mr. Lippmann was equally critical of New Century loans securitized by ACE, an entity created by and associated with Deutsche Bank. On September 21, 2006, for example, when asked by a Deutsche Bank salesperson for his opinion of ACE 2006-NC1 M9, an RMBS issued by ACE with New Century subprime loans, Mr. Lippmann responded that ACE was "generally horrible." 1409 On March 2, 2007, a client sent an email to Mr. Lippmann stating: "[T]hey areShow full note One week earlier, on November 29, 2006, when asked by a bank colleague about the same RMBS security, Mr. Lippmann labeled it a "pig."¹⁴⁰⁰¹⁴⁰⁰ With regard to the asset, Mr. Lippmann wrote: "pig probably a 400-525 market." 11/29/2006 email from Greg Lippmann to Francis Blair at Deutsche Bank, DBSI_PSI_EMAIL01853153. Two days later, on December 1, 2006, Mr. Lippmann declared in an email to a client that the security was "blowing up."¹⁴⁰¹¹⁴⁰¹ See 12/1/2006 email from Greg Lippmann to Tyler Duncan at Wayzata Investment Partners, DBSI_PSI_EMAIL01864446 (Mr. Lippmann wrote: "sabr 05-fr4 b3 another Fremont blowing up we traded in august at 260"). Later in January 2007, Greg Lippmann wrote: "SABR Fr [Fremont] blows." 1/25/2007 email from Greg Lippmann to Mark Lee at Contrarian Capital, DBSI_PSI_EMAIL01961580.

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¶Mr. Lippmann expressed a negative outlook for other assets as well, including SABR 2005-OP1, that was taken from Deutsche Bank's inventory and sold to Gemstone 7. On August 26, 2006, Mr. Lippmann wrote to a client about more securities "blowing up," including SABR 2005-OP1:

"I am encouraged that in spite of the virility of the cdo bid, there are numerous examples of bonds blowing up … the tripling of serious delinq [delinquencies] in sabr 05-opl to over 6.5% since feb even though the avg [average] mortgage age is now only 21 months i.e. hasn't reset yet .… What I'm saying is there is plenty of fundamental evidence that bonds are blowing up even as the new issue and index market are remaining buoyant."¹⁴²⁰¹⁴²⁰ 8/26/2006 email from Greg Lippmann to Richard Axilrod, DBSI_PSI_EMAIL01618236.

¶On December 12, 2006, with no objection from Mr. Lippmann's desk, Gemstone 7 purchased $5.5 million of SABR 2005-OP1 B4 from Deutsche Bank, the same asset that he had described months earlier as incurring "serious delinquencies."¹⁴²¹¹⁴²¹ Assets Purchased by Gemstone VII CDO during Warehouse Period, GEM7-00001831-33.

¶A third example involved securities issued by Ameriquest Mortgage Securities Inc. (AMSI), which Gemstone purchased from Deutsche Bank's inventory. On April 6, 2006, Mr. Lippmann called AMSI 2005-R7 M8 a "crap name."¹⁴²²¹⁴²² 4/6/2006 email from Greg Lippmann to himself, DBSI_PSI_EMAIL01075218. In a June 16, 2006 email, Mr. Lippmann called AMSI generally a "weakish name."¹⁴²³¹⁴²³ 6/16/2006 email from Greg Lippmann to Rocky Kurita, DBSI_PSI_EMAIL01314036. On December 12, 2006, Gemstone 7 purchased $5 million of another RMBS, AMSI 2005-R11 M10, with no objection from the Lippmann trading desk.¹⁴²⁴¹⁴²⁴ Assets Purchased by Gemstone VII CDO during Warehouse Period. GEM7-00001831-33.

¶In still another instance, Deutsche Bank praised its sales force for placing a security it was having difficulty selling as the underwriter, Deutsche Alt-A Securities Inc. (DBALT) 2006- AR6, in Gemstone 7. On November 17, 2006, the Deutsche Bank Option Arms Desk sent the following email, "The Arms Desk would like to express its sincere appreciation to the sales force for an outstanding job in helping us place the bonds off DBALT 06-AR6. Thanks a lot!!"¹⁴²⁵¹⁴²⁵ 11/17/2006 email from Deutsche Arms to Deutsche Bank employees, DBSI_PSI_EMAIL01831021; 11/14/2006 email from Deutsche Arms to Deutsche Bank employees, DBSI_PSI_EMAIL01822045. DBALT was "one of Deutsche Bank's own shelf offerings." 3/21/2011 letter from Deutsche Bank's counsel to the Subcommittee, PSI- Deutsche_Bank-32-0001-04. Less than two weeks later, on November 29, 2006, a member of the Deutsche Bank sales force wrote: "Some success in CMO [collateralized mortgage obligation] land today: Sold 9 mm [million] DBALT 06-AR6 M10 (Ba2/BBB-) to HBK. This class was never sold in the new issue marketing."¹⁴²⁶¹⁴²⁶ 11/29/2006 email from Larry Pike to Eleanny Pichardo and others, DB_PSI_01731794. HBK records indicate that, the next day, it agreed to purchase $8.8 million of DBALT 2006-AR6 M10.¹⁴²⁷¹⁴²⁷ 11/30/2006 email from Jason Lowry at HBK to Abhayad Kamat and others, GEM7-00005480. See also Assets Purchased by Gemstone VII CDO during Warehouse Period, GEM7-00001831-33.

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¶Many investors would likely have found the negative views of Mr. Lippmann, Deutsche Bank's top CDO trader, important to their decision as to whether or not to buy Gemstone 7, but his views, as described above, were not disclosed to them. At the time, the traders on his desk as well as other Deutsche Bank CDO personnel knew that many clients valued and relied on Mr. Lippmann's opinion when making investment decisions, yet did not disclose his views of the specific assets included in Gemstone 7.¹⁴²⁸¹⁴²⁸ See 7/6/2006 email from Axel Kunde to Greg Lippmann, DBSI_PSI_EMAIL01374694 ("If you tell the sales guy the bond is really bad his investor will use that as an argument against us and demand we buy back his note, because he trusted DB [Deutsche Bank] to pick a good portfolio etc, etc."). M&T Bank told the Subcommittee that had it known about Mr. Lippmann's views, it might have "thought twice" before purchasing Gemstone 7 securities.¹⁴²⁹¹⁴²⁹ Subcommittee Interview of M&T (9/20/2010).

¶(d) Gemstone Sales Effort

¶Deutsche Bank began aggressively marketing Gemstone 7 to investors beginning in January 2007.¹⁴³⁰¹⁴³⁰ See, e.g., 1/25/2007 Deutsche Bank internal email chain, DB_PSI_00346491-99, at 99. The bank communicated with potential investors about Gemstone 7 in a variety of ways, including through emails, telephone calls, face to face meetings, and at conferences. Deutsche Bank personnel also went on what they called "road shows" to cities around the world, to meet investors and pitch the CDO to them.¹⁴³¹¹⁴³¹ Subcommittee interview of Sean Whelan (9/22/2010). Sean Whelan, co-head of the Deutsche Bank CDO sales force, and Ilinca Bogza, a vice president in the Deutsche Bank syndicate group, worked to market Gemstone 7 to investors, including by scheduling road shows and personal meetings with potential investors.

¶Investors were typically shown a "Debt Investor Presentation" that had been prepared by HBK and Deutsche Bank.¹⁴³²¹⁴³² See, e.g., 1/2007 Gemstone 7 Debt Investor Presentation, DBSI_PSI_EMAIL01980000-60 and 2/8/2007 Gemstone 7 Debt Investor Presentation, GEM7-00001687-1747. That presentation provided an overview of the transaction, a description of HBK's organization, and its investment strategy. The presentation highlighted investment considerations, including HBK's expertise in the capital markets, how its structured products exhibit relatively stable performance, and their low default history. The presentation also contained a description of HBK's analytical systems and surveillance capabilities, and included an appendix describing the risk factors for the deal. HBK told the Subcommittee that its employees attended investor meetings, and were at times called upon to answer questions, but did not always participate in the Gemstone 7 sales efforts which were led by Deutsche Bank.¹⁴³³¹⁴³³ Subcommittee interview of Kevin Jenks (10/13/2010).

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¶One Gemstone investor, M&T Bank, told the Subcommittee that, after observing a presentation made by Mr. Jenks and receiving Deutsche Bank's assurances in connection with its solicitation efforts, it believed that Gemstone 7 securities posed minimal investment risk.¹⁴³⁴¹⁴³⁴ Subcommittee interview of M&T (9/20/2010). According to the transcript of a telephone call on February 5, 2007, Sean Whelan of Deutsche Bank's sales force pitched the Gemstone 7 deal to M&T Bank and stated in part: "If you indicate early, like Gemstone deals go very well, and this deal will all go very well and it will get oversubscribed."¹⁴³⁵¹⁴³⁵ 2/5/2007 telephone transcript between Sean Whelan and Alex Craig of M&T, MTSS000920-25, at 22. The following day, February 6, 2007, Mr. Whelan again pitched the deal to M&T and stated that Gemstone 7 "was like a lay up."¹⁴³⁶¹⁴³⁶ 2/6/2007 telephone transcript between Sean Whelan, Alex Craig, and David Borchard of M&T, MTSS000929- 31, at 31. When asked about these comments, Mr. Whelan told the Subcommittee that what he meant was that working with a quality hedge fund like HBK was a "lay up," not that the Gemstone 7 deal itself was a "lay up."¹⁴³⁷¹⁴³⁷ Subcommittee interview of Sean Whelan (9/22/2010). With regards to his comment about oversubscription, he said he was referring to the tranches that M&T Bank was considering purchasing, which ultimately were fully subscribed.¹⁴³⁸¹⁴³⁸ Id.

¶In early 2007, as the closing date for Gemstone 7 neared, the Deutsche Bank sales force was having difficulty getting commitments from investors to buy Gemstone securities. Many investors who were solicited declined to invest because of concerns about the high concentration in subprime RMBS with BBB or BB ratings.¹⁴³⁹¹⁴³⁹ See spreadsheet containing potential investor feedback regarding Gemstone 7, DBSI_PSI00117568. In the beginning of 2007, there was a general lack of buyer interest in mortgage related securities in the United States, other than from new CDOs purchasing CDO securities from prior deals. It was not the first time, however, that a Gemstone deal involving Deutsche Bank and HBK could not be fully sold. HBK had conditioned Deutsche Bank's participation in Gemstone 7 on its purchasing unsold securities from Gemstone 4 and 5, BB rated securities that HBK still had on its books for $13.1 million. In an email sent to a colleague, an HBK Managing Director Jamiel Akhtar wrote:

"As a condition for receiving the underwriting mandate, Kevin [Jenks] and I insisted that DB [Deutsche Bank] buy from us the $13.1mm of BB rated CDO liabilities HBK retained on its own books from Gemstone IV and V. This was a fairly sharp-elbowed tactic on our part, as the BB bonds are the worst part of the capital structure, but I felt like we should be sharp-elbowed with DB right now."¹⁴⁴⁰¹⁴⁴⁰ 10/5/2006 email from Jamiel Akhtar at HBK to Jon Mosle at HBK, GEM7-00006353.

¶The head of Deutsche Bank's CDO Group, Michael Lamont, sent an email to the CDO Group banker assigned lead responsibility for structuring Gemstone 7, acknowledging the risk the bank took on by purchasing the earlier unsold securities, but also noting the "nice" fee being paid to the bank: "[T]hat is part of the risk we took when we were awarded the mandate and we are still making a nice all in fee."¹⁴⁴¹¹⁴⁴¹ 2/8/2007 email from Michael Lamont to Abhayad Kamat, DBSI_PSI_EMAIL04045219-24. When Deutsche Bank told HBK that it intended to resell the Gemstone 4 and 5 securities, the HBK official indicated it was "ok with that as long as it is not blasted out to everyone so as not to affect his current deal [Gemstone 7] in the market."¹⁴⁴²¹⁴⁴² Id. at 24. Deutsche Bank and HBK did not disclose in the Gemstone 7 offering materials both the bank's purchase of the Gemstone 4 and 5 securities as a precondition to the deal and the bank's plan to sell the Gemstone 4 and 5 securities contemporaneously with the Gemstone 7 securities.

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¶Struggle to Sell Gemstone. Evidence obtained by the Subcommittee shows that both HBK and Deutsche Bank were concerned about their exposure should Gemstone 7 not be fully subscribed and worked hard to sell the deal in the face of U.S. investor disinterest.¹⁴⁴³¹⁴⁴³ Subcommittee interview of Kevin Jenks (10/13/2010). Mr. Jenks recalled that there were more non U.S. investors in CDOs in 2007, but he believed that was because there was not much of a CDO market in Europe. Subcommittee interview of Kevin Jenks (10/13/2010). Mr. Whelan told the Subcommittee that in 2006 and 2007, CDO subscription was "spotty." Subcommittee interview of Sean Whelan (9/22/2010). According to the terms of the Gemstone deal, if the securities were not fully sold, the risk of the first $80 million in losses would fall on HBK, while all remaining losses would fall on Deutsche Bank.¹⁴⁴⁴¹⁴⁴⁴ 12/20/2006 Gemstone 7 Securitization Credit Report, DB_PSI_00237655-71. On February 27, 2007, Mr. Kamat of Deutsche Bank wrote to Mr. Jenks of HBK about selling the Gemstone 4 and 5 securities and brought up the CDO Group's need to reduce risk: "[W]e are trying to reduce our exposure right now given internal very senior mgmt review of our business." Mr. Jenks responded: "We are also trying to reduce exposure."¹⁴⁴⁵¹⁴⁴⁵ 2/27/2007 email between Abhayad Kamat and Kevin Jenks, DB_PSI_00421609 (discussing potential exposure due to purchase of earlier Gemstone 4 and 5 tranches in Gemstone 7).

¶In January 2007, Michael Lamont, head of Deutsche Bank's CDO Group, and Mr. Jenks, the HBK collateral manager, discussed the urgency of selling Gemstone 7 in the face of a deteriorating market. On January 9, 2007, Mr. Jenks wrote to Mr. Lamont: "[W]ith this market this way and probably going to get worse we would like to really move on the cdo. Please allocate the resources to expedite this." Four minutes later Mr. Lamont responded: "[W]e are focused on this as well. We don't have a deal in the market and you will be first."¹⁴⁴⁶¹⁴⁴⁶ 1/9/2007 email chain between Michael Lamont and Kevin Jenks, GEM7-00002156.

¶Several developments in early 2007 signaled problems in the mortgage industry. On January 29, 2007, subprime lender Fremont Investment & Loan announced that it had "severed ties" with 8,000 brokers whose loans had high delinquency rates.¹⁴⁴⁷¹⁴⁴⁷ 2/1/2007 S&P internal email, "Defaults cause Fremont to end ties to 8,000 brokers," Hearing Exhibit 4/23-93d. The following week on February 7, 2007, New Century, another major subprime lender, disclosed in a conference call with investors that "the level of early-payment defaults and loan repurchases [had] led to tighter underwriting guidelines," that its nonprime loan production would be declining, and that it would be restating its earnings.¹⁴⁴⁸¹⁴⁴⁸ "New Century plunges on loan production," MarketWatch (2/8/2007), http://www.marketwatch.com/story/new- centurys-shares-punished-over-loan-production-warning. On the day before the New Century conference call, Deutsche Bank received a request from HBK to approve a New Century asset purchase for the Gemstone 7 deal and approved this request on February 9. See 2/9/2007 email from Jordan Milman to Ashley Bonilla at HBK, DB_PSI_00845552.Show full note An additional warning to the market that occurred as Gemstone was being marketed to investors was the plunge in the ABX Index that tracked the value of subprime RMBS securities. In February 2007, the ABX Index fell from a high of $0.90 early in the month to $0.69 by the end of the month, indicating a drop of more than 23% in the value of subprime RMBS securities.¹⁴⁴⁹¹⁴⁴⁹ On Feb. 23, 2007, MarketWatch announced: "The ABX.HE index that tracks CDS on the riskiest subprime loans, rated BBB-, that were sold in the second half of 2006 fell to $0.69 on Friday, according to Markit.com, which administers the indexes. That's down from $0.72 on Thursday and $0.79 at the beginning of the week. In early February, this index was above 90." "Subprime mortgage derivatives index plunges; Bankruptcies, losses in subprime home loan industry spark drop," MarketWatch (2/23/2007), http://www.marketwatch.com/story/index-of- subprime-mortgage-derivatives-plunges-on-sector-woes.Show full note These and other events affected both the RMBS and CDO markets, since so many CDOs included or referenced subprime RMBS securities.

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¶Emails reviewed by the Subcommittee show that CDO personnel at Deutsche Bank were well aware of the worsening CDO market and were rushing to sell Gemstone 7 before the market collapsed. On February 7, 2007, Mr. Lippmann, reacting to the New Century developments, raised concerns with Mr. Lamont about the ability of Deutsche Bank to continue to sell CDO securities: "I was calling about warehouse marks and distribution risk b/c [because] hearing rumors about other dealers having big trouble placing this stuff."¹⁴⁵⁰¹⁴⁵⁰ 2/7/2007 email from Greg Lippmann to Michael Lamont, DBSI_PSI_EMAIL02366193-96, at 94. When Mr. Lamont heard about the New Century developments he wrote: "yikes. I think we will stay short a while." 2/7/2007 email from Michael Lamont to Greg Lippmann, DBSI_PSI_EMAIL02366194. The next day, February 8, 2007, Mr. Lamont told Abhayad Kamat, the CDO Group employee structuring Gemstone 7: "[R]egardless we need to sell it [Gemstone 7] now while we still can."¹⁴⁵¹¹⁴⁵¹ 2/8/2007 email from Michael Lamont to Abhayad Kamat, DBSI_PSI_EMAIL04045219-24. The same day, Mr. Lamont wrote to Mr. Jenks at HBK: "Keep your fingers crossed but I think we will price this just before the market falls off a cliff."¹⁴⁵²¹⁴⁵² 2/8/2007 email from Michael Lamont to Kevin Jenks, DBSI_PSI_EMAIL04045360. The next day, February 9, 2007, Ilinca Bogza, of the Deutsche Bank syndicate group, wrote to Mr. Lamont: "Jenks just called me. … He is frightened that accounts will pull their orders given the widening in abx today. … He mentioned he was going to give you a call. He is very nervous."¹⁴⁵³¹⁴⁵³ 2/9/2007 email from Ilinca Bogza to Michael Lamont, DBSI_PSI_EMAIL04047421-23.

¶On February 13, 2007, the head of Deutsche Bank's syndicate group, Anthony Pawlowski, wrote to Mr. Lamont: "I am not sure how to push guys upstairs without having them crack. Everyone wants to price this deal asap (Sean Whelan [co-head of Deutsche Bank's CDO sales force] is pushing for Friday to lock up his guys on the AAA and AA)[.] Let me know."¹⁴⁵⁴¹⁴⁵⁴ 2/13/2007 email from Anthony Pawlowski at Deutsche Bank to Michael Lamont, DBSI_PSI_EMAIL04049521. A week later, on February 20, 2007, Mr. Lamont wrote to Deutsche Bank syndicate to ask:

"[O]n our managed mezz[anine] abs [asset backed security] CDOs last year what was the split by risk tranche across deals between real money and cdo warehouses. The street may be pulling back so this would be good info to have as we think about how we are going to place risk."¹⁴⁵⁵¹⁴⁵⁵ 2/20/2007 email from Michael Lamont to Ilinca Bogza, DBSI_PSI_EMAIL04054492. On February 20, 2007, a client of Mr. Lippmann's who was looking to short more RMBS commented in an email to him about the negative news concerning Novastar Financial Inc., which announced losses that day. His client described the situation in the market "like the plague." 2/20/2007 email from Steven Eisman at Frontpoint Partners to Greg Lippmann, DBSI_PSI_EMAIL02008182.Show full note

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¶In one odd instance, Ms. Bogza, from the CDO syndicate, sent an email to the Deutsche Bank sales force suggesting that Gemstone 7 was experiencing greater investor interest than it really was. The February 20, 2007 email by Ms. Bogza stated that the bank had received an "indication of [investor] interest" in 75% of the BBB securities in Gemstone 7.¹⁴⁵⁶¹⁴⁵⁶ 2/20/2007 email from Ilinca Bogza to sales force, DBSI_PSI_EMAIL02007608. After receiving this email, Mr. Lippmann wrote to Ms. Bogza: "[W]ow that much interest in the bbb? Is that real?? We would take as much as you can oversell."¹⁴⁵⁷¹⁴⁵⁷ 2/20/2007 email from Greg Lippmann to Ilinca Bogza, DBSI_PSI_EMAIL02007608. Ms. Bogza responded: "no. that is def[initely] not real .. it is at 50%.; cant oversell any tranche to be honest," to which Mr. Lippmann responded: "very sneaky."¹⁴⁵⁸¹⁴⁵⁸ 2/20/2007 email between Greg Lippmann and Ilinca Bogza, DBSI_PSI_EMAIL02007794.

¶In late February, as the market continued to deteriorate, Deutsche Bank attempted to motivate its employees to sell Gemstone 7 by providing special incentives to its sales force for selling the deal. On February 21, 2007, Mr. Kamat wrote to Ms. Bogza: "[W]e need help on selling the As and BBBs in the Gemstone CDO 7 transaction – we have nearly 50% unsold on both tranches in the transaction."¹⁴⁵⁹¹⁴⁵⁹ 2/21/2007 email from Abhayad Kamat to Ilinca Bogza, DBSI_PSI_EMAIL04055827. In another email the same day, he wrote: "[S]hould we offer more PCs for Gemstone 7 CDO given the market?"¹⁴⁶⁰¹⁴⁶⁰ Id. "PCs" refers to Production Credits, which were used to boost a salesperson's compensation including through an end-of-year bonus. Later the same night, Mr. Kamat sent an email to the co-head of the CDO Group seeking to increase the Production Credits that could be awarded for selling Gemstone 7: "[D]ouble digit PCs? I guess my original offer of 300 on single-As and 600 on triple-Bs is too low … what can we offer?"¹⁴⁶¹¹⁴⁶¹ 2/21/2007 email from Abhayad Kamat at Deutsche Bank to Michael Lamont and others at Deutsche Bank, DBSI_PSI_EMAIL04056326-36.

¶Showing Investors Higher Marks. As the value of mortgage related assets grew more volatile, some potential investors in Gemstone 7 inquired about the mark to market (MTM) value of the CDO's underlying assets. MTM is a valuation method by which the current value of an asset is recorded on a firm's books at the price it would sell in the marketplace on the day it is marked. Investors at times inquire about MTM values to determine if the underlying assets of a CDO have dropped in value since their inclusion in the warehouse account. Traders who closely follow buy and sell activity for a particular class of assets are generally best able to provide the most accurate current valuation. At Deutsche Bank, the CDO Trading Desk marked the value of assets monthly as a service to its clients and at times provided this service to HBK for the assets underlying Gemstone 7.¹⁴⁶²¹⁴⁶² 3/27/2007 email from Richard Leclezio at Deutsche Bank to Jordan Milman noting that HBK has requested marks from Deutsche Bank, DB_PSI_00423053-61. HBK also prepared its own internal marks valuing Gemstone's assets. According to both Deutsche Bank and HBK, assigning a mark is a very complicated process that involves credit analysis of the securities at issue. Both explained it was not unusual for different entities to mark an asset differently.¹⁴⁶³¹⁴⁶³ Subcommittee interview of Jordan Milman (10/22/2010). Subcommittee interview of Kevin Jenks (10/13/2010).

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¶During the marketing phase of Gemstone 7, documents indicate several potential investors asked Deutsche Bank to provide MTM values for the underlying assets in the CDO. In response, those potential investors were given HBK's marks, rather than the generally lower valuations assigned to the assets by Deutsche Bank's CDO Trading Desk. On January 23, 2007, Mr. Kamat sent an email to HBK explaining that some potential investors had requested marks for the Gemstone 7 assets:

"Some investors are asking for current marks on the Gemstone 7 CDO portfolio. The attached file has the purchase price and the current marks that we got from our desk. There are many bonds where the price difference between purchase price and current mark is more than 4% .… I have asked Jordan [Milman, a Deutsche Bank trader] to review the marks but it would be great if you could have someone at HBK review also to check if the current marks seem correct. It seems as if the entire portfolio price has dropped since purchase by 1.74% which does not show well to investors."¹⁴⁶⁴¹⁴⁶⁴ 1/23/2007 email from Abhayad Kamat to HBK, GEM7-00003101. This document has HBK showing a loss of $9.4 million in the value of the Gemstone assets, whereas Deutsche Bank showed a loss of $19 million. In interviews with the Subcommittee, both Mr. Milman and Mr. Lippmann said that a 1.74% drop would not have concerned them because of the relative small dollars involved compared to the $1.1 billion deal.Show full note

¶Before he heard back from HBK, Mr. Kamat sent a very similar request to Mr. Milman to review the marks to verify them. He wrote:

"There are many [Gemstone 7] bonds where the price difference between purchase price and the current mark is more than 4% .… Before we send these over to CDO investors, pls could you review to check if the current marks are correct. It seems as if the entire portfolio price has dropped since purchase by 1.74% which does not show well to investors."¹⁴⁶⁵¹⁴⁶⁵ 1/23/2007 email from Abhayad Kamat to Jordan Milman, DB_PSI_00465462.

¶The next day, a Deutsche Bank trader verified the marks: "I checked the names that Abhayad [Kamat] highlighted [and] most are marked within the recent color[.] [T]here are 4 which should be tightened."¹⁴⁶⁶¹⁴⁶⁶ 1/24/2007 email from Jashin Patel to Jordan Milman, DB_PSI_00843917.

¶On January 23, 2007, Mr. Kamat learned that HBK's marks showed a loss of 0.9% or $9.4 million in the Gemstone 7 portfolio, while Deutsche Bank's marks showed a greater loss of 1.7% or $19 million.¹⁴⁶⁷¹⁴⁶⁷ 1/23/2007 email from Abhayad Kamat to HBK, GEM7-00003101. On January 24, 2007, Mr. Kamat directed Deutsche Bank's syndicate group to share HBK's marks with investors instead of Deutsche Bank's. He wrote: "[F]or investors who have asked for current marks on the Gemstone CDO 7 portfolio, tell them: HBK says that the overall current portfolio is down USD 9 million."¹⁴⁶⁸¹⁴⁶⁸ 1/24/2007 email from Abhayad Kamat to Chehao Lu and others at Deutsche Bank, DB_PSI_00741750-52.

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¶A couple weeks later, a question arose about using Deutsche Bank marks for Gemstone 7. On February 7, 2007, Ms. Bogza from the syndicate group wrote to Mr. Kamat: "Why can we not show a priced [marked] portfolio?? We need to show this [to investors]." Mr. Kamat responded: "[T]he marks we got from Jordan are too low … and it will take quite some time if we try to take on an exercise where we try to get kevin and jordan to agree on the correct marks."¹⁴⁶⁹¹⁴⁶⁹ 2/7/2007 emails between Abhayad Kamat and Ilinca Bogza, DB_PSI_00434692-96. Mr. Kamat wrote to another colleague later that day: "[U]se this for the current prices to be sent to investors, but please note to investors that this is from HBK."¹⁴⁷⁰¹⁴⁷⁰ 2/7/2007 email from Abhayad Kamat to Chehao Lu, DB_PSI_00711486. HBK also appeared to want to show higher marks to investors. When Mr. Kamat emailed Mr. Jenks seeking marks for the Gemstone 7 portfolio on February 7, Mr. Jenks sent an internal email to an HBK assistant trader. Mr. Jenks wrote: "Need line item marks for cdo portfolio[.] use dec or jan depending on which is better[.] 1471

¶When asked about these documents, Mr. Kamat stated that he advised using HBK's marks instead of Deutsche Bank's marks, because HBK's marks were better due to the collateral manager's familiarity with the assets.¹⁴⁷²¹⁴⁷² Subcommittee interview of Abhayad Kamat (10/8/2010). However, Deutsche Bank's trading desk was one of the biggest traders in RMBS and CDOs on Wall Street, making it unlikely that the desk could not adequately price the assets that it traded. Deutsche Bank also chose not to share both sets of marks with investors; it shared only the HBK marks showing higher asset values.

¶When HBK was asked about this matter, Mr. Jenks told the Subcommittee that he did not authorize Deutsche Bank to give out HBK's marks to investors and would be "surprised" if Deutsche Bank had given out HBK's marks.¹⁴⁷³¹⁴⁷³ Subcommittee interview of Kevin Jenks (10/13/2010). Mr. Jenks only recalled one time when an investor asked Deutsche Bank for Gemstone 7 marks. When the Subcommittee asked several of the investors who ultimately purchased Gemstone securities if they had asked for marks showing the current value of the underlying assets, M&T Bank told the Subcommittee that it did not know to ask for marks.¹⁴⁷⁴¹⁴⁷⁴ Subcommittee interview of M&T (9/20/2010). Standard Chartered, Wachovia, and Commerzbank told the Subcommittee that they did not ask for the marks and it would have been unusual for them to do so. Eight days before the Gemstone CDO closed and its securities issued, HBK estimated that its portfolio marks were down approximately $30 million.¹⁴⁷⁵¹⁴⁷⁵ 3/7/2007 email from Kevin Jenks to Abhayad Kamat, GEM7-00001958.

¶$400 Million of Unsold Securities. The mortgage market continued to worsen in March as Deutsche Bank continued to market the Gemstone securities. On March 8, 2007, one week before the Gemstone 7 deal closed, New Century – the subprime lender whose RMBS securities made up part of Gemstone – filed an 8-K with the SEC which said: "The Company has only been able to fund a portion of its loans this week. In addition, its capacity to fund new originations is substantially limited due to its lenders' restrictions or refusals to allow the

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¶Company to access their financing arrangements."¹⁴⁷⁶¹⁴⁷⁶ 3/8/2007 New Century Financial Corporation 8-K filing with the SEC. Even senior Deutsche Bank management was aware of the problems involving New Century and Fremont during this time period. On March 2, 2007, Mr. Lippmann sent an email to Mr. Misra, copying Mr. D'Albert, with a subject line: "Fremont Shut Down Sub-Prime business" that contained a number of negative news headlines concerning New Century including, "New Century says U.S. attorney conducting criminal probe … New Century says NYSE reviewing transactions in its securities … New Century says SEC requested meeting on restatement." The next day Mr. Misra replied to Mr. Lippmann, "Well, no regrets. Let's hold tight on our shorts now. It will be a bumpy market to market ride but we will prevail." 3/2/2007 and 3/3/2007 email chain between Mr. Lippmann and Mr. Misra, DBSI_PSI_EMAIL02392659-61.Show full note New Century's financial troubles were prominently reported in the financial press on March 11, 2007.¹⁴⁷⁷¹⁴⁷⁷ See, e.g., "Crisis Looms In Market for Mortgages," The New York Times (3/11/2007), http://www.nytimes.com/ 2007/03/11/business/11mortgage.html. ("On March 1, a Wall Street analyst at Bear Stearns wrote an upbeat report on a company that specializes in making mortgages to cash-poor homebuyers. The company, New Century Financial, had already disclosed that a growing number of borrowers were defaulting, and its stock, at around $15, had lost half its value in three weeks. What happened next seems all too familiar to investors who bought technology stocks in 2000 at the breathless urging of Wall Street analysts. Last week, New Century said it would stop making loans and needed emergency financing to survive. The stock collapsed to $3.21.")Show full note On March 15, 2007, the day Gemstone 7 closed, Bear Stearns said that "residential mortgage-related revenue decreased from the prior year period, reflecting weakness in the U.S. residential mortgage-backed securities market. … New Century Financial Corp., which had been a major provider of loans to people with risky credit, said it has lost support from its financial backers and is being delisted from the NYSE."¹⁴⁷⁸¹⁴⁷⁸ "Bear Stearns 1Q profit rises 8 percent on strong results in bonds, credit," Associated Press Financial Wire (3/15/2007). Also see "New Century Understated Debt; Faces SEC Probe, Stock Delisting," Associated Press (3/13/2007), http://www.cnbc.com/id/17590171/New_Century_Understated_Debt_Faces_SEC_Probe_Stock_Delisting; "New Century Subpoenaed, Faces Delisting," Washington Post (3/13/2007), http://www.washingtonpost.com/wp-dyn/content/article/2007/03/13/AR2007031300603.html.Show full note New Century comprised 15% of Gemstone 7.

