Reports that Matter

Wall Street and the Financial Crisis: Anatomy of a Financial Collapse · 2011

Timberwolf I

Section 30 of 32

Timberwolf I

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

In September 2007, Mr. Montag asked for data tracking the drop in prices for a Goldman CDO that experienced a dramatic fall in value, such as Timberwolf.2475 In response, a Goldman employee provided prices for the A2 tranche of the Timberwolf securities using a combination of Goldman's internal marks and the bids provided to investors, from the issuance of the CDO on March 27, 2007 through September. The data showed that, in six months, prices for Timberwolf's AAA rated A2 security had fallen from $94 per security to $15, a drop of almost 80%:

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

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

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

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

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

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

Price

Sales Marks

3/1/2007 3/31/2007 4/30/2007 5/30/2007 6/29/2007 7/29/2007 8/28/2007 9/27/2007 10/27/2007 11/26/2007 12/26/2007 Prepared by the U.S. Senate Permanent Subcommittee on Investigations, February 2011. Derived from Goldman Sachs document, GS MBS-E-000779366.

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

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

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

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

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

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DD. Abacus 2007-AC1

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

A colleague replied:

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

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

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

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

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

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

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

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

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

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On March 22, 2007, ACA and Paulson agreed on the final $2 billion reference portfolio for Abacus 2007-AC1.2519 The assets consisted of 90 Baa2 rated mid and subprime RMBS securities issued after January 1, 2006.2520 The RMBS securities were "equally-sized," each with a $22.22 million notional value.2521 Each asset in the final reference portfolio was approved by both Paulson and ACA. Of the final 90 RMBS securities,49 "Revenue of the Three Credit Rating Agencies: 2002-2007," chart prepared by the Subcommittee using data from http://thismatter.com/money, Hearing Exhibit 4/23-1g. had been initially proposed by Paulson, and 41 had been initially proposed by ACA.2522

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

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

Answer: Right.

Question: Because you wanted to short those bonds?

Answer: Right.2525

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Mr. Tourre: Yes.2545

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

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

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

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

Senator Levin: It was not?

Mr. Tourre: No, it was not.2547

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

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Selling Abacus Securities. Abacus 2007-AC1 closed, and its securities were issued on April 26, 2007. They were issued later than the securities from the Hudson, Anderson, and Timberwolf CDOs and hit the market as subprime mortgages were hitting record delinquency and default rates. Goldman sold the Abacus 2007-AC1 securities to just three investors: IKB, the German bank; ACA, the portfolio selection agent; and ACA Financial Guaranty Corp., the owner of ACA and a wholly owned subsidiary of ACA Capital Holdings Inc.2549 IKB bought $150 million of the AAA rated Abacus securities. ACA bought about $42 million in the AAA securities for placement in another CDO it was managing.2550 See Goldman trading datasheet, GS MBS 0000004276 (showing closing dates and details on various deals, including Abacus). ACA Financial Guaranty Corp. was by far the largest investor, taking the long side of a $909 million CDS contract referencing the super senior portion of the CDO.2551 Goldman took the short side of the CDS contract, which it then transferred to Paulson.2552

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

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

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

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

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

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

(iii) Additional CDO Conflicts of Interest

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

AA. Liquidation Agent in Hudson 1

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

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

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

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

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

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

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

  • Goldman's role is Liquidation Agent and not Collateral Manager. Goldman is engaged by the CDO to liquidate Credit Risk Assets and will receive an ongoing Liquidation Agent Fee for such services;
  • Goldman does not determine whether an asset is a Credit Risk Asset. Such determination is made by the CDO based on specific rules . . . ;
  • Goldman must liquidate such Credit Risk Assets within 12 months of such determination and the price received on such liquidation must be in the context of a three-bid process;
  • Goldman does not receive additional compensation and or control of the CDO for acting as a Liquidation Agent. ...

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

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

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

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

577

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

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

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

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

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

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

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

578

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

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

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

The Hudson Offering Circular repeated that information and added:

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

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

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

579

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

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

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

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

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

580
  1. Even keeping the deal the way it is, the decision of when in the 12 month period to liquidate could be better handled by an experienced manager[.] 3. Potential amendment could be made to benefit the deal by giving more flexibility to agent."2586

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

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

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

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

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

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

581

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

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

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

On January 3, 2008, Daniel Sparks, the Mortgage Department head, was given a spreadsheet listing the Credit Risk Assets in each of the CDOs in which Goldman was serving as the liquidation agent, including Hudson 1. The spreadsheet showed that, in Hudson,44 3/11/2008 compliance letter from Moody's to SEC, SEC_OCIE_CRA_011212 and SEC_OCIE_CRA_011214. These numbers represent the RMBS or CDO pools that were presented to Moody's which then issued ratings for multiple tranches per RMBS or CDO pool. The data Moody's provided to the SEC on CDOs represented ABS CDOs, some of which may not be mortgage related. However, by 2004, most, but not all, CDOs relied primarily on mortgage related assets such as RMBS securities. Subcommittee interview of Gary Witt, former Managing Director of Moody's RMBS Group (10/29/2009). (See Chapter V below.) assets were Credit Risks with a face value of $635 million, totaling about 30% of the asset pool.2601

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

Credit Risk Assets (%)

35.00%

30.00% G) (,J

I Anderson c: nI 25.00% • Hout Bay - nI In II Hudson High Grade G) 20.00% II Hudson Mezz 1 I/) I/)

-e... <C c: 15.00%

II Hudson Mezz 2

:::l

... ()

10.00%

~ 0 5.00%

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

583

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

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

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

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

Weighted Average Levels

60.00%

50.00%

40.00%

~ 30.00% oJ

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

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

585

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

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

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

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

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

According to Morgan Stanley, Goldman continued to explain its seven-month delay in liquidating the Credit Risk Assets by asserting that the market would rebound during a rally to cover shorts, and it should wait to liquidate until asset prices rose. In a February 13, 2008 telephone call between Morgan Stanley and Goldman, for example, which was recorded and transcribed, Mr. Case stated:

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

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

586

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

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

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

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

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

587

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

On March 10, 2008, Goldman responded:

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

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

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

588

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

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

BB. Collateral Put Provider in Timberwolf

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

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

589

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

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

590

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

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

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

591

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

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

592

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

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

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

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

593

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

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

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

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

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

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

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

594

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Subcommittee did not locate any documents recounting exactly what was discussed at the meeting. The default swap collateral issue involved a significant number of Goldman CDOs, affected Goldman's relationships with investors and other financial firms serving as collateral managers of its CDOs, and entailed substantial financial risk for Goldman. Yet, when asked about it, the key participants said they could not recall whether the meeting took place, what was discussed at the meeting if it did take place, or what determinations were reached regarding Goldman's authority or actions. The participants who could not recall the meeting included Mr. Bieber, the Timberwolf deal captain; Tim Saunders, counsel from Goldman's legal department; Susan Helfrick, another legal counsel; and Jordan Horvath, the compliance officer. Mr. Saunders, the lead Goldman legal counsel on the matter, informed the Subcommittee that he had "no present recollection of the circumstances surrounding any disagreement between Goldman Sachs and Greywolf Capital Management LP regarding Goldman Sachs' right to consent to reinvestment of default swap collateral in Timberwolf."2657 Mr. Bieber, the Timberwolf deal captain, told the Subcommittee that he did not recall whether Goldman developed any specific strategy limiting the type of default swap collateral securities that could be purchased for its CDOs.2658

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

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

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

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

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

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

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

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

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

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

After indicating it would allow these new purchases, Goldman maintained tight control over the actual purchases made by the collateral managers. A September 27, 2007 email exchange between Mr. Marconi of Greywolf and Mr. Bieber of Goldman, for example, demonstrates Goldman's intense monitoring effort:

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

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

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

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

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(6) Analysis of Goldman's Conflicts of Interest

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

  1. Shorting Its Own Securities. In Hudson, Anderson, and Timberwolf, Goldman marketed CDO securities to clients, took a substantial portion of the short side of the CDO, bet the CDO would fall in value, and profited from its short position at the expense of the clients to whom it sold the securities.
  1. Failing to Disclose Key Information to Investors. In Hudson, Anderson, and Timberwolf, Goldman represented to potential investors that its interests "were aligned" with theirs or advertised its retention of a portion of the CDO's equity tranche, without disclosing that it had an even larger short position in the CDO and held a financial interest directly adverse to the investors to whom it was selling the CDO securities.
  1. Misrepresenting Source of Assets. In Hudson, Goldman provided 100% of the CDO assets using CDS contracts it controlled and priced, transferred $1.2 billion of risk from its own inventory to the CDO, and told investors the assets had been "sourced from the Street," when they had been supplied solely by Goldman and not priced from transactions with third parties.
  1. Failing to Disclose Client Involvement. In Abacus, Goldman enabled a client who was shorting the CDO to help select the CDO's assets, solicited investors to buy the Abacus securities without disclosing the short party's asset selection role or investment objective, and helped the client gain a $1 billion profit at the expense of the investors to whom Goldman sold the securities.
  1. Minimizing Premiums. In Abacus, Goldman entered into an undisclosed agreement with the sole short party to accept a fee for arranging low premium payments by the short party to the CDO, even though low premium payments meant less money for the long investors to whom Goldman had sold the Abacus securities.
  1. Selling Securities Designed to Fail. Goldman sold Hudson and Abacus securities to clients knowing the securities were designed to fall in value and benefit the short party, which was a client in the case of Abacus and itself in the case of Hudson.
  1. Delaying Liquidation. In Hudson, Goldman was paid a fee to serve as the liquidation agent, but delayed liquidating assets that were losing value for eight months, enhancing its financial gain as the CDO's short party at the expense of the long parties whose losses would have been staunched if the assets had been liquidated.
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  1. Misrepresenting Assets. In Anderson, when clients asked how Goldman got "comfortable" with poor quality New Century loans in the CDO, Goldman worked to dispel those concerns and failed to disclose its own discomfort with New Century loans and that it held 40% of the short side of the CDO, betting its assets would lose value.
  1. Taking Immediate Post-Sale Markdowns. In Timberwolf, Goldman knowingly sold Timberwolf securities to clients at prices above its own book values and then, often within days or weeks of a sale, marked down the value of the sold securities, causing clients to incur quick losses and requiring some to post higher margin or cash collateral.
  1. Evading Put Obligation. In Timberwolf, Goldman was paid a fee to serve as the collateral put provider, but refused for two months to allow the purchase of default swap collateral securities, even though they meant better returns for long investors, because Goldman did not want to assume the risk that the collateral securities might lose value.
  1. Using Poor Quality Loans in Securitizations. Goldman provided securitization services and warehouse accounts to lenders with a history of issuing high risk, poor quality loans, and knowingly included poor quality loans in Goldman-originated RMBS and CDO securities.
  1. Concealing Its Net Short Position. From late 2006 through most of 2007, Goldman engaged in a relentless effort to sell the CDO and RMBS securities it underwrote, without disclosing to the clients it solicited that Goldman was simultaneously shorting the subprime market and betting it would lose value.

These practices raise a wide range of ethical and legal concerns. This section examines the key issues of whether Goldman had a legal obligation to disclose to clients the existence of material adverse information, including conflicts of interest, when selling them RMBS and CDO securities; whether Goldman had material adverse interests that should have been disclosed to investors; and whether Goldman had an obligation not to recommend securities that were designed to lose value. Many of these issues hinge upon the proper treatment of financial instruments, such as credit default swaps and CDOs, which enable an investment bank to bet against the very same securities it is selling to clients.

(a) Securities Laws

To protect fair, open, and efficient markets for investors, federal securities laws impose a range of specific disclosure and fair dealing obligations on market participants, depending upon the securities activities they undertake. In the matters examined by the Subcommittee, the key roles under the securities laws include market maker, underwriter, placement agent, broker-dealer, and investment adviser.

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Market Maker. A "market maker" is typically a dealer in financial instruments that stands ready to buy and sell a particular financial instrument on a regular and continuous basis at a publicly quoted price.2671 Section 3(a)(38) of the Securities Exchange Act of 1934 ("The term 'market maker' means any specialist permitted to act as a dealer, any dealer acting in the capacity of block positioner, and any dealer who, with respect to a security, holds himself out (by entering quotations in an inter-dealer communications system or otherwise) as being willing to buy and sell such security for his own account on a regular or continuous basis."); see also SEC website, http://www.sec.gov/answers/mktmaker.htm; see also FINRA website, FAQs, "What Does a Market Maker Do?" http://finra.atgnow.com/finra/categoryBrowse.do. 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 that security.2672 SEC website, http://www.sec.gov/answers/mktmaker.htm. Market makers do not keep the financial instruments they buy and sell in their own investment portfolio, but instead keep them in their sales portfolio or "trading book."

