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.

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.²⁶⁷¹²⁶⁷¹ 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.Show full note 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.²⁶⁷²²⁶⁷² 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.²⁶⁷³²⁶⁷³ 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.²⁶⁷⁴²⁶⁷⁴ 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).²⁶⁷⁵²⁶⁷⁵ 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.Show full note 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.²⁶⁷⁶²⁶⁷⁶ 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.").Show full note 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.²⁶⁷⁷²⁶⁷⁷ 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.Show full note

¶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."²⁶⁷⁸²⁶⁷⁸ Basic v. Levinson, 485 U.S. 224, 231-32 (1988) (quoting TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 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.'"²⁶⁷⁹²⁶⁷⁹ 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."²⁶⁸⁰²⁶⁸⁰ 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."²⁶⁸¹²⁶⁸¹ 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.Show full note

¶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."²⁶⁸²²⁶⁸² 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."²⁶⁸³²⁶⁸³ 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.²⁶⁸⁴²⁶⁸⁴ 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.²⁶⁸⁵²⁶⁸⁵ 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").Show full note 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.²⁶⁸⁷²⁶⁸⁷ 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).Show full note

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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.²⁶⁸⁸²⁶⁸⁸ 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."²⁶⁸⁹²⁶⁸⁹ 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."²⁶⁹⁰²⁶⁹⁰ 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."²⁶⁹¹²⁶⁹¹ 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."²⁶⁹²²⁶⁹² 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].Show full note

¶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."²⁶⁹³²⁶⁹³ 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."²⁶⁹⁴²⁶⁹⁴ 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.²⁶⁹⁵²⁶⁹⁵ 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.²⁶⁹⁶²⁶⁹⁶ 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.²⁶⁹⁷²⁶⁹⁷ 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.²⁶⁹⁸²⁶⁹⁸ 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."Show full note In the April 27,²⁰¹⁰²⁰¹⁰ Subcommittee Hearing, at 2. See also 8/29/2006 email from Greg Lippmann, (Deutsche Bank), to Paolo Pellegrini (Paulson & Co.) and others, DBSI_PSI_EMAIL01625848 at 52 ("Since a CDO without a triple-A-rated senior tranche would be unmarketable, their imprimatur is indispensable."); 11/13/2007 email from Ralph Silva (Goldman Sachs), GS MBS-E-010023525, Tri-Lateral Combined Comments Attachment, GS MBS-E-01035693- 715, at 713 ("Investors in subprime related securities, especially higher rated bonds, have historically relied significantly on bond ratings particularly when securities are purchased by structured investing vehicles."); M&T Bank Corporation v. Gemstone CDO VII, Ltd., Index No. 200800764 (N.Y. Sup.), Complaint, (June 16, 2008) at 12. 12/13/2006 Firmwide Risk Committee December 13 Minutes, GS MBS-E-009582963-64.Show full note 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:²⁶⁹⁹²⁶⁹⁹ 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."²⁷⁰⁰²⁷⁰⁰ 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.²⁷⁰¹²⁷⁰¹ 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.²⁷⁰²²⁷⁰² 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."²⁷⁰³²⁷⁰³ 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.'"²⁷⁰⁴²⁷⁰⁴ "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.²⁷⁰⁵²⁷⁰⁵ 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."²⁷⁰⁶²⁷⁰⁶ 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.²⁷⁰⁷²⁷⁰⁷ 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."²⁷⁰⁸²⁷⁰⁸ 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."²⁷⁰⁹²⁷⁰⁹ 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."²⁷¹⁰²⁷¹⁰ 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."²⁷¹¹²⁷¹¹ 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.²⁷¹²²⁷¹² 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."²⁷¹³²⁷¹³ 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.²⁷¹⁴²⁷¹⁴ 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."²⁷¹⁵²⁷¹⁵ 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.²⁷¹⁶²⁷¹⁶ 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'").Show full note 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."²⁷¹⁷²⁷¹⁷ 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.²⁷¹⁸²⁷¹⁸ 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."²⁷¹⁹²⁷¹⁹ 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.²⁷²⁰²⁷²⁰ 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.²⁷²¹²⁷²¹ 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.²⁷²²²⁷²² 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.²⁷²³²⁷²³ 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."²⁷²⁴²⁷²⁴ 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.²⁷²⁵²⁷²⁵ 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.²⁷²⁶²⁷²⁶ 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).Show full note 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.²⁷²⁷²⁷²⁷ 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."²⁷²⁸²⁷²⁸ 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.²⁷³⁰²⁷³⁰ 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.²⁷³¹²⁷³¹ 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%."²⁷³²²⁷³² 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.²⁷³³²⁷³³ 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%.²⁷³⁴²⁷³⁴ 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.²⁷³⁵²⁷³⁵ 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,²⁷³⁶²⁷³⁶ 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.²⁷³⁷²⁷³⁷ 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.²⁷³⁹²⁷³⁹ 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.Show full note