¶Ultimately $400 million of Gemstone 7 was unsold. Although not contractually obligated to do so, Deutsche Bank agreed to split the unsold $400 million of Gemstone 7 securities between itself and HBK.¹⁴⁷⁹¹⁴⁷⁹ On 3/14/2007, Fred Brettschneider, head of Deutsche Bank institutional sales, wrote: "We believe that we have reached an acceptable compromise with HBK. We will be restructuring the unsold mezz AAA and we will underwrite the senior portion leaving them [HBK] with the junior piece." 3/14/2007 email from Fred Brettschneider to Anshu Jain and others, DBSI_PSI_EMAIL02064810-12. On 3/27/2007, Larry Pike of Deutsche Bank wrote with regard to Gemstone 7, "400mm of the unsold bonds were a middle (mezz) AAA class that were expected to be purchased by an investor who backed out at a late stage due to a deteriorating market. HBK was upset about this and wanted DB to take these bonds down, threatening to curtail business globally with HBK if we didn't." 3/27/2007 email from Larry Pike to Sean Whelan and others, DB_PSI_00859611.Show full note Meetings concerning taking back the $400 million were held at the highest levels of both Deutsche Bank and HBK.¹⁴⁸⁰¹⁴⁸⁰ Subcommittee interview of Michael Lamont (9/29/2010). As Mr. Lippmann put it: "[W]e don't have much choice … either we repo for them or we take it down."¹⁴⁸¹¹⁴⁸¹ Apparently, Mr. Lippmann was explaining that either Deutsche Bank could "repo" or loan money to HBK in order for HBK to purchase the unsold Gemstone 7 securities or Deutsche Bank would have to "take it down" – either purchase the securities itself or liquidate the CDO. 2/20/2007 email from Greg Lippmann to Rich Rizzo at Deutsche Bank, DBSI_PSI_EMAIL02377303.

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¶Deutsche Bank and HBK were unable to sell 36% of the securities and instead kept those securities on their books. Mr. Jenks of HBK told the Subcommittee that he always wanted to know if unsold portions of a CDO he was interested in investing in would be bought back by the underwriter, but he did not know if everyone asked about this.¹⁴⁸²¹⁴⁸² Subcommittee interview of Kevin Jenks (10/13/2010). M&T Bank told the Subcommittee that it would have been useful information, though it would have been more concerned if the tranches it was purchasing were not fully subscribed.¹⁴⁸³¹⁴⁸³ Subcommittee interview of M&T (9/20/2010). In addition, Standard Chartered reported that it didn't know that a portion of the CDO was unsold, and that it would have been information worth knowing but that it wouldn't have ultimately impacted its decision to invest in Gemstone 7. Subcommittee interview of counsel for Standard Chartered (10/14/2010).

¶(e) Gemstone Losses

¶Gemstone 7 closed on March 15, 2007, and received credit ratings from S&P and Moody's on the same day.¹⁴⁸⁴¹⁴⁸⁴ 3/15/2007 letter from S&P to Gemstone CDO VII Ltd, GEM7-00001658-61; 3/15/2007 letter from Moody's to Gemstone CDO VII Ltd., GEM7-00001657. The top three tranches, representing 73% of the value of the CDO, received AAA ratings. The next three tranches received investment grade ratings of AA, A, and BBB.¹⁴⁸⁵¹⁴⁸⁵ Gemstone 7 ratings from S&P's RatingsDirect on the Global Credit Portal, https://www.globalcreditportal.com/ratingsdirect/Login.do, with subscription. The CDO received these ratings even though one third of its underlying assets carried non-investment grade ratings.

¶Eight months later, in November 2007, five of its seven tranches were downgraded, including one of its AAA rated tranches. By July 2008, all seven tranches had been downgraded to junk status, and the Gemstone securities were nearly worthless. This chart, using S&P data, displays the downgrades.¹⁴⁸⁶¹⁴⁸⁶ Chart prepared by the Subcommittee using data from S&P's RatingsDirect on the Global Credit Portal, https://www.globalcreditportal.com/ratingsdirect/Login.do, with subscription.

¶Gemstone VII Ratings by Tranche

¶Tranche Initial Rating: Date 1st Downgrade: Date 2nd Downgrade: Date 3rd Downgrade: Date Class A-1a AAA: March 15, 2007 A+: Feb. 5, 2008 BB+: July 11, 2008 CC: August 19, 2009 Class A-1b AAA: March 15, 2007 B-: Feb. 5, 2008 CC: July 11, 2008 n/a Class A-2 AAA: March 15, 2007 AA-: Nov. 21, 2007 CCC-: Feb. 5, 2008 CC: July 11, 2008 Class B AA: March 15, 2007 BBB: Nov. 21, 2007 CC: Feb. 5, 2008 n/a Class C A: March 15, 2007 B-: Nov. 21, 2007 CC: Feb. 5, 2008 n/a Class D BBB: March 15, 2007 CCC+: Nov. 21, 2007 CC: Feb. 5, 2008 n/a Class E BB+: March 15, 2007 CCC: Nov. 21, 2007 CC: Feb. 5, 2008 n/a Preference Shares Not rated Source: S&P

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¶Investors contacted by the Subcommittee reported that they had lost all or most of their investments. In June 2008, M&T Bank wrote down the value of its Gemstone 7 securities to about 2% of their original value – from $82 million to $1.87 million.1487 Wachovia Bank told the Subcommittee that its $40 million investment in Gemstone paid out approximately $3 million from 2007-2010, but is currently worth nothing.¹⁴⁸⁸¹⁴⁸⁸ 11/19/2010, 11/23/2010 emails from counsel of Wachovia to Subcommittee staff. Standard Chartered Bank told the Subcommittee that, in 2008, it liquidated its Gemstone investment and received approximately 25-30% of its initial $224 million investment.1489 Commerzbank told the Subcommittee that its initial $16 million investment in Gemstone is currently worth nothing.¹⁴⁹⁰¹⁴⁹⁰ 12/7/2010 email from counsel of Commerzbank to Subcommittee staff.

¶(6) Other Deutsche Bank CDOs

¶Gemstone 7 was only one of many CDOs that Deutsche Bank assembled and underwrote as the mortgage market deteriorated in 2007. From December 2006 through December 2007, Deutsche Bank issued 15 new CDOs with assets totaling $11.5 billion.¹⁴⁹¹¹⁴⁹¹ ABS CDOs Issued by DBSI (between 2004 and 2008), PSI-Deutsche_Bank-02-0005-23. The Subcommittee did not examine these CDOs, but a brief discussion of a few shows that the bank's issuance of high risk mortgage related assets was not confined to Gemstone 7.

¶Magnetar CDOs. Magnetar is a Chicago based hedge fund that, according to press reports, worked with several financial institutions to create CDOs with riskier assets and then bet on those CDOs to fail.¹⁴⁹²¹⁴⁹² See, e.g., "The Magnetar Trade: How One Hedge Fund Helped Keep the Bubble Going," ProPublica (4/9/2010), http://www.propublica.org/article/the-magnetar-trade-how-one-hedge-fund-helped-keep-the-housing-bubble-going. Deutsche Bank underwrote one of those CDOs and served as trustee for two other Magnetar CDOs.

¶According to press reports, Magnetar's investment strategy was to purchase the riskiest portion of a CDO – the equity – and, at the same time, to purchase short positions on other tranches of the same CDO.¹⁴⁹³¹⁴⁹³ Id. Thus, Magnetar would receive a large return on the equity if the security did well, but would also receive a substantial payment from its short positions if the securities lost value. This strategy was dubbed by some as the "Magnetar Trade." It apparently generated large profits for Magnetar. By the end of 2007, when the market was in turmoil, Magnetar's Constellation Fund was up 76% and its Capital Fund was up 26%.¹⁴⁹⁴¹⁴⁹⁴ "Magnetar's Exit: A Deal So Bad Even a Credit-Rating Agency Balked," ProPublica (4/9/2010), http://www.propublica.org/article/magnetars-exit-a-deal-so-bad-even-a-credit-rating-agency-balked.

¶Mr. Lippmann disapproved of the Magnetar CDOs.¹⁴⁹⁵¹⁴⁹⁵ Subcommittee interview of Greg Lippmann (10/18/2010). In August 2006, when an investor asked Mr. Lippmann about Magnetar, he responded that it was a "Chicago based hedge fund that is buying tons of cdo equity and shorting the single names .… [T]hey are buying equity and shorting the single names … a bit devious."¹⁴⁹⁶¹⁴⁹⁶ 8/23/2006 email from Jeremy Coon at Passport Management to Greg Lippmann, DBSI_PSI_EMAIL01603121. In another email, when asked how Magnetar distorted the market, Mr. Lippmann responded, "easy but lengthy answer get him on the phone and call me." 8/31/2006 email from Warren Dowd at Deutsche Bank to Greg Lippmann, DBSI_PSI_EMAIL01641089.

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¶In May 2006, Magnetar created its first CDO, Orion 2006-1 Ltd., a $1.3 billion hybrid CDO with cash and synthetic assets.¹⁴⁹⁷¹⁴⁹⁷ See Loreley Financing v. Credit Agricole Corporate and Investment Bank, (N.Y. Sup.), (10/29/2010). Orion 2006-1 is one of two Magnetar CDOs that are the subjects of this lawsuit filed by Loreley Financing, a European- based investment fund, and Crédit Agricole, a French bank. See also "Magnetar Deals at Center of New Lawsuit," ProPublica (10/25/2010), http://www.propublica.org/article/magnetar-deals-at-center-of-new-lawsuit.Show full note The CDO closed on May 26, 2006, and was underwritten by Calyon and managed by NIBC Credit Management, Inc.¹⁴⁹⁸¹⁴⁹⁸ See Loreley Financing v. Credit Agricole Corporate and Investment Bank, (N.Y, Sup.), (10/29/2010) (alleging Calyon permitted Magnetar to select poor assets for the two Magnetar CDOs and fraudulently induced investors to purchase the securities). Deutsche Bank's Special Situations Group purchased equity in Orion, and helped create the CDO.¹⁴⁹⁹¹⁴⁹⁹ "Magnetar Gets Started," ProPublica (4/9/2010), http://www.propublica.org/article/magnetar-gets-started; Loreley Financing v. Credit Agricole Corporate and Investment Bank, (N.Y. Sup.), (10/29/2010). A Deutsche Bank employee, Michael Henriques, who worked on Orion as managing director of the Special Situations Group, left Deutsche Bank and ultimately went to work for Magnetar.¹⁵⁰⁰¹⁵⁰⁰ Loreley Financing v. Credit Agricole Corporate and Investment Bank, (N.Y. Sup.), (10/29/2010).

¶Although Orion received investment grade ratings from Fitch and Moody's in June 2006,¹⁵⁰¹¹⁵⁰¹ "Fitch Rates Orion 2006-1, Ltd./LLC.," BusinessWire (5/26/2006), http://www.thefreelibrary.com/Fitch+Rates+Orion+2006-1,+Ltd.%2FLLC.-a0146274727; 6/9/2006 "$292.5 Million of Debt Securities Rated, $936 Million of Senior Credit Swap Risk Rated," Moody's, http://v3.moodys.com/viewresearchdoc.aspx?docid=PR_109282. a little over a year later, on August 21, 2007, Fitch issued the first of several rating downgrades.¹⁵⁰²¹⁵⁰² Fitch downgraded the CDO's Class A notes from AAA to AA, the Class B notes from AA to A-, the Class C notes from A to BB, and the Class D notes from BBB to B+. "Fitch Downgrades $289MM of Orion 2006-1, Ltd.," BusinessWire (8/21/2007), http://www.highbeam.com/doc/1G1-167859601.html. In November 2007, Moody's downgraded the Class A notes six notches and the Class B notes seven notches.¹⁵⁰³¹⁵⁰³ 11/1/2007 "Moody's takes neg action on Orion 2006-1," Moody's, http://v3.moodys.com/viewresearchdoc.aspx?docid=PR_143474. By May 2008, every class of Orion's securities had been downgraded to junk status.¹⁵⁰⁴¹⁵⁰⁴ 10/28/2010 "Moody's lowers ratings of 95 Notes issued by 56 structured finance CDO transactions," Moody's, http://v3.moodys.com/viewresearchdoc.aspx?docid=PR_208444.

¶START CDOs. Deutsche Bank also underwrote six START CDOs with a combined value of $5.25 billion from June 2005 to December 2006.¹⁵⁰⁵¹⁵⁰⁵ They included Static Residential 2005-A for $1 billion; Static Residential 2005-B for $1 billion; Static Residential 2005-C for $500 million; Static Residential 2006-A for $1 billion; Static Residential 2006-B for $1 billion; and Static Residential 2006-C for $750 million. Chart, ABS CDOs Issued by DBSI (between 2004 and 2008), PSI-Deutsche_Bank-02-0005-23. In one of the deals, Deutsche Bank worked with Elliot Advisors, a hedge fund that bought the equity tranche in the CDO and simultaneously bought CDS protection against the entire structure, essentially shorting the deal and betting that the value of its assets would fall.¹⁵⁰⁶¹⁵⁰⁶ Subcommittee interview of Michael Lamont (9/29/2010). On four of the deals, Deutsche Bank worked with Paulson Advisors, a hedge fund that bought the equity tranche and apparently shorted the rest of the CDO, while Deutsche Bank sold the rest of the securities.¹⁵⁰⁷¹⁵⁰⁷ Subcommittee interview of Greg Lippmann (10/18/2010). An internal Deutsche Bank email explained one of the 2005 START CDOs as follows:

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"The $1 billion START 2005-B trade was backed by a static pool of CDS on mezzanine RMBS for Paulson Advisors ($4 bln risk arb hedge fund). Paulson retained the bottom 6% of the trade and we sold the rest of the capital structure. Paulson, who came to us with the strong desire to short the U.S. housing market, wrote CDS on underlying ABS (over 100 names) to DB [Deutsche Bank] and DB intermediated them into the deal."¹⁵⁰⁸¹⁵⁰⁸ 10/10/2005 email from Michael Raynes at Deutsche Bank to Greg Lippmann, DBSI_PSI_EMAIL00574452.

¶Mr. Lamont told the Subcommittee that Mr. Paulson shorted the START deals, and he believed investors were aware of that fact. Mr. Lamont told the Subcommittee that Mr. Lippmann's ABS desk shorted the START CDOs only in its role as an intermediary for other clients, which was confirmed by Mr. Lippmann. In an email discussing START with a Deutsche Bank colleague, Mr. Lippmann advised him to buy protection for the bank against START. He wrote: "Start is crap you should short because I bet we'll have to … buyback cash ones next year."¹⁵⁰⁹¹⁵⁰⁹ 12/14/2006 email from Greg Lippmann to Taranjit Sabharwal at Deutsche Bank, DBSI_PSI_EMAIL01895617.

¶Mr. Lippmann told the Subcommittee that Deutsche Bank ended up losing a great deal of money on the START deals. One Deutsche Bank employee wrote to Mr. Lippmann regarding one of the deals in June 2007: "This along with our remaining held inventory if we can't sell away we repack into a CDO 2 balance sheet dump later this summer. Worst case we hold it but it is probably the lesser of two evils (the greater evil being our held START position)."¹⁵¹⁰¹⁵¹⁰ 6/14/2007 email from Richard Kim at Deutsche Bank to Greg Lippmann, DBSI_PSI_EMAIL02202920.

¶(7) Analysis

¶Deutsche Bank was the fourth largest issuer of CDOs in the United States. It continued to issue CDOs after mortgages began losing money at record rates, investor interest waned, and its most senior CDO trader concluded that the mortgage market in general and the specific RMBS securities being included in the bank's own CDOs were going to lose value. Mr. Lippmann derided specific RMBS securities and advised his clients to short them, at the same time his desk was allowing the very same securities to be included or referenced in Gemstone 7, a CDO that the bank was assembling for sale to its clients. In fact, the bank was selling some assets that Mr. Lippmann believed contained "crap." While the Gemstone CDO was constructed and marketed by the bank's CDO Desk, which is separate from the trading desk controlled by Mr. Lippmann, both desks knew of Mr. Lippmann's negative views. The bank managed to sell

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¶$700 million in Gemstone 7 securities which then failed within months, leaving the bank's clients with worthless investments.

¶This case history raises several concerns. The first is that Deutsche Bank allowed the inclusion of Gemstone 7 assets which its most senior CDO trader was asked to review and saw as likely to lose value. Second, the bank sold poor quality assets from its own inventory to the CDO. Third, the bank aggressively marketed the CDO securities to clients despite the negative views of its most senior CDO trader, falling values, and the deteriorating market. Fourth, the bank failed to inform potential investors of Mr. Lippmann's negative views of the underlying assets and its inability to sell over a third of Gemstone's securities. Each of these issues focuses on the poor quality of the financial product that Deutsche Bank helped assemble and sell. Still another concern raised by this case history is the fact that the bank made large proprietary investments in the mortgage market that resulted in multi-billion-dollar losses – losses that, in this instance, did not require taxpayer relief but, due to their size, could have caused material damage to both U.S. investors and the U.S. economy.

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C. Failing to Manage Conflicts of Interest: Case Study of Goldman Sachs

¶The Goldman Sachs case study shows how one investment bank profited from the collapse of the mortgage market and engaged in troubling and sometimes abusive practices that raise multiple conflict of interest concerns. The first part of this case study shows how Goldman used structured finance products, including CDO, CDS, and ABX instruments, to take a proprietary net short position against the subprime mortgage market. Reaching its peak at $13.9 billion, Goldman's net short investments realized record gains for the Structured Products Group in 2007 of over $3.7 billion which, when combined with other mortgage losses, resulted in overall net revenues for Goldman's Mortgage Department of $1.1 billion. The second half of the case study shows how Goldman engaged in securitization practices that magnified risk in the market by selling high risk, poor quality mortgage products to investors around the world. The Hudson, Anderson, Timberwolf, and Abacus CDOs show how Goldman used these financial instruments to transfer risk associated with its high risk assets, assist a favored client make a $1 billion gain, and profit at the direct expense of the clients that invested in the Goldman CDOs. In addition, the case study shows how conflicts of interest related to proprietary investments led Goldman to conceal its adverse financial interests from potential investors, sell investors poor quality investments, and place its financial interests before those of its clients.

¶(1) Subcommittee Investigation and Findings of Fact

¶During the course of its investigation into the Goldman Sachs case study, the Subcommittee issued 13 document subpoenas as well as multiple document request letters to financial institutions, government agencies, hedge funds, due diligence firms, insurance companies, individuals, and others. The Subcommittee obtained tens of millions of pages of documents, including internal reports, memoranda, correspondence, spreadsheets, and email. The Subcommittee conducted over 55 interviews and one deposition, including interviews with a variety of senior executives and Mortgage Department personnel at Goldman Sachs. The Subcommittee also spoke with agency officials, law enforcement, and industry and academic experts in financial products and securities law. On April 27, 2010, the Subcommittee held a hearing which took testimony from Goldman senior executives and current and former employees of its Mortgage Department, and released 173 hearing exhibits.1511 After that hearing, the Subcommittee gathered additional information in post-hearing interviews and through post-hearing questions for the record.1512

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¶In connection with the hearing, the Subcommittee released a joint memorandum from Chairman Levin and Ranking Member Coburn summarizing the investigation to date into the role of the investment banks in the financial crisis. The memorandum contained the following findings of fact, which this Report reaffirms, regarding the Goldman Sachs case study.

Securitizing High Risk Mortgages. From 2004 to 2007, in exchange for lucrative fees, Goldman Sachs helped lenders like Long Beach, Fremont, and New Century, securitize high risk, poor quality loans, obtain favorable credit ratings for the resulting residential mortgage backed securities (RMBS), and sell the RMBS securities to investors, pushing billions of dollars of risky mortgages into the financial system.

Magnifying Risk. Goldman Sachs magnified the impact of toxic mortgages on financial markets by re-securitizing RMBS securities in collateralized debt obligations (CDOs), referencing them in synthetic CDOs, selling the CDO securities to investors, and using credit default swaps and index trading to profit from the failure of the same RMBS and CDO securities it sold.

Shorting the Mortgage Market. As high risk mortgage delinquencies increased, and RMBS and CDO securities began to lose value, Goldman Sachs took a net short position on the mortgage market, remaining net short throughout 2007, and cashed in very large short positions, generating billions of dollars in gain.

Conflict Between Client Interests and Proprietary Trading. In 2007, Goldman Sachs went beyond its role as market maker for clients seeking to buy or sell mortgage related securities, traded billions of dollars in mortgage related assets for the benefit of the firm without disclosing its proprietary positions to clients, and instructed its sales force to sell mortgage related assets, including high risk RMBS and CDO securities that Goldman Sachs wanted to get off its books, and utilizing key roles in CDO transactions to promote its own interests at the expense of investors, creating a conflict between the firm's proprietary interests and the interests of its clients.

Abacus Transaction. Goldman Sachs structured, underwrote, and sold a synthetic CDO called Abacus 2007-AC1, did not disclose to the Moody's analyst overseeing the rating of the CDO that a hedge fund client taking a short position in the CDO had helped to select the referenced assets, and also did not disclose that fact to other investors.

Using Naked Credit Default Swaps. Goldman Sachs used credit default swaps (CDS) on assets it did not own to bet against the mortgage market through single name and index CDS transactions, generating substantial revenues in the process.

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¶(2) Goldman Sachs Background

¶Goldman Sachs was established in 1869 as an investment bank.1513 Originally a private partnership, in 1999, it became a publicly traded corporation. In 2008, it converted to a bank holding company. Its headquarters are located in New York City, and the firm manages about $870 billion in assets.1514 Goldman employs about 14,000 employees in the United States and 32,500 worldwide. In 2007, it reported net revenues of $11.6 billion, of which $3.7 billion was generated by the Structured Products Group in the Mortgage Department, primarily as a result of its subprime investment activities.1515

¶Unlike other Wall Street banks, Goldman has no retail banking operations. It does not accept deposits from, nor lend to, retail customers, nor does its broker-dealer provide advice to or execute trades on behalf of retail customers. Goldman provides services only to so-called "sophisticated" institutional investors, generally large corporations, financial services firms, pension funds, hedge funds, and a few very wealthy individuals.1516

¶For most of its history, Goldman operated exclusively as an investment bank, providing investment advice to corporate clients, arranging and executing mergers and acquisitions, and arranging financing for customers through stock and bond offerings. After the 1999 repeal of the Glass-Steagall Act, which had restricted the activities that could be engaged in by investment banks, Goldman expanded its operations.1517

¶Over the last ten years, traditional investment banking activities have become a small percentage of Goldman's business. Goldman has instead become primarily a Wall Street trading house, providing broker-dealer services to institutional customers, acting as a prime broker to hedge funds,1518 structuring and financing deals for customers from its own capital, and conducting proprietary trading activities for its own benefit. In the years leading up to the financial crisis, Goldman became an active investor and participant in the deals and transactions that it was handling for clients as well as selling to investors.1519

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¶Goldman Sachs Mortgage Department. In 2006 and 2007, the time period reviewed by the Subcommittee, the most senior Goldman executives were the Chairman of the Board and Chief Executive Officer Lloyd Blankfein; Chief Operating Officer and Co-President Gary Cohn; Co-President Jon Winkelried; and Chief Financial Officer David Viniar. Goldman's Chief Risk Officer, Craig Broderick, was head of the Market Risk Management & Analysis area of the firm, which monitored and measured risk for the firm as a whole and for each business unit. Goldman's Treasurer, Sarah Smith, was in charge of the Controllers area of the firm, which was responsible for financial accounting, profit and loss statements, customer credit, collateral/margin matters, and position valuation verification.1520

¶In 2006 and 2007, Goldman Sachs' operating activities were divided into three segments: Investment Banking, Trading and Principal Investments, and Asset Management and Securities Services.1521 The Trading and Principal Investments Segment was divided into three businesses: Fixed Income, Currency and Commodities (FICC); Equities; and Principal Investments.1522 FICC had five principal businesses: commodities; credit products; currencies; interest rate products; and mortgage related securities and loan products and other asset backed instruments.1523

¶In its mortgage business, Goldman Sachs acted as a market maker, underwriter, placement agent, and proprietary trader in residential and commercial mortgage related securities, loan products, and other asset backed and derivative products.1524 The Mortgage Department was responsible for buying and selling virtually all of the firm's mortgage related assets. It originated and invested in residential and commercial mortgage backed securities; developed, traded, and marketed structured products and derivatives backed by mortgages; and traded mortgage market products on exchanges.1525

¶In 2006 and 2007, the head of the Mortgage Department was Daniel Sparks. Goldman Co-Presidents Gary Cohn and Jon Winkelried, as well as CFO David Viniar, had been involved in Mr. Sparks' earlier career at Goldman, and he maintained frequent, direct contact with them regarding the Mortgage Department.1526 In 2006, Mr. Sparks formally reported first to Jonathan Sobel, who had run the Mortgage Department prior to Mr. Sparks.1527 He next reported to Richard Ruzika, who was then co-head of Commodities.1528 In late 2006, Mr. Sparks began reporting directly to Thomas Montag, who was co-head of Global Securities for the Americas, which included both the FICC Division and the Equities Division.1529 In mid-2007, Mr. Sparks began reporting to Donald Mullen, who was head of U.S. Credit Sales & Trading, and Mr. Mullen in turn reported to Mr. Montag.1530

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¶The Mortgage Department was divided into seven different desks: (1) the Residential Whole Loan Trading Desk; (2) the Structured Product Group (SPG) Trading Desk; (3) the CDO Origination Desk, which also handled collateralized loan obligations (CLOs); (4) the Structured Product Syndicate and Asset Backed Security (ABS) Finance Desk; (5) the Collateralized Mortgage Obligations (CMO) and Derivatives Desk; (6) the Advisory Group Desk; and (7) the Commercial Real Estate Loan Trading Desk.1531

¶The Residential Whole Loan Trading Desk was headed by Kevin Gasvoda.1532 It bought packages of residential whole loans; issued RMBS securities in the subprime, Alt A and prime categories; originated residential and commercial mortgages; and gave lines of credit to certain selected mortgage lenders in exchange for direct access to pools of mortgages they originated, in so-called "conduit" arrangements.1533

¶The SPG Trading Desk was headed by Michael Swenson.1534 It was further subdivided into three different desks: the ABS Desk, the Correlation Trading Desk, and the Commercial Mortgage Backed Securities (CMBS) Desk. The ABS Desk was also headed by Michael Swenson and traded mainly synthetic asset backed securities, particularly RMBS and CDO securities and single name CDS contracts related to RMBS and CDOs. The ABS Desk also had an important sub-desk called the ABX Trading Desk, which was headed by Joshua Birnbaum, and traded synthetic mortgage backed securities based on the ABX Index. The Correlation Trading Desk was headed by Jonathan Egol. It structured, marketed, and traded complex synthetic structured finance products, including a series of 23 CDOs known as Abacus.1535 The CMBS Desk was headed by David Lehman and traded commercial mortgage backed securities. With the exception of the Correlation Desk, the SPG Trading Desk was primarily devoted to "secondary trading," meaning the buying and selling of pre-existing asset backed securities. The SPG Trading Desk was also sometimes referred to as the "Mortgage Secondary Trading Desk."

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¶The CDO Origination Desk was headed by Peter Ostrem.1536 This desk structured and originated most of Goldman's CDOs and CLOs, excluding Abacus. The CDO Desk was primarily an underwriting desk that arranged for the issuance of new securities which had not yet been sold in the marketplace. Because of its underwriting focus, the CDO Desk's activities required a higher level of disclosure to customers regarding newly issued securities than was ordinarily required of a secondary trading desk, which buys and sells only pre-existing securities.1537 Goldman maintained an inventory of RMBS and CDO securities to carry out activities for its clients and proprietary trading for the firm.

¶The Structured Product (SP) Syndicate and ABS Finance Desk was headed by Bunty Bohra and Curtis Probst.1538 This desk was often referred to simply as the "Syndicate." It coordinated Goldman's sales efforts and the issuance of different securities across different desks.

¶In the middle of 2007, the Mortgage Department was restructured. One key change was that the CDO Origination Desk was moved into the secondary trading area under the SPG Trading Desk. Mr. Lehman was designated as head of the CDO Origination Desk, with assistance from Mr. Swenson.1539 As a result, the SPG Trading Desk had responsibility for selling new Goldman-originated CDO securities as well as engaging in secondary trading of pre-existing CDOs and RMBS securities, related credit default swaps (CDS), ABX trading, correlation trading, property derivatives, CMBS, and other asset backed securities.1540

¶In 2006 and 2007, the Residential Whole Loan Trading Desk underwrote 93 RMBS worth $72 billion.1541 The CDO Origination Desk acted as a placement agent and underwrote approximately 27 mortgage based CDOs worth $28 billion.1542 Of the 27 CDOs, 84% were hybrid CDOs, 15% were synthetic, and only about 1% were cash CDOs with physical assets.1543 The mortgage-based CDOs included 8 CDOs on the Abacus platform, with $5 billion in issued securities;1544 a $2 billion synthetic CDO known as Hudson Mezzanine 2006-1; a $300 million synthetic CDO known as Anderson Mezzanine 2007-1; and $1 billion hybrid CDO known as Timberwolf I. (3) Overview of Goldman Sachs Case Study

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¶This Report looks at two activities undertaken by Goldman in 2006 and 2007. The first is Goldman's intensive effort, beginning in December 2006 and continuing through 2007, to profit from the subprime mortgage market collapse, particularly by shorting subprime mortgage assets. The second is how, in 2006 and 2007, Goldman used mortgage related CDOs to unload the risk associated with its faltering high risk mortgage assets onto clients, help a favored client make a $1 billion gain, and profit from the failure of the very CDO securities it sold to its clients.

¶(a) Overview of How Goldman Shorted the Subprime Mortgage Market

¶Beginning in December 2006 and continuing through 2007, Goldman twice built and profited from large net short positions in mortgage related securities, generating billions of dollars in gross revenues for the Mortgage Department. Its first net short peaked at about $10 billion in February 2007, and the Mortgage Department as a whole generated first quarter revenues of about $368 million, after deducting losses and writedowns on subprime loan and warehouse inventory.1545 The second net short, referred to by Goldman Chief Financial Officer David Viniar as "the big short,"1546 peaked in June at $13.9 billion. As a result of this net short, the SPG Trading Desk generated third quarter revenues of about $2.8 billion, which were offset by losses on other mortgage desks, but still left the Mortgage Department with more than $741 million in profits.1547 Altogether in 2007, Goldman's net short positions from derivatives generated net revenues of $3.7 billion.1548 These positions were so large and risky that the Mortgage Department repeatedly breached its risk limits, and Goldman's senior management responded by repeatedly giving the Mortgage Department new and higher temporary risk limits to accommodate its trading.1549 At one point in 2007, Goldman's Value-at-Risk measure indicated that the Mortgage Department was contributing 54% of the firm's total market risk, even though it ordinarily contributed only about 2% of its total net revenues.1550

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¶To build its net short positions, Goldman's Mortgage Department personnel used structured finance products to engage in multiple, complex transactions. Its efforts included selling high risk loans, RMBS, CDO, ABX, and other mortgage related assets from its inventory and warehouse accounts; shorting RMBS and CDO securities, either by shorting the assets themselves or by taking the short side of CDS contracts that referenced them, in order to profit from their fall in value; and shorting multiple other mortgage backed assets simultaneously, including different tranches of the ABX Index, tranches of CDOs, and CDS contracts on such assets. To lock in its profits after the short assets fell in value, Goldman often entered into offsetting CDS contracts to "cover its shorts," as explained below. Senior Goldman executives directed and monitored these activities.

¶The evidence reviewed by the Subcommittee shows that some of the transactions leading to Goldman's short positions were undertaken to advance Goldman's own proprietary financial interests and not as a function of its market making role to assist clients in buying or selling assets. In the end, Goldman profited from the failure of many of the RMBS and CDO securities it had underwritten and sold. As Goldman CEO Lloyd Blankfein explained in an internal email to his colleagues in November 2007: "Of course we didn't dodge the mortgage mess. We lost money, then made more than we lost because of shorts."1551

¶Covering Shorts to Lock In Profits. To understand how Goldman profited from its short positions, it is important to understand references in its internal documents to "covering" or "monetizing" its shorts. When Goldman built its short positions, it generally used CDS contracts to short a variety of mortgage related securities, including individual RMBS and CDO securities and baskets of 20 RMBS securities identified in the ABX indices. Goldman's shorts then gained or lost value over time, depending upon how the underlying referenced assets performed during the same period.

¶Most CDS contracts expire after a specified number of years. As explained earlier, during the covered period, the short party makes periodic premium payments to the opposing long party in the CDO. The short party is essentially betting that a "credit event" will take place during the covered period that will result in the long party having to provide it with a large payment that outweighs the cost of the short party's premium payments.1552 However, the short party does not have to wait for a credit event in order to realize a gain on its CDS contract.

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¶One possible alternative is for the short party simply to sell its short position to another party for a profit. If, however, the short party does not want to sell or has no ready buyer, the short party can still lock in a gain by entering into a second, offsetting CDS contract in which it takes the long position on an offsetting asset, an action often referred to as "covering the short."

¶In practice, there were several different, technical methods for a party to cover its short positions. The simplest example is if the short party bought a $100,000 CDS contract whose reference asset is a single RMBS security. Suppose after one month the RMBS security performs so poorly that the market value of the short position increases to $150,000. If the short party wanted to lock in the $50,000 gain, it could do so simply by entering into a new offsetting CDS contract, referencing the same RMBS security, in which it takes the long position with a new party who takes the short position at the new higher market value of $150,000. The result would be that the original short party would own a short position and a long position that offset each other, and would lock in the $50,000 difference in value as profit.