Market makers have among the most narrow disclosure obligations under federal securities law, since they typically 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.2673 1/2011 "Study on Investment Advisers and Broker-Dealers," study conducted by the U.S. Securities and Exchange Commission, at 55, http://www.sec.gov/news/studies/2011/913studyfinal.pdf, (hereinafter "SEC Study on Investment Advisers and Broker-Dealers"). 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.2674 See Goldman response to Subcommittee QFR at PSI_QFR_GS0046.

Underwriter and Placement Agent. Underwriters and placement agents have greater disclosure obligations than market makers, because in this role they are actively soliciting customers to buy new securities they have helped an issuer bring to market.

When securities are offered to the public for sale, they are typically underwritten by one or more investment banks, each of which is a broker-dealer registered with the Financial Industry Regulatory Authority (FINRA).2675 FINRA is the largest independent self-regulatory organization for securities firms doing business in the United States. FINRA has been delegated authority by the SEC and a number of securities exchanges to regulate the broker-dealer industry. Its stated mission is "to protect America's investors by making sure the securities industry operates fairly and honestly." See FINRA website, http://www.finra.org. An underwriter is typically hired by the issuer of the new securities to help the issuer register the securities with the SEC and conduct a public offering of the securities. The underwriter 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.

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Investment banks can also act as "placement agents," assisting those seeking to raise money through a private offering of securities by helping them design the securities, produce the offering materials, and market the new securities to investors. Placement agents are also registered broker-dealers. While public offerings of securities are required to be registered and filed with the SEC, private offerings are made to a limited number of investors and are exempt from SEC registration. In the securitization industry, RMBS securities are generally sold through public offerings, while CDO securities are generally sold through private placements.

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, an issuer selling new securities to potential investors has an affirmative duty to disclose material information that a reasonable investor would want to know.2676 See, e.g., SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 201 (1963) ("Experience has shown that disclosure in such situations, while not onerous to the advisor, is needed to preserve the climate of fair dealing which is so essential to maintain public confidence in the securities industry and to preserve the economic health of the country."). See also SEC Study on Investment Advisers and Broker-Dealers at 51 [citations omitted] ("Under the so-called 'shingle' theory … a broker-dealer makes an implicit representation to those persons with whom it transacts business that it will deal fairly with them, consistent with the standards of the profession. … Actions taken by the broker-dealer that are not fair to the customer must be disclosed in order to make this implied representation of fairness not misleading."). In addition, under securities law, a broker-dealer acting as an underwriter or placement agent is liable for any material misrepresentation or omission of material fact made in connection with a solicitation or sale of securities to an investor.2677 See Sections 11 and 12 of Securities Act of 1933. See also Rule 10b-5 of the Securities Exchange Act of 1934. See also SEC v. Capital Gains Research Bureau, Inc., 375 U.S. at 200 ("Failure to disclose material facts must be deemed fraud or deceit within its intended meaning, for, as the experience of the 1920's and 1930's amply reveals, the darkness and ignorance of commercial secrecy are the conditions upon which predatory practices best thrive."). See also Goldman response to Subcommittee QFR, at PSI_QFR_GS0046.

The Supreme Court has held that a fact is material if there is a "substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available."2678 Basic v. Levinson, 485 U.S. 224, 231-32 (1988) (quoting TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)). The SEC has provided this additional guidance:

"'The question of materiality, it is universally agreed, is an objective one, involving the significance of an omitted or misrepresented fact to a reasonable investor.' '[T]he reaction of individual investors is not determinative of materiality, since the standard is objective, not subjective.' '[M]ateriality depends on the significance the reasonable investor would place on the withheld or misrepresented information.' Although in general materiality is primarily a factual inquiry, 'the question of materiality is to be resolved as a matter of law when the information is 'so obviously important [or

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unimportant] to an investor, that reasonable minds cannot differ on the question of materiality.'"2679 In the Matter of David Henry Disraeli and Lifeplan Associates, Securities Exchange Act Rel. No. 34-2686 (December 21, 2007) at 10-11 [citations omitted].

Unlike when a broker-dealer is acting as a market maker, a broker-dealer acting as an underwriter or placement agent has an obligation to disclose material information to every investor it solicits, including the existence of any material conflict of interest or adverse interest. This duty arises from two sources: the duties of an underwriter specifically, and the duties of a broker-dealer generally, when making an investment recommendation to a customer.

With respect to the duties of an underwriter, the First Circuit has observed that underwriters have a "unique position" in the securities industry:

"[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."2680 SEC v. Tambone, 550 F.3d 106, 135 (1st Cir. 2008) [citations omitted].

With respect to 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."2681 In the Matter of Richmark Capital Corporation, Securities Exchange Act Rel. No. 48757 (Nov. 7, 2003) (citing Chasins v. Smith Barney & Co., Inc., 438 F.3d 1167, 1172 (2d. Cir. 1970) ("The investor… must be permitted to evaluate overlapping motivations through appropriate disclosures, especially where one motivation is economic self-interest"). See also SEC Study on Investment Advisers and Broker-Dealers at 55. In this recent study examining the disclosure obligations of broker-dealers and investment advisers, the SEC has explained: "Generally, under the anti-fraud provisions, a broker-dealer's duty to disclose material information to its customer is based upon the scope of the relationship with the customer, which is fact intensive." According to the SEC, when a broker-dealer acts as an order taker or market maker in effecting a transaction for a customer, the broker- dealer generally does not have a duty to disclose information regarding the security or the broker-dealer's economic interest. The duty to disclose this information is triggered, however, when the broker-dealer recommends a security. Id.

The SEC has also stated that, if a broker intends to sell a security from its own inventory and recommends it to a customer, "the broker dealer must disclose all material facts."2682 SEC Study on Investment Advisers and Broker-Dealers at 56, n.252.

To help broker-dealers understand when they are obligated to disclose to investors material information, including any material adverse interest, FINRA has further defined the term "recommendation":

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"[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."2683 FINRA Notice to Members 96-60.

Goldman's own compliance manual essentially incorporates this guidance and instructs Goldman personnel that a proactive effort to sell a specific investment to a specific customer constitutes a recommendation of that investment.2684 See 2/1/2001 Goldman document, "United States Policies for the Preparation, Supervision, Distribution and Retention of Written and Electronic Communications," at 9, GS MBS 0000035799.

Once a broker-dealer, acting in the role of an underwriter or placement agent, has made an investment recommendation and triggered the duty to disclose any material adverse interest to a potential investor, it must disclose not only that the adverse interest exists, but also the "nature and extent" of the adverse interest.2685 See ,e.g., In the Matter of Arleen Hughes, Securities Exchange Act Rel. No. 4048 (Feb. 1948) (holding a broker-dealer, who is also a registered investment adviser, violated the anti-fraud provisions of the federal securities laws by failing to at minimum disclose the "nature and extent" of its adverse interest); In the Matter of Edward D. Jones & Co., L.P., Exchange Act Rel. No. 50910 (Dec. 22, 2004) (settled order), at 21(broker-dealer consents to an order finding that disclosure to its customers was inadequate, because it failed to disclose the full nature and extent of its agreement, including "information about the source and the amount of the revenue sharing payments to [the broker-dealer] and the dimensions of the resulting potential conflicts of interest"). In addition, it is not enough to inform a customer that the underwriter or placement agent "may" have an adverse interest if, in fact, the adverse interest already exists.2686 Further, there is no indication in any law or regulation that the obligation to disclose material adverse information is diminished or waived in relation to the level of sophistication of the potential investor.2687 See FINRA Rules 2210(d)(1)(A) and 2211(a)(3) and (d)(1) (by rule all institutional sales material and correspondence may not "omit any material fact or qualification if the omission, in the light of the context of the material presented, would cause the communications to be misleading."); and FINRA Rule 2310 and IM-2310-3 (suitability obligation to institutional customers). See also Hanly v. SEC, 415 F.2d 589, 596 (2d Cir. 1969) (holding that sophistication and knowledge of a broker's customers do not warrant a less stringent standard of conduct under federal securities laws); Spatz v. Borenstein, 513 F. Supp. 571, 580 (N.D. Ill. 1981) (finding investors' experience does not mitigate a broker's duty to fully and truthfully disclose material facts, nor does the potential for investors to discover information not disclosed by a prospectus vitiate any legal liability stemming from a failure to disclose material facts); Department of Enforcement v. Kesner, FINRA Complaint No. 2005001729501 (February 26, 2010) (finding sophistication of investors does not relieve a securities representative from disclosing material facts to investors).

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Suitable Investment Recommendations. In addition to requiring disclosure of material adverse information, federal securities laws and FINRA rules prohibit broker-dealers from making investment recommendations that would be unsuitable for any customer.2688 SEC Study on Investment Advisers and Broker-Dealers at 61.

In a recent study, the SEC explained: "[W]hile the suitability obligation under the federal securities laws arises from the anti-fraud provisions, the SRO [Self Regulatory Organization] rules are grounded in concepts of ethics, professionalism, fair dealing, and just and equitable principles of trade."2689 Id. For example, FINRA Rule 2010, providing Standards of Commercial Honor and Principles of Trade, states: "A member, in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade."2690 FINRA Rule 2010. See also Study on Investment Advisers and Broker-Dealers at 55 (broker-dealers also have an obligation under the federal securities laws and FINRA rules to deal fairly with their customers).

A broker-dealer violates the suitability rule if it makes a recommendation that "is unsuitable for any investor, regardless of the investor's wealth, willingness to bear risk, age or other individual characteristics."2691 F.J. Kaufman and Co., Securities Exchange Act Rel. No. 27535 at 5 (December 13, 1989). Under the applicable case law and FINRA rules, a broker-dealer is also obligated "to have an 'adequate and reasonable basis' for any security or strategy recommendation that it makes."2692 SEC Study on Investment Advisers and Broker-Dealers at 63 [citations omitted]. The suitability rule also requires the broker to determine that the specific security recommended is appropriate based on the customer's financial situation and needs. FINRA Rule 2310. The suitability obligation clearly applies to institutional customers, FINRA IM-2310-3 (suitability obligations to institutional customers require members have a reasonable basis for recommending a particular security or strategy), but may not apply when a broker-dealer solicits another broker-dealer to buy an investment since, under FINRA Rules, the term "customer" does not include a broker or dealer. FINRA Manual, 0120 Definition. On the other hand, the term "customer" has been given a broad definition under the securities case law. See, e.g., Department of Enforcement v. Zayed, FINRA Complaint No. 2006003834901 (August 19, 2010) ("Cases interpreting the term 'customer' in the securities context have viewed the term broadly to encompass individuals or entities that have some brokerage or investment relationship with the broker-dealer. Specifically, courts have rejected the argument that an account is necessary to establish an investor's status as a customer." [citations omitted]). When the Subcommittee asked Mr. Blankfein whether he believed there was a difference between a "customer" and a "client," Mr. Blankfein said he had "never distinguished" between the two terms. Subcommittee deposition of Lloyd Blankfein (12/15/2009), Hearing Exhibit 4/27-176 [Sealed Exhibit].

Suitability rules are intended to prevent abuses that contributed to the stock crash of 1929 and the Great Depression of the 1930s, when Senators investigating investment bank activities at the time wrote the following:

"[Investors] must believe that their investment banker would not offer them the bonds unless the banker believed them to be safe. This throws a heavy responsibility upon the banker. He may and does make mistakes. There is no way that he can avoid making mistakes because he is human and because in this world, things are only relatively secure. There is no such thing as absolute security. But while the banker may make mistakes, he

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must never make the mistake of offering investments to his clients which he does not believe to be good."2693 6/16/1934 "Stock Exchange Practices," Report of the Senate Committee on Banking and Currency, S. Rep. 73- 1455, at 88 (quoting "Who Buys Foreign Bonds," Foreign Affairs (1/1927)).

Investment Advisers. For investment banks that act, not just as a broker-dealer, underwriter, or placement agent, but also as an investment adviser to their customers, federal securities laws impose still a higher legal duty. When acting as an investment adviser, the law imposes a fiduciary obligation on the investment bank to act in the "best interests of its clients."2694 SEC Study on Investment Advisers and Broker-Dealers at 15-16. A person qualifies as an "investment adviser" under the Investment Advisers Act if that person: provides advice regarding securities, is in the business of providing such advice, and provides that advice for compensation.2695 Id. A broker-dealer, however, is excluded from the Investment Advisers Act if the performance of its investment advisory services is "solely" incidental to its business as a broker-dealer, and the broker-dealer does not receive "special compensation" for providing those advisory services.2696 Id. Because Goldman appears to have acted primarily as an underwriter, placement agent, or broker-dealer in carrying out its securitization activities, this section analyzes Goldman's conduct in that context and not in the context of an investment adviser.2697 The Subcommittee did not examine the extent to which Goldman was acting as an investment adviser within the meaning of the Investment Advisers Act when recommending that various customers buy its RMBS and CDO securities.