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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.²⁷⁴⁰²⁷⁴⁰ 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.²⁷⁴¹²⁷⁴¹ 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.²⁷⁴²²⁷⁴² 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."²⁷⁴³²⁷⁴³ 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.²⁷⁴⁴²⁷⁴⁴ 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."²⁷⁴⁵²⁷⁴⁵ 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.²⁷⁴⁶²⁷⁴⁶ 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.²⁷⁴⁷²⁷⁴⁷ 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."²⁷⁴⁸²⁷⁴⁸ 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.²⁷⁴⁹²⁷⁴⁹ 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."²⁷⁵⁰²⁷⁵⁰ 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."²⁷⁵¹²⁷⁵¹ 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.²⁷⁵²²⁷⁵² 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."²⁷⁵³²⁷⁵³ 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."²⁷⁵⁴²⁷⁵⁴ 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."²⁷⁵⁶²⁷⁵⁶ 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.²⁷⁵⁷²⁷⁵⁷ 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,"²⁷⁵⁸²⁷⁵⁸ Goldman response to Subcommittee QFR at PSI_QFR_GS0249. and the CDO was an "exit for our long ABX risk."²⁷⁵⁹²⁷⁵⁹ 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."²⁷⁶⁰²⁷⁶⁰ 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."²⁷⁶¹²⁷⁶¹ 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.²⁷⁶²²⁷⁶² 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.²⁷⁶³²⁷⁶³ 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.²⁷⁶⁴²⁷⁶⁴ 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.²⁷⁶⁵²⁷⁶⁵ 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-Show full note 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.²⁷⁶⁸²⁷⁶⁸ 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.²⁷⁶⁹²⁷⁶⁹ 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.²⁷⁷⁰²⁷⁷⁰ 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.²⁷⁷¹²⁷⁷¹ 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.²⁷⁷²²⁷⁷² 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.²⁷⁷³²⁷⁷³ 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 write- down, but market at much higher levels" to avoid "leaving some money on the table."²⁷⁷⁴²⁷⁷⁴ 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.²⁷⁷⁵²⁷⁷⁵ 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.²⁷⁷⁶²⁷⁷⁶ 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."²⁷⁷⁷²⁷⁷⁷ 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."²⁷⁷⁸²⁷⁷⁸ 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."²⁷⁷⁹²⁷⁷⁹ 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.²⁷⁸⁰²⁷⁸⁰ 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.Show full note

¶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.²⁷⁸¹²⁷⁸¹ 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.Show full note In a recently issued "Report of the Business Practices Committee," Goldman reaffirmed as its first business principle: "Our clients' interests always come first."²⁷⁸²²⁷⁸² 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.Show full note 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."²⁷⁸³²⁷⁸³ 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.²⁷⁸⁴²⁷⁸⁴ 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.²⁷⁸⁵²⁷⁸⁵ 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.²⁷⁸⁶²⁷⁸⁶ 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.²⁷⁸⁷²⁷⁸⁷ 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.²⁷⁸⁸²⁷⁸⁸ 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.²⁷⁸⁹²⁷⁸⁹ 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.Show full note

¶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.²⁷⁹⁰²⁷⁹⁰ 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.²⁷⁹¹²⁷⁹¹ 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.²⁷⁹²²⁷⁹² 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.²⁷⁹³²⁷⁹³ 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."²⁷⁹⁴²⁷⁹⁴ 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.²⁷⁹⁵²⁷⁹⁵ 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.²⁷⁹⁶²⁷⁹⁶ 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."²⁷⁹⁷²⁷⁹⁷ 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.²⁷⁹⁸²⁷⁹⁸ 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.Show full note 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.²⁷⁹⁹²⁷⁹⁹ 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.").Show full note

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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.²⁸⁰⁰²⁸⁰⁰ 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."²⁸⁰¹²⁸⁰¹ 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.²⁸⁰²²⁸⁰² 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."²⁸⁰³²⁸⁰³ 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."²⁸⁰⁴²⁸⁰⁴ 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.²⁸⁰⁵²⁸⁰⁵ 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.)."²⁸⁰⁶²⁸⁰⁶ 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 2007.²⁸⁰⁷²⁸⁰⁷ 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").Show full note 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.²⁸⁰⁸²⁸⁰⁸ 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.²⁸⁰⁹²⁸⁰⁹ 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.²⁸¹⁰²⁸¹⁰ 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.²⁸¹¹²⁸¹¹ 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").Show full note

¶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!"²⁸¹²²⁸¹² 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.)."²⁸¹³²⁸¹³ 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."²⁸¹⁴²⁸¹⁴ 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 hedgeShow full note

¶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."²⁸¹⁵²⁸¹⁵ 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."²⁸¹⁶²⁸¹⁶ 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 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.").

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¶single name CDS and reductions of ABX."²⁸¹⁷²⁸¹⁷ 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."²⁸¹⁸²⁸¹⁸ 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."²⁸¹⁹²⁸¹⁹ 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.Show full note In an October 2007 letter sent to the SEC, Goldman wrote:

"[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."²⁸²⁰²⁸²⁰ 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."²⁸²¹²⁸²¹ 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."²⁸²²²⁸²² 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.²⁸²³²⁸²³ 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?"²⁸²⁴²⁸²⁴ 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."²⁸²⁵²⁸²⁵ Id. Later the same day, he later wrote to Mr. Ostrem: "Not going to happen."²⁸²⁶²⁸²⁶ 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.²⁸²⁷²⁸²⁷ 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."²⁸²⁸²⁸²⁸ 3/3/2007 email from Mr. Salem, "Another idea . . .," GS MBS-E-012511081.

¶Mr. Birnbaum replied: "I like it."²⁸²⁹²⁸²⁹ Id. Mr. Swenson responded: "Love it we will give dan [Sparks] a heart attack."²⁸³⁰²⁸³⁰ 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."²⁸³¹²⁸³¹ 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."²⁸³²²⁸³² 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.²⁸³³²⁸³³ 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.²⁸³⁴²⁸³⁴ 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.²⁸³⁵²⁸³⁵ 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.²⁸³⁶²⁸³⁶ 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.