¶During 2007, Goldman executives repeatedly directed the Mortgage Department to "cover its shorts" and lock in the gains from the increased value of its short positions. When it covered its short positions by entering into offsetting contracts, the Mortgage Department simultaneously "monetized" its short positions – recorded the locked in profit. That is because, when it covered a short by entering into an offsetting contract, the Mortgage Department's general practice was to record a profit on its books equal to the gain on the original short position. Because the original purchase price of the CDS was known and fixed, and the new higher price obtained in the offsetting transaction was known and fixed, the Mortgage Department was able to capture the difference between the two prices as profit.

¶Going Past Home: The First Net Short. Because Goldman's activities were so varied and complex during the period reviewed, this overview provides a brief summary of the key events detailed in the following sections. The review begins in mid to late 2006, when Goldman realized that the market for subprime mortgage backed securities was beginning to decline, and the large long positions it held in ABX assets, loans, RMBS and CDO securities, and other mortgage related assets began to pose a disproportionate risk to both the Mortgage Department and the firm.1553 In October 2006, the Mortgage Department designed a synthetic CDO called

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¶Hudson Mezzanine 2006-1, which included over $1.2 billion of long positions on CDS contracts to offset risk associated with ABX assets in Goldman's own inventory and another $800 million in single name CDS contracts referencing subprime RMBS securities that Goldman wanted to short; the Mortgage Department then sold the Hudson securities to its clients.1554 While this CDO transferred $1.2 billion of subprime risk from Goldman's inventory to its clients and gave Goldman an opportunity to short another $800 million in RMBS securities it thought would perform poorly, the Mortgage Department still held billions of dollars of long positions in subprime mortgage related assets, primarily in ABX index assets.1555

¶On December 14, 2006, as Goldman's mortgage related assets continued to lose value, Goldman's Chief Financial Officer, David Viniar, held a meeting with key Mortgage Department personnel and issued instructions for the Department to "get closer to home."1556 By "closer to home," Mr. Viniar meant for the Mortgage Department to assume a more neutral risk position, one that was neither substantially long nor short, but actions taken by the Mortgage Department in response to his instructions quickly shot past "home," resulting in Goldman's first large net short position in February 2007.1557

¶The actions taken by the Mortgage Department included selling outright from its inventory large numbers of subprime RMBS, CDO, and ABX assets, even at a loss, while simultaneously buying CDS contracts to hedge the long assets remaining in its inventory. The Mortgage Department also halted new RMBS securitizations, began emptying its RMBS warehouse accounts, and generally stopped purchasing new assets for its CDO warehouse accounts. It also purchased the short side of CDS contracts referencing the ABX index for a basket of AAA rated subprime residential loans, as a kind of "disaster insurance" in the event that even AAA rated mortgages started defaulting.

¶Within about a month of the "closer to home" meeting, in January 2007, the Mortgage Department had largely eliminated or offset Goldman's long positions on subprime mortgage related assets. The Mortgage Department then started to build a multi-billion-dollar short position to enable the firm to profit from the subprime RMBS and CDO securities starting to lose value. By the end of the first quarter of 2007, the Mortgage Department had swung from a $6 billion net long position in December 2006, to a $10 billion net short position in late February

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¶2007, a $16 billion reversal.1558 A senior Goldman executive later described a net short position of $3 billion in subprime mortgage backed securities as "huge and outsized."1559 But Goldman's net short position in February 2007 was $10 billion – more than triple that size.

¶In late February, Goldman's Operating Committee, a subcommittee of its Firmwide Risk Committee, became concerned about the size of the $10 billion net short position. The Firmwide Risk Committee was co-chaired by Mr. Viniar, and Messrs. Cohn and Blankfein regularly attended its meetings.1560 The concern arose, in part, because the $10 billion net short position had dramatically increased the Mortgage Department's Value-at-Risk or "VAR," the primary measure Goldman used to compute its risk. The Committee ordered the Department to lock in its profits by "covering its shorts," as explained above. The Mortgage Department complied by covering most, but not all, of the $10 billion net short and brought down its VAR. It then maintained a relatively lower risk profile from March through May 2007.

¶Attempted Short Squeeze. In May 2007, the Mortgage Department's Asset Backed Security (ABS) Trading Desk attempted a "short squeeze" of the CDS market that was intended to compel other market participants to sell their short positions at artificially low prices.1561 Goldman's ABS Desk was still in the process of covering the Mortgage Department's shorts by offering CDS contracts in which Goldman took the long side. The ABS Desk devised a plan in which it would offer those CDS contracts to short parties at lower and lower prices, in an effort to drive down the overall market price of the shorts. As prices fell, Goldman's expectation was that other short parties would begin to sell their short positions, in order to avoid having to sell at still lower prices. The ABS Desk planned to buy up those short positions at the artificially low prices it had caused, thereby rebuilding its own net short position at a lower cost.1562 The ABS Desk initiated its plan, and during the same period Goldman customers protested the lower values assigned by Goldman to their short positions as out of line with the market. Despite the lower prices, the parties who already held short positions generally kept them and did not try to sell them. In June, after learning that two Bear Stearns hedge funds specializing in subprime mortgage assets might collapse, the ABS Desk abandoned its short squeeze effort and recommenced buying short positions at the prevailing market prices.

¶The Big Short. In mid-June 2007, the two Bear Stearns hedge funds did collapse, triggering another steep decline in the value of subprime mortgage assets. In response, Goldman immediately went short again, to profit from the falling prices. Within two weeks, Goldman had massed a large number of CDS contracts shorting a variety of subprime mortgage assets. On

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¶June 22, 2007, Goldman's net short position reached its peak of approximately $13.9 billion, as calculated by the Subcommittee.1563 That total included the $9 billion in AAA ABX assets that Goldman had earlier acquired as "disaster protection," in case the subprime market as a whole lost value. The resulting net short, referred to by Mr. Viniar as the "big short," was nearly 40% larger than its first net short which had peaked at $10 billion in February 2007.

¶To lock in its profits on the $13.9 billion short, the Mortgage Department began working to cover its shorts, buying long assets and entering into offsetting CDS contracts in which it took the long position. On July 10, 2007, the credit rating agencies issued the first of many mass rating downgrades that affected hundreds and then thousands of RMBS and CDO securities, whose values began to fall even more rapidly.1564 The Mortgage Department was able to purchase long assets at a low cost, managed to cover most of its short positions, and locked in its profits. At the same time, the Mortgage Department maintained a net short position in higher risk subprime RMBS securities carrying credit ratings of BBB or BBB-, betting that those securities would lose still more value and produce still more profits for the firm. In August, however, Goldman senior management again became concerned about the size of the Department's net short position and its VAR levels, which had reached record levels. On August 21, 2007, Goldman's Chief Operating Officer Gary Cohn ordered the Mortgage Department to "get down now."

¶Big Short Profits. In response, the Mortgage Department began another round of covering its shorts and locking in its profits, including the shorts referencing BBB and BBB- rated RMBS securities. In the third quarter of 2007, the SPG Trading Desk reported record revenues from its short positions totaling $2.8 billion.1565 By the end of 2007, the SPG Trading Desk in the Mortgage Department recorded year-end net revenues totaling $3.7 billion, which were used to offset losses on other desks, leaving the Mortgage Department as a whole with record net revenues of over $1.1 billion for the year.1566 The head of the SPG Desk, Michael Swenson, later wrote that 2007 was "the [year] I am most proud of to date," because of the "extraordinary profits" from the short positions he had advocated.1567 His colleague, Joshua Birnbaum who headed the ABX Desk within SPG, also reviewed the year in terms of the profitable short positions it built. He wrote: "The prevailing opinion within the department was that we should just 'get close to home' and pare down our long," but he decided his ABS Desk should "not only

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¶... get flat, but get VERY short."1568 He wrote: "[W]e implemented the plan by hitting on almost every single name CDO protection buying opportunity in a 2-month period. Much of the plan began working by February as the market dropped 25 points and our very profitable year was under way." When the subprime mortgage market fell further in July after the credit rating mass downgrades, he wrote: "We had a blow-out [profit and loss] month, making over $1Bln that month."1569

¶The $3.7 billion in net revenues from the SPG's short positions helped to offset other mortgage related losses, and, at year's end, at a time when mortgage departments at other large financial institutions were reporting record losses, Goldman's Mortgage Department reported overall net revenues of $1.1 billion.1570

¶(b) Overview of Goldman's CDO Activities

¶This Report also examines four CDOs that Goldman originated, underwrote, and marketed in the years leading up to the financial crisis: Hudson Mezzanine 2006-1, Anderson Mezzanine 2007-1, Timberwolf I, and Abacus 2007-AC1. Hudson was conceived in 2006, and issued its securities in December 2006, as Goldman began its concerted effort to sell its mortgage holdings. Anderson, Timberwolf, and Abacus issued their securities in 2007, as RMBS and CDO securities were losing value, and Goldman was shorting the subprime mortgage market.

¶During 2007, as Goldman built and profited from its net short positions in the first and third quarters of the year, it continued to design, underwrite, and sell CDO securities. Due to waning investor interest, in February 2007, Goldman conducted a review of the CDOs in its pipeline. The Mortgage Department decided to cancel four pending CDOs, downsize another two, and bring all of its remaining CDOs to market as quickly as possible. Also in February 2007, the Mortgage Department limited its CDO Origination Desk to carrying out only the CDO transactions already underway.

¶"Gameplan" for CDO Valuation Project. In the first quarter of 2007, Goldman's Mortgage Department worked to sell the warehouse assets from the discontinued CDOs, the securities issued by past Goldman-originated CDOs, and the new securities from CDOs being originated by Goldman in 2006 and 2007. In May 2007, as CDO sales slowed dramatically, Goldman became concerned about the lack of sales prices to establish the value of its CDO holdings. Goldman needed accurate values, not just to establish its CDO sales prices, but also to value the CDO securities for collateral purposes and in compliance with Goldman's policy of using up-to-date market values for all of its holdings.1571 On May 11, 2007, Goldman senior executives, including Mr. Cohn and Mr. Viniar, Mortgage Department personnel, controllers, and others held a meeting and developed a "Gameplan" for a CDO valuation project.1572 The Gameplan called for the Mortgage Department, over the course of about a week, to use three different valuation methods to price all of its CDO warehouse assets, unsold securities from past CDOs, and new securities from the CDOs currently being marketed to clients.1573

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¶While the CDO valuation project was underway, Goldman senior executive Thomas Montag asked Daniel Sparks for an estimate of how much the firm would need to write down the value of its CDO assets. Mr. Sparks responded that "the base case from traders is down [$]382 [million]." He also wrote: "I think we should take the write-down, but market [the CDO securities] at much higher levels."1574 Another Goldman senior executive, Harvey Schwartz, expressed concern about selling clients CDO securities at one price and then immediately devaluing them: "[D]on't think we can trade this with our clients andf [sic] then mark them down dramatically the next day."1575 At the same time, Goldman's Chief Credit Risk Officer Craig Broderick told his staff to anticipate deep markdowns and highlighted the need to identify clients that might suffer financial difficulty if Goldman devalued their CDO securities and demanded they post more cash collateral.

¶On May 20, 2007, the Gameplan results were summarized in an internal presentation.1576 It projected that Goldman would have to take from $248 to $440 million in writedowns on unsold CDO securities and warehouse assets, making it clear to Goldman executives that its CDO assets were losing value rapidly.1577 In several drafts of the presentation, the Mortgage Department had also written that Goldman's CDOs were expected "to underperform," but that statement was removed from the final presentation given to senior executives.1578

¶Targeted Sales. The Gameplan also recommended a two-pronged approach to selling the firm's remaining CDO assets. First, it recommended transfer of the CDO warehouse assets to the Mortgage Department's SPG Trading Desk for further valuation and sale. Second, it recommended that the Mortgage Department use a "targeted" approach to sell off the existing and new securities from Goldman-originated CDOs, naming four hedge funds as the primary targets and providing a list of another 35 clients as secondary targets.1579

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¶At the same time, Mr. Sparks named David Lehman, a commercial mortgage backed securities trader, as the new head of the CDO Origination Desk. Shortly thereafter, Goldman dismantled the CDO Origination Desk and moved all remaining CDO securities to the SPG Trading Desk, where he was based. The SPG Trading Desk, which was a secondary trading desk and had little experience with underwriting, assumed responsibility for marketing the remaining unsold Goldman-originated CDO securities. The SPG Trading Desk's lack of underwriting experience meant that it was less familiar with the obligations of underwriters and placement agents to disclose all material adverse interests to potential investors.

¶The SPG Trading Desk worked with Goldman's sales force to market the CDO securities. Goldman employed "hard sell" tactics, repeatedly urging its sales force to sell the CDO securities and target clients with limited CDO familiarity.1580 After trying the Gameplan's "targeted" client approach during May, June, and July 2007, the Mortgage Department switched back to issuing sales directives or "axes" to its entire sales force, including sales offices abroad. Axes on CDOs generally went out at weekly or monthly intervals, identified specific CDO securities as top sales priorities, and offered additional financial incentives for selling them. Despite the CDOs' declining value, the sales force succeeded in selling some of the CDO securities, primarily to clients in Europe, Asia, Australia, and the Middle East, but was unable to sell all of them.

¶The four CDOs that the Subcommittee examined illustrate a variety of conflict of interest issues related to how Goldman designed, marketed, and administered them.

¶Hudson Mezzanine 2006-1. Hudson Mezzanine 2006-1 (Hudson 1) was a $2 billion synthetic CDO comprised of $1.2 billion in ABX assets from Goldman's own inventory, and $800 million in single name CDS contracts on subprime RMBS and CDO securities that Goldman wanted to short. It was called a "mezzanine" CDO, because the referenced RMBS securities carried the riskier credit ratings of BBB or BBB-. Goldman used the CDO to transfer the risk associated with its ABX assets to investors that bought Hudson 1 securities. Goldman also took 100% of the short side of the CDO, which meant that it would profit if any of the Hudson securities lost value. In addition, Goldman exercised complete control over the CDO by playing virtually every key role in its establishment and administration, including the roles of underwriter, initial purchaser of the issued securities, senior swap counterparty, credit protection buyer, collateral put provider, and liquidation agent.

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¶Goldman began marketing Hudson 1 securities in October 2006, soliciting clients to buy Hudson securities. It did not fully disclose to potential investors material facts related to Goldman's investment interests, the source of the CDO's assets, and their pricing. The Hudson 1 marketing materials stated prominently, for example, that Goldman's interests were "aligned" with investors, because Goldman was buying a portion of the Hudson 1 equity tranche.1581 In its marketing materials, Goldman did not mention that it was also shorting all $2 billion of Hudson's assets – an investment that far outweighed its $6 million equity share and which was directly adverse to the interests of prospective investors. In addition, the marketing materials stated that Hudson 1's assets were "sourced from the Street" and that it was "not a balance sheet CDO."1582 However, $1.2 billion of the Hudson assets had been selected solely to transfer risk from ABX assets in Goldman's own inventory.

¶Goldman also did not disclose in the materials that it had priced the assets without using any actual third party sales. The absence of arm's length pricing was significant, because the Hudson CDO was designed to short the ABX Index using single name RMBS securities, and there was a pricing mismatch between the two types of assets.1583 Goldman not only determined the pricing for the RMBS securities purchased by Hudson 1, but retained the profit from the pricing differential. The marketing materials did not inform investors of Goldman's role in the pricing, the pricing methodology used, or the gain it afforded to Goldman. In addition, the marketing materials stated Hudson 1 was "not a balance sheet" CDO, without disclosing that Hudson had been designed from its inception to remove substantial risk from Goldman's balance sheet.

¶The Hudson 1 Offering Circular contained language that may have also misled investors about Goldman's true investment interest in the CDO. The Offering Circular stated:

"[Goldman Sachs International] and/or any of its affiliates may invest and/or deal, for their own respective accounts for which they have investment discretion, in securities or in other interests in the Reference Entities, in obligations of the Reference Entities or in the obligors in respect of any Reference Obligations or Collateral Securities ... , or in credit default swaps ... , total return swaps or other instruments enabling credit and/or other risks to be traded that are linked to one or more Investments."1584

¶This provision seems to inform investors that Goldman "may invest" for its own account in the CDO's securities, reference obligations, or CDS contracts, while withholding the fact that, by the time the Offering Circular had been drafted, Goldman had already determined to take 100% of the short position in the CDO, an investment which was directly adverse to the interests of Hudson securities investors.

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¶Once Hudson issued its securities, Goldman placed a priority on selling them, and delayed the issuance of a CDO on behalf of another client in order to facilitate Hudson sales. Goldman sales representatives reported that clients expressed skepticism regarding the quality of the Hudson assets, but Goldman continued to promote the sale of the CDO.

¶In 2008, as Hudson's assets lost value and received rating downgrades from the credit rating agencies, Goldman, in its role as liquidation agent, was tasked with selling those assets to limit losses to the long investors. The major Hudson investor, Morgan Stanley, pressed Goldman to do just that. Goldman, however, delayed selling the assets for months. As the assets dropped in value, Goldman's short position increased in value. Morgan Stanley's representative reported to a colleague that when Goldman rejected the firm's request to sell the poorly performing Hudson assets, "I broke my phone."¹⁵⁸⁵¹⁵⁸⁵ 2/6/2008 email from John Pearce to Michael Petrick, HUD-CDO-00005146. He also sent an email to the head of Goldman's CDO Desk saying: "[O]ne day I hope I get the real reason why you are doing this to me."1586 Morgan Stanley lost nearly $960 million on its Hudson investment.

¶Anderson Mezzanine 2007-1. Anderson Mezzanine 2007-1 (Anderson) was another synthetic CDO referencing BBB and BBB- rated subprime RMBS securities. It was issued in March 2007. Among other roles, Goldman served as the CDO's placement agent, initial purchaser, collateral put provider, and liquidation agent. Goldman hired another firm, a New York hedge fund founded by former Goldman employees, GSC Partners, to act as the collateral manager. Goldman took a short position on approximately 40% of the $305 million in assets underlying Anderson.

¶Anderson referenced a number of poor quality assets. Those assets had been selected by GSC Partners, with the approval of Goldman. Over 45% of the referenced subprime RMBS securities contained mortgages originated by New Century, a subprime lender known within the industry, including Goldman, for issuing poor quality loans and which was experiencing financial problems while Anderson was being structured and marketed.1587 Inside Goldman, staff were aware of New Century's problems and were taking action to return substantial numbers of substandard loans purchased from New Century and demand repayment for them.1588 Other assets in the Anderson CDO were also performing poorly, and at one point, Goldman personnel estimated its warehouse assets had fallen in value by $22 million.1589 Due to the asset quality problems, the Mortgage Department head, Daniel Sparks, initially decided to cancel Anderson, but later changed his mind and decided to market the CDO as quickly as possible, using the $305 million in assets already in its warehouse account, rather than wait to accumulate all of the $500 million in assets initially planned.

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¶When Anderson issued its securities in March 2007, Goldman placed a high priority on selling them, even delaying another CDO – Abacus 2007-AC1 which was being organized at the request of the Paulson hedge fund – to allow its sales force to concentrate on promoting Anderson. Potential investors raised questions about the quality of its underlying assets, especially the New Century loans, and Goldman provided its sales representatives with talking points to dispel concerns about the New Century assets. When one client asked how Goldman had gotten "comfortable" with the New Century loans, Goldman did not disclose to the client its own negative views of New Century loans or that it had 40% of the short side of the CDO.

¶Goldman marketed Anderson securities to a number of its clients, including pension funds, and recommended using Anderson securities as collateral security in other CDOs.1590 In the end, Goldman sold only $102 million or about one third of the Anderson securities.1591 Seven months after the securities were issued, they suffered their first credit rating downgrade. Currently, all of the Anderson securities have been reduced to junk status, and the Anderson investors have lost virtually their entire investments.

¶Timberwolf I CDO. Timberwolf I was a $1 billion hybrid CDO2 transaction that referenced single-A rated securities from other CDOs. Those CDO securities referenced, in turn, RMBS securities carrying lower credit ratings, primarily BBB. Altogether, Timberwolf referenced 56 unique CDO securities that had over 4,500 unique underlying assets. Goldman served as the CDO's placement agent, initial purchaser, collateral put provider, and liquidation agent. It also hired a hedge fund with former Goldman employees, Greywolf Capital Management, to act as the collateral manager. Greywolf selected the CDO's assets, with Goldman's approval. Goldman took a short position on approximately 36% of the $1 billion in assets underlying Timberwolf.1592

¶Timberwolf's securities began losing value almost as soon as they were purchased. In February 2007, Goldman's Mortgage Department head told a senior executive that Timberwolf was one of two deals "to worry about." He also wrote that the assets in the Timberwolf warehouse account had declined so much in value that they had already exhausted Greywolf's responsibility to pay a portion of any warehouse losses, and any additional losses would be Goldman's exclusive obligation.1593 Goldman rushed Timberwolf to market, and it closed on March 27, 2007, approximately six weeks ahead of schedule.1594 Almost as soon as the Timberwolf securities were issued, they too began to lose value.

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¶Despite doubts about its performance and asset quality, Goldman engaged in an aggressive campaign to sell the Timberwolf securities. As part of its tactics, Mr. Lehman instructed Goldman personnel not to provide written information to investors about how Goldman was valuing or pricing the Timberwolf securities, and its sales force offered no additional assistance to potential investors trying to evaluate the 4,500 underlying assets. Mr. Sparks and Mr. Lehman sent out numerous sales directives or "axes" to the Goldman sales force, stressing that Timberwolf was a priority for the firm.1595 In April, Mr. Sparks suggested issuing "ginormous" sales credits to any salesperson who sold Timberwolf securities, only to find out that large sales credits had already been offered.1596 In May, while Goldman was internally lowering the value of Timberwolf, it continued to sell the securities at a much higher price than the company knew it was worth. At one point, a member of the SPG Trading Desk issued an email to clients and investors, advising them that the market was rebounding and the downturn was "already a distant memory."1597 Goldman also began targeting Timberwolf sales to "non-traditional" buyers and those with little CDO familiarity, such as increasing its marketing efforts in Europe and Asia.

¶On June 18, 2007, Goldman sold $100 million worth of Timberwolf securities to an Australian hedge fund, Basis Capital. Just 16 days later, on July 4, Goldman informed Basis Capital that the securities had lost value, and it had to post additional cash collateral to secure its CDS contract. On July 12, Goldman told Basis Capital that the value had dropped again, and still more collateral needed to be posted. In less than a month, the value of Timberwolf had fallen by $37.5 million. Basis Capital posted the additional capital, but soon after declared bankruptcy.

¶On June 1, 2007, Goldman Sachs sold $36 million in Timberwolf securities to a Korean life insurance company, Hungkuk Life, that had little familiarity with the product. The head of the Korean sales office said his office was willing to sell the company additional securities, if assured the office would receive a 7% sales credit. Goldman agreed, and said "get 'er done." The sales office sold another $56 million in Timberwolf securities to the life insurance company which paid $76 per share when Goldman's internal value for the security was $65.

¶Within ten days of that sale, Thomas Montag, a senior Goldman executive, sent an email to the Mortgage Department head, Daniel Sparks, stating: "boy that timeberwof [Timberwolf] was one shitty deal."1598 Despite that comment, Goldman continued to market Timberwolf securities to its clients.

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¶Goldman had also arranged for its subsidiary, Goldman Sachs International (GSI), to act as both the primary CDS counterparty and the collateral put provider in Timberwolf.1599 Although GSI received a fee for serving as the collateral put provider, GSI began to refuse to approve Timberwolf's purchase of new collateral securities whose values might decline below par value and put Goldman at risk of having to make up the difference. Instead, GSI pressured Timberwolf to keep its collateral in cash, even though an internal Goldman analysis had confirmed that cash collateral produced lower returns for Timberwolf investors than collateral securities. When Greywolf objected to this practice, Goldman backed down and allowed the purchase of a narrow range of very safe, short term asset backed securities as collateral.

¶In the fall of 2007, a Goldman analyst provided executives with a price history for Timberwolf A2 securities. It showed that, in five months, Timberwolf securities had lost 80% of their value, falling from $94 in March to $15 in September. Upon receiving the pricing history, the Timberwolf deal captain, Matthew Bieber, wrote that March 27 – the day Timberwolf issued its securities – was "a day that will live in infamy."1600 Timberwolf was liquidated in 2008.

¶Abacus 2007-AC1. Abacus 2007-AC1 was a $2 billion synthetic CDO that referenced BBB rated mid and subprime RMBS securities issued in 2006 and early 2007. It was a static CDO, meaning once selected, its reference obligations did not change. It was the last in a series of 16 Abacus CDOs that referenced primarily mortgage backed assets and were designed by Goldman. Those Abacus CDOs were known as single tranche CDOs, structures pioneered by Goldman to provide customized CDOs for clients interested in assuming a specific type and amount of investment risk. They enabled the client to select the assets, the size of the investment, the amount of subordination or cushion before the securities would be exposed to loss, and could be issued with a single tranche.1601 The Abacus CDOs 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 as a way for Goldman itself to short mortgage assets in bulk.1602

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¶Abacus 2007-AC1 was the first and only Abacus transaction in which Goldman allowed a third party client to essentially "rent" its CDO structure and play a direct, principal role in the selection of the assets. Goldman did not itself intend to invest in the CDO.1603 Instead, it functioned primarily as an agent, earning fees for its roles in structuring, underwriting, and administering the CDO. Those roles included Goldman's acting as the placement agent, collateral securities selection agent, and collateral put provider. Unlike previous Abacus CDOs, Goldman employed a third party to serve as the portfolio selection agent, essentially using that agent to promote sales and mask the role of its client in the asset selection process.

¶Goldman originated Abacus 2007-AC1 in response to a request by Paulson & Co. Inc. (Paulson), a hedge fund that was among Goldman's largest customers for subprime mortgage related assets. Paulson had a very negative view of the mortgage market, which was publicly known, and wanted Goldman's assistance in structuring a transaction that would allow it to take a short position on a portfolio of subprime mortgage assets that it believed were likely to perform poorly or fail. Goldman allowed Paulson to use the Abacus CDO for that purpose. In entering into that arrangement with Paulson and simultaneously acting as the placement agent responsible for marketing the Abacus securities to long investors, Goldman created a conflict of interest between itself and the investors it would be soliciting to buy the Abacus securities.

¶Paulson established a set of criteria to select the reference assets for the Abacus CDO to achieve its investment objective.1604 After establishing those parameters, Paulson worked with the actual portfolio section agent to select the assets. Documents show that Paulson proposed, substituted, rejected, and approved assets for the reference portfolio. Goldman was aware of Paulson's investment objective, the role it played in the selection of the reference assets, and the fact that the selection process yielded a set of poor quality assets. Of the final set of 90 assets referenced in the Abacus CDO portfolio,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. Yet Goldman did not publicly disclose the central role played by Paulson in the asset selection process or the fact that the economic interest held by an entity actively involved in the asset selection process was adverse to the interest of investors who would be taking the long position.

¶ACA Management LLC, the company hired by Goldman to serve as the portfolio selection agent, told the Subcommittee that, while it knew Paulson was involved, it was unaware of Paulson's true economic interest in the CDO. The ACA Managing Director who worked on the Abacus transaction stated that ACA believed that Paulson was going to invest in the equity tranche of the CDO, thus aligning its interests with those of ACA and other investors.1605 ACA and its parent company both acquired long positions in the Abacus CDO as did a third investor. The Abacus securities lost value soon after purchase. The three long investors together lost more than $1 billion, while Paulson, the sole short investor, recorded a corresponding profit of about $1 billion. Today, the Abacus securities are worthless.

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¶In addition to not disclosing the asset selection role and investment objective of the Paulson hedge fund, Goldman did not disclose to investors how its own economic interest was aligned with Paulson. In addition to accepting a sizable placement fee paid by Paulson for marketing the CDO securities, Goldman had entered into a side arrangement with the hedge fund in which it would receive additional fees from Paulson for arranging CDS contracts tied to the Abacus CDO that included low premium payments falling within a specified range.1606 While those lower premium payments would benefit Paulson by lowering its costs, and benefit Goldman by providing it with additional fees, they would also reduce the amount of cash being paid into the CDO, disadvantaging the very investors to whom Goldman was marketing the Abacus securities. Goldman nevertheless entered into the arrangement, contrary to the interests of the long investors in Abacus, and failed to disclose the existence of the fee arrangement in the Abacus marketing materials.

¶On April 16, 2010, the SEC filed a complaint against Goldman and one of the lead salesmen for the Abacus CDO, Fabrice Tourre, alleging they had failed to disclose material adverse information to potential investors and committed securities fraud in violation of Section 17(a) of the Securities Act of 1933 and Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. On July 14, 2010, Goldman reached a settlement with the SEC, admitting:

"[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 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."1607

¶Goldman agreed to pay a $550 million fine.

¶The Hudson, Anderson, Timberwolf, and Abacus CDOs provide concrete details about how Goldman designed, marketed, and administered mortgage related CDOs in 2006 and 2007. The four CDOs also raise questions about whether Goldman complied with its obligations to offer suitable investments that it believed would succeed, and provide full disclosure to investors of material adverse interests. They also illustrate a variety of conflicts of interest in the CDO transactions that Goldman resolved by placing its financial interests and favored clients before those of its other clients.

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¶Each of the four CDOs examined by the Subcommittee presents conflict of interest concerns and elements of deception related to how information about the CDO was presented to investors, including disclosures related to the relevant CDO's asset selection process, the quality and value of the CDO's assets and securities, and the nature and size of Goldman's proprietary financial interests. The Subcommittee's investigation raises questions regarding whether Goldman complied with its obligations to disclose material information to investors, including its material adverse interests, and to refrain from making investment recommendations that are unsuitable for any investor by recommending financial instruments designed to lose value and perform poorly. A key issue underlying much of this analysis is the structuring of and disclosures related to financial instruments that enable an investment bank to bet against the very financial products it is selling to clients.

¶(4) How Goldman Shorted the Subprime Mortgage Market

¶Having provided an overview of Goldman's shorting activities and CDO activities in the years leading up to the financial crisis, this next section of the Report provides detailed information about how Goldman shorted the subprime mortgage market.

¶(a) Starting $6 Billion Net Long

¶By mid-2006, Goldman's Mortgage Department had a predominantly pessimistic view of the U.S. subprime mortgage market. According to Michael Swenson, head of the Mortgage Department's Structured Products Group: "[D]uring the early summer of 2006 it was clear that the market fundamentals in subprime and the highly levered nature of CDOs [were] going to have a very unhappy ending."1608

¶$6 Billion Long. In mid-2006, Goldman held billions of dollars in long subprime mortgage related securities, in particular the long side of CDS contracts referencing the ABX Index. In September 2006, Mortgage Department head Daniel Sparks and his superior, Jonathan Sobel, initiated a series of meetings with Mr. Swenson, head of the Structured Products Group (SPG), and Mr. Birnbaum, the Mortgage Department's top trader in ABX assets, to discuss the Department's long holdings.1609 In those meetings, they discussed whether the Asset Backed Security (ABS) Trading Desk within SPG should get out of its existing positions or "double- down." After the first meeting, Mr. Birnbaum emailed Mr. Swenson:

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"Sobel and Sparks want to know if we should exit or double down. We double down if we have a structured place to go with the risk. ... [W]e are going to sit down with the CDO guys and talk about a deal."1610

¶If the Department's existing long positions could be transferred off SPG's books by finding a "structured place to go with the risk," the ABS Trading Desk would then be free to "double down" by taking on new positions and risk.

¶That same month, September 2006, the ABS and CDO Desks reached agreement on constructing a new CDO to provide the ABS Desk with a "structured exit" from some of its existing investments. The result was Hudson Mezzanine 2007-1, a CDO designed by Goldman to transfer to Hudson investors the risk associated with $1.2 billion in net long ABX assets then in Goldman's inventory. The Hudson CDO was also designed to allow Goldman to short $800 million in RMBS securities to offset a portion of its long ABX assets.1611

¶In December 2006, even after the $2 billion Hudson CDO was constructed, the Mortgage Department calculated that it still had a $6 billion net long position in subprime mortgage related assets.1612 Goldman's ABX holdings continued to be a major source of its long assets.