(b) Analysis

One key issue is whether Goldman was acting as a market maker versus an underwriter or placement agent when it recommended that its clients purchase its CDO and RMBS securities, since those roles have different disclosure and suitability obligations under the law. A second key issue is whether Goldman withheld material adverse information when recommending its securities to its clients, including the fact that it was shorting the securities it was selling. A third key issue is whether Goldman violated its obligation to make suitable investment recommendations when urging customers to purchase securities that Goldman knew were designed to lose value.

(i) Claiming Market Maker Status

Given its active role in the securitization markets, Goldman assumed a variety of roles in the development, marketing, and trade of RMBS and CDO products. At times, it acted as a market maker responding to client orders to buy and sell RMBS and CDO products. In addition, from 2006 to 2007, Goldman originated and served as an underwriter or placement agent for 27 CDOs and 93 RMBS securitizations, and sold the resulting RMBS and CDO securities to a broad range of clients around the world.

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In public statements and testimony regarding the financial crisis, Goldman has often highlighted its role as a market maker and downplayed its role as an underwriter or placement agent in the securitization markets.2698 See, e.g., 3/1/2010 letter from Goldman's legal counsel to the Financial Crisis Inquiry Commission, GS-PSI-01310 (discussing Goldman Sachs' "Role as a market maker" in detail and distinguishing it, in a much shorter description, from its underwriting and placement roles). Although the letter acknowledged that Goldman acted as an underwriter and placement agent for RMBS and CDO transactions, it also suggested that those transactions were commonly designed in response to client inquiries and did not discuss efforts by the firm to solicit customers to buy the securities: "Goldman Sachs' CDOs ... 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." In the April 27, 2010 Subcommittee hearing, for example, Goldman executives repeatedly highlighted the firm's role as market makers – buying and selling RMBS and CDO securities at the request of clients – while deemphasizing that the firm also originated new securities and affirmatively solicited clients to buy those new securities.

In an exchange with Senator Susan Collins, for example, executives from Goldman's Mortgage Department were asked questions about whether they were investment advisers with a fiduciary duty to their clients. While not denying this duty, they emphasized their role as market makers with more limited client obligations:2699 April 27, 2010 Subcommittee Hearing Transcript at 26-27.

Senator Collins: Thank you, Mr. Chairman. I would like to start my questioning by asking each of you a fundamental question. Investment advisers have a legal obligation to act in the best interests of their clients. Mr. Sparks, when you were working at Goldman, did you consider yourself to have a duty to act in the best interests of your clients?

Mr. Sparks: Senator, I had a duty to act in a very straightforward way, in a very open way with my clients. Technically, with respect to investment advice, we were a market maker in that regard. But with respect to being a prudent and a responsible participant in the market, we do have a duty to do that.

Senator Collins: Mr. Swenson?

Mr. Swenson: I believe it is our responsibility as market makers to provide a market- level bid and offer to our clients and to serve our clients and helping them transact at levels that are fair market prices and help meet their needs.

Mr. Tourre made similar representations in his prepared testimony to the Subcommittee:

"Between 2004 and 2007, my job was primarily to make markets for clients. I made markets by connecting clients who wished to take a long exposure to an asset – meaning they anticipated the value of the asset would rise – with clients who wished to take a short exposure to an asset – meaning they anticipated the value of the asset would fall. I

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was an intermediary between highly sophisticated professional investors – all of which were institutions. None of my clients were individual, retail investors."2700 Prepared statement of Fabrice Tourre, April 27, 2010 Subcommittee Hearing at 1.

In another exchange, when Subcommittee Chairman Levin asked Goldman CEO Lloyd Blankfein about the firm's duty as an underwriter and placement agent to disclose its adverse interests when selling its CDO securities to potential investors, Mr. Blankfein responded that market makers had no such disclosure obligations:

Senator Levin: You are betting against the very security that you are selling to that person. You don't see any problem? You don't see that you have to disclose, when you have put together a deal and you go looking for people to buy those securities, it just adds insult to injury when your people think it is a pile of junk. But the underlying injury is that you have determined that you are going to keep the opposite position from the security that you are selling to someone. You just don't see any obligation to disclose that. That is what seems to be coming through here.

Mr. Blankfein: I don't believe there is a disclosure obligation, but as a market maker, I am not sure how a market would work if it was premised on the assumption that the other side of the market cared what your opinion was about the position they were taking.

Senator Levin: Do they have a belief that you, at least when you are going out peddling securities, that you want that security to succeed? Don't they have that right to assume that if you are going out selling securities, that you have a belief that that is something which would be good for that client?

Mr. Blankfein: I think we have to have a belief, and we do have a belief that if somebody wants an exposure to housing –

Senator Levin: They don't want – you are out there selling it to them. You are out there selling these securities. This isn't someone walking in the door.

Mr. Blankfein: Again, I want –

Senator Levin: You are picking up the phone. You are calling all these people. You don't tell them that you think it is a piece of junk. You don't tell them that this is a security which incorporates or which in some way references a whole lot of bad stuff in your own inventory – bad lemons, they were called. ... You are out there looking around for buyers of stuff, whether it is junk or not junk, where you are betting against what you are selling. You are intending to keep the opposite side. This isn't where you are just selling something from your inventory. This is where you are betting against the very product you are selling, and you are just not troubled by it. That is the bottom line. There is no trouble in your mind –

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Mr. Blankfein: Senator, I am sorry. I can't endorse your characterization.

Senator Levin: It is a question, not a characterization. I am saying, you are not troubled.

Mr. Blankfein: I am not troubled by the fact that we market make as principal and that we are the opposite – when somebody sells, they sell to us, or when they buy, they buy from us.2701 April 27, 2010 Subcommittee Hearing at 137-138.

Although Goldman representatives routinely emphasized the firm's role as a market maker, when asked directly if the firm also functioned as an underwriter or placement agent when selling the CDO securities it originated, its executives agreed that in some circumstances, the firm played that role:

Senator Pryor: OK. But let me ask this: When you are selling a security such as a CDO, my understanding is you are not a market maker. Isn't it true that you are placement agent and as a placement agent you have a duty of full disclosure?

Mr. Sparks: Senator, that is correct.2702 Id. at 53.

Similarly, in a written response to a Subcommittee question asking about the firm's role in relation to Anderson, Hudson 1, Timberwolf and other CDOs, Mr. Blankfein wrote: "Goldman Sachs or an affiliate served as a placement agent."2703 Goldman response to Subcommittee QFR at PSI_QFR_GS0026.

Despite this acknowledged fact, Goldman continued to claim it was a market maker with limited disclosure and client obligations. On May 1, 2010, for example, less than a week after the Subcommittee's April 27 hearing, an article entitled, "Goldman Sachs' Lloyd Blankfein Defends 'Market Maker' Firm on 'Charlie Rose' Show," described Mr. Blankfein's statements on the televised show as follows:

"Asked by Rose whether Goldman investment advisers had ever bought securities from the firm, sold them to clients, and then bet against those same securities, Blankfein paused. And after a solid six seconds of silence, sought to explain … Goldman's role as a 'market maker.'

'We're like a machine, that lets people buy and sell what they want to buy and sell' Blankfein said. 'That's not the advisory business. That's just a facility for market making.'"2704 "Goldman Sachs' Lloyd Blankfein Defends 'Market Maker' Firm On 'Charlie Rose Show,'" Huffington Post (5/1/2010), http://www.huffingtonpost.com/2010/05/01/goldman%1esachs%1elloyd%1eblank_n_559606.html (video of Charlie Rose interview of Lloyd Blankfein embedded).

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During the interview, Mr. Blankfein compared Goldman's activity to that of the New York Stock Exchange, claiming that the firm was a market maker taking buy and sell orders from clients.2705 Id. At one point, Mr. Rose asked: "Has there ever been a time when Goldman's investment advisers bought securities from Goldman for a client and at the same time Goldman was simultaneously shorting it?" Mr. Blankfein responded: "I have to explain, see this is a problem. As a market maker, we are buying and selling a thousand times a minute, probably." Mr. Blankfein also stated during the interview: "If we believed it would fail, the security wouldn't work, we would not sell it."2706 April 30, 2010 Transcript of The Charlie Rose Show at 12-14. Mr. Blankfein made similar claims the following week on CNBC's "Power Lunch" during a one-on-one interview with David Faber. May 7, 2010 Transcript of Power Lunch at 4.

(ii) Soliciting Clients and Recommending Investments

Under federal securities law and FINRA Rules detailed above, when a broker-dealer, acting as an underwriter or placement agent brings a specific security to the attention of a particular customer, it is considered to be recommending the security to that customer and has an obligation to disclose all material adverse information to that customer, including any adverse interest that a reasonable investor would consider material in considering the broker-dealer's recommendation. Despite Goldman's frequent efforts to characterize its CDO and RMBS sales efforts as a market making activity in response to client demand, Goldman's internal documents, emails, and interviews indicate that, from late 2006 through 2007, Goldman was not always responding to client demand, but was also aggressively soliciting customers in an attempt to sell its CDO and RMBS products.

In December 2006, for example, Goldman CFO David Viniar instructed the Mortgage Department to reduce its long position in mortgage related assets, including by selling RMBS and CDO products on its books.2707 See, e.g., 12/14/2006 email from Daniel Sparks to Thomas Montag, "Subprime risk meeting with Viniar/McMahon Summary," GS MBS-E-009726498, Hearing Exhibit 4/27-3; Subcommittee interview of David Viniar (4/13/2010). The Mortgage Department responded with a concerted effort to sell to clients the bulk of the RMBS and CDO products in its inventory. The Subcommittee saw no evidence that this intensive selling campaign was undertaken in response to client demand. To the contrary, the evidence shows that the sales effort was undertaken at the request of senior management, despite what was then waning investor interest in securitization products.

In December 2006, on the same day Mr. Viniar directed the Mortgage Department to reduce its long assets, Kevin Gasvoda, head of the desk that handled RMBS securities, told his staff to "move stuff out even if you have to take a small loss."2708 12/14/2006 email from Kevin Gasvoda to his staff, "Retained bonds," GS MBS-E-010935323, Hearing Exhibit 4/27-72. In January 2007, Mr. Sparks, head of the Mortgage Department, asked a senior executive to compliment the CDO Origination Desk head and his staffer for their efforts to sell a specific CDO's securities over the prior month: "They structured like mad and traveled the world, and worked their tails off to make some lemonade out of some big old lemons."2709 1/31/2007 email from Daniel Sparks to Tom Montag, "MTModel," Hearing Exhibit 4/27-91. In March 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."2710 3/9/2007 email exchange between Mr. Sparks and sales managers, "help," GS MBS-E-010643213. He wrote: "I can't over state the importance to the business of selling these positions and new issues. … Priority 1 – sell our new issues and cash positions."2711 Id. In April 2007, the Mortgage Department issued one of many sales directives to Goldman's global sales force, placing a priority on selling certain CDO securities in its inventory, including securities from Anderson, Timberwolf, Point Pleasant, and Altius CDOs, and Mr. Sparks recommended providing large sales credits for those able to complete the sales.2712 4/19/2007 email from Daniel Sparks to Bunty Bohra, GS MBS-E-010539324, Hearing Exhibit 4/27-102.

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The documents also show that Goldman personnel worked relentlessly to identify possible clients and pitch CDO securities to them. In March 2007, for example, the Syndicate Desk contributed a list of "non-traditional buyers" that could be targeted for CDO sales, writing that "we continue to push for leads."2713 3/21/2007 email from Syndicate, "Non-traditional Buyer Base for CDO ASEX," GS MBS-E-003296460, Hearing Exhibit 4/27-78. A Goldman sales manager suggested targeting European and Middle Eastern banks and hedge funds.2714 3/9/2007 email exchange between Mr. Sparks and sales managers, "help," GS MBS-E-010643213, Hearing Exhibit 4/27-76. In New York, a Goldman sales representative recounted that the Abacus CDO security "has been showed to selected accounts for the past few weeks. Those selected accounts previously declined participating in Anderson mezz, Point Pleasant, and Timberwolf."2715 3/30/2007 email from Fabrice Tourre to Mr. Sparks and others, GS MBS-E-002678071.