¶Goldman's Long ABX Assets. In January 2006, Goldman, Deutsche Bank, and several other Wall Street firms launched the ABX Index which, for the first time, allowed investors to use standardized CDS contracts to invest in baskets of subprime RMBS securities. The ABX Index measured the aggregate performance of a selected basket of 20 RMBS securitizations, producing a single value that rose or fell over time in line with the performance of the underlying RMBS securities.1613 Investors could enter into CDS contracts that used a particular ABX Index as the "reference obligation," without physically purchasing or holding any of the RMBS securities in the underlying basket. Because the ABX Index itself was synthetic, and did not depend upon the acquisition of large blocks of RMBS securities, it enabled an unlimited number of investors to make unlimited bets on the performance of a group of subprime RMBS securities, using standardized contracts that could be bought and sold. The ABX Index also made it economical for investors to short subprime RMBS securities in bulk.1614

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¶In internal documents, Goldman described itself as "the leader and principal driver in the creation of" the ABX Index.1615 In July 2006, Joshua Birnbaum, Rajiv Kamilla, David Lehman, and Michael Swenson from the Mortgage Department nominated Goldman's role in the creation of both the ABX and CMBX – a similar index based on Commercial Mortgage Backed Securities – for an internal Goldman award, called the "Mike Mortara Award for Innovation."1616 That award "recognize[d] the creative, forward-looking, and entrepreneurial contributions of an individual or team" within the equities or fixed income divisions.1617 The Mortgage Department personnel wrote that the new indices "enable[d] market participants to trade risk without ownership of the underlying SP [structured product] security – thereby permitting market participants to efficiently go short the risk of these securities."1618 They also wrote that "Goldman Dominates Client Trading Volume" with "an estimated 40% market share," and also "dominates the inter-dealer market."1619 In 2007, Rajiv Kamilla, the ABS trader who spearheaded Goldman's efforts to launch the ABX Index, wrote that he "[c]ontinued to enhance our trading dominance in ... ABX indices."1620

¶While Mr. Kamilla led Goldman's efforts to develop the ABX Index, the firm's day-to-day ABX trading was conducted primarily by Joshua Birnbaum on the Mortgage Department's Structured Products Group (SPG) Trading Desk.1621 Mr. Birnbaum had a negative view of the subprime mortgage market, and favored the firm's building a net short position.1622 However, during 2006, Goldman's overall ABX position was net long, not net short.

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¶Goldman was net long because, as a market maker that helped launch the ABX Index in 2006, it facilitated ABX trades for a number of clients, and many of those clients – primarily hedge funds – went almost exclusively short, requiring Goldman to take the opposing long side of the CDS contracts referencing the ABX indices.1623 These transactions enabled Goldman to amass a 30-40% market share in ABX trading during its first year of existence. But by mid-2006, they had also contributed to the Mortgage Department's net long position in subprime mortgage related assets. When the mortgage market began showing signs of strain in the second half of 2006, the risks associated with the firm's net long ABX position became more of a concern.1624 Senior

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¶Goldman executives expressed the view that the subprime mortgage related market was likely to get much worse, and the firm should prepare for it.1625

¶In December 2006, Goldman used the Hudson CDO to transfer the risk associated with $1.2 billion of its ABX long holdings to Hudson investors. But even after this transfer, Goldman still had billions of dollars in long ABX holdings on its books.

¶Goldman's Long Mortgage Holdings. In addition to its long ABX holdings, the Mortgage Department's $6 billion net long position in December 2006 was due to a large inventory of RMBS, CDO, and other mortgage related assets in Goldman's investment and sale inventories and in its CDO warehouses. In 2006, the Mortgage Department conducted numerous RMBS and CDO securitizations that required it to acquire and repackage whole loans, RMBS and CDO securities, and other mortgage related assets. When assembling CDOs, Goldman often worked with third party partners. These strategic partners bought a portion of the equity and bore some of the risk of loss in the CDO. The partners were generally smaller financial firms, such as hedge funds or asset managers with expertise in CDOs or a particular asset class. For a fee, the partners also sometimes served as a CDO's collateral manager, helping to select the assets.1626

¶Peter Ostrem, who was head of the CDO Origination Desk from 2006 until May 2007, was aware of substantial problems in the subprime mortgage market, but believed that the market distress was temporary and the market would stabilize.1627 Mr. Ostrem wanted to continue to increase the CDO Desk's business by producing as many marketable CDOs as possible.1628 Darryl Herrick, who worked for Mr. Ostrem on the CDO Origination Desk expressed the view that hedge funds were shorting only the worst CDOs: "[CDO] shelves people are shorting are enhanced garbage."1629

¶The CDO Origination Desk was a primary contributor to the Mortgage Department's net long position, as Goldman often had to hold or "warehouse" subprime assets until they were packaged into a CDO.1630 Each CDO was designed to include or reference hundreds of millions or billions of dollars in assets, which the CDO Origination Desk and its partners had to locate and acquire, a process called "ramping" that averaged six to nine months per CDO.1631 Goldman and its partners acquired these assets from other large Wall Street broker-dealers, often called "the Street," or took them from their own inventory of assets.

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¶When assembling a CDO, Goldman generally opened an internal "warehouse account" for the CDO in which it stored the acquired assets until a target amount was achieved, and the CDO was brought to market. While the assets were in the warehouse account, they were included in Goldman's warehouse balance sheet and contributed to its long or short positions. When the bulk of the target assets were acquired for a particular CDO, perhaps 75% to 95% of the total, in some cases Goldman priced the CDO securities and began selling them to clients who were told what the remaining assets would likely be.1632 When a CDO transaction "closed" and its securities were issued, Goldman transferred the relevant assets from its warehouse account to the corporation or trust established for the CDO.1633 The CDO entity then housed the long assets that had been on Goldman's warehouse books, and Goldman was left with a corresponding short position which it could keep or sell to the CDO's short parties.

¶In 2006 and early 2007, since it was often acquiring assets for several CDOs at once, the CDO Desk generally had a substantial net long position in subprime assets in its CDO warehouse accounts.1634 For example, as of March 16, 2007, Goldman calculated that its CDO warehouses contained $4.7 billion in mortgage related assets.1635 After deducting potential liabilities assumed by Goldman's partners and making other adjustments, Goldman calculated that it had $2.3 billion in net long warehouse risk.1636 In early 2007, Goldman executives began to express concern about the risks posed by the subprime mortgage related assets in the CDO warehouse accounts.1637

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¶On December 7, 2006, Daniel Sparks, the Mortgage Department head, exchanged emails with Goldman senior executive Thomas Montag about why Goldman was not doing more to reduce the firm's risk associated with its net long positions.1638 On the same day, Mr. Montag complained to CFO David Viniar about the Mortgage Department's lack of aggressiveness in trying to reduce its net long ABX position:

"[O]n ABX having numerous conversations–I don't think we should panic out but we certainly didn't do a good job of keeping pressure on ... makes me mad because they should have kept doing it ugh."1639

¶The next week, Mr. Viniar called a meeting with the Mortgage Department to discuss its holdings.

¶(b) Going Past Home: Goldman's First Net Short

¶CFO David Viniar told the Subcommittee that, in early December 2006, he received reports showing that the Mortgage Department had lost money on ten successive days.1640

¶Viniar Meeting. On December 14, 2006, Mr. Viniar convened a meeting in the conference room next to his office on the 30th floor, in which he and other senior Goldman executives met for several hours with Mortgage Department managers, as well as representatives from Market Risk Management & Analysis and from the Controllers group.1641 At the meeting, Mr. Viniar and other Goldman executives conducted an in-depth review of the Mortgage Department's holdings. Mr. Viniar concluded the Mortgage Department's position in subprime mortgage related assets was too long, and its risk exposure was too great.1642

¶Mr. Viniar and others told the Subcommittee that Mr. Viniar's basic message to the Mortgage Department at the December meeting was not necessarily to go short, but instead to "get closer to home."1643 In trading parlance, "home" means a net neutral trading position – a position that is neither significantly short nor long.1644 Mr. Viniar told the Subcommittee that, by telling the Mortgage Department to "get closer to home," he meant that it should assume a more neutral risk position.1645 One way to "get closer to home" was for the Department to sell its long assets. Another way to achieve a more neutral risk position was for the Department to take new short positions to offset its existing long positions.1646

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¶Internal documents indicate that the directions given to the Mortgage Department in the December meeting were more detailed than the general instruction to "get closer to home." In an email sent on the same day by Mr. Sparks to Goldman executives Messrs. Montag and Ruzika entitled, "Subprime risk meeting with Viniar/McMahon Summary," Mr. Sparks wrote:

"Followups: 1. Reduce exposure, sell more ABX index outright, basis trade of index vs. CDS too large. 2. Distribute as much as possible on bonds created from new loan securitizations and clean previous positions. 3. Sell some more resid[ual]s 4. Mark [the value of assets in] the CDO warehouse more regularly ... 5. Stay focused on the credit of the originators we buy loans from and lend to 6. Stay focused and aggressive on MLN [Mortgage Lending Network] (warehouse customer and originator we have EPDs [early payment defaults] to that is likely to fail) 7. Be ready for the good opportunities that are coming (keep powder dry and look around the market hard)."1647

¶The next day, December 15, 2006, Mr. Montag forwarded Mr. Sparks' email to Mr. Viniar asking: "is this a fair summary?"1648 Mr. Viniar replied: "Yes." Mr. Viniar noted:

"On ABX, the position is reasonably sensible but is just too big. Might have to spend a little to size it appropriately. On everything else my basic message was let's be aggressive distributing things because there will be very good opportunities as the markets [go] into

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what is likely to be even greater distress and we want to be in a position to take advantage of them."1649

¶In response to the Viniar meeting, the Mortgage Department took immediate action. It began selling its long ABX positions outright when possible and entering into large single name CDS shorts to offset its remaining long assets. Goldman personnel developed a chart depicting the long positions the Mortgage Department had taken on BBB and BBB- rated ABX assets.1650 This chart also showed how quickly the Mortgage Department moved after the Viniar meeting to offset those long positions by amassing single name RMBS and CDS short positions.

[SEE CHART NEXT PAGE: Notionals (ABX convention), prepared by Goldman Sachs, reformatted by the Permanent Subcommittee on Investigations to be readable in black and white print, GS MBS-E- 010214410.]

¶Notionals (ABX convention)

¶10,000,000,000

¶8,000,000,000

¶6,000,000,000

¶BBB Index Only

¶4,000,000,000

BBB Index + CDS BBB- Index Only BBB- Index + CDS

¶2,000,000,000 All BBBs Index Only

¶All BBBs Index + CDS

¶19-Jan 18-Feb 20-Mar 19-Apr 19-May 18-Jun 18-Jul 17-Aug 16-Sep 16-Oct 15-Nov 15-Dec 14-Jan 13-Feb

¶-2,000,000,000

¶BBB bucket includes BBB+ CDS -4,000,000,000 Notionals: refers to current notionals

¶Positive notionals: long risk

¶Prepared by the U.S. Senate Permanent Subcommittee on Investigations, February 2011. Derived from Goldman Sachs document, GS MBS-E-010214410.

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¶Within about a month, in January 2007, the Mortgage Department had largely eliminated or offset its long subprime mortgage assets, but it didn't stop there. In January and February, the Mortgage Department began building a multi-billion-dollar short position as part of a plan by the SPG Trading Desk to profit from the subprime RMBS and CDO securities starting to lose value. The plan was discussed with Mr. Sparks and Mr. Ruzika before it was set in motion. By the end of February 2007, the Department had swung from a $6 billion net long position to a $10 billion net short position, a $16 billion reversal in the span of two months.

¶Selling Assets Outright. On December 14, 2006, the same day as the Viniar meeting, Kevin Gasvoda, head of the Residential Whole Loan Trading group, instructed his staff to begin selling the RMBS securities in Goldman's inventory, focusing on RMBS securities issued from Goldman-originated securitizations. He urged them to "move stuff out" even at a loss:

"[P]ls refocus on retained new issue bond positions and move them out. ... [W]e don't want to be hamstrung based on old inventory. Refocus efforts and move stuff out even if you have to take a small loss."1651

¶In February 2007, to further encourage sales, Mr. Gasvoda issued a sales directive or "axe" to the Goldman sales force to sell the remaining RMBS securities from Goldman-originated RMBS securitizations. On February 9, 2007, the sales force reported a substantial number of sales, and Mr. Gasvoda replied: "Great job syndicate and sales, appreciate the focus."1652

¶In February 2007, Goldman CEO Lloyd Blankfein personally reviewed the Mortgage Department's efforts to reduce its subprime RMBS whole loan, securities, and residual equity positions, asking Mr. Montag: "[W]hat is the short summary of our risk and the further writedowns that are likely[?]"1653 After a short report from Mr. Montag, Mr. Blankfein replied:

"[Y]ou refer to losses stemming from residual positions in old deals. Could/should we have cleaned up these books before and are we doing enough right now to sell off cats and dogs in other books throughout the division?"1654

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¶At the end of February, Goldman's controllers prepared a summary of the changes in Goldman's RMBS and whole loan inventory since December 2006, and reported:

"Residential Credit Loans: The overall loans inventory decreased from $11bn to $7bn. ... subprime loans decreased from $6.3bn to $1.5bn, Second Liens decreased from $1.5bn to $0.7bn and S&D [scratch and dent] Loans remained unchanged at $0.8bn."1655

¶This analysis indicates that, in less than three months, Goldman had reduced its subprime loan inventory by over two-thirds, and its second lien inventory by half.

¶The Mortgage Department reduced its inventory, not only by selling assets outright, but also by reducing its purchase of whole loans and securitization efforts. In March 2007, Goldman informed its Board of Directors and the SEC that it had stopped purchasing subprime loans and RMBS securities through, in its words, the use of "conservative bids."1656 While those presentations did not explain the phrase "conservative bids," an email to Goldman's Chief Credit Officer, Craig Broderick, discussing a March 2007 presentation to Goldman's Audit Committee about the subprime mortgage business, was much more explicit: "Just fyi not for the memo, my understanding is that the desk is no longer buying subprime. (We are low balling on bids)."1657 Still another method to reduce its loan inventory was an ongoing effort by the Mortgage Department to return defaulted or fraudulent loans to the lenders from which it had purchased them.

¶On April 23, 2007, Mr. Gasvoda reported to Messrs. Montag and Sparks a dramatic reduction in Goldman's inventory of subprime loans and RMBS securities:

"[W]e have $180mm in loans (unsecuritized) and $255mm of residuals off old deals. The $180mm of loans is the smallest we've been since we started the business in 2002. We had been running at an average loan position balance in subprime of around $4B . ... The $255mm we have retained is from deals dating back to 2002 and while we've developed some buying partners, it is not a deep market. These have been intentional principal retained positions."1658

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¶The subprime loan balance of $180 million was just over one-tenth of the $1.5 billion total Goldman had held at the end of February 2007, reflecting a reduction in its subprime inventory over a two-month span by nearly 90%. Overall, the $180 million loan balance was down from an average subprime loan position balance of $4 billion, which was a 95% reduction in overall subprime loan inventory levels.

¶Building the First Short Position. At the same time the Residential Whole Loan Trading Desk was selling loans and RMBS securities, the Structured Product Group (SPG) Trading Desk was working to sell its inventory of long CDS contracts linked to the ABX indices.1659 At first, in December and January, because so many market participants were going short, the SPG's ABX Trading Desk found its long ABX positions difficult to sell.1660 The ABS Desk then decided to offset the long ABX assets in part by purchasing the short side of single name CDS contracts on certain RMBS and CDO securities.1661 Within about six weeks, by February 2007, the ABS Desk had acquired a huge net short position in single name CDS contracts referencing RMBS and CDO securities that totaled more than $5 billion. By then, the ABX market had stabilized somewhat, and the ABS Desk was able to sell outright more of its long ABX positions. Rather than slow down once its $6 billion long position was offset, however, the ABS Desk used CDS contracts to short RMBS and CDO securities "at every opportunity," in the words of one trader, going increasingly net short.1662

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¶On February 12, 2007, Mr. Sparks reported to senior management on the Mortgage Department's progress and the substantial profits that its new net short position was already showing:

"(1) +20mm [million] P&L [profit and loss] today. Secondary trading desk is net short risk in the form of single names and structured index vs index longs (some index shorts also). Large move down again today ....

(2) Possible significant upside in book. The desk has been moving [marking down] single names about 1/3 of what they feel the correct correlation [to ABX Index] is (around 70%) .... As the market has moved so much one way, there is the potential for the book to currently have significant upside embedded in it.1663

¶(3) Loan & resid[ual] books flat [i.e., already hedged]."1664

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¶On February 14, 2007, Mr. Sparks again reported to senior management on the Department's progress, describing how it was neutralizing its net long position:

"[O]ur risk reduction program consisted of: (1) selling index outright (2) buying single name protection and (3) buying protection on super-senior portions of the BBB/BBB- index. ... That is good for us position-wise, bad for accounts who wrote that protection ... but could hurt our CDO pipeline position as CDOs will be harder to do."1665

¶"Overall," Mr. Sparks wrote, "as a business we are selling our longs and covering our shorts."1666

¶With respect to market conditions, Mr. Sparks reported:

"Subprime environment – bad and getting worse. Everyday is a major fight for some aspect of the business (think whack-a-mole). Trading position has basically squared ... plan to play from short side. Loan business is long by nature and goal is to mitigate. Credit issues are worsening on deals and pain is broad (including investors in certain GS-issued deals). Distressed opportunities will be real, but we aren't close to that time yet."1667

¶In order to "play from the short side," the Mortgage Department continued building a net short position, employing aggressive strategies.1668 Mr. Birnbaum, Goldman's ABX trader, later wrote: "I concluded that we should not only get flat, but get VERY short."1669 He wrote that he then "socialized," or discussed, his proposal with others in the Mortgage Department, and "we all agreed the plan made sense."1670 The ABS Desk began implementing the plan by taking a very large short position in single name CDS contracts referencing RMBS and CDO securities to offset the Department's remaining ABX long position:

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"After socializing the plan with [Daniel] Sparks and ultimately [Richard] Ruzika, we implemented the plan by hitting on almost [every] single name CDO protection buying opportunity in a 2-month period. Much of the plan began working by February when the market dropped 25 points and our profitable year was underway."1671

¶By clearing the plan with Mr. Sparks and Mr. Ruzika first, SPG Trading Desk informed senior management of its intent to use the firm's capital to build the net short position. Mr. Birnbaum also wrote:

"When we were socializing our plan to get short in the beginning of the year, I put together a tool . . . quantifying our position risk and the p&l [profit and loss] under various market level scenarios. I believe this was key for senior management to gain confidence that we were taking controlled and quantifiable risk that was well understood."1672

¶The Mortgage Department's lead trader in single name CDS contracts referencing RMBS securities, Deeb Salem, also described the plan in his 2007 performance self-evaluation:

"Mike [Swenson], Josh [Birnbaum] and I were able to learn from our bad long position at the end of 2006 and layout the game plan to put on an enormous directional short. The results of that are obvious."1673

¶In an interview, Mr. Salem told the Subcommittee that the "obvious" results he was referring to were the desk's resulting profits.1674

¶The ABS Desk within the Structured Product Group (SPG) used CDS contracts to short RMBS and CDO securities as well as the ABX Index. The Correlation Desk within SPG used a different technique, obtaining approval to use a Goldman-designed CDO platform, Abacus, "to short structured product CDOs in bulk. The ABACUS transactions are currently one of the unique formats available to . . . [short] in large size on this type of structured product risk."1675

¶From January to late February, the Mortgage Department continued to pile on short positions in the subprime mortgage market.1676 By the end of the first quarter in 2007, it had built a

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¶$10 billion net short position. In a later performance self-evaluation, Mr. Salem described the aggregate $10 billion net short position as "HUGE" and "enormous."1677 A Goldman senior executive, Thomas Montag, later referred to a net short position of $3 billion in subprime mortgage backed securities as "huge and outsized."1678 Goldman's net short position in February 2007 was more than three times that size.

¶Profiting from the First Net Short. In February 2007, Goldman's senior management decided that the $10 billion net short position had become too risky, and ordered the Mortgage Department to cover a portion of the short. Covering some of the short not only reduced the risk, but also locked in some of the profit associated with the position.

¶In late February 2007, the Mortgage Department's net short position, coupled with added volatility in the subprime mortgage market, caused a sharp increase in the Department's risk profile, as measured by Value at Risk or "VAR." Goldman had assigned a VAR limit of $35 million to the Mortgage Department.1679 In November 2006, the Department's reported VAR was $13 million, well below its limit.1680 By late February 2007, however, its VAR had reached $85 million – an increase of over 550%.1681

¶Goldman senior management closely monitored the Department's increasing VAR. On February 23, 2007, Goldman risk controllers told senior executives that the Mortgage Department's increasing VAR was "primarily driven by a combination of increased volatility in ABX market and the [SPG] desk increasing their net short risk in RMBS subprime sector."1682 On February 14, 2007, Justin Gmelich, a managing director asked to help Mr. Sparks with the Mortgage Department on a short term basis, sent an email to Mr. Montag expressing unease with the Department's increasing risk profile:

"Abx risk should be working to get closer to home. My opinion, singles v. short index is too big (no news here). Abx correlation trade is good. I think we should be covering a bit of our short. There is a lot to do."1683

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¶Mr. Montag forwarded Mr. Gmelich's email to Goldman's Co-Presidents, Gary Cohn and Jon Winkelried, as well as to Mr. Ruzika, commenting: "clearly need to opportunistically take position down."1684

¶On February 21, 2007, senior management told Mr. Sparks to reduce the size of the Mortgage Department's $10 billion net short position by covering $3 billion.1685 Mr. Sparks communicated the decision to personnel on the SPG Desk:

"We need to buy back $1 billion single names and $2 billion of the stuff below [CDO securities] – today. I know that sounds huge, but you can do it – spend bid/offer, pay through the market, whatever to get it done.

It is a great time to do it – bad news on HPA [housing price appreciation], originators pulling out, recent upticks in unemployment, originator pain. . . .

This is a time to just do it, show respect for risk, and show the ability to listen and execute firm directives.

¶You called the trade right, now monetize a lot of it.

¶You guys are doing very well."1686

¶Although some SPG traders disagreed with the decision,1687 the Mortgage Department took immediate action in response to the order. By the end of the day, February 21, 2007, Mr. Sparks reported to senior management that the ABS Desk had covered $400 million in single name CDS contracts, but had not been able to reach the $3 billion goal:

"Market sold off significantly (BBB and BBB- indices over 100 bps wider) We covered over $400mm single names – still significant work to do. ...

"We are net short, but mostly in single name CDS and some tranched index vs the some [sic] index longs. We are working to cover more, but liquidity makes it tough. Volatility is causing our VAR numbers to grow dramatically."1688

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¶Mr. Ruzika sent an email to Mr. Montag and Mr. Sparks commenting on the covering efforts:

"I think Dan's guys are being practical. I know Bill [McMahon] was upset but covering the single name bbb and bbb- is prudent as it cuts vol and var the most. ... Guys didn't give up bid ask but they also didn't stand on the bid."1689

¶The Mortgage Department found that its single name CDS contracts were difficult to cover, in part because many of the referenced RMBS and CDO securities had already been acquired by securitizers for inclusion in CDOs and so were not for sale.1690 That meant the SPG Trading Desk could not cover its single name short positions simply by buying the offsetting long asset – the RMBS and CDO securities were no longer available for purchase.1691 Instead, the SPG Desk had to use offsetting CDS contracts, ones which referenced the same RMBS or CDO securities, but in which Goldman took the long side.1692 The problem with those contracts, however, was that many market participants had already acquired short positions on RMBS and CDO securities and weren't in the market to buy more. In addition, their purchases had driven up the price of short contracts. Between market saturation and high price levels, Goldman found few buyers when it wanted to cover its shorts.1693 The Mortgage Department's inability to cover its single name shorts concerned Messrs. Montag and Ruzika, who continued to press for quick progress.

¶On February 25, 2007, Mr. Sparks reported to Messrs. Montag and Ruzika on the Mortgage Department's progress after a week of effort:

"Cover[ed] around [$]1.55 billion single name subprime BBB- CDS and about $700mm single name subprime BBB CDS. The desk also net sold over $400mm BBB- ABX index. Desk is net short, but less than before. Shorts are in senior tranches of indexes sold and in single names. Plan is to continue to trade from short side, cover more single names and sell BBB- index outright."1694

¶On February 27, 2007, Mr. Ruzika sent an email to Messrs. Montag, Gmelich, and Sparks indicating that the Mortgage Department needed to reduce its net short position by covering even more than $3 billion in shorts: "There are two issues – first is the size of the short – I want to see us getting the short down to 4.5 bil[lion] net. ... Second – the basis in the book needs to be reduced as well."1695 Less than an hour later, Mr. Ruzika sent Mr. Sparks another email at the conclusion of a meeting of Goldman's Operating Committee (OpCom), comprised of Goldman's senior executives. In an email entitled, "OpCom Directive," Mr. Ruzika wrote:

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"Dan. Directly from the opcom we have to pick up the pace of buying back single names even if it costs us some money. I know your guys are trying but we can pay away some if it helps to get size done."1696

¶In response, Mr. Sparks immediately sent an email to Messrs. Swenson, Lehman, and Birnbaum regarding the "Opcom directive." He wrote: "Buyback single names in size today."1697 He also sent the SPG and CDO Desk managers a set of "Goals":

"Reduce risk. That means: (1) get m[o]re super-seniors done on CDOs or take other steps to reduce CDO pipeline risk; (2) cover more single name shorts BBB- and BBB (3) reduce the basis trade between BBB- index and BBB- single names (4) reduce the index/index trades in A and AAA."1698

¶Mr. Sparks' list of goals showed that he was closely tracking the SPG Desk's activities and directed them to reduce rather than eliminate its basis and index trades.

¶At the end of February, the Mortgage Department's efforts got a substantial boost when a new hedge fund client, Harbinger, purchased the short side of $4 billion in single name CDS contracts referencing RMBS securities.1699 By taking the long side in those contracts, the Mortgage Department was able to cover its shorts by the same amount.

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¶On February 28, 2007, Mr. Sparks reported at a Firmwide Risk Committee meeting on the Mortgage Department's progress in reducing its VAR.1700 The committee minutes reflect that Mr. Sparks' report stated the following:

"–VaR up due to vols. Business working to reduce exposures; a lot of shorts already covered. –ABX widened 500bp on the week. Business covered $4BN in single names. –Noted a lot of negative news in the subprime market with rumors on everyone. –CDS on CDOs started to widen significantly over the week. ... –Business continuing to clear out loans."1701

¶Five days later, on March 5, 2007, Mr. Montag requested another update: "Do we think the business is net short, long or flat right now?" Mr. Sparks responded: "We think the overall business is net short." Mr. Gmelich added: "I think we have a very modest short across all the businesses at current market levels. I concur with Dan."1702

¶The Mortgage Department's efforts to cover its $10 billion net short position reduced its VAR; it also allowed the Department to lock in and record large profits from its net shorts. In March 2007, in connection with Goldman's quarterly earnings call with analysts, "Mortgage Talking Points" prepared for Mr. Viniar stated that the Department's revenues were primarily the result of its short positions:

"The Mortgage business' revenues were primarily driven by synthetic short positions concentrated in BBB/BBB- sub prime exposure and single A CDO exposure which benefitted from spread widening."1703

¶At the end of the first quarter of 2007, the Mortgage Department reported total net revenues of $368 million.1704

¶The Mortgage Department continued its efforts to cover the rest of its short position. On March 14, 2007, Mr. Sparks reported to Messrs. Cohn and Montag that a Goldman salesperson

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¶"did a fantastic job for the desk by bringing in $1.2BB [billion] in A-rated single names today."1705 Mr. Montag in turn reported to Goldman CEO Lloyd Blankfein: "Covered another 1.2 billion in shorts in mortgages–almost flat–now need to reduce risk."1706

¶That same day, March 14, 2007, in response to his request, the Mortgage Department sent Mr. Ruzika a detailed breakdown of its subprime mortgage holdings.1707 It disclosed that, despite offsetting short and long positions in a number of areas, the SPG Desk still held three sizeable net short positions involving about $2.6 billion in ABX assets, $2.2 billion in single name CDS contracts, and $2 billion in mezzanine CDOs.1708

¶Goldman personnel prepared the following chart tracking the SPG Trading Desk's efforts to cover its BBB and BBB- net short position from February through mid-May 2007.1709

[SEE CHART NEXT PAGE: Notionals (ABX convention), prepared by Goldman Sachs, reformatted by the Permanent Subcommittee on Investigations to be readable in black and white print, GS MBS-E- 012890600.]

¶AAA Disaster Insurance. Despite all the attention paid to the Mortgage Department's subprime mortgage holdings beginning in December 2006, one large short position seemed to have escaped the directives of senior management in the first quarter of 2007 to cover the Department's shorts. It consisted of a massive $9 billion net short position made up of CDS contracts referencing an ABX index that tracked a basket of 20 AAA rated subprime RMBS securities.1710 Goldman representatives could not recall when that short position was acquired, who acquired it, or whether proprietary funds were used,1711 but the CDS contracts appear to have been held at a relatively constant level of $9 billion from some time in 2006 until July 2007.1712 Mr. Sparks told the Subcommittee that the net short position served as a form of low cost "disaster insurance" that would pay off only in a "worst case" scenario – when even the top tier AAA rated RMBS securities, among the safest of all subprime mortgage investments, lost value.1713

¶Notionals (ABX convention)

10,000,000,000 — 105

¶Index Price

¶100 8,000,000,000

¶95 6,000,000,000

¶90 BBB Index Only

¶4,000,000,000 BBB Index + CDS

¶BBB- Index Only

¶BBB- Index + CDS 2,000,000,000

¶All BBBs Index Only

¶All BBBs Index + CDS

¶0 06-2 BBB- Index Equiv

19-Jan18-Feb20-Mar19-Apr19-May18-Jun18-Jul17-Aug16-Sep16-Oct15-Nov15-Dec14-Jan13-Feb15-Mar14-Apr14-May13-Jun 75 06-2 BBB- Idx Eq (MRMA)

¶06-2 BBB- Index Equiv -2,000,000,000 (w/Cash)

¶06-2 BBB- Index Price

¶-4,000,000,000

BBB bucket includes BBB+ CDS Notionals: refers to current notionals Positive notionals: long risk

¶-6,000,000,000 60 CDS:²⁰⁰⁵²⁰⁰⁵ Id. at 98. / 2006 vintages only

¶Prepared by the U.S. Senate Permanent Subcommittee on Investigations, February 2011. Derived from Goldman Sachs document, GS MBS-E-012890600.

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¶The most comprehensive description of the AAA ABX short position located by the Subcommittee was a chart prepared by a Mortgage Department analyst in August 2007. The analyst sent the chart to Mr. Birnbaum at his request, to show the Mortgage Department's overall position in synthetic products, including CDS contracts referencing ABX, RMBS, and CDO assets.1714 The chart includes the AAA ABX short position as a long, nearly flat line showing an approximately $9 billion net short until early July 2007, when the value turned sharply upward.1715 The analyst wrote in an August email, after much of the AAA ABX net short position had been covered: "M[ortgage] department is short ABX AAA [$]8.7b[illion], splitting among ABS/Alt A/prime/conduit in the beginning of fiscal year 2007, and is now long [$]410m[illion]." While this chart and the covering email do not reveal the origin of the AAA short, they indicate that, by early 2007, it was split between the ABS Trading Desk in the Structured Product Group and three desks in Mr. Gasvoda's Residential Whole Loan Trading area – the Alt A Trading Desk under Genevieve Nestor, the Prime Trading Desk under Clay DeJacinto, and the Conduit for conducting subprime loan pool securitizations under Matt Nichols.

¶Goldman emails provide additional information about the AAA ABX short. One series of emails, from March 2007, indicates that about $8 billion of the $9 billion AAA short was then held by the three desks in Mr. Gasvoda's Residential Whole Loan Trading area, and that he favored maintaining the short, because it provided billions of dollars in coverage and cost only $5 million per quarter in premiums to maintain. On March 4, 2007, Mr. Gasvoda emailed Mr. Sparks with "Quick Thoughts on ABX AAA risk":

"I talked to [Matt] Nichols and Clay [DeJacinto] about the AAA ABX short. Think it offers a good amount downside protection w/ relatively light pain if we're wrong. Below is a $8B ABX AAA short #s. It costs us $5mm/quarter to carry. On the downside, if the market rallies to par ... we drop $50mm. Taking it to 0 spread we lose $80mm.

"On the upside front, we get good jump risk. If AAA's widen to current AA levels ... we gain $70mm and if spreads move up to super senior risk pricing in CDOs ... we're up $190mm.

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"Net, think this is a good position to have on given downside protection and relatively light upside pain. If we get an opportunity to buy some back next week, think we should but I'm thinking buy back $1-2B, not $8B."1716

¶Mr. Sparks replied to Mr. Gasvoda: "Good trading response and thought process. We need to consider daily."1717

¶The next day, March 5, 2007, the Residential Whole Loan Trading Desk under Mr. Gasvoda and the CDO Origination Desk under Peter Ostrem exchanged information about the "ABX hedges" that each business was carrying to reduce the risk associated with its respective long assets.1718 The Residential Whole Loan Trading Desk reported: "[b]elow are all our ABX hedges across our Resi Credit + Prime books," which included approximately $7 billion in AAA ABX holdings.1719 The CDO Origination Desk, in turn, reported holding another $2.25 billion in AAA ABX "hedges."1720 A few days earlier, with respect to the CDO Origination Desk's holdings, Mr. Egol had remarked: "Love that huge AAA abx short."1721

¶Although the $7 billion figure reported by Mr. Gasvoda's group on March 5 was $1 billion less than the $8 billion reported the day before,1722 and the $2.25 billion reported by the CDO Origination Desk was larger than the $1 billion that the August 2007 email later ascribed to the Structured Product Group, all of the evidence indicates that Goldman had a massive AAA ABX short position in 2007. A few days later, on March 8, 2007, in an email to senior management entitled, "Mortgage Risk," Mr. Sparks described the AAA ABX short as a hedge against long positions in the Department's loan books and CDO warehouse accounts:

"[O]verall the department has significant shorts against loan books and the CDO warehouse. The bulk of these shorts ($9BB) are on the AAA index, so the downside is limited as the index trades at 99."1723

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¶In this email to senior executives, Mr. Sparks put the size of the AAA ABX short at $9 billion, which seems to have been the amount most commonly cited for the short.1724

¶When asked about the Gasvoda email which described the AAA ABX short as an inexpensive "jump risk,"1725 Mr. Sparks told the Subcommittee that the email was referring to acquiring "jump insurance" against a sudden, huge loss arising from the total default of an asset.1726 In this context, the short was acquired as insurance against the unlikely event that a significant portion of the AAA rated RMBS securities identified in the ABX Index defaulted simultaneously.1727 Since AAA rated RMBS securities were typically the safest of the RMBS securities offered for sale, it was widely believed in 2006 and 2007, that they would remain untouched even if defaulting mortgages harmed riskier RMBS securities. By shorting AAA rated RMBS securities, Goldman was insuring against a "tail risk" – the risk of an event that appeared to have a very small probability of ever actually occurring, but which was likely to cause catastrophic losses if it did occur. Mr. Sparks also explained that, since the subprime mortgage industry considered losses in AAA rated RMBS securities to be exceedingly unlikely, the price of acquiring and holding such a short position was relatively inexpensive.1728

¶From the time the $9 billion AAA ABX short was acquired in 2006 until July 2007, it was not included in Goldman senior management's directives to cover shorts, and it does not appear to have been part of the Mortgage Department's efforts to get "closer to home," build a net short position in early 2007, or cover that net short in February and March.1729 The $9 billion AAA ABX short may have been left out of management's directives on the first net short, because it was serving as a hedge for long subprime mortgage assets held by several Mortgage Department desks.1730 As those long assets were sold or written down, however, no apparent steps were taken to unwind or remove the $9 billion AAA ABX hedge.1731 By June 2007, it remained almost entirely intact as a net short. The value, cost, and risk associated with the AAA ABX short had been monitored, but not acted upon, until the short suddenly began approaching profitability and began contributing to high VAR levels for the Mortgage Department. It then drew the attention of Goldman senior management which included the AAA ABX short in its directive to cover the firm's second big net short. Covering the AAA ABX net short contributed to the multi-billion- dollar profits realized by Goldman in the third and fourth quarters of 2007.

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¶Report To Board. On March 26, 2007, Mr. Sparks and Goldman senior executives gave a presentation to Goldman's Board of Directors regarding the firm's subprime mortgage business.1732 The presentation recapped for the Board the various steps the Mortgage Department had taken since December 2006, in response to the deterioration of the subprime mortgage market.1733 The presentation noted, among other measures, the following steps:

"– GS reduces CDO activity – Residual assets marked down to reflect market deterioration – GS reverses long market position through purchases of single name CDS and reductions of ABX – GS effectively halts new purchases of sub-prime loan pools through conservative bids – Warehouse lending business reduced – EPD [early payment default] claims continue to increase as market environment continues to soften."1734

¶By the time this presentation was given to the Board of Directors, Goldman's Mortgage Department had swung from a $6 billion net long position in December 2006, to a $10 billion net short position in February 2007, and then acted to cover much of that net short. Despite having to sell billions of dollars in RMBS and CDO securities and whole loans at low prices, and enter into billions of dollars of offsetting long CDS contracts, Goldman's mortgage business managed to book net revenues for the first quarter totaling $368 million.1735

¶In a section entitled, "Lessons Learned," the presentation stated: "Capital markets and financial innovation spread and increase risk,"1736 an acknowledgment by Goldman that "financial innovation," which in this context included ABX, CDO, and CDS instruments, had magnified the risk in the U.S. mortgage market.

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¶(c) Attempted Short Squeeze

¶In May 2007, Goldman's Structured Product Group (SPG) continued to work to cover the Mortgage Department's short position by offering to take the long side of CDS contracts referencing RMBS and CDO securities, but found few buyers. Many market participants had already shorted subprime mortgage assets, driving the price relatively high, and few wanted to buy additional short positions at the prevailing price. In order to turn the situation to its benefit, SPG's traders attempted to carry out a "short squeeze" of the subprime CDS market in May 2007.1737

¶The ABS Desk's traders were already offering single name CDS contracts in which Goldman would take the long position, in order to cover the Mortgage Department's short position.1738 To effectuate a short squeeze, they appear to have decided to offer the short positions on those contracts at lower and lower prices, in order to drive down the market price of subprime CDS shorts to artificially low levels. Once prices fell below what the existing CDS holders had paid for their short positions, the CDS holders would have to record a loss on their holdings and might have to post additional cash collateral with their opposing long parties. Goldman hoped the CDS holders would react by selling their short positions at the lower market price. When the sell off was large enough and the price low enough, Goldman planned to move in and buy more shorts for itself at the artificially low price.

¶This short-squeeze strategy was later laid out in a 2007 performance self-evaluation by one of the traders on Goldman's ABS Desk who participated in the activity, Deeb Salem. In the self-evaluation he provided to senior management, Mr. Salem wrote:

"In May, while we were remain[ing] as negative as ever on the fundamentals in sub-prime, the market was trading VERY SHORT, and susceptible to a squeeze. We began to encourage this squeeze, with plans of getting very short again, after the short squeezed [sic] cause[d] capitulation of these shorts. This strategy seemed do-able and brilliant, but once the negative fundamental news kept coming in at a tremendous rate, we stopped waiting for the shorts to capitulate, and instead just reinitiated shorts ourselves immediately."1739

¶When interviewed by the Subcommittee, Mr. Salem denied that the ABS Desk ever intended to squeeze the market, and claimed that he had wrongly worded his self-evaluation.1740 He said that reading his self-evaluation as a description of an intended short squeeze put too much emphasis on "words."1741

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¶Mr. Salem's description of an attempted short squeeze by Goldman's Structured Product Group is supported by other evidence. In May 2007, Michael Swenson, the head of both SPG and ABS Desks and Mr. Salem's supervisor, wrote emails that appear to confirm the attempted short squeeze. In the first email, dated May 25, 2007, Mr. Swenson wrote:

"We should be offering sn [single name] protection down on the offer side to the street on tier one stuff to cause maximum pain."1742

¶Four days later, on May 29, 2007, Mr. Swenson followed up with another email:

"We should start killing the sn [single name] shorts in the street – let's pick some high quality stuff that guys are hoping is wider today and offer protection tight – this will have people totally demoralized."1743

¶When asked about these emails, Mr. Swenson also denied that Goldman had attempted to squeeze the CDS short market. He claimed that the cost of single name CDS shorts had gone too high, and the purpose behind Goldman's actions was to restore balance to the market.1744 Mr. Swenson could not explain, however, why in an effort to restore balance to the market, he used the phrases "cause maximum pain," and "this will have people totally demoralized."

¶Goldman documents show there was a plan and an attempt to conduct a short squeeze, despite the harm that might be caused to Goldman's clients. Contemporaneous emails further show that clients were complaining about a sudden markdown by Goldman in the value of their short positions, especially compared to prevailing market prices and the worsening of the subprime market itself.1745

¶On May 18, 2007, a Friday, the ABS Desk marked down the value of many of its clients' CDS short positions. On Monday, May 21, Mr. Salem sent an email to Mr. Swenson and Edwin Chin entitled, "A few things . . . pain-related."1746

"Guys r gonna complain about their marks [hedge fund] already emailed me. I would talk about the recent flow of OWICS [offers] and the levels ... they have been trading as the

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reason we moved marks on Friday. ... [Another customer] lost 6 pct based on fridays moves."1747

¶That same day, a Goldman sales representative sent Mr. Chin a complaint from a hedge fund customer named Stanfield Capital regarding the lower values assigned to its CDS short positions. The sales representative wrote:

"Stanfield feels we are marking them tighter than other dealers with whom they have similar protection. ...

In addition, 14 of the 25 names below were marked over 100 bps [basis points] tighter week-on-week. That is a massive move and is creating major stress at the clients, as we can't see a similar move in the broader market. ...

Finally, be aware that Stanfield may look for you to offer protection very close to your mark. ... I'm hoping your attention to the marks below will defuse a situation in which they think we're messing with them via our marks on their protection."1748

¶Mr. Chin forwarded the email to Mr. Swenson and Mr. Salem. Mr. Swenson replied: "We are ok with that they do not have much more gun powder."1749 Mr. Swenson's response suggested that Goldman did not have to be concerned about Stanfield's threat to buy CDS shorts at the same low price Goldman had applied to his CDS holdings, since Stanfield did not have the financial resources – the "gun powder" – to make a large purchase.

¶On May 24, 2007, the Stanfield trader wrote to Goldman that he had thought the purchase of the CDS contract signaled the beginning of a partnership between Stanfield and Goldman, but he had lost credibility with his company because of the CDS contracts and expressed concern that he may have been "naive to trust the pitch" from Goldman:

"When we put on the Single A protection trade the underlying names were suppose[d] to have a large similarity to the index. ... The indexes are up only a couple of points since we did the trade. Looking at the mid's on our Single A trades we have tightened roughly 33%. ... I'm just trying to figure out how we can reverse some of the losses we have incurred.

Also, from where our BBB trade was marked last Friday ... [t]his trade is tighter by 35% as well. ...

I had always thought that these trades were meant to be the start of a partnership building of future business between Stanfield and Goldman Sachs. I know we are big boys and we did the trade there is no doubt of that. What I am attempting to do is either cut our losses and

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get out or determine what I can say to keep this trade on .... I've lost a lot of credi[b]ility on the desk with this trade. Maybe I was naive to trust the pitch on the trade. It has cost me a lot."1750

¶A week later, on May 31, 2007, Stark Investments indicated interest in buying a short on certain RMBS securities backed by home equity loans. The Goldman sales representative trying to close the sale emailed SPG personnel that the client was hesitating due to Goldman's valuations which were "drastically different" from other dealers:

"Stark has an interest in looking at this trade; but there is an obstacle we need to address: They feel Goldman is very inconsistent in the single name HEL [Home Equity Loan] CDS marks that we provide them. We are drastically different in marking positions versus other dealers. It is an annoyance that would potentially limit their interest in putting on incremental CDS trades. I can name specific examples if you would like. Please advise."1751

¶Mr. Salem replied: "you couldn't be more wrong," while Mr. Swenson replied:

"Frankly, we believe we are best in class and have numerous data from controllers, collateral posting and markit (the company, not market) that reflect upon this. This process is thoroughly reviewed by all levels of senior management at GS. ...

"Unlike other dealers we stand by our marks and are willing to transact in the context of our marks. ...

We also don't mark our book wide if we are long protection and tight if we are short. [W]e mark to market."1752

¶When the salesman replied: "I am trying to work with you guys," Mr. Swenson chided him: "You need to manage their opinions on marks – that has been fully vetted over here."1753

¶On June 7, 2007, Mortgage Department personnel learned that two Bear Stearns hedge funds specializing in subprime mortgage assets were in financial distress.1754 In response, the ABS Desk immediately decided to buy more shorts at the prevailing market price to take advantage of the possible collapse of the Bear Stearns hedge funds, which would send subprime mortgage prices still lower. To do so meant the ABS Desk had to sacrifice its "short squeeze" play. On June 7, 2007, Mr. Salem emailed Messrs. Swenson and Chin:

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"We need to go to magnetar [a hedge fund] and see if we can buy a bunch of the cdo protection. ... Can tell them we have a protection buyer, who is looking to get into this trade now that spreads have tightened back in."1755

¶Raising no concerns about the proposed deception, Mr. Swenson replied "Great idea."1756 Mr. Salem continued:

"Should we also send an email to select sales people in the mtg [mortgage] sales force saying that we r looking to buy a block of single name protection vs a cdo OUT OF COMP [in a private, off-market transaction]? It's a no lose situation . . . either we get some sn [single name] protection that we want or we gave these guys a chance and nobody can say we aren't working with them."1757

¶Mr. Swenson responded: "We need to be careful." Mr. Chin wrote that he knew of another CDO collateral manager that might also be willing to sell some shorts: "I mentioned there was a hedge fund on the side and he was very axed to do something."1758

¶Having decided to start buying shorts outright, the ABS Desk also stopped offering to sell CDS short positions to Goldman customers, effectively abandoning the attempted short squeeze. On June 8, 2007, Mr. Swenson told his traders: "[w]ant to slow down on protection offers."1759 On June 10, 2007, in response to a customer inquiry about a CDS short, Mr. Salem wrote: "Not sure if we have any to offer any more."1760 Mr. Swenson was less equivocal: "Really don't want to offer any."1761 On June 13, 2007, a Goldman salesman emailed SPG personnel: "[Customer] is looking to buy protection on cdos."1762 Mr. Salem replied: "too late!"

¶Once it began buying CDS shorts, the SPG Desk immediately changed its CDS short valuations and began increasing their value. Clients with long positions began to complain that the marks were too high, and internal Goldman business units also raised questions. For example, on June 11, 2007, a Goldman valuation specialist sent an email to Mr. Swenson, with copies to Compliance and the Controller's Office noting that "Client challenging marks," followed by

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¶"Trading has agreed to change ... marks."1763 The next day, June 12, 2007, a Goldman representative from the Controller's Office sent an email to Mr. Salem, asking: "Given recent gyrations in the ABX and CDS markets, when can I come by to discuss how you are marking the book tonight?"1764 The following week, on June 19, 2007, the Controller's office sent an email to Mr. Swenson raising questions about values assigned to certain CDS contracts: "These levels look quite wide. Do you have any specific market color that points this direction?"1765

¶The May 2007 attempted short squeeze described in Mr. Salem's performance self-evaluation did not succeed in compelling existing CDS holders to sell their short positions. In Subcommittee interviews, Mr. Salem and Mr. Swenson denied that an attempted short squeeze even took place. Any attempt that did take place was apparently abandoned in June 2007, when Goldman stopped offering to sell CDS short positions. Trading with the intent to manipulate market prices, even if unsuccessful, is a violation of the federal securities laws.1766 Given the novelty of credit default swaps and their use in the mortgage field, however, the Subcommittee is unaware of any enforcement action or case applying an anti-manipulate prohibition to the CDS market. Because Goldman is a registered broker-dealer subject to the supervision of the Financial Industry Regulatory Authority (FINRA), the conduct of its ABS traders raises questions about their compliance with FINRA's Rule 2010, which provides: "A member, in the conduct of his or her business, must observe high standards of commercial honor and just and equitable principles of trade."

¶(d) Building the Big Short

¶In the months of June and July 2007, Goldman's Mortgage Department went short again. This time, it built an even larger net short position than earlier in the year, reaching a peak of $13.9 billion in late June,1767 which Mr. Viniar later referred to as "the big short."1768 This net short position included the $9 billion AAA ABX short which had suddenly begun gaining value as the subprime market worsened. In June, two Bear Stearns hedge funds specializing in subprime mortgage assets collapsed. In July 2007, the credit rating agencies began downgrading ratings for hundreds and then thousands of RMBS and CDO securities. Soon after, the subprime mortgage backed securities market froze and then collapsed. Each of these events increased the value of Goldman's net short position.

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¶Bear Stearns Hedge Fund Collapse. The collapse of the Bear Stearns hedge funds in mid-June triggered Goldman's effort to rebuild its net short position. On June 7, 2007, the Mortgage Department learned that the Bear Stearns hedge funds were seeking quietly to sell some of their subprime portfolio to meet client redemption requests, which Goldman interpreted as a signal of serious financial distress.1769 After reviewing the hedge funds' assets, one Goldman employee remarked:

"In total these two portfolios add up to roughly $17bil in total exposure after leverage. It goes without saying that if this portfolio were to be released into the market the implications would be pretty severe."1770

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¶On June 8, 2007, Mr. Sparks received an urgent early morning email from Goldman's Japan office regarding "unprecedented overnight [rates] market volatility," suggesting that he call in the ABX traders early.1771 "Given the recent correlation of risk assume this is not a good sign for RMBS/ABS spreads."1772 Later that day, when another trader complained about "getting crushed" in the ABX market, Mr. Birnbaum replied: "Patience, patience. The CDO unwind has only begun."1773

¶Around June 12, 2007, public news accounts indicated that the two Bear Stearns funds were unable to meet collateral calls on their subprime mortgage backed securities holdings.1774 The funds also devalued their Net Asset Valuations (NAVs) to significantly lower levels, which effectively triggered the funds' total collapse.1775

Mr. Lehman: Told Egol I'm comfortable w/ the prices, especially when u include the 5 pt [percent] HC [haircut.] Don't think mar[k]ing him down 1 or 2 pts makes sense or sends the right message .... I wud run it by Dan [Sparks] and get his take .... [M]y opinion is that the Firm is appropriately protected w/ current HC [haircut] and mark. Mr. Swenson: W e need to mark him he is the biggest elephant by far and it has an impact on the m$arket[.] Mr. Lehman: How much do u [sic] want to mark him by? Mr. Swenson: A lot[.] Mr. Lehman: I disagree on this one ... Let's talk tomorrow[.] Mr. Swenson: He is done[.]

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¶The failure of the Bear Stearns hedge funds triggered another decline in the value of subprime mortgage related assets. The ABX Index, which was already falling, began a steep, sharp decline. The collapse had further negative effects when the hedge funds' massive subprime holdings were suddenly dumped on the market for sale, further depressing prices of subprime RMBS and CDO assets.

¶The creditors of the Bear Stearns hedge funds met with Bear Stearns management in an attempt to organize a "workout" solution to stabilize the funds.1776 While those efforts were underway, Goldman and Bear Stearns agreed to an unwind in which Goldman bought back $300 million of two AAA CDO tranches of Goldman's Timberwolf CDO, which the hedge funds had purchased two months earlier in April 2007. Goldman paid Bear Stearns 96 and 90 cents on the dollar, respectively, for the two Timberwolf tranches.1777 Goldman also bought a few other RMBS and CDO assets, which it immediately sold.1778 The attempt to organize a workout solution for the funds was ultimately unsuccessful. Large blocks of subprime assets from the Bear Stearns hedge funds' inventory began flooding the market, further depressing subprime asset values.1779

¶Goldman's Structured Product Group (SPG) took the collapse of the Bear Stearns hedge funds as the signal to begin rebuilding its net short position. As Joshua Birnbaum, the head ABX trader on the SPG Desk, later wrote:

"[T]he Bear Stearns Asset Management (BSAM) situation changed everything. I felt that this mark-to-market event for CDO risk would begin a further unraveling in mortgage

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credit. Again, when the prevailing opinion in the department was to remain close to home, I pushed everyone on the [SPG] desk to sell risk aggressively and quickly. We sold billions of index and single name risk."1780

¶In a later internal presentation for Goldman senior executives which Mr. Birnbaum drafted for another purpose,1781 Mr. Birnbaum wrote that, after the Bear Stearns funds collapsed, SPG's Trading Desks went net short outright and that the shorts were not a hedge for long positions:

"By June, all retained CDO and RMBS positions were identified already hedged. ... SPG trading reinitiated shorts post BSAM [Bear Stearns Asset Management] unwind on an outright basis with no accompanying CDO or RMBS retained position longs. In other words, the shorts were not a hedge."1782

¶On June 29, 2007, the ABX Index and the value of single name CDS contracts referencing RMBS and CDO securities plummeted in value and continued dropping until mid-July. Mr. Swenson, head of the SPG Trading Desk, exchanged emails with Mr. Lehman and other Goldman executives about that day's trading: "There is absolutely no support at the lower levels from the street. CDOs are wider by 50 bps or more." Mr. Lehman responded: "[W]e r in the middle of a mkt meltdown."1783

¶On July 10, 2007, the two primary ratings agencies, Standard & Poor's and Moody's, began the first of many mass ratings downgrades for subprime RMBS and CDO securities.1784 The downgrades sent another negative shockwave through the subprime mortgage market as investors scrambled to assess the impact of the downgrades on their RMBS and CDO holdings.1785 On July 12, 2007, when still more RMBS and CDO ratings downgrades were announced, Mr. Birnbaum wrote to his colleagues: "Seen massive flows recently. Many accounts 'throwing in the towel'. Anybody who tried to call the bottom left in bodybags."1786

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¶On July 27, 2007, a Goldman senior sales executive summarized the state of the market:

"Whether you remember '94, '98, or '03, the general themes/patterns are consistent. An initial dislocation to the market (in this instance a credit deterioration in sub prime mortgages) acts as a tipping point and leads to spread widening in other sectors. This in turn quickly becomes a liquidity crunch/crisis. It appears this is where the structured product market is now – searching for liquidity. This has produced numerous capitulation/liquidation situations and forced customers to trade. . . . The impact of this week leaves the account base in three camps: The Paralyzed . . . The Wounded (some fatally) . . . The Opportunistic."1787

¶Although the July subprime market meltdown was a disaster for many investors, the value of Goldman's net short positions climbed rapidly. Senior management at all levels were aware of the Mortgage Department's net short and the profits it was generating. On July 20, 2007, CEO Lloyd Blankfein and COO Gary Cohn received a profit and loss report showing that the Mortgage Department was up $72.7 million for the day, across almost every mortgage trading desk. Mr. Cohn wrote to Mr. Blankfein: "There is a net short."1788 On July 24, 2007, the Mortgage Department posted a profit of $83 million for the day, while the firm's overall net revenue for the day was only $74 million.1789 Mr. Viniar forwarded the report to Mr. Blankfein with a note saying: "Mergers, overnight asia and especially short mortgages saved the day." On July 29, 2007, Mr. Sparks reported to Messrs. Montag and Mullen:

"Department-wide P&L [Profit & Loss] for the week was $375mm (this is after adjusting for the $100mm [error] discussed today). Correlation P&L on the week was $234mm, with CMBS, CDOs, and RMBS/ABX shorts all contributing."1790

¶Mr. Birnbaum later recapped the SPG Trading Desk's profits during this period: "[W]hen the [ABX] index dropped 25 pts in July, we had a blow-out p&l month, making over $1Bln that month."1791

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¶Covering the Big Short to Lock in Profits. Starting in July and throughout August 2007, Goldman undertook an intensive effort to cover its $13.9 billion net short and lock in its profits. To do so, the Mortgage Department bought long assets, offered CDS contracts in which it took the long side, and even sold some short positions.

¶The Mortgage Department was particularly focused on purchasing long AAA assets to cover Goldman's $9 billion AAA ABX short, to lock in the unexpected profits on that position. In August 2007, Mr. Lehman, co-head of the SPG Desk, wrote: "[A]s swenny/deeb/josh have done an awesome job sourcing risk, the CDO transition book AAA ABX short decreased from 1.55bb to 250m over the past two weeks – we love covering that trade."1792 On August 23, 2007, Mr. Montag reported to Messrs. Cohn and Viniar: "We ... bought back almost 9 billion of aaa abx over last two weeks."1793

¶From mid-July through the end of August, the Mortgage Department also covered a range of other shorts.1794 On August 5, 2007, Mr. Swenson reported a "phenomenal week":

"In summary, a phenomenal week for covering our Index shorts on the week. The ABS Desk bought $3.3bb of ABX Index across various vintages and ratings over the past week. $1.5 billion was retained by the ABS desk to cover shorts in ABX ($900mm in ABX 06-1 As being the most significant) and $1.0 billion was sold to internal desks across the mortgage department ($925mm in triple-As)."1795

¶Mr. Swenson also reported that the Mortgage Department was still $8.3 billion net short across all subprime asset classes, including $4 billion of AAA ABX assets.1796

¶On August 8, the market rallied for a short period, and the Mortgage Department's net short position suffered a $100 million loss. Mr. Swenson explained: "Market rallied especially at the top end of the capital structure – AAA (up 2 pts), AA (up 3 pts), and A (up 2 pt.)." He reported that the Department still held a $3.1 billion net short in AAA rated subprime mortgage assets.1797 Mr. Montag replied: "now on to the 3 billion short."1798 The next day, August 9, 2007, Mr. Montag reported to his colleagues: "mortgages bought back 1 billion of 3 billion short in AAA indices at ½ to 1 point better than yesterday."1799

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¶On August 11, 2007, reports of firms having to sell CDO securities in Asia prompted Mr. Mullen to ask: "Did we cover to[o] soon? Looks like more selling at the higher end of cap stack"1800 Mr. Lehman replied: "Don't th[in]k so – we haven't covered any CDO risk (we have gone the other way by 1.44bb since June 1st ) and that is where the market still has bad longs – th[in]k AAA rmbs is a very different trade."1801

¶On August 20, 2007, Mr. Sparks reported on the Mortgage Department's progress in covering its net short, telling Mr. Montag: "[L]oan books had been heavily net short (still are some – especially ... in alt a) and I have been forcing them to cover over the past 2 weeks." Mr. Montag responded: "[H]eavily isn't the half of it – we have bought back 4 - 5 billion and still short."1802

¶Buying More AAA RMBS Securities. In August 2007, the Mortgage Department proposed buying $10 billion in AAA rated RMBS securities, but did not receive permission to initiate the investment.

¶By August 2007, AAA rated RMBS and CDO securities were available from many financial firms at a very low price. On August 14, 2007, in summarizing the prior week's trading Mr. Swenson wrote: "Top of the capital structure is where all the action is. AAAs are extremely cheap .... [W]ant to scale into a large long."1803 Mr. Sparks agreed: "[T]he AAA ABX index is a great opportunity and we continue to like it."1804 On August 19, 2007, Mr. Lehman reported that the Mortgage Department had purchased $1.6 billion of the long side of CDS contracts referencing the ABX Index for AAA RMBS securities, and that its value had increased 1.5 percent over the prior week. Given Goldman's dominant market share and recent large purchases, however, Mr. Montag was skeptical: "How much of the aaa outperforming was us buying?"1805 Mr. Birnbaum responded: "On the AAA outperformance question, I think AAAs would have performed similarly without our adding."1806 He also wrote that the "likelihood of loss on 'real' RMBS AAAs (i.e., not AAA CDOs)," was "remote."1807

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¶According to Mr. Birnbaum, a key reason for buying the AAA rated assets was that Mr. Birnbaum and others in the Mortgage Department wanted to maintain a large short position in ABX assets referencing BBB and BBB- rated RMBS securities, because they believed the ABX Index for those securities would fall even further.1808 Mr. Birnbaum told the Subcommittee that covering the BBB/BBB- net short position in August would have amounted to leaving money on the table.1809 He explained that the Mortgage Department thought that buying a proportionate amount of AAA ABX long positions could be used to offset the risks of continuing to hold the BBB/BBB- short until the ABX Index bottomed out.1810

¶On August 14, 2007, Mr. Sparks updated Goldman senior executives on the success of the Mortgage Department's efforts to cover its shorts and added that the Department was interested in increasing its purchase of AAA rated RMBS securities: "we will likely come to you soon and say we'd like to get long billions[.]"1811 Senior executives reacted with skepticism.1812 Mr. Sparks responded: "We're continuing to cover some shorts and we may cover some BBB with AAA, but I got the message clearly that we shouldn't get long without Gary [Cohn]/Tom [Montag]/Don [Mullen] all saying OK."1813

¶On August 20, 2007, Mr. Sparks pitched the idea again to Mr. Montag and other senior executives in an email entitled, "Big Opportunity":

"We are seeing large liquidations – we bought $350mm AAA subprime RMBS from ... SIV unwinds today. ... We think it is now time to start using balance sheet and it is a unique opportunity with real upside – specifically for AAA RMBS. We've sold over $100mm of what we bought today – most up 1-2 points.

That's a great trade – buy and flip up 1-2 points, however, we're not always going to be able to do that – and there's the opportunity for us to make 5-10 points if we have a longer term hold."1814

¶is a significant escalation of the subprime meltdown. ... At its heart, the main shoe to fall will be when the rating agencies downgrade to the aaa level. I don't see as they have much of a choice. Mez[zanine] aaa cdo trade in the 20 and 30s cannot be overlooked even by the agencies." Id.

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¶On August 21, 2007, Mr. Birnbaum presented the Mortgage Department's plan to buy up to $10 billion in AAA rated RMBS securities.1815 The plan had dual objectives, to profit from the intrinsic financial value of the proposed assets and to use those assets to preserve, rather than cover, the Department's existing $3.5 billion BBB/BBB- net short:

"– The mortgage department thinks there is currently an extraordinary opportunity for those with dry powder to add AAA subprime risk in either cash or synthetic form.

– We would like to be opportunistic buyers of up to $10Bln subprime AAAs in either cash or synthetic (ABX) form and run that long against our $3.5Bln in mezzanine subprime shorts.

– Mortgage dept VAR would be reduced by $75mm and Firmwide VAR would be reduced by $25mm.

– At current dollar prices, the implied losses at the AAA level are 2.5x higher than the implied losses at the BBB level where we have our shorts (the ratio is even cheaper for cash due to technicals). If AAAs were priced consistent with BBB implied loss levels, they would be trading 5-10pts higher in synthetics and 10-15 points higher in cash. ...

– On the demand side, we plan to share this trade quietly with selected risk partners. We began doing so yesterday when we sold 1/3 of the AAAs purchased off the [seller] list to [customer] and 100% of the AAAs from [seller] to [customer] and [customer]."1816

¶Mr. Montag responded that he wanted to discuss the concept further.1817 Mr. McMahon wrote: "What are we holding against the 3.5b mezz shorts right now? Why don't we just cover the shorts?"1818 Co-President Gary Cohn emailed Messrs. Mullen, Winkelried, and Montag: "I do like the idea but you[r] call."1819 Before any further discussion took place, however, events overtook the debate.

¶[M cMahon]. W e aren't going crazy with it, just being opportunistic. Before we get large, we are going to lay out a strategy for the four of you.").

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¶(e) "Get Down Now"

¶Despite direction from senior management to cover its $13.9 billion net short position, the Mortgage Department continued to maintain several large net shorts, including at least $3 billion in single name CDS contracts referencing BBB and BBB- rated RMBS securities that it expected to gain in profits. In August 2007, Co-President Gary Cohn finally issued an order to "get down now."1820

¶Excessive VAR. By late August, a combination of the large net short and volatility in the subprime mortgage market had driven the Mortgage Department's VAR to an all-time high. When the AAA ABX short position was far out-of-the-money, it entailed little market risk, as it was not actively traded and had little likelihood of ever paying off. Once the AAA ABX short became profitable, however, the $9 billion position was so large that it had a major impact on the firm's risk measurements. Even a small percentage change in $9 billion can cause substantial changes in a profit and loss statement. As Mr. Sparks explained: "The combination of our large AAA ABX index shorts and the relatively new volatility in the AAA part of the index will result in much larger daily swings in P&L [profit and loss] both ways."1821

¶As predicted, due to the $9 billion short, the Mortgage Department's daily profit and loss reports began to show much larger swings.1822 For example, while the Mortgage Department showed a profit of $71 million on July 21, 2007,1823 it showed a loss of $100 million on August 8.1824 Upon hearing of that loss, Mr. Montag asked "so who lost the hundy?"1825 Mr. Birnbaum wrote to a colleague: "I'm sure the AAA ABX is being blamed as the reason the dept was down 100 yest[erday]."1826 While some in the Mortgage Department disagreed with the use of VAR as a measure of risk,1827 the gyrations in daily profit and loss figures demonstrated that the $9 billion net short posed real risk to Goldman.

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¶VAR depends primarily on the aggregate size of net asset positions and the volatility of the relevant market. Goldman was holding several large net short positions, the subprime market had become extremely volatile, and the Department's efforts to cover its shorts further complicated matters. Although Goldman's covering of its $9 billion net short AAA position would ordinarily be expected to reduce risk, the massive size of the position, combined with unprecedented levels of volatility in the market, the speed of Goldman's covering, and the size of the trades involved, resulted in steep increases in the Department's VAR.