When CDO sales slowed in May 2007, the Mortgage Department produced a new "target" list of four primary and 35 secondary clients for CDO sales.2716 5/20/2007 Goldman presentation, "Mortgage Department, May 2007," GS MBS-E-010965212. See also 3/1/2007 email from Michael Swenson, "names," GS MBS-E-012504595 (SPG Trading target list tiered according to likelihood of purchasing); 2/14/2007 email to Matthew Bieber, "Timberwolf I, Ltd. – Target Account List," GS MBS-E-001996121 (list of U.S. accounts "we should be directly targeting" for Timberwolf sales); 3/2/2007 email from David Lehman, "ABX/Mtg Credit Accts," GS MBS-E-011057632 (mortgage credit business shared with SPG Trading Desk "a fairly lengthy list of accounts that are considered to be 'key'"). A few days later, a Goldman salesperson reported that he planned to contact a hedge fund about Timberwolf and Point Pleasant securities, noting that the customer was "[n]ot expert[] in this space at all but [I] made them a lot of money in correlation dislocation and will do as I suggest."2717 5/24/2007 email from Ysuf Aliredha to Mr. Sparks and others, "Priority Axes," GS MBS-E-001934732. In Australia, a Goldman sales representative contacted an Australian hedge fund, Basis Capital, and mounted a sustained effort to sell it $100 million in Timberwolf securities, overcoming investor concerns to make the sale.2718 See, e.g., 5/20/2007 email from George Maltezos to Mr. Lehman, "T/wolf and Basis," GS MBS-E-001863555; 5/22/2007 email from Mr. Maltezos to Basis Capital, JUL 000685. In Korea, a Goldman sales representative attempting to sell $56 million in

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Timberwolf securities to a Korean life insurance firm was encouraged to "Get 'er done" and "go for it" by his superiors when he informed them "we are pushing on our personal relationships to get this done."2719 6/7/2007 email from Omar Chaudhary to Mr. Sparks and others, GS MBS-E-001866450, Hearing Exhibit 4/27-104.

These and other documents show that, in late 2006 and 2007, Goldman was not acting as primarily a market maker responding to client demand when it originated and sold Hudson, Anderson, Timberwolf, and Abacus securities, or when it sold other RMBS and CDO assets that senior management wanted to remove from the firm's books due to their declining values and increasing risk. Instead, Goldman was acting as an underwriter, placement agent, or broker-dealer, aggressively soliciting its clients to purchase the CDO and RMBS products that senior management wanted to eliminate from its inventory.

(iii) Failing to Disclose Material Adverse Information

Goldman's marketing and solicitation efforts to sell Hudson, Anderson, Timberwolf, and Abacus securities, along with other CDO and RMBS assets, to clients raise multiple questions about whether Goldman met its obligation to disclose material adverse information to potential investors. A related question is whether Goldman met its obligation to avoid material misrepresentations and omissions of material facts when recommending the purchase of those securities. One key issue is whether Goldman's failure to disclose its shorting activities, which would enable it to profit from a decline in the value of the very securities Goldman was recommending to its clients to purchase, qualified as an "omitted fact" that "would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available" about the security being recommended by Goldman.2720 Basic v. Levinson, 485 U.S. 224, 231-32 (1988) (quoting TSC Industries v. Northway, 426 U.S. 438, 449 (1976)). Utilizing the SEC's guidance, the issue could also be framed as evaluating "the significance the reasonable investor would place on the withheld or misrepresented information."

Taking the Short Side of a CDO. In the four CDOs examined in this Report, Goldman took 100% of the short side of Hudson, 40% of the short side of Anderson, and 36% of the short side of Timberwolf.2721 Goldman Response to Subcommittee QFR at PSI_QFR_GS0192. In each of these CDOs, Goldman also made a relatively small investment in the long side of the CDO by initially retaining all or a portion of its equity tranche, allowing Goldman to claim an "interest" in the CDO's long term success.2722 Typically, the equity tranche, which is the first to incur any losses sustained by a securitization, is retained by the originator. Equity tranches are typically not rated by the credit rating agencies and often not sold to third parties. In Abacus, Goldman did not intend to make any investment in the CDO itself, and instead enabled the client that had requested construction of the CDO and played a key role in selecting its assets to hold 100% of the short side of the CDO.

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Goldman did not accurately or fully disclose its short interest in Hudson, Anderson, or Timberwolf to potential investors.2723 In Abacus, Goldman also failed to disclose the role of the hedge fund in the Abacus asset selection process. See Abacus section C(5)(b)(ii)DD, above. Instead, the CDOs' offering materials advised potential investors, in difficult to understand language, that a Goldman affiliate "may" adopt a financial interest or investment position adverse to the investors when, in fact, Goldman had already determined to do so. In a section entitled, "Certain Conflicts of Interest," for example, the Hudson 1 Offering Circular stated in part:

"Certain Conflicts of Interest. Various potential and actual conflicts of interest may arise from the overall activities of the Credit Protection Buyer, the overall underwriting, investment and other activities of the Liquidation Agent, the Senior Swap Counterparty and the Collateral Put Provider, their respective affiliates and its clients and employees and from the overall investment activity of the Initial Purchaser, including in other transactions with the Issuer. The following briefly summarizes some of these conflicts, but is not intended to be an exhaustive list of all such conflicts.

"The Credit Protection Buyer and Senior Swap Counterparty. GSI [Goldman Sachs International] will be the initial Credit Protection Buyer and the initial Senior Swap Counterparty. The following briefly summarizes some potential and actual conflicts of interests related to the Credit Protection Buyer and Senior Swap Counterparty, but the following isn't intended to be an exhaustive list of all such conflicts. ...

"GSI 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 (the "Investments") or in credit default swaps (whether as protection buyer or seller) .... In addition, GSI and/or any of its affiliates may invest and/or deal, for their own respective accounts or for accounts for which they have investment discretion, in securities (or make loans or have other rights) that are senior to, or have interests different from or adverse to, any of the Investments and may act as adviser to, may be lenders to, and may have other ongoing relationships with, the issuers or obligors of Investments and obligations of any Reference Entities."2724 12/3/2006 Goldman Offering Circular, "Hudson Mezzanine 2006-1, LTD.," at 56, GS MBS-E-021821196. The Goldman offering circulars for Timberwolf and Anderson contain similar sections. See 3/23/2007 Goldman Offering Circular, "Timberwolf I, LTD.," GS MBS-E-021825371 at 427; 3/16/2007 Goldman Offering Circular, "Anderson Mezzanine Funding 2007-1, LTD.," GS MBS-E-000912574, at 623.

This disclosure indicates that GSI or an affiliate "may invest and/or deal" in securities or other "interests" in the assets underlying the Hudson CDO, and "may invest and/or deal" in securities that are "adverse to" the Hudson "investments." The Offering Circular, however, misrepresented Goldman's investment plans. At the time it was created in December 2006, Goldman had already determined to keep 100% of the short side of the Hudson CDO and act as the sole counterparty to the investors buying Hudson securities, thereby acquiring a $2 billion financial interest that was directly adverse to theirs.2725 See, e.g., Goldman response to Subcommittee QFR at PSI_QFR_GS0192 and PSI_QFR_GS00235.

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A federal court has held that disclosing a potential adverse interest, when a known adverse interest already exists, can constitute a material misstatement to investors.2726 See, e.g., SEC v. Czuczko, Case No. CV06-4792 (USDC CD Calif.), Order Granting Plaintiff's Unopposed Motion for Summary Judgment (Dec. 5, 2007) (finding defendant made a material misstatement to potential investors when he disclosed that officers, directors, employees and members of their families "may" trade in the stocks recommended on his website, without disclosing that he, his father, and business partner were trading in those stocks and had an interest in them). See also In the Matter of Arleen Hughes, Securities Exchange Act Rel. No. 4048 (Feb. 1948) (holding a broker-dealer, who is also a registered investment adviser, had to disclose the "nature and extent" of its adverse interest); In the Matter of Edward D. Jones & Co., L.P., Exchange Act Rel. No. 50910 (Dec. 22, 2004) (settled order), at 21 (disclosure inadequate for failing to disclose full nature and extent of the broker-dealer's conflict of interest). In the case of the Hudson CDO, much of the profit Goldman obtained would be generated from the losses incurred by clients that bought Hudson securities, creating an actual, undisclosed adverse interest. This construct, in which Goldman's profits depended in part upon its clients' losses, created a clear conflict of interest between Goldman and the clients to whom it was selling the Hudson securities, once Goldman had decided to become a short party in the CDO it was simultaneously marketing.

In another part of the Offering Circular, Goldman stated that GSI would serve as the sole counterparty to the CDO, but that disclosure was made in the context of a common industry practice in which the CDO originator or its designate typically took the entire short side of the transaction in the first instance and was the only party that dealt directly with the shell corporation actually issuing the CDO's securities. The CDO originator, or its designate, then acted as an intermediary between the shell corporation and the other broker-dealers buying short positions in the CDO on behalf of themselves or a customer. By placing itself in the middle of each CDS contract, the originator or its designate provided stronger financial backing for the CDS contracts being issued by the CDO and obtained more favorable credit ratings for the CDO securities. In the CDOs examined by the Subcommittee, Goldman followed industry practice by designating its affiliate, GSI, as the initial sole counterparty in the Hudson, Anderson, and Timberwolf CDOs.2727 Goldman sometimes referred to this position as the "Credit Protection Buyer" or "Synthetic Security Counterparty." Customers learning of GSI's role as the initial sole counterparty in the Hudson CDO would likely have assumed that GSI planned to sell its initial short position to other parties, since that was industry practice. What Goldman failed to disclose to those customers is that it planned to hold (or already held) all or a substantial portion of the short side of the CDO as a proprietary investment adverse to the interests of the customers to whom Goldman was selling the CDO securities. Had those customers known of Goldman's substantial short investment, they would likely have understood that Goldman viewed the very CDO securities it was recommending they purchase as likely not to perform.

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Goldman's failure to disclose its short interest was further compounded when it told investors that its interests "were aligned" with those of the long investors or when it advertised its retention of a portion of the CDO's equity tranche. The Hudson marketing booklet stated: "Goldman Sachs has aligned incentives with the Hudson program by investing in a portion of equity and playing the ongoing role of Liquidation Agent."2728 10/2006 Hudson Mezzanine Funding 2006-1, LTD., GS MBS-E-009546963, at 966, Hearing Exhibit 4/27-87. What made the statement misleading and what Goldman failed to disclose in the booklet was that its $6 million equity investment 2729 was far outweighed by its $2 billion short investment.2730 See, e.g., 10/30/2006 email from Mr. Ostrem, "Great Job on Hudson Mezz," GS MBS-E-0000057886, Hearing Exhibit 4/27-90. In addition, Goldman later used its liquidation agent position to benefit its short investment at the expense of the long investors in Hudson.2731 See discussion of Goldman's actions as the Hudson liquidation agent, above. In Anderson, talking points prepared for the Goldman sales force advocated telling investors: "Goldman is underwriting the equity and expects to hold up to 50%."2732 3/13/2007 email from Mr. Ostrem to Scott Wisenbaker and Matthew Bieber, GS MBS-E-000898410, Hearing Exhibit 4/27-172. What the talking points left out was that Goldman's $21 million equity investment in Anderson was less than one sixth the size of its $135 million short position.2733 See Goldman response to Subcommittee QFR at PSI_QFR_GS0192. In Timberwolf, the marketing booklet stated that Goldman was purchasing 50% of the equity tranche, and the collateral manager Greywolf was purchasing the other 50%.2734 Timberwolf flipbook, GS MBS-E-000676809, Hearing Exhibit 4/27-99a. Again, the booklet failed to disclose that Goldman's equity investment was far outweighed by its short investment.2735 Goldman purchased its share of the Timberwolf equity tranche in March 2007, actually held it for only two months, and then, in May, sold it to Greywolf. See also Goldman response to Subcommittee QFR at PSI_QFR_GS0226. In each CDO, Goldman withheld from investors information that it had a more significant financial interest in seeing the CDO decline in value than increase in value. In light of its short investments, Goldman's claims that its interests were aligned with, rather than adverse, to the investors to whom it was selling the CDO securities were misleading.

Shorting the Subprime Market. Goldman also failed to disclose to clients that, at the same time it was recommending investments in Goldman-originated RMBS and CDO securities, it was committing billions of dollars to short the same types of securities, as well as their underlying assets,2736 See, e.g., 6/5/2007 email from Benjamin Case to David Lehman, GS-MBS-E-001919861 (indicating Goldman was shorting some of the assets underlying Timberwolf using CDS contracts outside of the CDO). and even some of the lenders whose mortgage pools were included or referenced in the securities.2737 See, e.g., Goldman spreadsheet produced in response to a Subcommittee QFR, at GS MBS 0000037361 (identifying lenders whose stock Goldman shorted). In February 2007, Goldman's net short totaled about $10 billion.2738 In June 2007, its net short reached about $13.9 billion. A significant issue is whether this omitted information – that Goldman was heavily shorting the same types of investments it was recommending – "would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available" about the securities Goldman was recommending.2739 That Goldman's own investment decisions might be material information for an investor is demonstrated by a court ruling in a famous case in the 1970s, in which Goldman, an exclusive dealer, was sued by an investor who alleged that Goldman had sold it Penn Central notes without disclosing, among other things, that Goldman had recently reduced and placed limits on its own inventory of those same notes. Alton Boxboard v. Goldman, Sachs and Company, 560 F.2d 916 (8th Cir. 1977). Although the court decided the case on another basis, the Eighth Circuit found that the materiality of the undisclosed facts alleged was a question to be decided by a trier of fact. The court took note of the testimony from two sophisticated institutional purchasers concerning Goldman's reduction of inventory in Penn Central notes. Id at n.10. One sophisticated investor "testified that this information would have been a 'red flag' to him, and had he known of Goldman Sachs' inventory decision, he would have wanted notes from another issuer." Id. The other witness "stated he would have been concerned about such information and would have conveyed it to his customers, because it indicated that Goldman, Sachs did not have confidence in ... [the] notes." Id.