¶The Mortgage Department's VAR had increased from around $13 million in mid-2006, well under the Department's permanent limit of $35 million, to $85 million in February 2007, to a high of around $113 million in August 2007.1828 The $113 million figure exceeded the Department's $35 million permanent VAR limit by more than 350%. Moreover, the Mortgage Department, which had never contributed more than about 2% of firmwide net revenue prior to 2007, was generating some 54% of all the risk incurred by the firm in August 2007. The Mortgage Department's risk level, however profitable, was of increasing concern from a firmwide perspective.1829

¶In an effort to maximize the profit potential from its net short positions, SPG personnel in the Mortgage Department argued against indiscriminately covering all of the Department's shorts.1830 But the Mortgage Department's VAR level proved to be both intractable and highly unpredictable.1831 It also contributed to record high levels of firmwide VAR, a figure carefully monitored by the firm's most senior management. The Mortgage Department and its risk controllers tried unsuccessfully to reduce the Department's VAR, and were discussing new alternatives,1832 when Goldman's Co-President Gary Cohn intervened. On August 15, 2007, the same day that Goldman's firmwide VAR hit a then-record high of $165 million, Mr. Cohn emailed the Mortgage Department's senior managers, risk analysts and controllers: "There is no room for debate – we must get down now."1833

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¶The Mortgage Department took immediate action. To reduce its VAR, the Department had to sell at least some of its BBB/BBB- net short position.1834 On August 23, 2007, Mr. Swenson reported that Harbinger had bought a large block of single name CDS contracts shorting BBB/BBB- rated RMBS securities which allowed Goldman to take the long side: "We just printed $400mm of Singles with Harbinger. 130mm of BBB and 270mm BBB-." Mr. Montag passed the message on to Messrs. Cohn and Viniar: "Finally actuall[y] covering singles." Mr. Cohn responded: "Great."1835

¶But even after that $400 million sale, Mr. Sparks reported to Mr. Montag: "[W]e are short ... about $3BB single names."1836 Mr. Montag responded that the $3 billion net short position was "huge and outsized" and $800 million had to be sold: "[I]f I make you sell a whopping 800 [million] out of 3 billion which is less than 30% how can anyone complain–the position is huge and outsized."1837 At the end of the trading day on August 23, Mr. Montag asked Mr. Sparks: "How much did we cover–shooting for $1 billion." Mr. Sparks responded: "Not much more today – trying."1838

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¶Although the Mortgage Department did not cover its shorts as quickly as Mr. Montag wanted, within days of Mr. Cohn's August 15 order to "get down," Goldman's firmwide trading VAR had dropped by $40 million and the Mortgage Department's VAR had dropped below $100 million.1839 On August 23, 2007, Mr. Cohn forwarded a VAR report to CEO Lloyd Blankfein: "The message got through." Mr. Blankfein responded: "Good job." Mr. Cohn wrote: "Down 40 in 2 days."1840

¶Although the Mortgage Department's VAR measure fell substantially, it remained well above its permanent risk limit of $35 million throughout the rest of 2007.1841 In addition, although Goldman senior executives rejected the Mortgage Department's plan to buy $10 billion in AAA rated RMBS securities,1842 the Department ultimately purchased over $2.2 billion in AAA rated RMBS securities1843 and continued to hold and strategically sell off its BBB and other short positions through the end of 2007.1844

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¶(f) Profiting from the Big Short: Making "Serious Money"

¶Goldman's short positions continued to produce profits for the firm, as mortgage related assets continued to lose value. In September 2007, one of the key traders in the Mortgage Department, Deeb Salem, summarized four key short-side trading strategies that enabled the Mortgage Department to profit from the collapse of the subprime mortgage market:1845

(a) a "dispersion trade," in which Goldman took advantage of "mispriced" single name CDS contracts that referenced very poorly performing RMBS securities, but were not priced much lower than better performing RMBS securities, resulting in profits of $750 million "so far";

(b) a massive purchase of single name CDS contracts referencing a variety of RMBS securities, taking advantage of Goldman's estimated 33% "dominant" market share in single name CDS to make a "HUGE directional bet" against the subprime mortgage market, resulting in profits of $1.7 billion;1846

(c) the purchase "at a discount" of single name CDS contracts referencing Alt A and A rated RMBS securities, which "others don't want/know where to price," resulting in profits of $400 million "so far"; and

(d) the purchase of single name CDS contracts on A, AA and AAA rated CDO securities "in size," amassing an "enormous" market share whose profits had "exceeded all of our high expectations" at $900 million "so far."1847

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¶In October 2007, after the credit rating agencies downgraded hundreds of CDO securities,1848 Mr. Swenson wrote to Mr. Mullen that the downgrades would eventually cause defaults in many CDO securities that Goldman had shorted, meaning that Goldman's "CDS protection premiums paid out will go to zero,"1849 and Goldman would receive substantial CDS payments on those CDOs from the long parties. Mr. Mullen responded: "Looks like we're going to make some serious money." Mr. Swenson replied: "Yes, we are well-positioned."1850

¶Indeed, the Mortgage Department made $110 million the very next day.1851 Mr. Swenson explained: "65mm was from yesterday's downgrades which lead to the selloff." Mr. Mullen replied: "Great day!"1852 By the end of 2007, the Mortgage Department had brought in approximately $3.7 billion in net revenues from its SPG Trading Desk.1853

¶(g) Goldman's Records Confirm Large Short Position

¶In addition to contemporaneous emails, presentations, and reports, Goldman's large net short position is reflected in its own financial records, including its Mortgage Department Top Sheets.1854 Goldman's Mortgage Department kept records of its overall net short positions across

¶"c. W illingness to put on trades that others don't want/know where to price The 2 most successful trades in this regard have been our $70mm long Alt-A protection and our $1-2bb long subprime Single-A protection [i.e., being "short risk" or taking short side in a CDS transaction]. W hen CDOs wanted to sell Alt-A and single-A protection ... the rest of the street was tentative. ... W e viewed this as a tremendous opportunity to buy cheap out-of-the-money options at a significant discount to fair-value. Our exit strategy was always that if sub-prime fundamentals got bad enough, and they did, that the contagion would have to spread up the capital structure because cum loss vol/uncertainty has to go up thus. . . .$400mm so far for the desk ....

¶"d. CDO CDS trade: This trade has made $900mm so far, which exceeded all of our high expectations for the trade. I had the confidence and desire for the desk to buy A, AA, and AAA CDO CDS protection in size during the fall of 2006 for several reasons: ... [T]he rating agencies' correlation assumptions were out of whack with the growing concern about the housing market and the remarkable similarity between the bonds in a CDO, the difficulty that GS was having in placing such mezzanine liabilities and the complexity of such securities scared hedge funds from buying the protection themselves. Edwin and I used the same aggressive strategies in purchasing protection that we used to dominate the SN CDS market. Our market share was enormous ... and we did every ... trade possible." Id.

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¶various subprime asset classes on a daily basis throughout most of 2007.1855 Those records indicate that the Mortgage Department had large net short positions in the subprime mortgage market throughout most of 2007. Goldman's documents reveal that it had a $10 billion net short position at the end of February 2007, and a $13.9 billion net short position in mid-June 2007.1856

¶(i) Top Sheets

¶Daniel Sparks told the Subcommittee that, in 2006 and earlier, he was frustrated because he felt Goldman had inadequate systems to track and aggregate the daily positions of the various desks in the Mortgage Department.1857 At the end of each trading day, he had to review up to a dozen separate reports from the desks to develop a composite mental picture of the Mortgage Department's overall positions. To remedy this shortcoming, in February 2007, Mr. Sparks and the Department's strategic analysts, sometimes called "strats," developed a single-page report called the Mortgage Department Top Sheet.1858

¶The Mortgage Department Top Sheet became the primary report through which the Mortgage Department tracked its daily positions in various classes of mortgage related assets. It provided a comprehensive listing of the Mortgage Department's long and short positions in different asset classes across all desks at the end of each trading day. The Top Sheet drew data from up to a dozen separate reports generated by Goldman's electronic systems. Mr. Sparks told the Subcommittee that the Top Sheet evolved over time to become a good tool that provided a comprehensive record of the Department's positions.1859 The Goldman Controller's office told the Subcommittee that Goldman did not maintain any other type of comprehensive daily report regarding the Mortgage Department's net positions in various asset classes.1860

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¶The Top Sheet was literally the top sheet, or cover page, to a comprehensive report distributed daily to Mr. Sparks and other Mortgage Department managers.1861 The top line of the Top Sheet listed the aggregate total amounts held by the Mortgage Department in various asset classes, including AAA, AA, BBB, and BBB- rated assets.1862 During most of 2007, the Top Sheet also provided an overall net short or long figure that summed across the top line totals for each of the respective asset classes, providing an overall figure by which the Mortgage Department was net long or net short across all asset classes each day. By plotting this overall net figure for each daily Top Sheet, the Subcommittee developed a graph of the Mortgage Department's net position during 2007, as indicated on the chart on the following page.1863

[SEE CHART NEXT PAGE: Goldman Sachs Mortgage Department Total Net Short Position, prepared by the Permanent Subcommittee on Investigations.]

¶Goldman Sachs Mo rtgage Department Tot al Net Short Position, February - December 2007 in S Billions

¶(Market Value, Including All Synt hetic and Cash Positions in Mortgage Related Products)

¶5.0

¶0.0

¶2/ /07 3/5/07 4/5/07 5/5/07 6/5/07 7/5/07 8/5/07 9/5/07 10/5/0 11/5/07 12/5/07

¶-5.0

¶-10.0

¶-15.0 Prepared by the U.S. Senate Permanent Subcommittee on Investigat ions, April 2010. Updated Ja nuary, 2011. Derived from Goldman Sachs Mortgage Strategies, Mortgage Dept Top Sheet s provided by Goldman Sachs.

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¶The Subcommittee's net short chart is generally consistent with a Goldman chart that Mr. Birnbaum asked one of the Mortgage Department's analysts to prepare for him in August 2007, which can be seen on the following page.

[SEE CHART NEXT PAGE: RMBS Subprime Notional History, prepared by Goldman Sachs.]1864

¶The "zero" line in the middle of the chart represents a neutral trading position that is neither net long nor net short. To use Mr. Viniar's description, the zero line represents "home." The area below the zero line represents net short positions; the area above the line represents net long positions. The chart shows that the Goldman Mortgage Department was net short throughout 2007, with a total net short position that reached $13.9 billion in July.

¶8/17/2007 Goldman internal chart, "RMBS Subprime Notional History (Mtg Dept - 'Mtg NYC SPG Portfolio')," GS MBS-E-012928391, Hearing Exhibit 4/27-56a. The title of the Goldman chart, "NYC SPG Trading" is confusing, as Mr. Birnbaum asked the analyst, Kevin Kao, for a chart of all synthetic positions across the entire Mortgage Department (including areas other than SPG Trading). In an email to M r. Birnbaum, Mr. Kao confirmed that despite the title, the chart actually included all synthetic positions across the entire Mortgage Department, and not just the SPG Trading Desk positions. 8/17/2007 email from Mr. Kao to Mr. Birnbaum, GS MBS-E-012929469. Mr. Kao explained that his chart did not include cash positions, meaning long positions in mortgage loans or RMBS from any remaining warehouse inventory. Id. That omission was not significant, however, since Goldman had rapidly sold off the vast bulk of its cash inventory starting in November 2006. 4/2010 "Goldman Sachs Long Cash Subprime Mortgage Exposure, Investments in Subprime Mortgage Loans, and Investments in Subprime Mortgage Backed Securities November 24, 2006 vs. August 31, 2007 - in $ Billions," chart prepared by the Subcommittee, Hearing Exhibit 4/27-163. In any event, the Subcommittee's net short chart includes the Department's cash positions and demonstrates that any long cash positions were insufficient to offset the shorts, as the Mortgage Department was massively net short throughout most of 2007. See PSI Net Short Chart.

¶In his Supplemental Responses to Questions for the Record from the Subcommittee, Mr. Birnbaum conceded that the Subcommittee's net short chart includes cash positions and therefore fixed the problem of being limited to synthetics as was the case with Goldman's own net short chart. See 8/17/2007 Goldman internal chart, "RM BS Subprime Notional History (Mtg Dept - Mtg NYC SPG Portfolio)," GS M BS-E-012928391, Hearing Exhibit 4/27-56a; Birnbaum responses to Subcommittee QFRs at PSI_QFR_GS0509. Mr. Birnbaum maintained his objection that the Subcommittee's net short chart improperly summed the notional amounts of different asset classes. Id. However, as noted in the text, the Mortgage Department's Top Sheet actually converted the notional amounts of each asset class into their market values, making it fair to sum across all asset classes.

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¶Some Goldman representatives told the Subcommittee that they objected to both the Subcommittee's net short chart, and Goldman's own similar chart, on the grounds that the charts are too simplistic and fail to account for the relative "weight" or value of short positions in differing asset classes.1865 For example, in a 2010 interview with the Subcommittee, Mr. Birnbaum said that because of their differing "weights" or values relative to one another, the notional amounts in each asset class could not simply be summed up together. For example, he said the notional amount of AAA assets cannot be added to the notional amount of BBB assets, because the market assigns each of those positions different weights or values relative to each other.1866 He said that these relative weights or values are often expressed as specific "hedge ratios" which Goldman traders can call up on their computer screens in real time to tell them, for example, the amount of AAA assets they should buy long to hedge a given net short position in BBB assets.1867 Each class also poses a different level of risk than the others. For example, short positions in AAA assets were relatively inexpensive, as the risk of loss in that tier was considered relatively low, while short positions in BBB assets would have higher prices, because the risk of loss was considered high. Mr. Birnbaum said the only chart of Goldman's net short position that he would accept as fairly representative would be one that was "Beta-adjusted" to account for differences in the relative weights, but he admitted that he was unaware of any such charts or reports created by Goldman during 2007.1868 Without considering these relative weights (which continually change based on market price movements in various asset tiers), Mr. Birnbaum said it would be impossible to say that Goldman was ever "net short" at all or in what amount.1869

¶Goldman's own documents provide a different picture, however. The Top Sheet was the primary comprehensive record used by the Mortgage Department to track all net positions across the Mortgage Department. Goldman did not keep any other records that identified the Mortgage Department's net positions in various asset classes,1870 and did not keep any records that used the "Beta-adjustment" method advocated by Mr. Birnbaum. By early March 2007, the Top Sheet generally expressed the market values of positions in different asset classes, rather than the notional amount of the positions.1871 By using the market values of positions in each asset class on a given day, the Mortgage Department did, in fact, create a reasonable method for summing across all asset classes in a single common denominator – the amount of cash the assets would bring in the market that day. Since the Subcommittee's net short chart relies on the Department's daily Top Sheet figures as expressed in market values rather than notional amounts, it does not suffer from the incompatibility defect pointed out by Mr. Birnbaum.

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¶Mr. Birnbaum's position that the notional amounts of each asset class cannot be summed up together is also inconsistent with what Goldman's Mortgage Department did on a day-to-day basis in 2007. Mr. Sparks, the Mortgage Department head who helped design the Top Sheet, used it to measure the Department's daily position. Mortgage Department personnel and other Goldman executives also discussed the Department's being "net short"– either overall or in specific asset classes – on a daily basis.1872

¶Indeed, the phrase "net short" appears more than 3,400 times in the documents produced to the Subcommittee by Goldman.1873 Since Mr. Birnbaum claimed that one could never really say whether Goldman was truly "net short," the Subcommittee asked him why the phrase "net short" appeared so many times in Goldman's documents. Mr. Birnbaum said that the use of the phrase "net short" was a "shorthand" that was used internally in the Mortgage Department.1874 In fact, neither Mr. Birnbaum, Goldman, nor the Subcommittee could identify any specific document or instance from 2007 in which the weighting exercise advocated by Mr. Birnbaum in his September 2010 interview was ever used or suggested.

¶Aside from the Top Sheet that summed up totals across different asset classes to obtain an aggregate total, there are also many documents in which Goldman personnel described the total amounts by which Goldman was net short in respective asset classes. For example, Mr. Swenson, and later Mr. Lehman, compiled an email summary each week that described each Mortgage Department desk's net position in different asset classes. A typical format was as follows:

¶"Current [SPG Trading] Desk Position Summary:

RMBS Single-As - net short 900mm 100% in single-name CDS

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RMBS BBB/BBB- - net short 3,000mm (80% in single-name CDS - 50% 2005 vintage

Correlation Desk - net short $400mm of ABX 06-1 BBB and BBB-

Mortgage Department short approx $4bb AAA ABX"1875

¶Mr. Swenson's email summaries were forwarded to Mr. Montag and other senior executives to keep them apprised of the Department's positions.1876 While these documents did not provide an aggregate overall net short position for the Mortgage Department, they did establish net short positions in each of the various specific asset classes described, and they were apparently acceptable to and relied upon by various Goldman executives. Throughout most of 2007, these weekly reports clearly show very large net short positions in mortgage related assets.1877

¶Email correspondence among Goldman's senior executives also routinely referred to the Mortgage Department's net short positions in "billions."1878 CFO David Viniar told the Subcommittee that a loss (or gain) in the amount of even $25 million was considered "large" and would immediately be brought to his attention.1879 By that standard, net revenues of $2 billion from the Mortgage Department's net short positions in the third quarter of 2007 would have been considered significant and monitored by senior management, as indeed they were.

¶In testimony before the Subcommittee and other public statements, Goldman attempted to minimize the size of its net short position by suggesting to the Subcommittee that the short positions held by the Mortgage Department were hedges for other, unidentified long assets.1880 Mr. Blankfein even made that argument to his colleagues in September 2007: "The short position wasn't a bet. It was a hedge."1881 But Mr. Birnbaum contradicted that position just a few days later. On October 4, 2007, Mr. Birnbaum prepared on behalf of the SPG Trading Desk a presentation entitled, "SPG Trading – 2007," in which he advocated that SPG Trading Desk personnel should be compensated like hedge fund managers and not as ordinary participants in Goldman's traditional bonus pool system.1882 The presentation, which Mr. Birnbaum prepared to anticipate and refute counter-arguments that might be made by Goldman senior executives, explicitly addressed and rejected the contention that the profitable net short positions managed by the SPG Trading Desk were hedges for long assets held by other desks. Mr. Birnbaum, one of the chief architects of Goldman's big short, stated:

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"By June [2007], all retained CDO and RMBS positions were identified as already hedged. ... SPG trading re-initiated shorts post BSAM [Bear Stearns Asset Management] unwind on an outright basis with no accompanying CDO or RMBS retained position longs. In other words, the shorts were not a hedge."1883 (Emphasis in original).

¶In response to Questions for the Record from the Subcommittee, Mr. Birnbaum once again stated that SPG Trading initiated the "shorts on an outright basis with no accompanying CDO or RMBS retained position longs following the Bear Stearns Asset Management unwind in 2007, and that these positions were not a hedge."1884

¶Mr. Birnbaum's statement that "all retained CDO and RMBS positions were identified as already hedged" by June 2007 is also supported by other documents provided by Goldman's Mortgage Department. On February 28, 2007, for example, David Rosenblum, Co-Head of the CDO/CLO Origination Desk, initiated a project to ensure that all of the CDO Origination Desk's warehouse accounts were "fully hedged."1885 As a result, the CDO Origination Desk initiated new hedges and specifically allocated others to cover all the desk's warehouse risk. Learning of these actions, Mr. Rosenblum responded: "Great. Getting pretty nailed down."1886 In addition, in a February 12, 2007 email, Mr. Sparks reported to senior management: "Loan and residual books flat," and indicated that the Department's long positions were fully hedged with the short ABX positions.1887 In a third example, after conclusion of the CDO valuation project, all of the remaining CDO assets were transferred from the CDO Origination Desk to the SPG Trading Desk in May 2007. Even after the transfer of those long assets, the SPG Trading Desk remained short, suggesting again that the CDO assets may have already been hedged.1888 These Goldman documents all support Mr. Birnbaum's statement that all retained CDO and RMBS positions were identified as already hedged when the SPG desk started rebuilding its net short position in June 2007.

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¶(ii) Risk Reports

¶The Mortgage Department's large net short positions were also demonstrated by the periodic risk reports that recorded Goldman's key risk measure, "Value at Risk" or "VAR," throughout 2007. At a 95% confidence level, VAR represents the dollar amount a business unit, here the Mortgage Department, could expect to make or lose once every 20 trading days – or about once a month.1889

¶The Mortgage Department's VAR skyrocketed during 2007, climbing far beyond the Mortgage Department's permanent VAR limit of $35 million and hitting a record high of $113 million in mid-August 2007.1890 In 2007, with notable exceptions discussed below, whenever the Mortgage Department's trading exceeded its risk limits, Goldman's risk managers simply assigned the department a new, higher "temporary" risk limit to accommodate the Department's trading.1891

¶At the same time, the higher VAR did signal the presence of a large net short position and functioned to limit the size of that position. Twice during 2007, in late February and again in late August, Goldman's senior executives ordered the Mortgage Department to reduce its large short positions in order to bring the firm's overall VAR measure down.1892 The senior executives were aware of the Mortgage Department's large net short positions, in part, because those positions had contributed to increases in Goldman's firmwide or trading VAR.

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¶The firm tolerated the exceptionally high levels of VAR generated by the Mortgage Department, despite the risks reflected in those high VAR levels.1893 On the few days when the market rallied, the Mortgage Department incurred huge losses from its net short position that were immediately reported up the chain to senior management. For example, upon hearing of a $100 million loss in a single day, Mr. Montag asked: "Okay, who lost the hundy?"1894 Mr. Viniar told the Subcommittee that he was notified of even a $25 million loss in a single day.1895 Allowing the Mortgage Department to maintain high VAR levels meant that Goldman's large net short positions left the firm exposed to large losses, which in some instances did occur, though not as often as its VAR predicted they might.1896

¶Risk Management at Goldman. Every business unit and trading desk at Goldman had a counterpart in the firm's risk management area.1897 Risk managers were assigned to "shadow" the relevant business unit and trading desk operations to ensure that their respective trading activities did not exceed pre-determined risk limits.1898 Separate VAR limits were set for the firm as a whole and for each division. The division then allocated its VAR limit among each department or business area within a division. Some trading desks within a department also had assigned risk limits.

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¶At the end of a typical trading day, Goldman's Risk Department prepared risk reports containing some or all of the risk measures used for the Mortgage Department. The Risk Department prepared daily, weekly, and quarterly risk reports, as well as reports for the Board of Directors and various management committees.1899 Goldman's Firmwide Risk Committee (FWRC) was co-chaired by David Viniar and its weekly meetings were often attended by Co- President Gary Cohn and CEO Lloyd Blankfein.1900 In preparation for a meeting with regulators, Goldman senior executives noted that the Mortgage Department was discussed at every meeting of the FWRC throughout 2007.1901 Goldman also noted that risk "[l]imits are set by the FWRC. Decisions regarding, e.g., short positions in mortgages taken by business units but with full knowledge of the 30th floor."1902

¶Goldman executives told the Subcommittee that, in general, risk limits were firm and compliance was mandatory.1903 At the end of each day, department and divisional personnel, their respective risk managers, and other executives were provided with risk reports from which they could readily see whether a trading desk had breached its limits. In the event of a violation, the desk would be directed to curtail its activities or to take whatever steps were necessary to bring its trading within the applicable limits. Once a desk was notified of its breach of a limit, it was generally required to act immediately to comply with the existing limits.1904

¶At times, the Mortgage Department proposed various modifications or alternatives to its existing risk measures. Some of these proposals were adopted and some were not.1905 But from the perspective of the firm's most senior executives, VAR appeared to have been the predominant risk measure by which the Department's activities were judged.1906

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¶VAR Levels Show Net Short. The primary factors that influence VAR are: (1) the relative size and correlation of positions, and (2) the volatility of trading.1907 While VAR is computed by applying a complex algorithm to trading data, the VAR measure directly reflects position size and correlation, and volatility – or a combination of both factors.1908 Changes in VAR levels over time can also provide information about the general magnitude and direction of trading positions.

¶In the fourth quarter of 2006, the Mortgage Department's permanent VAR limit was $20 million, of which it consumed only $13 million.1909 Early the next year, on February 5, 2007, the Mortgage Department exceeded its limit with a VAR of $20.5 million.1910 On February 8, 2007, a senior risk manager recommended that the Mortgage Department's permanent VAR limit be increased to $30 million to accommodate anticipated increased price volatility in the mortgage markets that year.1911 A senior manager concurred and increased the Mortgage Department's permanent VAR limit to $35 million, which remained the Mortgage Department's "permanent" limit throughout 2007.1912

¶Almost immediately, however, the Mortgage Department breached its new limit, and its VAR continued to climb. Over the course of a single quarter, the Mortgage Department's VAR jumped from $13 million at the end of 2006, to $85 million in the first quarter of 2007 – a 550% increase. Goldman's Chief Risk Officer, Craig Broderick, told the Subcommittee that he would be concerned about any breach of a VAR limit, and would certainly investigate the doubling of a business unit's VAR, but he admittedly took no action when the Mortgage Department's VAR more than quintupled over the course of a single quarter. Mr. Broderick attributed the steep rise in VAR almost exclusively to unprecedented market volatility,1913 although other Goldman officials stated that the VAR levels were being driven by Goldman's large net short positions.1914

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¶For the most part, Goldman's risk managers ignored the Mortgage Department's VAR violations and did not demand immediate compliance with the last applicable limit, as would ordinarily be the case.1915 With notable exceptions in late February and late August 2007, Goldman's risk managers continually assigned the Mortgage Department new "temporary" VAR limits large enough to accommodate whatever risk levels resulted from the Department's trading. Mr. Birnbaum later described this pattern as the risk area's "policy to just keep increasing ou[r] limit."1916

¶The first quarter of 2007 is illustrative of the pattern. During that quarter, the Mortgage Department's trading activities exceeded three new VAR limits in as many weeks. The Mortgage Department received its new permanent VAR limit of $35 million on February 8, 2007.1917 Four days later, on February 12, the Department's VAR hit $49 million.1918 On February 14, the

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¶Department was assigned a new "temporary" limit of $50 million that would expire on February 20.1919 By February 20, however, the Department's VAR was $63 million, well in excess of its temporary limit of $50 million.1920 So the Department was assigned a new temporary limit of $60 million – a level it was already exceeding – until February 27.1921 Instead of dropping below the new temporary limit of $60 million, the Mortgage Department's VAR continued to rise until it hit a quarter-high level of $85 million on February 23 and February 26.1922 In response, on February 27, the Department was given yet another temporary limit of $90 million through the end of the month.1923 But the precipitous rise in VAR apparently alarmed Goldman's Operating Committee, which ordered the Department to reduce the size of its net short position to $4.5 billion.1924 The Department responded immediately and, by February 28, had reduced its VAR to $81 million.1925

¶The pattern created by the Mortgage Department's increasing VAR levels, and the lagged reaction of Goldman's risk managers in setting new "temporary" limits over the course of 2007 is shown in the chart on the next page.

[SEE CHART NEXT PAGE: Goldman Sachs Mortgage Department Value at Risk (VaR), prepared by Permanent Subcommittee on Investigations.]

¶The continual increases in the Mortgage Department's VAR also had an impact on VAR for all of Goldman's trading activities, called "Trading VAR" or "Firmwide VAR." Goldman carefully tracked the amount of its trading VAR that was attributable to the activities of each of its trading desks or units. During the first quarter of 2007, its records show that the firm's Trading VAR rose from $119 million in the prior quarter to $154 million.1926 Goldman has stated that its Mortgage Department's activities have historically resulted in only about 2% of the firm's net revenues.1927 At the end of 2006, the Mortgage Department's VAR of $14 million contributed only about 3% of the Firmwide Trading VAR of $119 million, which is roughly consistent with or proportionate to the 2% contribution to firmwide net revenues that Goldman has reported.1928

Goldman Sachs Mortgage Department Value at Risk (VaR) December 2006 - December 2007 (in $ Millions)

¶Mortgage Department VaR

¶20 Mortgage Department Permanent VaR Limit

¶Mortgage Department Temporary VaR Limit

¶Derived from Goldman Sachs Firmwide Risk Committee Appendices and Market Risk End of Day Summaries provided by Goldman Sachs. Prepared by the U.S. Senate Permanent Subcommittee on Investigations, April 2010.

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¶At the end of the first quarter in 2007, however, the Mortgage Department's VAR of $85 million was contributing a total of 23% to the Firmwide VAR.1929 During the rest of 2007, the Mortgage Department's percentage contribution to Firmwide VAR continued to rise until it hit an all-time high of 54% on August 14, 2007, when the Mortgage Department's VAR reached $110 million on a Firmwide VAR of $165 million.1930

¶The 54% contribution rate to Firmwide VAR means that the Mortgage Department's trading alone accounted for a 54% of total firmwide risk, while all of Goldman's other trading activities combined – including all equities, commodities, foreign exchange, and interest rate instruments – accounted for the rest. Given the serious financial ramifications of such a large and highly concentrated position, the decision to allow the Mortgage Department to incur such a high level of firmwide risk would have required approval at the highest levels of firm management. Indeed, it was Goldman's Operating Committee and its Co-President, Mr. Cohn, who decided in February and August 2007, respectively, that the Mortgage Department's VAR had risen too high and had to be brought down.1931

¶Because of the net short's impact on the Mortgage Department and Firmwide VAR levels, Goldman's senior executives not only knew about the "big short," but made frequent inquiries and exercised frequent control over the Mortgage Department's activities.1932 On August 16, 2007, for example, Jon Winkelried, who served as Co-President with Mr. Cohn, asked Mr. Sparks: "Do you still feel we are being conservative with our marks .... Good time to make sure we're conservative." Mr. Sparks replied:

"I try, but it is much harder than you think with all the things we are dealing with – completely dislocated markets with little price transparency, systems/tools that are not where they should be, focused controllers (who I think are doing a very good job in a tough market) and many cooks in the kitchen who like to micro-manage. ... But I hear your message."

¶Mr. Winkelried replied: "I think you should drop the micro manage theme in this environment."1933

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¶Mr. Mullen also expressed concern that the Mortgage Department's practice of skirting the normal decisionmaking channels and communicating directly with the Co-Presidents Gary Cohn and Jon Winkelried, among other very senior officers, could create problems. When Mr. Birnbaum drafted the Mortgage Department's proposal to buy $10 billion in AAA RMBS securities, he sent it directly to Mr. Cohn and Mr. Winkelried, as well as to his more immediate superiors, Messrs. Mullen, Montag, and Sparks, among others. Mr. Mullen wrote to Messrs. Cohn and Winkelried, the Co-Presidents of Goldman: "It would help to manage these guys if u would not answer these guys and keep bouncing them back to Tom and I." Mr. Cohn replied: "Got that and am not answering," but then added: "I do like the idea but you[r] call."1934

¶For his part, Mr. Montag was also aware that he and Mr. Mullen were taking a more active role in the management of the Mortgage Department than they normally would. Mr. Montag, for example, was Global Co-Head of Securities for the Americas, which encompassed both the FICC Division and the Equities Division, and was responsible for numerous departments. Nonetheless, he was involved in management decisions regarding the Mortgage Department on a near-daily basis in 2007. In August of that year, Mr. Lehman reported to Mr. Sparks that Mr. Montag had asked:

"how the desk thought about him and mullen being very involved. I told him we understood the scrutiny on the business given the overall pressure on our market, large P+L [profit and loss] and risk swings, etc."1935

¶Given the scrutiny by senior executives, the fact that the Mortgage Department's VAR was permitted to reach over $113 million in mid-August 2007 – more than three times its permanent limit – suggests that senior management knew and approved of the magnitude of the risk the Department incurred. It also suggests that the net short positions the Mortgage Department took were proprietary.1936 Goldman's senior executives would have no reason to take such large risks if they were seeking only the small spread arbitrage available from market-making activities for customers.