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Other Adverse Information. In addition to its failure to disclose that it was shorting specific CDOs as well as the subprime mortgage market as a whole, Goldman failed to disclose other arrangements which created conflicts of interest and undisclosed financial interests that were adverse to its clients. Concerning Abacus, Goldman failed to disclose a compensation arrangement in which Goldman agreed to accept a fee for arranging low premium payments by the short party; those lower payments disadvantaged the long investors by reducing cash payments to the CDO. Concerning Hudson, Goldman failed to disclose that its dual roles as liquidation agent and sole short party meant that it could delay liquidating Hudson assets that were losing value and simultaneously increase the value of its short position; that same action increased the losses of the long investors. In Timberwolf, Goldman failed to disclose that it viewed its role as collateral put provider allowed it to refuse to consent to the purchase of default swap collateral securities and avoid any risk that the securities would decline in value – the very risk the long investors were paying Goldman a fee to assume.2740 Each of these matters is discussed in detail, above. In each CDO, Goldman took actions that created an undisclosed conflict of interest between itself and the investors to whom it recommended and sold the CDO securities.

These types of arrangements, when undisclosed, can result in conflicts of interest that disadvantage investors. The existence, nature, and extent of such arrangements are the type of material adverse information that the securities laws were designed to ensure were accurately described and disclosed to investors.

(iv) Making Unsuitable Investment Recommendations

In addition to the disclosure issues, Goldman's efforts to sell Hudson, Anderson, Timberwolf, and Abacus securities raise a set of issues related to whether Goldman met its obligation to engage in fair dealing with its clients and avoid recommending investments that were unsuitable for any investor. The focus here is on Goldman's sale of CDO securities that were designed to lose value, either because the short party selected the assets or the assets were so poor that Goldman knew or should have known they would perform poorly or fail, yet marketed them to customers anyway.

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As detailed earlier, broker-dealers are required to deal fairly with their customers and observe high standards of honor in the conduct of their business.2741 SEC Study on Investment Advisers and Broker-Dealers at 55. When a broker-dealer, acting as an underwriter, makes an investment recommendation to a client, it is implicit that the broker-dealer has a reasonable basis to believe that the issue is sound.2742 SEC v. Tambone, 550 F.3d 106, 135 (1st Cir. 2008) [citations omitted]. A broker-dealer is also required "to have an 'adequate and reasonable basis' for any security or strategy recommendation that it makes."2743 SEC Study on Investment Advisers and Broker-Dealers at 63 [citations omitted]. Broker-dealers are barred from offering investments that are unsuitable for any investor.2744 Id. at 61. Goldman itself, in response to a Subcommittee question, has acknowledged that broker-dealers owe a "general suitability" obligation to its institutional investors, and "[t]his suitability duty requires the broker-dealer to determine, in the first instance, that the transaction is suitable for at least some investors."2745 See Goldman response to Subcommittee QFR at PSI_QFR_GS0048. Despite those requirements, the evidence gathered by the Subcommittee indicates that Goldman did not view any of the four CDOs examined in this Report as sound investments for the clients to whom it sold the securities.2746 See, e.g., 1/23/2007 email from Fabrice Tourre to Marine Serres, GS MBS-E-003434918, Hearing Exhibit 4/27-62 (Tourre wrote: "[S]tanding in the middle of all these complex, highly levered, exotic trades he [Mr. Tourre] created without necessarily understanding all the implications of these monstruosities [sic] !!!").

Selection of Assets by Short Party. Internal documents and emails from Goldman indicate that both Abacus and Hudson were designed with the expectation they would lose value and produce a profit for the short side of the CDOs. The sole short party in Abacus was the Paulson hedge fund; the sole short party in Hudson was Goldman itself.

With respect to Abacus, Goldman knew that the Paulson hedge fund wanted to take 100% of the short side and would profit only if the CDO lost value, yet allowed the hedge fund to play a major but hidden role in selecting the CDO assets.2747 See discussion of Abacus in section C(5)(b)(ii)DD, above. The Goldman employee with lead responsibility for Abacus, Fabrice Tourre, called it a "weak quality portfolio."2748 12/18/2006 email from Fabrice Tourre, "Paulson," GS MBS-E-003246145, Hearing Exhibit 4/27-107. The Paulson hedge fund executive who participated in the asset selection process acknowledged he selected assets that he expected would not perform well.2749 SEC deposition of Paolo Pellegrini (12/3/2008). PSI-Paulson-04 (Pellegrini Depo)-0001, at 175-76. A Moody's executive who oversaw CDO ratings when Abacus was rated – and testified that he did not know of Paulson's role in the Abacus asset selection process – explained that "[i]t just changes the whole dynamic of the structure where the person who is putting it together, choosing it, wants it to blow up."2750 April 23, 2010 Subcommittee Hearing Transcript at 64. When Goldman began to publicly market the Abacus securities, Ed Steffelin, a Senior trader at GSC who had declined Goldman's request that his firm serve as the CDO's portfolio selection agent, sent an email to Peter Ostrem, head of Goldman's CDO Origination Desk, stating: "I do not have to say how bad it is that you guys are pushing this thing."2751 2/27/2007 email from Ed Steffelin to Peter Ostrem, GS MBS-E-009209654. When asked by the Subcommittee what he meant by that comment, Mr. Steffelin said that he believed the Abacus

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CDO created "reputational risk" for the collateral manager industry and the whole market.2752 Subcommittee interview of Ed Steffelin (12/10/2010). When Mr. Tourre later sought to book two CDS contracts referencing the Abacus securities, a Goldman salesman wrote: "seems we might have to book these pigs."2753 4/15/2007 email from Cactus Raazi to Daniel Chan, "Dan: ABACUS 07-AC1," Hearing Exhibit 4/27-82.

As planned, once issued, the Abacus securities quickly lost value. In October 2007, six months after the Abacus securities were issued, the credit rating agencies downgraded them, and a Goldman salesperson noted: "This deal was number 1 in the universe of CDO's that were downgraded by Moody's and S&P. 99.89% of the underlying assets were downgraded."2754 10/26/2007 email from Goldman salesman to Michael Swenson, "ABACUS 2007-AC1 – Marketing Points (INTERNAL ONLY) [T-Mail]," GS MBS-E-016034495. The three investors that bought Abacus securities together lost more than $1 billion, while the Paulson hedge fund, as the sole short party, recorded a corresponding $1 billion profit.2755 In July 2010, Goldman agreed to settle a securities fraud complaint brought by the SEC by paying a fine of $550 million and "acknowledging 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."2756 SEC v. Goldman, Sachs & Co. and Tourre, Case No. 10-CV-3329 (BSJ) (S.D.N.Y.), Consent of Defendant Goldman, Sachs & Co (July 14, 2010).

With respect to Hudson, Goldman designed the CDO from its inception as a way to transfer the risk of loss associated with ABX assets from Goldman's inventory to the Hudson investors.2757 See discussion of Hudson CDO in section C(5)(b)(ii)AA, above. Goldman documents state, for example, that Hudson was "initiated by the firm as the most efficient method to reduce long ABX exposures,"2758 Goldman response to Subcommittee QFR at PSI_QFR_GS0249. and the CDO was an "exit for our long ABX risk."2759 9/20/2006 email from Arbind Jha to Josh Birnbaum, GS MBS-E-012685289. Goldman created and took the short side of $2 billion in single name CDS contracts referencing RMBS securities that it wanted to short, and sold them to the Hudson CDO. The end result was that Goldman wrote 100% of the CDS contracts that made up Hudson's assets and took 100% of the short side of the CDO, which meant that Goldman would profit if the CDO fell in value. Goldman marketed the CDO without disclosing its status as the sole short party, instead telling investors that its interests were "aligned" with theirs. The Hudson securities immediately began losing value. Within a year, while the holders of the Hudson securities lost virtually their entire investments, Goldman's profits reached $1.7 billion, which it then used to offset other mortgage related losses.

In both CDOs, Goldman took actions that disguised that the transactions were designed to lose value. In Abacus, Goldman omitted mention of the Paulson hedge fund's involvement in the asset selection process and hired a well known third party portfolio agent, ACA

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Management, to "leverage ACA's credibility."2760 3/12/2007 Goldman memorandum to Mortgage Capital Committee, "ABACUS Transactions sponsored by ACA," GS MBS-E-002406025, Hearing Exhibit 4/27-118. In Hudson, Goldman omitted that it had written all of the CDO's CDS contracts and it referenced $1.2 billion in ABX assets in Goldman's own inventory, and instead told investors that Hudson's assets were "sourced from the Street" and Hudson was "not a Balance Sheet CDO."2761 10/2006 Hudson Mezzanine Funding 2006-1, LTD., GS MBS-E-009546963, at 978, Hearing Exhibit 4/27-87.

Goldman marketed the Abacus and Hudson securities to clients knowing that each CDO had been designed to lose value and produce a profit for the short party. Given that information, Goldman marketed CDOs that it knew or should have known were not suitable for any investor.

Selection of Poor Quality Assets. Similar concerns apply to Goldman's origination and marketing of the Anderson and Timberwolf CDOs, which contained such poor quality assets that Goldman knew or should have known that they would perform poorly or fail. Yet Goldman recommended them to investors anyway. The issue is whether, by recommending that investors purchase the Anderson and Timberwolf securities, Goldman violated its fair dealing obligation and recommended investments that were not suitable for any investor.

With respect to Anderson, Goldman personnel knew before marketing its securities that the CDO had poor quality assets that were losing value. Nearly 45% of the referenced RMBS securities in Anderson were dependent upon loans issued by New Century, while another 7% depended upon loans issued by Fremont, two subprime lenders known, including by Goldman personnel, for issuing poor quality loans and poorly performing RMBS securities.2762 See discussion of Anderson CDO in section C(5)(b)(ii)BB, above. Another 8% were dependent upon loans issued by Countrywide. On February 24, 2007, Goldman personnel calculated that the assets in the Anderson warehouse account had already lost $60 million in value from the time they were purchased.2763 2/24/2007 email from Deeb Salem to Michael Swenson and others, GS MBS-E-018936137. In response, Mr. Sparks, the Mortgage Department head, decided to cancel the CDO.2764 2/24/2007 email from Mr. Sparks to Mr. Ostrem and others, GS MBS-E-001996601, Hearing Exhibit 4/27-95. Later, he changed his mind and rushed Anderson to market with only $305 million of the $500 million in assets that had been planned. Goldman was the largest short party, with 40% of the short interest in Anderson.

Anderson issued its securities on March 20, 2007. Goldman knew at the time that both New Century and Fremont were in financial distress.2765 See, e.g., 2/8/2007 email from Craig Broderick to Mr. Sparks and others, GS MBS-E-002201486 (calling New Century's announcement that it would restate its earnings "a materially adverse development"); 3/14/2007 Goldman email, "NC Visit," GS MBS-E-002048050 (stating Fremont still has cash "but not for long"); 3/13/2007 email from Mr. Ostrem to Scott Wisenbaker and Matthew Bieber, GS MBS-E-000898410, Hearing Exhibit 4/27- 172 (providing talking points for selling Anderson securities to customers). In addition, the week before, Goldman had conducted reviews of both a New Century and a Fremont loan pool on the firm's books, and found that 26% of the New Century loans 2766 and 50% of the Fremont loans 2767 reviewed had deficiencies and should be returned to the lender for refunds. Goldman nevertheless continued to market the Anderson securities. When some potential investors expressed concerns about Anderson's underlying assets, in particular the New Century loans, Goldman tried to dispel those concerns even while harboring its own low opinion of New Century loans.2768 See, e.g., 3/6/2007 email from Joshua Bissu to Mr. Ostrem and Mr. Bieber, GS MBS-E-014597705 (talking points for Goldman personnel to respond to investor concerns about the New Century loans). Goldman managed to sell approximately $102 million in Anderson securities to nine investors who lost virtually their entire investments within a year.2769 See e.g., Goldman response to Subcommittee QFR at PSI_QFR_GS0223.

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With respect to Timberwolf, Goldman personnel knew that the CDO's assets had begun losing value almost from the time they were acquired.2770 See, e.g., 9/17/2007 email from Christopher Creed, "Timberwolf," GS MBS-E-000766370, Hearing Exhibit 4/27-106 (showing price for Timberwolf securities dropped from $94 on 3/31/2007 to $87 on 4/30/2007). Timberwolf was a CDO2 transaction comprised of 56 different CDO assets with over 4,500 unique underlying securities.2771 8/23/2007 email from Jay Lee to Mr. Lehman and others, GS MBS-E-001927784. In February 2007, Mr. Sparks told a senior Goldman executive that it was a deal "to worry about," and that its assets had already incurred such significant losses that they had exhausted the share of the warehouse risk held by Goldman's partner in the transaction.2772 2/26/2007 email exchange between Mr. Sparks and Mr. Montag, GS MBS-E-019164799, Hearing Exhibit 4/27-71. Despite that loss in value, Goldman continued with the issuance of the Timberwolf securities in March 2007. By May, a special CDO valuation project undertaken by the Mortgage Department found that the Timberwolf's assets had lost still more value.2773 5/20/2007 email from Paul Bouchard, "Materials for Meeting," GS MBS-E-001863725. Despite its lower internal valuation, Mr. Sparks advised Goldman senior executives that his CDO pricing strategy was to "take the writedown, but market at much higher levels" to avoid "leaving some money on the table."2774 5/14/2007 email from Mr. Sparks to Mr. Montag and Mr. Mullen, GS MBS-E-019642797.

During the spring and summer of 2007, Goldman aggressively marketed Timberwolf securities to investors around the world, eventually selling about $853 million in Timberwolf securities to 12 investors.2775 See, e.g., Goldman response to Subcommittee QFR at PSI_QFR_GS0223. Goldman sold the securities at prices substantially above its internal book values for the Timberwolf securities. After making a sale, Goldman then, sometimes only days or weeks later, marked down the value of the securities it had sold, resulting in investors realizing losses and sometimes requiring the investor to post additional cash margin or collateral.2776 See, e.g., example involving Basis Capital in discussion of Timberwolf in section C(5)(b)(ii)CC, above. In September 2007, an internal Goldman analysis found that, in just six months, Timberwolf's AAA rated securities had lost 80% of their value. One of Goldman's senior executives monitoring Timberwolf pronounced it "one shitty deal."2777 6/22/2007 email from Mr. Montag to Mr. Sparks, "Few Trade Posts," GS MBS-E-010849103, Hearing Exhibit 4/27-105. The CDO was liquidated in October 2008, and the investors who purchased Timberwolf securities lost virtually their entire investments.

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Goldman CEO Lloyd Blankfein said publicly about the firm's securities: "If we believed it would fail … the security wouldn't work, we would not sell it."2778 April 30, 2010 transcript of The Charlie Rose Show, at 14. But Goldman marketed the Anderson and Timberwolf securities to clients knowing that each CDO had poor quality assets that were continually losing value. It marketed them at the same time it was investing on the short side of the CDOs and the subprime mortgage market as a whole, and its Mortgage Department head was telling his staff that it was "Game Over" and time to "get out of everything."2779 3/12/2007 Goldman Firmwide Risk Committee, "March 7th FWR Minutes," GS MBS-E-00221171, Hearing Exhibit 4/27-19; 3/3/2007 email from Mr. Sparks, "Call," GS MBS-E-010401251, Hearing Exhibit 4/27-14. Within a year, the Anderson and Timberwolf securities were virtually worthless. Given what Goldman knew when marketing Anderson and Timberwolf, Goldman was recommending investments that were most likely not suitable for any investor.

This analysis examines Goldman's conduct in the context of the law prevailing in 2007. Since then, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 has established new conflict of interest prohibitions that would apply to this type of conduct, including Section 621 which bars any underwriter or placement agent of an asset backed security from engaging in any transaction "that would involve or result in any material conflict of interest with respect to any investor in a transaction arising out of such activity."

(7) Goldman's Proprietary Investments

When reviewing the conflict of interest issues related to Goldman's mortgage related activities in 2006 and 2007, another issue examined by the Subcommittee was the extent to which Goldman's Mortgage Department was engaged in proprietary trading.2780 Until its repeal in 1999, the Glass-Steagall Act prohibited banks from engaging in proprietary trading. Glass- Steagall Act, Section 16. The Act's prohibition on proprietary trading was weakened over the years and finally repealed by the Financial Services Modernization Act of 1999, P.L. 106-102 (1999). Since Goldman did not become a bank holding company until 2008, neither the Glass-Steagall prohibition nor its repeal affected its activities during the time period examined by the Subcommittee.

In 2007, Goldman was not a commercial bank, and proprietary trading was not illegal. The issue that concerned the Subcommittee was the extent to which its proprietary activities may have contributed to the conflicts of interest that affected how Goldman operated.2781 Financial institutions that trade for their own accounts at the same time that they conduct trades on behalf of their clients may experience conflicts of interest. See, e.g., 4/23/2010 letter from John Reed, former Chairman and CEO of Citigroup, to Senators Merkley and Levin ("When a firm is focused on market gain through proprietary trading, it too often will employ every available device to achieve those gains B including take advantages of clients and putting the firm at risk."); In re Merrill Lynch, Pierce, Fenner & Smith, Incorporated, Exchange Act Rel. No. 34-63760, Admin. Proc. 3-14204 (Jan. 25, 2011) (settling allegations that Merrill Lynch's proprietary traders misused information about their customers' trading); 7/19/2005 speech by Annette Nazareth before the Securities Industry Association Compliance and Legal Division Member Luncheon (discussing increased potential for conflicts of interest). In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act, P.L. 111-603, restored the prohibition on proprietary trading by banks, subject to certain exceptions. See Section 619, amending the Bank Holding Company Act of 1956, to be codified at 12 U.S.C. §1851. Regulations implementing Section 619, also known as the Merkley-Levin provisions after the Senators who authored them or the Volcker Rule after former Federal Reserve Chairman Paul Volcker who championed the ban, are due by October 2011. In a recently issued "Report of the Business Practices Committee," Goldman reaffirmed as its first business principle: "Our clients' interests always come first."2782 1/2011 "Report of the Business Standards Committee," at 1. In May 2010, at Goldman's annual shareholders' meeting, CEO Lloyd Blankfein announced the formation of a Business Standards Committee to conduct an extensive review of the firm's business standards and practices to determine the extent to which the firm was adhering to its own written "Business Principles," and to make appropriate recommendations. Id. The Committee's January 2011 report provided recommendations in the areas of Client Relationships and Responsibilities, Conflicts of Interest, Structured Products, Transparency and Disclosure, Committee Governance, and Training and Professional Development. Contrary to that statement, however, Goldman documents showed its employees repeatedly expressing concern about the firm's interests, but rarely mentioning or placing a priority on the interests of its clients. In fact, after Goldman announced record profits for its Mortgage Department in the third quarter of 2007, when many of its clients were suffering substantial losses from the mortgage investments they purchased from Goldman, Peter Kraus, co-head of the Investment Banking Division, wrote the following to Goldman CEO Lloyd Blankfein:

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"I met with 10+ individual prospects and clients … since earnings were announced. The institutions don't and I wouldn't expect them to, make any comments like ur good at making money for urself but not us. The individuals do sometimes, but while it requires the utmost humility from us in response I feel very strongly it binds clients even closer to the firm, because the alternative of take ur money to a firm who is an under performer and not the best, just isn't reasonable. Clients ultimately believe that association with the best is good for them in the long run."2783 9/26/2007 email to Mr. Blankfein, "Fortune: How Goldman Sachs Defies Gravity," GS MBS-E-009592726, Hearing Exhibit 4/27-135.

The tension between Goldman's efforts to make money on behalf of itself versus on behalf of its clients raises a number of conflict of interest concerns, particularly when its efforts to profit from shorting the mortgage market or particular RMBS or CDO securities occurred simultaneously with its efforts to market mortgage related securities to its clients.

Goldman's Proprietary Activities. Until recently, when asked about the extent of the firm's proprietary activities, Goldman generally claimed that its proprietary investments contributed only approximately 10% of the firm's profits.2784 See, e.g., 1/21/2010, The Goldman Sachs Group Inc., 4Q 2009 Earnings Call Transcript, Q&A (CFO David Viniar states that, in most years, proprietary trading accounts for "10% roughly plus or minus a couple of percent."), http://seekingalpha.com/article/183723-the-goldman-sachs-group-inc-q4-2009-earnings-call-transcript?part=qanda. In January 2011, however, Goldman announced in an SEC filing that it was changing the categories under which it reported income. Goldman added a new category called "Investments and Lending" to segregate the firm's proprietary investment income from the income it derived from activities undertaken on behalf of clients.2785 1/11/2011 Goldman Form 8-K filed with the SEC (announcement of change in reporting categories). Goldman's change in its reporting categories implemented one of the recommendations outlined in Goldman's "Report of the Business Standards Committee" published in January 2011. Based on earnings reported in January 2011 for Goldman=s full fiscal year 2010, the proprietary investment income recorded under "Investments and Lending" accounted for $7.5 billion, or about 20% of Goldman's net revenues.2786 See 1/19/2011 Goldman press release on 2010 earnings, available at www2.goldmansachs.com. Goldman did not specify how it defined proprietary investments and lending for purposes of its earnings report, nor what desks or activities contributed to the total, how it calculated the reported amount, or why it was double the amount cited a year earlier.

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To date, three Goldman units have been identified as engaging explicitly in investments on behalf of the firm. One, based in New York, is called Goldman Sachs Principal Strategies or "GSPS," which Goldman is reportedly in the process of dismantling.2787 Subcommittee interview of David Viniar (4/13/2010). See also "More Goldman Traders to Exit for Funds," Financial Times (1/9/2011). Goldman may be eliminating the desk in response to the Dodd-Frank prohibition on proprietary trading. The second is the Global Macro Proprietary Trading Desk, which had traders in New York and London and reportedly invested in foreign exchange markets, interest rate markets, stocks, commodities and other fixed income markets.2788 See "Goldman to Shut Global Macro Trading Desk," New York Times (2/16/2011). Goldman may be eliminating this desk in response to the Dodd-Frank prohibition on proprietary trading. The third, according to Goldman, is the Special Situations Group or SSG, which is reportedly engaged primarily in long term investments on behalf of the firm and clients, with little short term trading or sales activities.2789 Subcommittee interview of Darryl Herrick (10/13/2010). To the extent that its activities are limited to long term investments, the SSG unit would not be affected by the Dodd-Frank prohibition on proprietary trading which applies only to trading accounts used "principally for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements)," and does not affect long term investments. See Section 619(h)(6). Under Section 620 of the Dodd-Frank Act, banking regulators are also conducting an 18-month review of all permitted bank investment activities, both long and short term, to gauge the risk of each activity, any negative effect the activity may have on the safety and soundness of the banking entity or the U.S. financial system, and the "appropriateness" of each activity for a federally insured bank.

Proprietary Activities in the Mortgage Area. In the mortgage area, until 2005, Goldman had a dedicated proprietary investment desk in the Mortgage Department called the Principal Finance Group, often referred to as Principal Investments.2790 Subcommittee interview of Darryl Herrick (10/13/2010). According to Goldman personnel, that desk specialized in long term investments on behalf of Goldman in assets such as distressed mortgages and credit card and energy receivables, but only rarely engaged in short term trading.2791 Id. In 2005, Principal Investments was folded into the Special Situations Group (SSG), which was then a Goldman business unit located in Asia and not part of the Mortgage Department.2792 Id. After Principal Investments personnel moved to SSG, the Mortgage Department operated without a desk that was explicitly dedicated to proprietary trading during 2006 and 2007.

When asked whether the Mortgage Department engaged in proprietary activities during 2006 and 2007, Goldman executives and traders in the Mortgage Department generally resisted providing a direct answer, declined to identify any proprietary trades or investments, and declined to estimate or calculate how much of the Mortgage Department=s 2007 revenues or profits were proprietary.

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When asked about particular transactions, Goldman executives or traders often described them as examples, not of "proprietary trading," but "principal trading" in which Goldman acted as a market maker. Goldman personnel told the Subcommittee that to fulfill the firm's role as a market-maker, Goldman used its own capital to amass an inventory of assets in anticipation of customer demand, and acted as a "principal" when building that inventory. They indicated that the mortgage related assets were acquired for the purpose of accommodating existing or anticipated client buy and sell orders and not to produce proprietary profits for the firm.