¶On February 26, 2007, the Mortgage Department's VAR reached a quarterly high of $85.4 million.1937 On February 22, Mr. Sparks had told Messrs. Swenson, Lehman, and Birnbaum that they would have to cover $2 billion in subprime mortgage related net short positions that same day.1938 On February 27, 2007, Mr. Ruzika wrote Mr. Sparks and others: "I want to see us getting the short down to 4.5 bil[lion] net."1939 Later that day, Mr. Ruzika forwarded the "OpCom Directive" to Mr. Sparks: "Dan. Directly from the opcom we need to step up the pace of buying back single names even if it costs us some money."1940 Mr. Birnbaum told the Subcommittee that the SPG Trading Desk's actions in February were taken to reduce the level of VAR.1941

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¶On August 9, 2007, Mr. Birnbaum received a note from the Department's risk managers indicating that the Department's temporary VAR limit might not be extended, which would reverse the prior policy of continually extending temporary limits:

"–Temporary MTG [Mortgage Department] SPG VaR limit of $110mm expired on 8/7/2007[.] –MTG SPG is over its permanent VaR limit of $35mm."1942

¶Mr. Birnbaum told the Subcommittee that he read the note as an indication that the temporary trading limit would not be renewed, and he was being directed to reduce his net short positions to bring VAR under the permanent limit of $35 million.1943 On the same day, August 9, Mr. Birnbaum sent an email to the ABS Desk trader, Mr. Salem:

"Are you getting any more heat to cut/cover risk? These VAR numbers are ludicrous, btw. Completely overestimated for SPG trading, underestimated for other mortgage desks."1944

¶Mr. Salem replied that he had "waved in ~120mm in bbb and bbb- protection in the last 2 days," which covered shorts, so he felt no heat about covering.1945 Mr. Birnbaum said:

"I just asked b/c I saw the note about mortgages dropping back down to a permanent limit of 35mm (which we are way over). This would mark a change of their recent policy to just keep increasing ou[r] limit. Makes me a little nervous that we may be told to do something stupid."1946

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¶Mr. Birnbaum continued: "I do think it is a real concern. How quickly can you work with strats to get them to revise our VAR to a more realistic number?"1947

¶Mr. Birnbaum explained to the Subcommittee that by the phrase, "be told to do something stupid," he meant being ordered by senior Goldman leadership to cover all of the desk's lucrative BBB and BBB- short positions immediately.1948 Mr. Birnbaum and others were reluctant to cover all of SPG Trading's BBB/BBB- shorts, because they believed the ABX Index for BBB and BBB- rated RMBS securities would fall further in coming months, so covering the entire short immediately would amount to leaving significant money on the table.1949 The Department's traders, analysts, and risk managers designed and executed specific transactions over the month of August to lower VAR, but they were unsuccessful.1950

¶For a week between August 14 and August 21, 2007, the Mortgage Department's VAR hovered around $100 million.1951 The Department's record-high VAR contributed to a record Firmwide VAR of $167 million on August 17, 20, and 21, all of which exceeded the Firmwide VAR limit of $150 million.1952 On August 15, 2007, Goldman's Co-President Gary Cohn issued his order: "[G]et down now."1953 In response, the Mortgage Department began selling and covering a portion of its BBB/BBB- net short position, and its VAR quickly dropped to $68 million by August 31. The Mortgage Department was allowed to keep a substantial net short in certain assets, and was granted renewed "temporary" VAR limits at levels between $80 and $110 million through the end of Goldman's fiscal year 2007.1954 The Risk Reports recording these VAR levels throughout 2007 further demonstrate Goldman's net short position. By 2010, the Mortgage Department's permanent VAR limit had increased from $35 million to only $40 million.1955

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¶The dates on which Goldman senior executives ordered the Mortgage Department to reduce its VAR – on February 21 and August 21 – were within two weeks before the end of Goldman's fiscal quarters. In each case, the result was an immediate drop in VAR through the end of the quarter. In February 2007, the Department's VAR dropped from $92 million to $81 million by the end of the quarter. In August 2007, the Department's VAR dropped even more sharply, from a record high of over $110 million to $79.7 million by the end of the quarter.1956 The lower Firmwide VAR figures that resulted from the Mortgage Department's VAR reductions were publicly reported in Goldman's quarterly financial reports.1957

¶(h) Profiting From the Big Short

¶In the third quarter of 2007, Goldman posted financial results showing that it had shorted the subprime mortgage market and profited from its net short position. After posting those third quarter financial results, Goldman continued to trumpet its success, both inside and outside the firm.

¶Third Quarter Financials. On September 20, 2007, Goldman announced record net revenues of $12.3 billion for its third quarter.1958 On September 19, 2007, in a conference call with financial analysts on Goldman's third quarter results, Goldman's CFO, David Viniar, highlighted the performance of the Mortgage Department:

"Let me also address Mortgages specifically. The mortgage sector continues to be challenged and there was a broad decline in the value of mortgage inventory during the third quarter. As a result, we took significant markdowns on our long inventory positions during the quarter, as we had in the previous two quarters. However, our risk bias in that market was to be short and that net short position was profitable."1959

¶Goldman also issued a press release about its third quarter earnings that mentioned mortgages:

"Net revenues in mortgages were also significantly higher, despite continued deterioration in the market environment. Significant losses on non-prime loans and securities were more than offset by gains on short mortgage positions."1960

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¶Internal Statements. In September 2007, Goldman summarized its third quarter results for its Board of Directors, highlighting the Mortgage Department's record profits: "[W]e were overall net short the mortgage market and thus had very strong results."1961

¶In early October, the Mortgage Department held an internal Global Townhall to discuss its third quarter profits in detail. In a draft of the presentation he prepared for the Townhall, Mortgage Department head Daniel Sparks reported that global mortgages generated aggregate net revenues of $741 million, a 152% increase over the same quarter in the prior year, while benefitting from a "proprietary short."1962 Under the heading of "Performance Drivers (Net Revenues)," Mr. Sparks wrote:

"SPG Trading: +2.04bn [up] $1.92bn vs. Q3 2006 – The desk benefited from a proprietary short in CDO and RMBS single names – Additionally, we captured P&L [profit & loss] on spread widening [price declines] in various indices"1963

¶To put the SPG Trading Desk's performance in perspective, it had generated $80 million in the third quarter of 2006, a big year for mortgage related products, but in the third quarter of 2007, an exceptionally poor year for mortgage related products, Goldman's SPG Trading Desk generated $2.04 billion in net revenues – nearly 25 times more. SPG Trading's $2.04 billion in net revenues was offset by other mortgage related losses, including losses from the CDO Origination, Residential Credit, and Residential Prime Desks, but left an aggregate net profit of $741 million for the Mortgage Department as a whole – more than twice the comparable quarter net profit of $294 million in the prior year.1964 The $2.04 billion in net revenues from the SPG Desk accounted for over 16% of Goldman's overall net revenues of $12.3 billion in the third quarter of 2007. The $741 million in net revenues for the Mortgage Department as a whole contributed about 6% of the firm's total net revenues of $12.3 billion for the third quarter, which was three times the department's historical average contribution of about 2% to net revenue.1965

¶In his draft presentation, Mr. Sparks wrote that the "desk benefited from a proprietary short in CDO and RMBS single names."1966 In industry parlance, a "proprietary" position is one acquired with the firm's own capital, solely for the benefit of the firm and not related to customer orders or the firm's role as a market maker. In a later version of the presentation, Mr. Sparks revised the line to read that the desk benefitted from "strong results from trading long correlation and net short bias."1967 When asked why he had originally written that "the desk benefitted from a proprietary short," Mr. Sparks told the Subcommittee that the language was inaccurate.1968

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¶Later in October 2007, Goldman's Chief Risk Officer, Craig Broderick, discussed the Mortgage Department's performance before an internal Goldman audience:

"So what happened to us? A quick word on our own market and credit risk performance in this regard. In market risk – you saw in our 2nd and 3rd qtr results that we made money despite our inherently long positions. – because starting early in '07 our mortgage trading desk started putting on big short positions, mostly using the ABX index, which is a family of indices designed to replicate cash bonds. And did so in enough quantity that we were net short, and made money (substantial money in the 3rd quarter) as the subprime market weakened. (This remains our position today)."1969

¶Goldman's net short positions were also featured in the internal self-evaluations that Mortgage Department personnel were required to prepare and which they expected to be read by their supervisors. In these self-evaluations, which were completed in September 2007, two months before Goldman's fiscal year end on November 30, 2007, several Mortgage Department traders who were active in its shorting activities described the profits produced by the Department's net shorts. Mr. Birnbaum, the senior ABX trader, wrote:

"As a co-head of ABS and SPG trading, my performance in 2007 has been my best ever by any objective measure: 1. P&L. YTD: ABS synthetics: $2.5Bln, ABS: $2.0Bln, SPG Trading: $3.0Bln, all #1 on the street by a wide margin, #2 in the world trading subprime risk (behind Paulson Partners)."1970

¶His self-evaluation showed that the SPG Trading Desk alone generated profits of $3 billion.1971

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¶Mr. Swenson, the head of the SPG and ABS trading desks, wrote:

"It should not be a surprise to anyone that the 2007 year is the one that I am most proud of to date. ... I ... [built] a number one franchise that was able to achieve extraordinary profits (nearly $3bb to date). ... The contributions to the $3bb of SPG Trading profits and $2bb of ABS trading p & l are spread out across various trades and strategies."1972

¶Mr. Salem, one of the ABS traders, wrote:

"Obviously the most important aspect of my 2007 and my contribution to the firm has been the desk's P&L. Mike, Josh, and I were able to learn from our bad long position at the end of 2006 and layout the game plan to put on an enormous directional short. The results of that are obvious."1973

¶Mr. Salem went on to outline estimated profits from four specific trading strategies pursued by the ABS Desk that generated profits totaling $3.75 billion.1974

¶In these three internal documents, key Mortgage Department personnel involved in constructing the Department's net short positions describe the profits generated by those net shorts as "#1 on the street by a wide margin," "extraordinary," and "an enormous directional short" that produced $3.7 billion in profits for the firm.

¶Statements to Regulators. Goldman also described its short positions and the profits they produced to its regulators. In October 2007, Goldman sent a letter to the Securities and Exchange Commission answering questions about its trading activities and reporting that it had been "net short" during "most of 2007":

"[W]e are active traders of mortgage securities and loans and . . . we may choose to take a directional view of the market .... For example, during most of 2007, we maintained a net short sub-prime position and therefore stood to benefit from declining prices in the mortgage market."1975

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¶In November 2007, in another letter to the SEC, Goldman explained further:

"During most of 2007, we maintained a net short subprime position with the use of derivatives, including ABX index contracts and single name CDS which hedged [our] long cash exposure."1976

¶Also in November 2007, in talking points prepared for a meeting with the Tri-Lateral Review Group, which included the Federal Reserve Bank, the SEC, and the United Kingdom's Financial Services Authority, Goldman wrote: "[W]e were able to maintain a short throughout the year."1977 Goldman also wrote:

"The press and others have discussed an anticipated Q4 [2007 fourth quarter] write-down for GS. Our remaining long subprime exposure totals $695 million, inclusive of whole loans and CDO positions. However, we're net short – as we have been throughout 2007. Accordingly, we have nothing to write down."1978

¶Public Statements. Goldman also discussed its net short and related profits in public settings. In November 2007, the Bloomberg news service reported that Goldman's CEO, Lloyd Blankfein, told a public audience at a securities industry conference that Goldman was, and would continue to be, net short the subprime markets:

"[Mr. Blankfein] said the firm is still betting that mortgage-backed assets and collateralized debt obligations will drop. ... 'Given that point of view, we continue to be net short in these markets.'"1979

¶In reaction to another November 2007 news report on how Goldman "dodged the mortgage mess,"1980 Mr. Blankfein sent an email to his colleagues stating: "Of course we didn't dodge the mortgage mess. We lost money, then made more than we lost because of shorts."1981

¶Goldman also prepared for public use a corporate statement entitled, "How Did GS Avoid the Mortgage Crisis? Our Response."1982 The statement was prepared for Mr. Viniar's use in responding to questions about the Mortgage Department's performance in a fourth quarter conference call with analysts. Goldman's public statement outlined the steps it took to reduce its subprime mortgage inventory and related subprime risks in late 2006 and early 2007, characterizing these "proactive" steps as part of its ordinary risk management efforts. Goldman went on to state: "[O]ne should not be led to believe that we went through this period unscathed and somehow significantly profited from a 'bet' on the downturn in mortgage markets."1983 After noting that significant writedowns in the value of its long mortgage inventory had resulted in a "weak" second quarter for mortgages, Goldman wrote:

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"[D]uring the third quarter we were able to make money on mortgages as a result of our net short position. As a consequence, we believe that we are well-positioned to opportunistically participate in the inevitable restructuring of the mortgage market."1984

¶Despite denying earlier in its statement that it significantly profited from a "bet" against a downturn in mortgage markets, Goldman wrote that, in the third quarter of 2007, it had profited from a "net short position" on mortgages. A "net short position" is, in essence, a bet on a downturn in the relevant market, and Goldman's bet was "able to make money."²⁰⁰⁷²⁰⁰⁷ See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0252, at 0262. Year-End Results. The SPG Trading Desk's net revenues for the full fiscal year 2007 were approximately $3.7 billion.1985 In fiscal year 2007, Goldman's total net revenues were approximately $46 billion, and its net earnings (after tax) were approximately $11.6 billion.1986

¶At the Subcommittee hearing, Goldman's Chief Financial Officer, David Viniar, stated that the Mortgage Department's net revenue for 2007 was "less than $500 million, approximately 1 percent of Goldman Sachs's overall net revenues."1987 He insisted that its 2007 net short position in the mortgage market "was not a large short,"1988 and was largely offset by its long positions, omitting that, in 2007, the Mortgage Department's SPG Trading Desk generated a record $3.7 billion in net revenues for the Department as a whole from its net shorts.1989 Those profits sustained the Mortgage Department and Goldman through the harsh financial environment of the subprime mortgage market meltdown and the global credit crisis in 2007. While much of those revenues were offset by other losses, they were a bulwark of profitability in what would otherwise have been a disastrous year for Goldman's mortgage business.

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¶In contrast, other major Wall Street banks reported losses in the third quarter of 2007, primarily due to multi-billion-dollar writedowns in the value of their subprime mortgage related assets.1990 Goldman had not only profited from its net shorts, but had also sold off the bulk of its subprime mortgage assets earlier and at higher prices than many other banks. After observing the losses and writedowns suffered by other Wall Street banks, Mr. Viniar wrote: "Tells you what might be happening to people without the big short."1991

¶At one point, Mr. Birnbaum also contrasted Goldman's performance with its competitors:

"Results out of DB, Citi, UBS, Bear, Lehman etc. all bear evidence that we were far ahead of our competition in marking down positions and moving CDO risk before the market cratered and came to a standstill post-BSAM [Bear Stearns Asset Management]."1992

¶All of these explanations point to actions taken by Goldman to transfer the risks of its own subprime mortgage inventory to others, including many of its own customers, before they became fully aware of the risks entailed in the products Goldman was marketing to them.

¶Goldman Denials. In late 2007, Goldman spoke openly of shorting the subprime mortgage market and that its net short position was profitable. Afterward, as mortgage losses erupted into a full blown financial crisis in the United States and abroad, Goldman began to downplay and even deny the size of its short position, its proprietary nature, and the profits it generated for the firm.1993

¶Goldman had not been the only market participant to profit from a large net short position in mortgage related products. Other investors also aggressively shorted the mortgage market and profited from their short positions. A particularly large short position taken by one hedge fund – Goldman's customer, the Paulson Credit Opportunity Fund of Paulson & Co. Inc. – netted billions of dollars in what was later characterized as "the greatest trade ever."1994 Mr. Birnbaum, however, had described Goldman's own massive net short position as the "greatest trade ever" as early as July

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¶2007.1995 Earlier in the year, Mr. Birnbaum had also described Goldman as the market leader in shorting the housing market, but by July 2007, Mr. Birnbaum conceded that Paulson was "definitely the man in this space, up 2-3 bil on this trade. We were giving him a run for his money for a while but now are a definitive #2."1996 When preparing his case for SPG traders to be paid additional compensation for their 2007 efforts, Mr. Birnbaum again made a comparison to Paulson: "RMBS- related revenues: #1 on the street by a wide margin. #2 in the world behind Paulson Partners."1997

¶In the aftermath of the financial crisis, however, Goldman no longer claimed credit for its market-leading performance during the subprime meltdown. After many of its customers suffered major losses, and several had declared bankruptcy during the financial crisis,1998 Goldman began to downplay the size of its short position and the impact on its profits.1999 In particular, Goldman attempted to dispel the perception that it sold its own customers CDOs it knew were destined to fail, and then profited by betting against them, as discussed in the next section.2000

¶In April 2010, Goldman posted a statement on its website entitled, "Goldman Sachs: Risk Management and the Residential Mortgage Market."2001 In the statement's Executive Summary, Goldman made the following assertions, among others:

–"Goldman Sachs did not take a large directional 'bet' against the U.S. housing market, and the firm was not consistently or significantly net 'short the market' in residential mortgage-related products in 2007 and 2008, as the performance of our residential mortgage-related products business demonstrates.

– Goldman Sachs did not engage in some type of massive 'bet' against our clients. The risk management of the firm's exposures and the activities of our clients dictated the firm's overall action, not any view of what might or might not happen to any security or market."2002

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¶On April 7, 2010, Goldman CEO Lloyd Blankfein and Co-President Gary Cohn made similar assertions in a letter to shareholders contained in Goldman's Annual Report:

– "The firm did not generate enormous net revenues or profits by betting against residential mortgage-related products, as some have speculated; rather our relatively early risk reduction resulted in our losing less money that we otherwise would have when the residential housing market began to deteriorate rapidly ....

–Although Goldman Sachs held various positions in residential mortgage-related products in 2007, our short positions were not a 'bet against our clients.' Rather, they served to offset our long positions."2003

¶At the Subcommittee hearing, Mr. Blankfein repeated the same claims. He testified:

"Much has been said about the supposedly massive short Goldman Sachs had on the U.S. housing market. The fact is, we were not consistently or significantly net short the market in residential mortgage-related products in 2007 and 2008. Our performance in our residential market-related business confirms this. During the 2 years of the financial crisis, while profitable overall, Goldman Sachs lost approximately $1.2 billion from our activities in the residential housing market. We didn't have a massive short against the housing market and we certainly did not bet against our clients. Rather, we believe that we managed our risk as our shareholders and our regulators would expect."2004

¶Mr. Viniar, Goldman's Chief Financial Officer, testified:

"[A]cross 2007, we were primarily, although not consistently short, and it was not a large short. ... The short positions themselves made a lot of money in 2007, but they offset long positions that lost a lot of money in 2007."2005

¶Goldman's denials of its net short positions in the subprime mortgage market, and the large profits produced by those net short positions, are directly contradicted by its own financial records and internal communications, as well as its own public statements in 2007, and are not credible.

(5) How Goldman Created and Failed to Manage Conflicts of Interest in its Securitization Activities

¶In the years leading up to the financial crisis, Goldman was an active trader in the mortgage market, buying and selling a variety of mortgage related assets, including RMBS, CDO, ABX, and

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¶CDS instruments, as described in the prior section. In addition, Goldman was one of the leaders in mortgage related securitizations, helping to originate both CDO and RMBS securities. Goldman's 2006 and 2007 securitization activities are the focus of this section.

¶In 2006 and 2007, Goldman originated 27 CDOs and 93 RMBS securitizations with a total value of about $100 billion.2006 Goldman designed the structure of each securitization, including the number of tranches, how the payments would be allocated, and the projected rate of return or "coupon rate" that would be paid to investors. In some, Goldman selected the assets to be securitized; in others, it hired a portfolio selection agent or collateral manager to help select the assets and manage the portfolio. For each securitization, Goldman typically housed all of the assets to be securitized in a "warehouse" account until the transaction was ready to go to market. The assets in the warehouse accounts were then included in Goldman's balance sheet. Goldman also typically worked with one or more credit rating agencies to obtain favorable credit ratings for the proposed securities.

¶In addition, Goldman typically established a domestic and an offshore corporation to act as the nominal owners of the securitization's incoming cash, assets, and collateral securities; to serve as the actual issuers of the securities; and to perform certain administrative services. Goldman also established arrangements for the servicing of any underlying mortgages. In some CDOs, Goldman or its affiliate provided additional services as well, acting in such roles as the collateral securities selection agent, the collateral put provider, or the liquidation agent charged with selling impaired assets. Goldman also used its global sales force to market its securities to investors around the world, typically selling Goldman-issued CDO securities through a private placement and RMBS securities through a public offering.

¶In late 2006, when subprime residential mortgages began to incur higher than expected rates of delinquency, fraud, and default, and its inventory of mortgage related assets began to lose value, Goldman took a number of actions. It sold the mortgage related assets in its inventory; returned poor quality loans to the lenders from which they were purchased and demanded repayment; limited new RMBS securitizations; sold or securitized the assets in its RMBS warehouse accounts; limited new CDO securitizations to transactions already in the pipeline; and sold assets from discontinued CDOs.

¶Throughout this process, Goldman made a concerted effort to sell securities from the CDO and RMBS securitizations it had originated, even when those securities included or referenced poor quality assets and began losing value. Many of the CDO and RMBS securities that Goldman sold to its clients incurred substantial losses. The widespread losses caused by CDO and RMBS securities originated by investment banks are a key cause of the financial crisis that affected the global financial system in 2007 and 2008.

¶The 27 CDOs securitized about $28 billion in assets. See undated chart prepared for Subcommittee by Goldman Sachs, GS M BS 0000004276. The 93 RMBS securitized about $72 billion in home loans. See undated chart prepared for Subcommittee by Goldman Sachs, GS-PSI-00172.

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¶This section of the Report examines how Goldman originated, marketed, and sold its mortgage related securities, in particular CDO securities, during late 2006 and in 2007, as the mortgage market deteriorated and as Goldman was profiting from its own net short positions. The section begins with general information about Goldman's securitization activities, followed by detailed case studies of four Goldman-originated CDOs: Hudson 1, Anderson, Timberwolf I, and Abacus 2007-AC1.

¶The evidence discloses troubling and sometimes abusive practices which show, first, that Goldman knowingly sold high risk, poor quality mortgage products to clients around the world, saturating financial markets with complex, financially engineered instruments that magnified risk and losses when their underlying assets began to fail. Second, it shows multiple conflicts of interest surrounding Goldman's securitization activities, including its use of CDOs to transfer billions of dollars of risk to investors, assist a favored client make a $1 billion gain at the expense of other clients, and produce its own proprietary gains at the expense of the clients to whom Goldman sold its CDO securities.

¶Under Goldman's sales policies and procedures, an affirmative action by Goldman personnel to sell a specific investment to a specific customer constituted a recommendation of that investment.2007 Under federal securities law, when acting as an underwriter, placement agent, or broker-dealer recommending an investment to a customer, Goldman had an obligation to sell investments that were suitable for any investor and were not designed to fail. When acting in those roles and affirmatively soliciting clients to buy securities, Goldman also had an obligation to disclose material information that a reasonable investor would want to know, including material conflicts of interest or adverse interests in connection with its sale of a security.2008

¶In 2006 and 2007, when selling subprime CDO securities to customers, Goldman did not always disclose that the securities contained or referenced assets Goldman believed would perform poorly, and that the securities themselves were rapidly losing value. Goldman also did not disclose that the firm had built a large net short position betting that CDO and RMBS securities similar to the ones it was selling would lose value. In the case of the Hudson, Anderson, and Timberwolf CDOs, Goldman failed to disclose to potential investors that it was shorting the very securities Goldman was selling to them. In the case of the Abacus CDO, Goldman failed to disclose to potential investors that it had allowed an interested party to help select the CDO assets and act as the sole short party, with the expectation that the selected assets would lose value and that party would make money at the expense of the long investors to whom Goldman had sold the securities. Goldman created these and other conflicts of interest with its clients in connection with its CDO activities.

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¶(a) Background

¶To understand Goldman's securitization activities, this section provides general background about its CDO and RMBS business and how Goldman changed its securitization activities when the mortgage market began to deteriorate in late 2006.

¶(i) Goldman's Securitization Business

¶The Goldman Mortgage Department originated CDOs through two different desks within the Department. Approximately half of Goldman's CDOs were originated by its CDO Origination Desk, which assembled the assets, structured the CDOs, and worked with the Goldman sales force to market the resulting securities to a broad range of investors. The CDO Origination Desk was headed by Peter Ostrem from 2006 until May 2007, after which all remaining Goldman-originated CDOs were transferred to the Structured Product Group (SPG) Trading Desk and were overseen by David Lehman.

¶Goldman's other CDOs, which were part of a series issued under the name of Abacus, were originated by the Correlation Trading Desk, which was a sub-desk of the SPG Trading Desk. The Correlation Trading Desk specialized in arranging customized trades for investors and used the Abacus series of CDOs as one of its investment alternatives. The Correlation Trading Desk was headed by Jonathan Egol. The CDO Origination and Correlation Trading Desks were located on the same floor as the other SPG Trading Desks.

¶RMBS securitizations were handled by the Residential Whole Loan Trading Desk, headed by Kevin Gasvoda. Sub-desks within the Residential Whole Loan Trading area oversaw the purchase of residential loan pools, constructed the RMBS securitizations, and worked with the Goldman sales force to sell the resulting securities to investors.

¶After a desk originated a CDO or RMBS securitization and sold the Goldman-originated securities for the first time, all secondary trading of the securities was handled by the Structured Products Group's Asset-Backed Security (ABS) Desk. In mid-2007, Goldman shut down its CDO Origination Desk and directed the ABS Desk to sell all remaining Goldman-originated CDO securities, in addition to conducting the secondary trading it normally handled.

¶Daniel Sparks, as head of the Mortgage Department, oversaw all of Goldman's CDO and RMBS origination activities. Mr. Sparks reported at times to Jonathan Sobel, the prior department head, and Richard Ruzika, then head of Commodities Trading. He also worked with Justin Gmelich, a managing director asked to help him run the Department on a short term basis. Mr. Sparks also had frequent contact with more senior Goldman executives, including Thomas Montag, then global co-head of Securities Trading, and Donald Mullen, then head of Credit Trading. On occasion, he also received directives from Chief Financial Officer David Viniar and Co-Presidents Gary Cohn and Jon Winkelried.

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¶(ii) Goldman's Negative Market View

¶As established earlier in the Report, all of Goldman's securitization activities from 2006 to 2007 took place against the backdrop of a subprime mortgage market that, in Goldman's view, was in distress and worsening.

¶On December 7, 2006, for example, Mr. Sparks sent this gloomy assessment to senior executive Thomas Montag:

"Generally, originators are struggling with EPDs [early payment defaults] which require them to buy back loans and take losses – thinly capitalized firms can't take much of it. Lower margins and volumes are also causing pain. Ownit [a mortgage originator] ... closed Monday. Premiums for these originators – all of whom are for sale – are rapidly falling. ... Likely fall-out – more originators close and spreads in related sectors widen."2009

¶A week later, on December 13, 2006, Mr. Sparks repeated his negative view of the subprime mortgage market before senior Goldman executives on the Firmwide Risk Committee. The committee minutes described his report as follows:

"Dan Sparks: Noted the stress in the subprime market; Concern around '06 originators, as two more failed last week; Concern around early payment defaults, $5BN in loans to subprime borrowers, warehouse lines to 6 subprime lenders, and $16MM in '06 residual positions and alt-a and subprime residual positions from '04-'05; Street aggressively putting back early payment defaults to originators thereby affecting the originator's business. Rumors around more failures are in the market."2010

¶On December 14, 2006, CFO David Viniar held a meeting with senior Mortgage Department executives, reviewed their mortgage related holdings, and directed them to offset the risk posed by declining values.2011 The Mortgage Department then initiated its first multi-billion- dollar net short positions in 2007, essentially betting that subprime mortgage related assets would fall in value.

¶In early 2007, Mr. Sparks made increasingly dire predictions about the decline in the subprime mortgage market and issued emphatic instructions to his staff about the need to get rid of subprime loans and other assets. On February 8, 2007, for example, Mr. Sparks wrote:

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"Subprime environment – bad and getting worse. Everyday is a major fight for some aspect of the business (think whack-a-mole). . . . [P]ain is broad (including investors in certain GS-issued deals)."2012

¶On February 14, 2007, Mr. Sparks wrote some notes to himself:

¶"Bad week in subprime

collateral performance on loans was poor – we took a write-down on second lien deals and on the scratch and dent book last week ...

¶Synthetics market got hammered – around 150 [basis points] wider ...

Originators are really in a bad spot. Thinly capitalized, highly levered, dealing with significant loan putbacks, some with retained credit risk positions, now having trouble selling loans above par when it cost them 2 points to produce.

¶What is the next area of contagion."2013

¶That same day, February 14, 2007, Mr. Sparks exchanged emails with Goldman's Co- President Jon Winkelried about the deterioration in the subprime market:

¶Mr. Winkelried: "Another downdraft?"

Mr. Sparks: "Very large – it's getting messy. ... Bad news everywhere. Novastar bad earnings and 1/3 of market cap gone immediately. Wells [Fargo] laying off 300 subprime staff and home price appreciation data showed for first time lower prices on homes over year broad based."2014

¶On February 26, 2007, when Mr. Montag asked him about two CDO2 transactions being assembled by the CDO Origination Desk, Timberwolf and Point Pleasant, Mr. Sparks expressed his concern about both:

¶Mr. Montag: cdo squared–how big and how dangerous

¶Mr. Sparks: Roughly 2bb, and they are the deals to worry about.2015

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¶On March 3, 2007, Mr. Sparks made notes after a telephone call: "Things we need to do .... Get out of everything."2016 On March 7, 2007, Mr. Sparks again reported to Goldman's Firmwide Risk Committee on accelerating problems in the subprime mortgage market:

"– 'Game Over' – accelerating meltdown for subprime lenders such as Fremont and New Century. – The Street is highly vulnerable . ... Current strategies are to 'put back' inventory and liquidate positions. – The Mortgage business is currently closing down every subprime exposure possible."2017

¶On March 8, 2007, Mr. Sparks emailed several senior executives, including Mr. Viniar and Mr. Cohn about "Mortgage Risk": "[W]e are trying to close everything down, but stay on the short side."2018

¶Other Mortgage Department personnel gave similarly bleak assessments of the subprime mortgage market. As early as January 2007, Jonathan Egol, head of the Correlation Trading Desk, wrote to a colleague expressing his clients' views: "The mkt is dead."2019 In February 2007, when discussing plans to issue an Abacus CDO with a Correlation Desk Trader, Fabrice Tourre, Mr. Egol repeated that assessment as his own:

Mr. Egol: [T]he paulson trade may already be dead (although given it is baa2 it may still have a decent shot).

Mr. Tourre: Don't think the Paulson trade is dead. Supersenior pretty much done with ACA, AAAs could be placed in 2 shots, this is sufficient. Remember we make $$$ per tranche placed. ...

Mr. Egol: You know I love it all I'm saying is the cdo biz is dead we don't have a lot of time left.2020

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¶On March 8, 2007, in an email to senior management, Mr. Sparks listed a number of "large risks I worry about."2021 At the top of the list was "CDO and Residential loan securitization stoppage – either via buyer strike or dramatic rating agency change." Mr. Sparks was referring to the possibility that Goldman would be unable to securitize and sell its remaining subprime mortgage related inventory by repackaging it into RMBS and CDOs for sale to customers. His concern was either that buyers would refuse to purchase such products ("buyer strike"), or that the ratings agencies might realize the poor quality and high risks associated with these products and downgrade them so they could not be sold with AAA ratings ("dramatic rating agency change"). In essence, Mr. Sparks was worried about Goldman's being left with a large inventory of unsold and unsaleable subprime mortgage related assets when the market finally collapsed.2022

¶At the same time Goldman personnel were expressing these negative views of the securitization business, the Mortgage Department was building its large net short positions in the first and third quarters of the year.

¶(iii) Goldman's Securitization Sell Off

¶In response to the December 14, 2006 meeting at which CFO David Viniar ordered the Mortgage Department to offset the risk associated with its mortgage related holdings, the Department initiated an intensive effort to sell off the subprime RMBS and CDO securities and other assets in its inventory and warehouse accounts.2023

¶AA. RMBS Sell Off

¶As described earlier, on the same day as the Viniar meeting, December 14, 2006, Kevin Gasvoda, head of the Mortgage Department's Residential Whole Loan Trading Desk, instructed his staff to undertake an immediate, concerted effort to sell the whole loans and RMBS securities in Goldman's inventory and warehouse accounts, focusing on RMBS securities from Goldman-originated securitizations.2024 By February 9, 2007, the Goldman sales force reported a substantial growth and the market are DEAD if that's the case.") [emphasis in original].

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¶number of sales,2025 and by the end of February, Goldman's controllers reported that Goldman's inventory of whole loans had "decreased from $11bn to $7bn" with "subprime loans decreased from $6.3bn to $1.5bn," a reduction of more than two-thirds.2026

¶In addition, during the first quarter of 2007, the Mortgage Department drastically slowed its RMBS origination business and its purchase of whole loans and RMBS securities.2027 Those actions meant that Goldman was not only reducing its inventory, but also reducing its intake of what had previously been a constant inflow of billions of dollars in whole loans and RMBS securities purchased as part of its securitization business.