At the same time, several Goldman executives and traders told the Subcommittee that all of Goldman's trading desks, including those in the Mortgage Department, were given discretion to trade some amount of the firm's capital within certain limits.2793 Subcommittee interviews of Mr. Sparks (4/15/2010); Mr. Birnbaum (4/22/2010); and Mr. Broderick (4/9/2010). See also 12/17/2007 email from Michael DuVally to Mr. Sparks, "WSJ Responses," GS MBS-E-013821884 ("Some traders are allowed to express their own market views using the firm's capital."). Daniel Sparks told the Subcommittee: "We told [the Firmwide Risk Committee] what we wanted to do, and they told us how much we could do."2794 Subcommittee interview of Daniel Sparks (4/15/2010). Joshua Birnbaum said that the amount of proprietary trading that a desk was allowed to do depended upon certain risk limits, but could not recall a specific or typical dollar amount of any risk limit assigned to the Mortgage Department as a whole or to any of its trading desks for proprietary trading purposes.2795 Subcommittee interview of Joshua Birnbaum (4/22/2010). Goldman's Chief Risk Officer Craig Broderick told the Subcommittee that the firm did not distinguish between "proprietary" versus other types of risk, because the aggregate risk levels would be the same.2796 Subcommittee interview of Craig Broderick (4/9/2010). Mr. Broderick said that the firm's proprietary trading, outside of GSPS, was "embedded" in the routine business conducted by various trading desks and was not specifically segregated as "proprietary."2797 Id. Goldman's Chief Financial Officer David Viniar provided similar information in response to questions from the Financial Crisis Inquiry Commission, indicating that Goldman did not specifically "break out" its proprietary trading from its other business results. See FCIC Hearing, Testimony of David Viniar (7/2/2010), www.fcic.gov.

Until enactment of the Dodd-Frank Act in 2010, federal securities law contained no statutory or regulatory definition of proprietary trading by banks and generally did not require firms to identify or monitor their proprietary investments.2798 The Dodd-Frank Act defines "proprietary trading" as "engaging as a principal for the trading account of [a] banking entity . . . in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, any derivative, any contract of sale of a commodity for future delivery, any option on any such security, derivative, or contract or any other security or financial instrument that the appropriate Federal banking agencies ... may, by rule ... determine." 12 U.S.C. ' 1851(h)(4). The Act further defines "trading account" as one used for "near term" trading or for capturing profits from "short term price movements." Section 1851(h)(6). These provisions are subject to further refinement through implementing regulations. The Subcommittee investigation found that the terms "proprietary" and "prop" were commonly used in the financial services industry to describe business performed on behalf of, or for the benefit of, a financial firm itself, while the term "flow" was used to refer to market-making transactions involving, or for the benefit of, the firm's customers.2799 See, e.g., description of proprietary trading in Deutsche Bank's 3/26/2008 Form 20-F filed with the SEC at 24 ("Within Corporate Banking & Securities, we conduct proprietary trading, or trading on our own account, in addition to providing products and services to customers. Most trading activity is undertaken in the normal course of facilitating client business. For example, to facilitate customer flow business, traders will maintain long positions (accumulating securities) and short positions (selling securities we do not yet own) in a range of securities and derivative products, reducing this exposure by hedging transactions where appropriate. While these activities give rise to market and other risk, we do not view this as proprietary trading. However, we also use our capital to exploit market opportunities, and this is what we term proprietary trading.").

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A number of internal Goldman documents in 2006 and 2007, used the terms "prop" and "flow" when referring to mortgage related activities. In a 2006 email to Goldman senior executives, for example, Mr. Sparks, the Mortgage Department head, used the terms when criticizing a decision by Morgan Stanley to move its most experienced mortgage traders from its mortgage department's "franchise" desk to a dedicated proprietary desk.2800 4/13/2006 email from Mr. Sparks to Messrs. Cohn, Sobel, and Mullen, "Morgan Super Traders Worry Hedge Funds," GS MBS-E-016187625. Mr. Sparks argued against Goldman=s doing the same by claiming exposure to customer trades or "flows" made mortgage traders "more effective" in their proprietary trades:

"Morgan Stanley is going overboard by taking most of their experienced and known traders out of the franchise. We should keep our franchise leaders in the seats and continue to allow them to take prop views B the customer flows they see make them more effective."2801 Id. See also Glenn Bedwin, International Research Director, Thomson Financial, Trading for Investors Forum, Financial News Supplement at 14 (2004) (noting the value of "information [banks] gain from looking at the flow going through their desk").

This email shows, not only that Mr. Sparks and other Goldman executives used the terms "prop" and "flow," but they also knew Goldman mortgage traders were handling both customer and proprietary transactions at the same time.

In November 2007, Mr. Sparks received an email from the Mortgage Department's business manager, John McHugh, indicating that proprietary trades made up a substantial portion of the Department's activities.2802 11/16/2007 email from John McHugh to Mr. Sparks, "FICC 2008 business plan presentation to Firm," GS MBS-E-013797964. In the email, Mr. McHugh provided Mr. Sparks with a draft of the Department=s 2008 business plan which included a description of the projected business activities of the Structured Product Group – the Mortgage Department trading desk that then handled RMBS, CDO, and other mortgage related trading activities. Under the heading, "Prop vs. Flow," the draft plan stated: "Prop/flow components of SPG Trading will be roughly equal."2803 Id. Under another section entitled, "Assumptions/ Initiatives in ABS [Asset Backed Security] p&l [profit and loss]," the draft business plan stated:

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$ "Good prop opportunity capitalizing on selling pressure, selective distressed asset purchases. $ Expect prop flow split to be roughly 50/50."2804 Id.

The draft business plan suggests that fully half the 2008 SPG and ABS activities were expected to involve proprietary investments.

When the Subcommittee asked Mr. Sparks about the "prop/flow components of SPG Trading" in the Department's 2008 draft business plan, Mr. Sparks indicated that he was not sure what his business manager meant and was unable to estimate what percentage of the SPG Trading Desk's activities was spent on proprietary trades.2805 Subcommittee interview of Daniel Sparks (10/3/2010). In a later written response to Subcommittee questions about the email, Mr. Sparks wrote: "'Prop' or 'proprietary' can mean different things to different people." He continued that Mr. McHugh=s email appeared to use "prop" to refer to investments made with a longer holding period, such as months or years, while "flow" seemed to refer to investments with a shorter holding period:

"Defined this way, both 'prop' and 'flow' trades can involve customers, although sometimes the term 'proprietary' is used to describe business that does not involve a customer. (Sometimes proprietary is used to describe any activity that involves use of a firm's own capital.)."2806 Daniel Sparks response to Subcommittee QFR at PSI-QFR_GS0452.

Goldman's Net Shorts As Proprietary Investments. Goldman's practice of embedding its proprietary trading activities within the ordinary trading conducted on its market-making mortgage trading desks, together with its unwillingness to estimate its proprietary activities, made it difficult to determine the extent of the proprietary trading that took place within the Mortgage Department from 2006 to 2007.2807 The difficulties associated with distinguishing between proprietary trading and market making activities are examined in a recent study by the new Financial Stability Oversight Council (FSOC), an intra-governmental council established by the Dodd-Frank Act, comprised of ten regulators in the financial services sector, and charged with identifying risks and responding to emerging threats to U.S. financial stability. See FSOC FAQs, www.treasury.gov; 1/2011 "Study & Recommendations on Prohibitions on Proprietary Trading & Certain Relationships with Hedge Funds & Private Equity Funds" (hereinafter "FSOC Study"), at 22-44. The FSOC Study observed: "Absent robust rules and protections, banking entities may have the opportunity to migrate existing proprietary trading activities from the standalone business units that are presently recognized as 'proprietary trading" into more mainstream 'sales and trading' or other operations that engage in permitted activities." Id. See also "Proprietary Trading Goes Under Cover: Michael Lewis," Bloomberg, (10/27/2010) (quoting a bank trader who reportedly said "from here on out, if he wants to take a proprietary position ... he will argue that he bought the position because a customer wanted to sell the position, and he was providing liquidity"). Nonetheless, many of the transactions undertaken by the Mortgage Department from late 2006 to late 2007 appear to have been undertaken to advance the financial interests of the firm, rather than primarily to make markets for clients.

Several factors suggest that transactions undertaken to build and profit from Goldman's two large net short positions in 2007 were completed for Goldman's own benefit, rather than on behalf of its clients. First, the two net short positions – totaling $10 billion in February and $13.9 billion in June 2007 – were far larger than a financial institution would establish simply to meet anticipated client demand.2808 These totals include Goldman's net shorts from both its mortgage trading and CDO securitization activities. Second, the magnitude of the risk attached to those short positions was also outsized. As indicated earlier, the Mortgage Department typically contributed only about 2% of Goldman's total net revenues, yet in 2007, it was allowed to continually exceed its permanent Value-at-Risk (VAR) limit and incur up to 54% of firmwide risk. The Subcommittee uncovered no evidence to suggest that Goldman incurred and sustained that disproportionately high level of risk to accommodate client demands or to hedge positions taken on to accommodate clients.

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A third factor indicating the net short positions were proprietary in nature was how long Goldman held onto them. For example, the Mortgage Department maintained a $9 billion ABX AAA short for six to nine months in 2007. While that short was initially used to hedge certain long positions held by various Mortgage Department desks, it was retained even after those long positions were sold off or written down. Mr. Sparks later described the ABX AAA short as "disaster insurance" in case the subprime market collapsed.2809 Subcommittee interview of Daniel Sparks (4/15/2010). The Subcommittee found no evidence indicating that the $9 billion short was maintained over such a long period of time to accommodate client demand.

A fourth factor indicating Goldman's net short positions were proprietary in nature was the Mortgage Department's affirmative effort to solicit clients to buy RMBS and CDO assets in its inventory.2810 See, e.g., documents cited in Section C(4)(b) (sales efforts to reduce Goldman's $6 billion long position) and Section C(5)(a)(iii) (sales efforts to reduce Goldman-originated RMBS and CDO securities), above. The Subcommittee saw no evidence that this sales activity was undertaken to accommodate client demand; to the contrary, the documents show that the Mortgage Department's sales efforts took place amid a deteriorating mortgage market and waning investor interest in mortgage related products.2811 See, e.g., emails noting difficult sales environment. 1/31/2007 email from Mr. Sparks to Mr. Montag, "MTModel," Hearing Exhibit 4/27-91 (making "lemonade out of some big old lemons"); 3/9/2007 email from Mr. Sparks to Mr. Schwartz and others, GS MBS-E-010643213, Hearing Exhibit 4/27-76 ("team is working incredibly hard and is stretched"); 3/27/2007 email from Mr. Ostrem to Mr. Bieber, GS MBS-E-000907935, Hearing Exhibit 4/27-172 (congratulating Mr. Bieber for "an excellent job pushing to closure these deals in a period of extreme difficulty"); 6/11/2007 email from Mr. Montag, GS MBS-E-001866144 (after a sale of Timberwolf securities, telling the sales team they had done an "incredible job B just incredible").

Still another indicator that the Mortgage Department's net shorts were proprietary was that, when clients expressed interest in acquiring certain short positions, Goldman at times refused to accommodate their requests. For example, in June 2007, when Goldman began building its second large net short position, its Mortgage Department refused client requests to purchase the short side of CDS contracts with Goldman: "Really don=t want to offer any [shorts to customers]" and "too late!"2812 6/10/2007 email from Michael Swenson, "CDS on CDOs," GS MBS-E-012568089; 6/13/2007 email from sales, "CDO protection," GS MBS-E-012445931. See also 9/7/2007 Fixed Income, Currency and Commodities Annual Individual Review Book, Salem 2007 Self-Review, GS-PSI-03157 at 71 (in his self-evaluation Mr. Salem On another occasion in March 2007, a Goldman employee told Goldman's Chief Risk Officer Mr. Broderick that the Mortgage Department was no longer buying subprime assets: "Just fyi not for the memo, my understanding is that desk is no longer buying subprime. (We are low balling on bids.)."2813 3/2/2007 email exchange between Mr. Broderick and Patrick Welch, GS MBS-E-009986805, Hearing Exhibit 4/27-63. Refusing client requests and lowballing bids to avoid purchases indicate that the Goldman Mortgage Department was not acting as a market maker to accommodate client demand.

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Perhaps the strongest indicator that Goldman's large net short positions were proprietary investments are the statements made by Goldman's own executives and traders. Goldman's head ABX trader, Joshua Birnbaum, described the Department's decisions in February and June to build and profit from its net short positions, not as efforts to accommodate anticipated client demand, but as investments made on behalf of the firm to produce large profits:

"Whereas execution of strategies has clearly been a concerted team effort, I consider myself the initial or primary driver of the macro trading direction for the business. I would highlight 3 major calls here: 1. Dec-Feb: ... The prevailing opinion within the department was that we should just 'get close to home' and pare down our long. ... I concluded that we should not only get flat, but VERY short. ... [W]e all agreed the plan made sense. ... [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 when the market dropped 25 points and our profitable year was underway. ... 3. Jun-Jul: the BSAM [Bear Stearns Asset Management failure] changed everything. I felt that this mark-to-market event for CDO risk would begin a further unraveling in mortgage credit. Again, when the prevailing opinion in the department was to remain close to home, I pushed everyone on the desk to sell risk aggressively and quickly. We sold billions of index and single name risk such that when the index dropped 25pts in July, we had a blow-out p&l [profit & loss] month, making over $1Bln that month. ...