¶In addition to selling whole loans and RMBS securities, the Mortgage Department wrote down the value of its remaining subprime mortgage portfolio. On February 8, 2007, for example, Mr. Gasvoda recommended that certain whole loan pools and RMBS securities be marked down by $22 million.2028 On February 9, 2007, Mr. Sparks reported a $30 million writedown on non performing loans.2029 Mr. Ruzika responded: "Ok, you've been communicating the write down was coming. Let's go through the residual risk and make sure we get to the correct number for the quarter."2030 Residual risk referred to the non rated equity tranches that underwriters like Goldman often retained from the RMBS securitizations they originated; those tranches were also written down in value. Those writedowns not only implemented Goldman's policy of using current market values for its assets, but also effectively reduced the size of Goldman's "long" position in subprime mortgage related assets. As Mr. Ruzika wrote to Mr. Cohn: "working with Dan to uncover exactly what else needs to be written down so that we can pnl [profit and loss] it this quarter and be clean going into next quarter."2031

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¶Loan Repurchase Campaign. In addition to its sales and writedowns, the Mortgage Department intensified its efforts to identify and return defaulted or otherwise deficient loans to the originating lender from which they had been purchased in exchange for a refund of the purchase price. Altogether in 2006 and 2007, Goldman made about $475 million in repurchase claims for securitized loans, and recovered about $82 million.2032 It also made about $40 million in repurchase claims for unsecuritized loans, and recovered about $17 million.2033

¶In the years leading up to the financial crisis, most subprime loan purchase agreements provided that if a loan experienced an early payment default (EPD), meaning the borrower failed to make a payment within three months of the loan's purchase, or if the loan breached certain representations or warranties, such as representations related to the loan's characteristics or documentation, the loan could be returned or "put back" to the seller which was then obligated to repurchase it. In late 2006, as subprime loans began to experience accelerated rates of EPDs and fraud,2034 Wall Street firms began to intensify their efforts to return those loans for refunds. Some subprime lenders began to experience financial distress due to unprecedented waves of repurchase requests that drained their cashflows.2035

¶Although Goldman, either directly or through a third party due diligence firm, routinely conducted due diligence reviews of the mortgage loan pools it bought from lenders or third party brokers for use in its securitizations, those reviews generally examined only a sample of the loans and did not attempt to identify and weed out all deficient mortgages.2036 Instead, Goldman purchased loan pools with the expectation that they would incur a certain rate of defaults. In late 2006, however, like other Wall Street firms, Goldman began to see much higher than anticipated delinquency and default rates in the loan pools in its inventory and warehouse accounts, and in the subprime RMBS and CDO securitizations it originated.2037 Defaulted loans generally could not be sold or securitized, and had to be terminated through foreclosure proceedings or sold in so-called "scratch and dent" pools that generally produced less money than the loans cost to buy. In addition, defaulted loans meant that the borrowers who took out those loans stopped making loan payments to the securitized loan pool, reducing the cashflow into the related securities. RMBS and CDO securities whose underlying assets incurred high rates of loan delinquencies and defaults experienced reduced cashflows, lost value, and sometimes failed altogether, resulting in substantial losses for investors.

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¶In early 2007, Goldman's Mortgage Department initiated an intensive review of the loans in its inventory, warehouse accounts, and RMBS and CDO securitizations, to identify deficient loans and return them for refunds. On February 2, 2007, Mr. Sparks reported to senior Goldman executives Messrs. Viniar, Montag, and Ruzika that obtaining refunds from the loan originators would be "a battle":

"The team is working on putting loans in the deals back to the originators (New Century, WAMU, and Fremont – all real counterparties), as there seem to be issues potentially including some fraud at origination, but resolution will take months and be contentious. ... The put backs will be a battle."2038

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¶To manage its loan repurchase campaign, Goldman expanded an operations center in St. Petersburg, Florida,2039 and made extensive use of third party due diligence firms hired to review its securitized loan pools.2040 Goldman instructed the firms to "re-underwrite" every loan in pools of mortgages purchased from specific lenders, including New Century, Fremont, Long Beach, and later Countrywide.2041

¶By March 2007, the average EPD rate for subprime loans in Goldman's inventory had climbed from 1% of aggregate volume to 5%, a dramatic increase.2042 On March 7, 2007, Mr. Sparks described Goldman's exposure as follows:

"As for the big 3 originators – Accredited, New Century and Fremont, our real exposure is in the form of put-back claims. Basically, if we get nothing back we would lose around $60mm vs loans on our books (we have a reserve of $30mm) and the loans in the [CDO and RMBS] trusts could lose around $60mm (we probably suffer about 1/3 of this in ongoing exposures). ... Rumor today is that the FBI is in Accredited."2043

¶Five days later, on March 12, 2007, Mr. Sparks wrote: "The street is aggressively putting things back, like a run on the bank before there is no money left to fulfill the obligations."2044

¶One of the lenders that was an initial focus of Goldman's loan repurchase effort was New Century, a subprime lender whose loans Goldman had used in many Goldman-originated RMBS securitizations. After completing a review of one New Century loan pool, an analyst recommended "putting back 26% of the pool ... if possible."2045 A putback rate of 26% meant that about one in four of the loans in the New Century pool had EPDs, were fraudulent, or otherwise breached New Century's contractual warranties. It also implied that about 25% of the expected mortgage payments might not be made to the relevant RMBS securitization. Unless the problem loans could be successfully "put back" to New Century in exchange for a refund, a fail rate of that magnitude would likely impair the performance of all of the securities dependent upon that pool of mortgages.

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¶Goldman made a total of about $67 million in repurchase requests to New Century, which was among the five mortgage originators to whom Goldman directed the most repurchase requests in 2006 and 2007.2046 In March 2007, however, New Century stopped paying Goldman's claims due to insufficient cash, and the loan repurchase team sought advice from Mr. Gasvoda:

"As you know, we have an extensive re-underwrite review underway on 06 NC2 [New Century second lien loans] and also other NC loans in the 2nds deals that are in the pipeline for scrubs. Should we change course at all here given the fact NC can't pay?"2047

¶Mr. Gasvoda responded:

"Yes .... I think priority s/b [should be] on Fremont and Long Beach on 2nd lien deals. Fremont first since they still have cash but may not for long. ... [O]n NC2 we need not halt that entirely but should pull back resources there. We should also move 06FM2 [Fremont second lien loans] up the priority list."

¶Goldman made a total of about $46 million in repurchase requests to Fremont, another subprime lender for whom Goldman had underwritten multiple securities and which was also among the five mortgage originators to whom Goldman made the most repurchase requests in 2006 and 2007.2048 When Goldman personnel reviewed a loan pool purchased from Fremont, the results were even worse than for the New Century loans. Goldman concluded that "on average, about 50% of about 200 files look to be repurchase obligations."2049 Later, Goldman came to a similar

(if 2nd liens). ... – approx 5% of the pool was possibly originated fraudulently based on the dd [due diligence] results. Main findings: possible ID theft, broker misrepresentations, straw buyer, and falsification of information in origination docs. ... "approx 62% of the pool has not made any payments (4% were reversed pymts/nsf [non-sufficient funds]) ... "approx 38% of the loans are out of [loan to value] tolerance."

487

¶conclusion after reviewing certain loans purchased from Countrywide, again finding that about 50% of the loans reviewed were candidates for return to the lender.2050

¶Goldman made a total of about $34 million in repurchase requests to Long Beach, a subprime lender for whom Goldman had underwritten billions of dollars in RMBS securities and which was also among the five mortgage originators to whom Goldman made the most repurchase requests in 2006 and 2007.2051 Goldman pressed both Long Beach and its parent Washington Mutual for repayment of millions of dollars in refunds. At one point, a Goldman executive involved in the repurchase effort sent an email to the head of Washington Mutual Home Loans Division, David Schneider. After noting that Long Beach second lien loans were "performing dramatically worse" than other 2006 RMBS securities, the Goldman executive wrote: "As you can imagine, this creates extreme pressure, both economic and reputational, on both organizations."2052

¶Goldman's loan repurchase campaign recovered substantial funds from some lenders,2053 but little or none from others.2054 Non performing loans that were not repurchased by the lender generally remained in Goldman's inventory or the relevant securitized loan pool. Many other securitizers engaged in similar loan repurchase efforts which continued in 2011.2055

¶Poor Quality RMBS Securities. As a result of its loan repurchase and writedown efforts, the Mortgage Department was keenly aware of the poor quality of many of the loan pools in its warehouse accounts. Nevertheless, during this time period, Goldman continued securitizing many of those loans and selling the resulting RMBS securities to clients.

¶In March 2007, for example, Goldman securitized over $1 billion in subprime loans that it had purchased from Fremont, originating an RMBS securitization called GSAMP Trust 2007- FM2.2056 Goldman underwrote the security in the same month that it was attempting to return millions of dollars in deficient loans to the lender,2057 and regulators ordered Fremont to stop issuing subprime loans.2058 Goldman marketed and sold the RMBS securities to clients. Within seven months, by October 2007, the rating downgrades began; by August 2009, every tranche of the GSAMP securities had been downgraded to junk status.2059

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¶On March 26, 2007, the Mortgage Department sought permission from Goldman's Mortgage Capital Committee to securitize and underwrite a new RMBS called GSAMP Trust 2007- HE2, which contained nearly $1 billion in subprime mortgage loans in a Goldman warehouse account, over 70% of which had been purchased from New Century.2060 Goldman approved this securitization even though it knew at the time that New Century's subprime loans were performing poorly, many of the New Century loans in Goldman's inventory were problematic, and New Century was in financial difficulty.2061 The securitization was approved for issuance in April 2007, the same month New Century declared bankruptcy.2062 Goldman marketed and sold the RMBS securities to its clients. The securities first began to be downgraded in October 2007, and all of the securities have since been downgraded to junk status.2063

¶Had Goldman not securitized the $2 billion in Fremont and New Century loans, the Mortgage Department would likely have had to liquidate the warehouse accounts containing them and either sell the loan pools or keep the high risk loans on its own books.

¶On April 11, 2007, a Goldman salesman forwarded to Mr. Egol a scathing letter from a customer, a Wachovia affiliate, which had purchased $10 million in RMBS securities backed by Fremont loans and underwritten by Goldman. The client wrote that it was "shocked" by the poor performance of the securities "right out of the gate," and concerned about Goldman's failure to have disclosed information about the poor quality of the underlying loans in the deal termsheet:

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" As you know, we own $10mm of the GSAMP 06-S3 M2 bond. ... We are shocked by how poorly this bond has performed right 'out of the gate' and had asked [Goldman] to send us the attached ProSupp [Prospectus Supplement]. After having read the ProSupp and compared it to the termsheet we have several concerns:

According to the Prosupp, approximately $2.2mm ... of loans were delinquent when they were transferred to the trust. However, there is no mention of delinquent loans anywhere in the termsheet that was sent to investors when the deal was priced.

According to the Prosupp, approximately $3.3mm ... are re-performing loans. However, there is no mention of reperforming loans anywhere in the termsheet.

Approx. 53.14% of the loans in the deal allow for a Prepayment Premium and that all Prepayment Premiums collected from borrowers are paid to the Class P certificateholders. None of this was disclosed in the termsheet and my concerns are two-fold: (1) The presence of Prepayment Premiums effects prepayment speeds which affects ... [the deal's performance]; (2) Prepayment Premiums are not staying inside the deal for the benefit of all investors but are being earmarked for the Class P holder (which is not mentioned in the termsheet). Note that ... $1.2mm in Prepayment Premiums has already been paid out to the Class P holder.

... [T]he servicer must charge off any loan that becomes 180 days delinquent, giving rise to a Realized Loss inside the deal. Currently losses are at 9.71% of the original deal balance, or approximately $48mm despite the fact that the deal is only 11 months old (note that this figure already exceeds Moody's expec[ta]tion for cumulative losses for the deal over the ENTIRE LIFE of the deal). I will also note that there are an additional $57.5mm of loans in the delinquency pipeline. This seems to indicate significant fraud at either the borrower or lender level ....

... [A]ny subsequent recoveries on the charged-off loans do not inure to the benefit of all investors in the deal but ONLY to the Class X1 certificateholder. This is not mentioned anywhere in the termsheet. Who owns the Class X1 notes? Is that Goldman or an affiliate? How much has been recovered so far? This is a material fact to me especially considering that loss severities are coming in at around 105% on the charged-off loans."2064

¶Reduced RMBS Business. By the end of 2007, Goldman had substantially reduced its RMBS securitization business. In November 2007, in response to a request, Goldman provided specific data to the SEC about the decrease in its inventory of subprime mortgage loans and RMBS securities. Goldman informed the SEC that the value of its subprime loan inventory had dropped from $7.8 billion on November 24, 2006, to $462 million on August 31, 2007. Over the same time period, the value of its inventory of subprime RMBS securities had dropped from $7.2 billion to

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¶$2.4 billion, a two-thirds reduction.2065 The graph below, which was prepared by the Subcommittee using the data provided by Goldman to the SEC, illustrates the rapid decline in Goldman's subprime holdings.2066

[SEE CHART NEXT PAGE: Goldman Sachs Long Cash Subprime Mortgage Exposure, prepared by the Permanent Subcommittee on Investigations, Hearing Exhibit 163.]

Goldman Sachs Long Cash Subprime Mortgage Exposure, Investments in Subprime Mortgage Loans, and Investments in Subprime Mortgage Backed Securities November 24, 2006 vs. August 31, 2007 - in $ Billions

¶Investments in Subprime

¶12 Mortgage Loans

¶10 Investments in Subprime

¶Mortgage Backed Securities

7.8 Long Cash Subprime Mortgage Exposure (Total of Loans and 7.2

¶6 Securities)

¶2.862

¶2 2.4

¶0.462

¶Prepared by the U.S. Senate Permanent Subcommittee on Investigations, April 2010. Data from Nov. 7, 2007, letter from Goldman Sachs to the Securities and Exchange Commission, GS MBS‐E‐015713460, at 5 (Exhibit 50).

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¶BB. CDO Sell Off

¶Goldman reduced its inventory of subprime loan pools and RMBS securities through outright sales, writedowns, and its loan repurchase campaign. It was equally aggressive in reducing its subprime CDO warehouse inventory.

¶In January 2007, after the CDO Origination Desk worked to sell securities from a CDO called Camber 7, Mr. Sparks wrote to Mr. Montag: "Need you to send message to peter ostrem and darryl herrick telling them what a great job they did. They structured like mad and traveled the world, and worked their tails off to make some lemonade out of some big old lemons."2067

¶In February 2007, the Mortgage Department conducted a review of the CDOs in its origination pipeline.2068 As part of that review, Mr. Sparks cancelled four pending CDOs that had acquired some but not all of the assets needed for the CDOs to go to market.2069 On February 25, 2007, Mr. Sparks reported to Mr. Montag and Mr. Ruzika:

"The CDO business liquidated 3 warehouses for deals of $530mm (about half risk was subprime related). Business also began liquidation of $820mm [redacted] warehouse – all synthetics done, cash bonds will be sold in the next few days."2070

¶The Mortgage Department rushed several remaining CDOs to market, including Anderson, Timberwolf, and Point Pleasant, which issued their securities in March and April 2007.2071 In May and June 2007, the Mortgage Department began closing all of its remaining CDO warehouse accounts and transferring the assets to the SPG Trading Desk for sale.2072 On June 22, 2007, Mr. Lehman reported that the ABS Desk had just sold another $50 million in RMBS securities from the CDO warehouse accounts for a profit of $1 million, and that: "[o]nly 40mm RMBS A3/A- remain in the WH [warehouse] accounts, ½ of which is Long Beach paper - continue to work."2073

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¶Throughout 2007, Goldman sought to sell all of its remaining subprime assets from the CDO warehouse accounts as well as the new securities issued by Goldman-originated CDOs.2074

¶Aggressive Sales Efforts. On March 9, 2007, Mr. Sparks emailed a call for "help" to Goldman's top sales managers around the world to "sell our new issues – CDOs and RMBS – and to sell our other cash trading positions."2075 In response, Mr. Sparks and key sales managers had a dialogue about "reaching the next wave of players here and abroad."2076

¶The Goldman sales manager for Europe and the Middle East suggested that Mr. Sparks focus the CDO sales efforts abroad, because the clients there were not involved in the U.S. housing market and therefore were "not feeling pain":

"The key to success in the correlation melt-down 2 years ago was getting new clients/capital into the opportunity quickly. Saved/made us a lot of money. Lots of banks and real money clients in Europe and middle east and lots of macro hedge funds are not involved and not feeling pain. In Europe we need a summary of key opportunities/axes and I will get the team to focus on. 2-3 most important things plus sales talking points rather than laundry list."2077

¶Mr. Ostrem, head of the CDO Origination Desk, agreed with expanding Goldman's CDO sales efforts in Europe and the Middle East: "I agree with [sales manager's] comments on new clients. Middle east, french banks, macro hedge funds could and are making these deals 'work' currently."2078 The following week, Mr. Lehman issued three new sales directives or "axes" to the Goldman sales force placing a priority on selling securities from the Anderson, Timberwolf, and Hudson CDOs:2079

"As per [European/Middle East sales manager's] suggestion last Friday, below are the three main focus areas for SP CDOs/SPG Trading, including Anderson Mezzanine, Timberwolf CDO^2 and secondary CDO positions (Hudson Mezzanine and high grade BBBs)."

¶Goldman's New York sales office forwarded the axe sheet to the European/Middle East sales office saying: "London – this is for you."2080

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¶In an additional effort to expand Goldman's sales effort, the Mortgage Department's sales syndicate provided a list of "non-traditional buyers" to the CDO and SPG Trading Desks:

"We have pushed credit sales to identify accounts in the credit space that would follow yield into the ABS [asset-backed security] CDO market, and tried to uncover some non-traditional buyers. ... Below is a list of higher delta accounts uncovered so far; and we continue to push for leads. We are working with sales on these accounts to push our axes."2081

¶Goldman personnel worked diligently to pitch CDO securities to various clients, internal documents show. On March 30, 2007, for example, Fabrice Tourre reported to senior Mortgage Department executives about his efforts and plans to sell the CDO securities:

"This transaction [Abacus 2007-AC1] has been showed to selected accounts for the past few weeks. Those selected accounts had previously declined participating in Anderson mezz, Point Pleasant and Timberwolfe. ... Plan would still be to ask sales people to focus on Anderson mezz, Point Pleasant and Timberwolfe, but if accounts pass on these trades, steer them towards available tranches in ABACUS 07-AC1 since we make $$$ proportionately with the notional amount of these tranches sold. Wanted to make sure everyone is comfortable with this plan."2082

¶In April 2007, the Mortgage Department issued a new directive to its sales force with a list of new and old CDO securities in its inventory that it wanted sold, including Timberwolf and Anderson as well as CDOs known as Point Pleasant and Altius.2083 Dissatisfied with the pace of sales, Mr. Sparks suggested issuing a separate axe for each CDO and offering additional sales credits: "Why don't we go one at at a time with some ginormous credits - for example, let's double the current offering of credit for timberwolf."2084 A sales manager responded: "We have done that with timberwolf already. Don't want to roll out any more focus axes until we get some traction there but at the same time, don't want to stop showing inventory."

¶"Gameplan" for CDO Valuation Project. By May 2007, CDO sales had slowed significantly. Goldman executives became concerned about the lack of sales prices to establish the value of its CDO holdings.2085 Goldman needed accurate values, not just to establish its CDO sales prices, but also to value the CDO securities for collateral purposes and to comply with Goldman's policy of using up-to-date market values for all of its holdings. Mr. Sparks expressed concern that the value of the remaining CDO assets were rapidly declining, warning one senior executive: "We are going to have a very large mark down – multiple hundreds. Not good."2086

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¶On May 11, 2007, Goldman senior executives, including Mr. Cohn and Mr. Viniar, held a lengthy meeting with Mortgage Department personnel, their risk controllers, and others to develop a "Gameplan" for a CDO valuation project.2087 The Gameplan called for the Mortgage Department, over the course of about a week, to use three different valuation methods to price all of its remaining CDO warehouse assets and unsold securities from the Goldman-originated CDOs then being marketed to clients.2088

¶A few days later, on May 14, 2007, while the CDO valuation project was underway, Mr. Montag asked Mr. Sparks for an estimate of how much the firm would need to write down the value of its CDO assets. Mr. Sparks responded that the "base case from traders is down [$]382 [million]." He also wrote:

"I think we should take the write-down, but market [the CDO securities] 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."2089

¶The valuation project's results were summarized in a presentation dated Sunday, May 20, 2007, prepared for a 9:00 p.m. conference call that night with Mr. Viniar, in which Mr. Mullen, Mr. Sparks, Mr. Lehman, and others also participated.2090 Using the three valuation methods, the presentation estimated that the loss in value and the total writedowns required for the firm's CDO assets were between $237 and $448 million.2091 The executive summary of the presentation also expressed concern about Goldman-originated CDO securities, especially its two CDO2 transactions, Timberwolf and Point Pleasant, since "[t]he complex structure of these positions makes them difficult to value and distribute."2092 The presentation estimated that the market value of those CDO securities, plus the equity and super senior tranches that had been retained by Goldman, was $4.3 billion. The executive summary also estimated the market value of the remaining assets from the CDO warehouse accounts at $1.5 billion, and expressed particular concern about selling $742 million in CDO securities from non Goldman originated CDOs due to "limited liquidity and price transparency in this space." The executive summary stated that since "securitization is no longer a viable exit, the warehouse collateral will be marked to market on an individual basis."2093

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¶The presentation also presented "Next Steps." It recommended that Goldman "unwind the warehouses" and use "[i]ndependent teams to continue to value" the CDO securities, equity tranches, and super senior tranches from the Goldman-originated securitizations. It also recommended that sales of the Goldman-originated CDO securities be targeted, first, at four hedge fund customers, Basis Capital, Fortress, Polygon, and Winchester Capital.2094 The presentation also attached a list of 35 other target customers with notes regarding the status of efforts to sell them CDO securities in the past.2095

497

¶The CDO valuation project undertaken in May provided clear notice to Goldman senior management at the highest levels that its CDO assets had fallen sharply in value, and that despite their lower value, the Mortgage Department planned to aggressively market them to customers. In an earlier draft of the presentation, the Mortgage Department had also stated that it expected Goldman's CDO and CDO2 securities "to underperform":

"The complexity of the CDO^2 product and the poor demand for CDOs in general has made this risk difficult to sell and the desk expects it to underperform."2096

¶Mr. Sparks reviewed that draft language and made comments about other items on the same page, but did not change the phrase, "the desk expects it to underperform."2097 The same phrase appeared

¶011057632 (mortgage credit business shared with SPG Trading Desk "a fairly lengthy list of accounts that are considered to be 'key'"). In December 2006, the Correlation Trading Desk drew up a list of target customers for 2007: the "proposed top 20 correlation customer list." 12/29/2006 email from Fabrice Tourre, "Last call–any other comments on the proposed top 20 correlation customer list," GS MBS-E-002527843, Hearing Exhibit 4/27-61. Mr. Tourre issued a "last call" for comments on the list and suggested focusing on "buy-and-hold rating-base buyers" who might be more profitable for the desk than more sophisticated and demanding hedge fund customers:

"[T]his list might be a little skewed towards sophisticated hedge funds with which we should not expect to make too much money since (a) most of the time they will be on the same side of the trade as we will, and (b) they know exactly how things work and will not let us work for too much $$$, vs. buy-and-hold rating- based buyers who we should be focused on a lot more to make incremental $$$ next year."

¶The proposed top 20 list identified a number of European accounts, as well as customers who had purchased asset backed security products from Goldman in the past.

498

¶in several earlier versions of the presentation as well, but was removed from the final version sent to Mr. Viniar.2098

¶CDO Desk Shutdown. In May 2007, Goldman decided to stop issuing new CDOs, and the head of its CDO Origination Desk, Peter Ostrem, left the firm.2099 Mr. Sparks named as his replacement David Lehman, who was a senior member of the Structured Product Group (SPG) and head of its CMBS Trading Desk, but had little experience in either underwriting or CDOs.2100 On May 19, 2007, Mr. Lehman received an email from a former Goldman managing director who wrote: "Congratulations, but seems like you have a lot ofwork [sic] ahead of you."2101 Mr. Lehman asked Mr. Egol: "What do u th[in]k he means by 'lot of work to do?'"2102 Mr. Egol responded:

"I know what he means. If you talk to people knowledgeable about cdos, you will find that external perception of GS franchise in this space is much lower than Sparks and Sobel believed. Over the last 2 years, GS [Goldman Sachs] is perceived to be a bottom quartile abs [asset-backed security] cdo underwriter and to have done several poor deals. There is a reason [the CDO desk] didn't sell much paper. The fact that [the CDO desk] was basically giving money away in these no-fee principal deals and could still only get TCW, GSC (both street wh—e managers) and some start up managers to work with GS is a stain that will take time to remove. The HG [high-grade] deals in particular are very poor. I thought the alladin deals had some potential but fortius 2 is going to be a real mess.

"These are not just my views – they are from customers whose views resonate in the market. Sales people have just been too timid internally or not engaged enough with their accounts to provide accurate feedback. It pains me to say it but citi, ubs, db [Deutsche Bank], lehman and ms [Morgan Stanley] have much stronger franchises – among large dealers only ML [Merrill Lynch] is more reviled than [Goldman's] business. ...

¶"I should add altius 3 is a doozy as well. I'll spare you the detailed list."2103

¶That May 19, 2007 email provided Mr. Lehman with additional notice of the poor quality of the CDO securities he was charged with selling.

499

¶The CDO valuation project presentation given the next day, May 20, 2007, recommended that all assets from the CDO warehouse accounts be transferred to the SPG Trading Desk for sale. A CDO "transition book" was created to account for profits and losses from some of the assets, and the transfer took place the following week.2104 In addition, by June 1, 2007, Goldman eliminated the CDO Origination Desk as a separate entity, and moved all of the remaining Goldman-originated CDO securities to the SPG Trading Desk, where Mr. Lehman was based.2105 As a result, the SPG Trading Desk, which was a secondary trading desk and had little experience with the greater disclosure obligations involved with selling newly minted securities, became solely responsible for selling all Goldman-originated CDO securities.

¶Renewed Sales Efforts. After the transfer of the CDO assets, the SPG Trading Desk began to work with the Goldman sales force to identify potential customers and sell the CDO products. On May 24, 2007, a Goldman salesperson contacted Messrs. Sparks and Lehman regarding two potential customers interested in Timberwolf and Point Pleasant securities.2106 With respect to one customer, the salesman wrote that it was "[n]ot experts in this space at all but [I] made them a lot of money in correlation dislocation and will do as I suggest." With respect to the second customer, the Goldman salesperson wrote that the customer had "just raised another $1bln for their ABS [asset backed security] fund and they are very short the ABX so are natural buyers of our axe."2107

¶A couple of weeks before the CDO valuation project, Goldman's Australia sales representative, George Maltezos, announced he had found a potential Australian buyer for a Goldman CDO being constructed by the Correlation Desk: "I think I found white elephant, flying pig and unicorn all at once."2108 On the same day the project identified Basis Capital as a primary target for CDO sales, May 20, 2007, Mr. Maltezos sent Mr. Lehman an email saying he would contact the Basis principals as soon as they returned from a business trip the following day.2109

¶On May 24, 2007, the CDO sales dry spell ended, when Paramax Capital Group, a U.S. investment adviser, purchased $40 million in AA Timberwolf securities.2110 On May 30, Mr. Lehman announced the sale of $20 million in AAA Timberwolf securities to Tokyo Star Bank in Japan.2111

500

¶CDO Sales in Asia. On June 11, 2007, Mr. Lehman received a note from the Mortgage Department's sales syndicate desk asking whether the directive listing high priority CDO sales could be sent to the Japan sales office, which oversaw sales throughout Asia:

"Know there was sensitivity w/ sending this out, but asia sales management is asking again. Do you want to consider sending more broadly for asia sales or do you want to stick with the more targeted approach?"2112

¶The Japan sales group wrote that the head of the Japan office "is saying that we need it to go more broadly to all Sales at least in Japan. Given her request twice now and her help in getting focus, think we should at least push this in Japan."2113 Mr. Lehman responded: "Fine – let's send to all Japan sales then."2114

¶The Japan sales office responded to the new directive with several quick sales. On June 13, 2007, the Japan sales office sent out this celebratory note:

"We have moved over $250mm of SP CDO axes to account in Japan, Australia and Korea over the past 2+ weeks. These are HUGE orders for the firm as they have helped reduce balance sheet risk and further exhibits the importance of the Asia franchise to the global Structured Products Group business. Note that in line with these trades we have paid out over $14mm of gross credits – this is clearly the top focus for us now in SP [Structured Product] CDO space. ... Call the SPG Asia desk in Tokyo for updated axes and offer levels. We hope to trade another $20mm of CDO^2 risk with a Japanese account in the coming week+. Thanks."2115

¶Mr. Lehman replied: "Thx for sending this out."2116

¶A few days later, Mr. Lehman reported to senior management that the Japan sales office had been successful in selling another $20 million in CDO securities. Mr. Lehman wrote:

"Great job by [Japan sales] (again) on our CDO^2 axes. Tonight we will trade $20mm Point Pleasant A1s @90.7 to Tokyo Star Bank .... We hope to trade another $20mm of these bonds next week w/ this account."2117

501

¶Mr. Lehman sent an email to the head of the Japan sales office letting him know that Goldman's senior management was aware of the sales effort: "Montag ve[r]y involved in this fyi." The Japan sales manager responded: "Yes – he made that clear when he spent almost 20 minutes on the desk with me in TKO [Tokyo] last week going through every potential lead."2118 That same day, the Japan sales manager sent out a new email urging the trading team to bring in another $20 million from Tokyo Star Bank and promising them additional sales incentives:

"To reward your strong effort and in hopes of the follow on 20mm order from the client on this deal, we plan on paying you a total bonus GC payment of $40 / bond (double our $20/bond for AAA's on our axes that are not lower mezz AAA). We look forward to additional trades from Tokyo Star Bank on our CDO axes."2119

¶During June and July, additional sales took place in Japan, Korea, Taiwan, and Australia.2120 Goldman also made sales to customers in Europe and the Middle East.2121

¶Despite the sales in June and July, Goldman continued to have a significant inventory of unsold CDO securities. On August 15, 2007, Mr. Mullen even made a casual reference to "our cdo business which remains unsaleable."2122 If Goldman's CDOs remained unsaleable, however, it was not for lack of trying. In August and September 2007, Goldman switched from its targeted customer approach to issuing broad directives to its entire sales force in the United States and abroad urging them to concentrate on its CDO securities. On August 17, 2007, for example, the SPG Trading Desk issued a new directive to certain salespersons asking them to place a priority on selling interests in two Timberwolf super senior tranches.2123 These tranches were first in line to receive payments within the CDO and so had the lowest risk. Super senior CDO positions were often sold through CDS contracts, sometimes called super senior swaps, in which the customer took the long side and the CDO originator took the short side, and that's what Goldman wanted the sales force to market. But the following week, on August 23, 2007, Goldman sent a new directive to the sales force urging them to find customers willing to take the short side of the super senior tranches, so the Mortgage Department could take the long side and cover some of its shorts.2124 When asked his opinion of the directive, the head of Japan sales office expressed skepticism about sales to Asian customers:

"The only question in my mind is that we have not seen many accounts pushing hard to find ways to get short (typically they are long only). That being said, the reality of the current

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market may have finally sunk in and investors may be able to convince their boards [n]ow to put on this sort of trade."2125

¶On September 5, 2007, notwithstanding "the reality of the current market," the SPG Trading Desk issued a "Refresh of Axe Priorities" to its entire sales force.2126 The directive placed a priority on selling Goldman's residual CDO equity tranches as well as a variety of other assets to help Goldman cover and lock in the profits from its big short. Mr. Sparks emailed senior sales executives:

"Please let me know how these are going. I am personally going to work to do a better job making sure you understand the things we are trying to achieve as a business. In addition to this, the super-senior ABX trade [Jonathan] egol sent around and general securities financing trades are priorities for us."2127

¶Mr. Sparks forwarded this email to Mr. Cohn, who responded "Great to see."2128 On September 6, Mr. Sparks emailed the syndicate desk about the "Refresh of Axe Priorities": "Want to get you to send out daily 1-3 priority axes for department – let's discuss."2129

¶Goldman has at times suggested that many of its CDO sales were not the result of affirmative client solicitations and recommendations made by the firm, but were in response to client requests–generally known as "reverse inquiries." In a letter to the Financial Crisis Inquiry Commission, for example, Goldman's General Counsel, Gregory Palm, made the following statement about Goldman's role as an underwriter of synthetic CDOs:

"Goldman Sachs' CDOs containing primarily residential mortgage-related synthetic assets were initially created in response to the request of a sophisticated institutional investor that approached the firm specifically seeking that particular exposure. Reverse inquiries from clients were a common feature of this market. ... These transactions often are initiated by our clients, and when proposed by us are often in response to previously expressed

503

investment interests of the client. We are responding to our clients' desires either to establish, or to increase or decrease, their exposure to a position based on their own investment views."2130

¶Mr. Palm's characterization of Goldman as playing only a passive, responsive role is at odds with the firm's documented and concerted efforts to market its CDO securities in the face of investor disinterest and falling values. Throughout 2007, Goldman issued directives to its sales force to sell specific CDO securities on a "first priority" basis. It expanded its selling efforts to "nontraditional buyers" as well as to banks, hedge funds, and other clients in Asia, Europe, and the Middle East. It offered its sales force substantial incentives, such as "ginormous" sales credits, to push the sales to clients.2131 Under its CDO Gameplan, Goldman "targeted" four primary and 35 secondary clients for CDO sales, and celebrated selling CDO securities to several of them. The weight of this evidence demonstrates that Goldman was soliciting sales rather than responding solely to client inquiries.