We made money: a) taking large directional views, the direction of which we changed several times, b) ... betting the bad names would get much worse vs. the good ones, c) shorting CDOs, d) capturing the index to single name basis ... among other things."2814 9/26/2007 EMD Reviews, Joshua Birnbaum Self-Review, GS-PSI-01975, Hearing Exhibit 4/27-55c. Mr. Birnbaum's comments indicate that Goldman's proprietary activities extended to its CDO activities. As explained earlier, while Abacus 2007-AC1 was undertaken in response to a client request, Hudson 1 was conceived by the Mortgage Department as a way to transfer risk associated with poorly performing ABX assets in its inventory. Goldman supplied 100% of the CDS contracts that made up Hudson's assets, took 100% of the short side, and profited at the expense of the Hudson investors. In October 2006, Mr. Ostrem, head of the CDO Origination Desk, wrote to Mr. Sparks that a client was upset, because it knew "Hudson Mezz (GS prop deal) is pushing their deal back," clearly identifying Hudson as a "prop" or proprietary transaction. 10/16/2006 email from Mr. Ostrem to Mr. Sparks, GS MBS-E 010916991, Hearing Exhibit 4/27-59. See also 2/25/2007 email exchange between Peter Ostrem and Matthew Bieber, at GS MBS-E-001996601, Hearing Exhibit 4/27-95 (Mr. Ostrem proposed allowing a hedge fund to include assets in Anderson and then short them, but Mr. Bieber thought Mr. Sparks would want to "preserve that ability for Goldman"); 12/29/2006 email from Mr. Birnbaum to Mr. Lehman, GS MBS-E-011360438, Hearing Exhibit 4/27-5 (when discussing certain proposed CDO deals that would generate $1 to $3 billion in short positions and reference certain RMBS securities, Mr. Birnbaum stated: "On baa3 [RMBS securities with credit ratings of BBB-], I'd say we definitely keep it for ourselves. On baa2 [RMBS securities with BB ratings], I'm open to some sharing to the extent that it keeps these customers engaged with us.").

wrote that his desk sold short positions on single name CDS contracts only to customers that could provide Goldman with useful information: "We were very aggressive with pricing and only shared risk [short positions] with smart guys if they gave us insight on names to go short or go long in return.").

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In a later presentation put together to propose a new compensation arrangement for the SPG Trading Desk's trading activities, Mr. Birnbaum was unequivocal that the net shorts the desk had acquired were not hedges to offset risk, but "outright" short investments to produce profits:

"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."2815 10/3/2007 "SPG Trading B 2007," presentation prepared by Joshua Birnbaum with input from other SPG employees, but which was not ultimately provided to senior management, GS MBS-E-015654036, at 44 [emphasis in original]. Mr. Birnbaum reaffirmed his analysis in a 2010 written response to Subcommittee questions. See Mr. Birnbaum's response to Subcommittee QFR at PSI_QFR_GS0509.

In his 2007 self-evaluation, Michael Swenson, head of the Mortgage Department=s SPG Trading Desk, described the net short positions undertaken by the firm in this way:

"It should not be a surprise to anyone that the 2007 year is the one that I am most proud of to date. ... extraordinary profits (nearly $3bb [billion] to date). … I directed the ABS desk to enter into a $1.8 bb short in ABS CDOs that has realized approx. $1.0bb of p & l [profit and loss] to date. … [W]e aggressively capitalized on the franchise to enter into efficient shorts in both the RMBS and CDO space."

Mr. Swenson's description of the net short position he "directed" to be built in CDOs and the resulting $1 billion in profit makes no reference to client demands. Mr. Salem, a trader on the ABS Desk, was equally clear in his 2007 self-evaluation that the desk made a deliberate bet on the direction of the mortgage market: "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."2816 9/7/2007 Fixed Income, Currency and Commodities Annual Individual Review Book, Salem 2007 Self-Review, GS-PSI-03157, at 71. Each of these three Mortgage Department employees played a key role in building the firm's net short positions. Their own statements indicate that they perceived acquiring the 2007 net short positions to be for the benefit of the firm, and not to build an inventory of assets to respond to anticipated client demand.

Other internal documents also portray the net short positions as decisions made by the firm to advance its own financial interests. In an internal presentation to the Goldman Board of Directors regarding the "Subprime Mortgage Business," for example, the Mortgage Department wrote that, in the first quarter of 2007, "GS reverse[d] long market position through purchase of single name CDS and reductions of ABX."2817 3/26/2007 Presentation to Goldman Board of Directors, "Subprime Mortgage Business," GS MBS-E- 005565527, Hearing Exhibit 4/27-22. In September 2007, the Goldman Board of Directors summarized its mortgage business this way: "Although broader weakness in the mortgage markets resulted in significant losses in cash position, we were overall net short the mortgage market and thus had very strong results."2818 9/17/2007 Board of Directors Meeting Financial Summary, GS MBS-E-009776907, Hearing Exhibit 4/27-42. Talking points prepared for CFO David Viniar prior to a March 2007 earnings call with analysts stated: "The Mortgage business' revenues were primarily driven by synthetic short positions."2819 3/9/2007 email from Sheara Fredman to David Viniar and others, GS MBS-E-009762678, Hearing Exhibit 4/27-16. When preparing a later internal presentation, in October 2007, Dan Sparks was even more blunt: "The desk benefitted from a proprietary short position in CDO and RMBS single names." 10/5/2007 draft of "Business Unit Townhall Presentation, Q3 2007," prepared by Mr. Sparks, Hearing Exhibit 4/27-47. Mr. Sparks removed this phrase from the final version of the presentation and told the Subcommittee he had been mistaken to include it in the earlier draft. In an October 2007 letter sent to the SEC, Goldman wrote:

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"[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."2820 10/4/2007 letter from Goldman to the SEC, GS MBS-E-009758287, Hearing Exhibit 4/27-46.

In an October 2007 internal presentation to another Goldman unit, Chief Risk Officer Craig Broderick wrote:

"So what happened to us? ... In market risk B you saw in our 2nd and 3rd qtr results that we made money despite our inherently long cash positions. – because starting early in '07 our mortgage trading desk started putting on big short positions ... and did so in enough quantity that we were net short, and made money (substantial $$ in the 3rd quarter) as the subprime market weakened."2821 10/29/2007 presentation by Craig Broderick to the Tax Department, GS MBS-E-010018512, Hearing Exhibit 4/27-48. See also 10/5/2007 draft presentation by Mr. Sparks, for a Business Unit Townhall meeting, GS MBS-E- 013703468, Hearing Exhibit 4/27-47 ("The desk benefited from a proprietary short position in CDO and RMBS single names.").

In a November 2007 email to his colleagues, Goldman CEO Lloyd Blankfein wrote: "Of course we didn't dodge the mortgage mess. We lost money, then made more than we lost because of shorts."2822 11/18/2007 email from Mr. Blankfein, "NYT," GS MBS-E-009696333, Hearing Exhibit 4/27-52. None of these internal documents suggests that the Mortgage Department's net short transactions were undertaken to accommodate existing or anticipated client trades.

In January 2011, the new Financial Stability Oversight Council (FSOC) issued a study that focused, in part, on criteria that can be used to distinguish between proprietary and market making activities.2823 1/2011 "Study & Recommendations on Prohibitions on Proprietary Trading & Certain Relationships with Hedge Funds & Private Equity Funds," at 22-44. Applying those recently developed criteria to the Mortgage Department's 2007 activities also supports viewing that activity as the result of proprietary rather than market making activities. For example, the Mortgage Department was building its net shorts with the expectation that they would appreciate in value rather than provide assets to facilitate customer transactions; the position created risks out of proportion to those necessary to accommodate customer demand; the Mortgage Department actively and aggressively solicited clients to build its short positions; the Mortgage Department accumulated an unpredictable inventory profile in terms of volume and in relation to customer demand; and it had a relatively low inventory turnover with the bulk of the profits derived from inventory appreciation when Goldman covered its shorts.

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Advocating More Proprietary Trading. One last set of documents shines additional light on the role of proprietary investments in the Goldman Mortgage Department in 2006 and 2007. As indicated earlier, for several years, Goldman's Mortgage Department had a proprietary trading desk, Principal Investments, that was explicitly and exclusively dedicated to engaging in transactions for the benefit of the firm. In 2005, it was moved to the SSG unit. Internal Goldman documents show that some in the Mortgage Department wanted to revive that desk, increase the amount of proprietary trading in the mortgage area, or claim a greater share of the proprietary profits created by the Mortgage Department for the firm.

In August 2006, for example, the CDO Origination Desk proposed that Goldman establish a formal proprietary trading fund or proprietary trading operation within the Mortgage Department to conduct mortgage related transactions on behalf of the firm. In an August 2006 email, Peter Ostrem, the CDO Origination Desk head, made the proposal to Mr. Sparks, the Mortgage Department head:

"Let's do our own fund. SP [Structured Product] CDO desk. Big time. GS [Goldman Sachs] commits to hold proportion of equity outright. This could be big. ... I need real leverage. Got some structured ideas too. When can we talk strategy for an hour or so?"2824 8/10/2007 email from Mr. Ostrem to Mr. Sparks, "Leh CDO Fund," GS MBS-E-010898470.

Mr. Sparks responded: "Next week. In the meantime calm the blank down."2825 Id. Later the same day, he later wrote to Mr. Ostrem: "Not going to happen."2826 8/10/2007 email from Mr. Sparks to Mr. Ostrem, "Leh CDO Fund," GS MBS-E-010898476. When asked about these emails, Mr. Sparks told the Subcommittee that Goldman decided not to allow the Mortgage Department to set up its own hedge fund or explicit proprietary trading desk.2827 Subcommittee interview of Daniel Sparks (10/4/2010).

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In March 2007, after a series of large trades with the Harbinger hedge fund on the ABS Desk, Deeb Salem, an ABS trader, emailed Mr. Birnbaum, Mr. Swenson, and Mr. Chin with a proposal for a proprietary CDO:

"Am I crazy to be thinking we might want to grow the harbinger trade and do our own abs desk cdo. There'll be so much juice in it. It would blow out. We could sell supersenior and maybe some equity. Then the remaining mezz would be a cover of a couple hundred million of our cdo short. Haven't crunched the numbers, but I'm guessing we'd effectively cover well north of 1000 plus own some call rights. Or we also keep the equity and own it for free.

To select the portfolio, we look at the underlying rmbs deals in our cdo shorts. And replicate that as best as possible."2828 3/3/2007 email from Mr. Salem, "Another idea . . .," GS MBS-E-012511081.

Mr. Birnbaum replied: "I like it."2829 Id. Mr. Swenson responded: "Love it we will give dan [Sparks] a heart attack."2830 Id. Two months later, in June 2007, Mr. Swenson wrote Mr. Salem: "Talk to me now things are developing - dan wants you to be the epicenter of the subprime universe which is not a bad position to be in."2831 6/7/2007 email from Mr. Swenson to Mr. Salem, "Fyi," GS MBS-E-012444245. Mr. Salem replied:

"That's fine. My number 1 concern is that it[']s traded by the right people bc [because] the opportunity is huge. It's a product that needs to be traded as a prop product. ... U need to be in charge and we need prop minded guys involved."2832 Id.

That same month, however, the Bear Stearns' hedge funds collapsed due to losses from their subprime holdings. In July, the mass ratings downgrades took place, and the RMBS subprime market began to shut down as well. The Subcommittee saw no evidence that the proprietary CDO proposed by Mr. Salem was carried out.

In July 2007, Mr. Birnbaum, Goldman's head ABX trader, remarked that Goldman was giving John Paulson, the head of the Paulson Partners hedge funds, "a run for his money" in shorting the mortgage market, and claimed Goldman was "No. 2" behind the Paulson hedge funds in profiting from a massive net short position.2833 7/12/2007 email from Mr. Birnbaum, GS MBS-E-012944742, Hearing Exhibit 4/27-146 ("He's 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."). In October 2007, Mr. Birnbaum drafted a proposal that the SPG Trading Desk be compensated in accordance with a hedge fund model, rather than through Goldman's bonus pool, so the desk could obtain a portion of the proprietary profits it was generating.2834 See slides prepared by Mr. Birnbaum, "SPG Trading B 2007," GS MBS-E-015654036 -50. He discussed the proposal with other Mortgage Department personnel, but did not present it to senior management.2835 Mr. Birnbaum response to Subcommittee QFR at PSI_QFR_GS0509. The Mortgage Department personnel who helped build the net shorts nevertheless received substantial compensation for their 2007 efforts.2836 Mr. Birnbaum, for example, received $17 million in 2007. Subcommittee interview of Joshua Birnbaum (4/22/2010).

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Proprietary trading was not prohibited by law in 2007, and Goldman was free to and did engage in billions of dollars in mortgage related trades for its own account. The Goldman case study also demonstrates how proprietary trading, when undertaken at the same time as trading on behalf of clients, can give rise to conflicts of interest between the bank's financial interests and those of its clients. The new proprietary trading and conflict of interest restrictions in the Dodd- Frank Act are designed to address and reduce these conflicts.