Wall Street and the financial crisis: The role of investment banks (Sen. Carl Levin)

Our Subcommittee’s goal is to construct a record of the facts in
order to deepen public understanding of what went wrong; to inform the
ongoing legislative debate about the need for financial reform; and to
provide a foundation for building better defenses to protect Main
Street from the excesses of Wall Street.

Our first hearing dealt with the impact of high-risk mortgage
lending, and focused on a case study of Washington Mutual Bank, known
as WaMu, a thrift whose leaders embarked on a reckless strategy to
pursue higher profits by emphasizing high-risk exotic loans. WaMu
didn’t just make loans that were likely to fail, creating hardship for
borrowers and risk for the bank. It also built a conveyor belt that fed
those toxic loans into the financial system like a polluter dumping
poison into a river. The poison came packaged in mortgage-backed
securities that WaMu sold to get the enormous risk of these loans and
their growing default rates off its own books, dumping that risk into
the financial system.

Our second hearing examined how federal regulators saw what was
going on, but failed to rein in WaMu’s reckless behavior. Regulation by
the Office of Thrift Supervision that should have been conducted at
arm’s length was instead done arm in arm with WaMu. OTS failed to act
on major shortcomings it observed, and it thwarted other agencies from
stepping in.

Our third hearing dealt with credit rating agencies, specifically
case studies of Standard & Poor’s and Moody’s, the nation’s two
largest credit raters. While WaMu and other lenders dumped their bad
loans into the river of commerce and regulators failed to stop their
behavior, the credit rating agencies assured everyone that the poisoned
water was safe to drink, slapping AAA ratings on bottles of high risk
financial products. The credit rating agencies operate with an inherent
conflict of interest – their revenue comes from the same firms whose
products they are supposed to critically analyze, and those firms exert
pressure on rating agencies who too often put market share ahead of
analytical rigor.

Today we will explore the role of investment banks in the
development of the crisis. We focus on the activities during 2007 of
Goldman Sachs, one of the oldest and most successful firms on Wall
Street. Those activities contributed to the economic collapse that came
full-blown the following year.

Goldman Sachs and other investment banks, when acting properly, play
an important role in our economy. They help channel the nation’s wealth
into productive activities that create jobs and make economic growth
possible, bringing together investors and businesses and helping
Americans save for retirement or a child’s education.

That’s when investment banks act properly. But in looking at this
crisis, it’s hard not to echo the conclusion of another congressional
committee, which found, “The results of the unregulated activities of
the investment bankers … were disastrous.” That conclusion came in
1934, as the Senate looked into the reasons for the Great Depression.
The parallels today are unmistakable.

Goldman Sachs proclaims “a responsibility to our clients, our
shareholders, our employees and our communities to support and fund
ideas and facilitate growth.” Yet the evidence shows that Goldman
repeatedly put its own interests and profits ahead of the interests of
its clients and our communities. Its misuse of exotic and complex
financial structures helped spread toxic mortgages throughout the
financial system. And when the system finally collapsed under the
weight of those toxic mortgages, Goldman profited from the collapse.
The evidence also shows that repeated public statements by the firm and
its executives provide an inaccurate portrayal of Goldman’s actions
during 2007, the critical year when the housing bubble burst and the
financial crisis took hold. The firm’s own documents show that while it
was marketing risky mortgage-related securities, it was placing large
bets against the U.S. mortgage market. The firm has repeatedly denied
making those large bets, despite overwhelming evidence.

Why does this matter? Surely there is no law, ethical guideline or
moral injunction against profit. But Goldman Sachs didn’t just make
money. It profited by taking advantage of its clients’ reasonable
expectation that it would not sell products that it didn’t want to
succeed, and that there was no conflict of economic interest between
the firm and the customers it had pledged to serve. Goldman’s actions
demonstrate that it often saw its clients not as valuable customers,
but as objects for its own profit. This matters because instead of
doing well when its clients did well, Goldman Sachs did well when its
clients lost money. Its conduct brings into question the whole function
of Wall Street, which traditionally has been seen as an engine of
growth, betting on America’s successes and not its failures.

To understand how the change in investment banks helped bring on the
financial crisis, we need to understand first how Wall Street turned
bad mortgage loans into economy-wrecking financial instruments.

Our previous hearings have covered some of this ground. The story
begins with mortgage lenders such as WaMu, which loaned money to home
buyers and then sought to move those loans off its books. That activity
spawned an ever more-complex market in mortgage-backed securities, a
market that for a while worked pretty well. But then things turned
upside down. The fees that banks and Wall Street firms made from their
securitization activities were so large that they ceased to be a means
to keep capital flowing to housing markets and became ends in
themselves. Mortgages and mortgage-backed securities began to be
produced for Wall Street instead of Main Street. Wall Street bond
traders sought more and more mortgages from lenders in order to create
new securities that generated fees for their firms and large bonuses
for themselves.

Demand for securities prompted lenders to make more and riskier
mortgage loans. Making and packaging new loans became so profitable
that credit standards plummeted and mortgage lenders began making
risky, exotic loans to people with little chance of making the
payments. Wall Street designed increasingly complex financial products
that produced AAA ratings for high-risk products that flooded the
financial system.

As long as home prices kept rising, the high risk mortgages posed
few problems. Those who couldn’t pay off their loans could refinance or
sell their homes, and the market for mortgage-related financial
products flourished.

But the party couldn’t last, and we all know what happened. Housing
prices stopped rising, and the bubble burst. Investors started having
second thoughts about the mortgage backed securities Wall Street was
churning out. In July 2007, two Bear Stearns offshore hedge funds
specializing in mortgage related securities suddenly collapsed. That
same month, the credit rating agencies downgraded hundreds of subprime
mortgage backed securities, and the subprime market went cold. Banks,
securities firms, hedge funds, mutual funds, and other investors were
left holding suddenly unmarketable mortgage backed securities whose
value was plummeting. America began feeling the consequences of the
economic assault.

Goldman Sachs was an active player in building this mortgage
machinery. During the period leading up to 2008, Goldman made a lot of
money packaging mortgages, getting AAA ratings, and selling securities
backed by loans from notoriously poor-quality lenders such as WaMu,
Fremont and New Century.

Of special concern was Goldman’s marketing of what are known as
“synthetic” financial instruments. Ordinarily, the financial risk in a
market, and hence the risk to the economy at large, is limited because
the assets traded are finite. There are only so many houses, mortgages,
shares of stock, bushels of corn or barrels of oil in which to invest.
But a synthetic instrument has no real assets. It is simply a bet on
the performance of the assets it references. That means the number of
synthetic instruments is limitless, and so is the risk they present to
the economy. Synthetic structures referencing high-risk mortgages
garnered hefty fees for Goldman Sachs and other investment banks. They
assumed an ever-larger share of the financial markets, and contributed
greatly to the severity of the crisis by magnifying the amount of risk
in the system.

Increasingly, synthetics became bets made by people who had no
interest in the referenced assets. Synthetics became the chips in a
giant casino, one that created no economic growth even when it thrived,
and then helped throttle the economy when the casino collapsed.

But Goldman Sachs did more than earn fees from the synthetic
instruments it created. Goldman also bet against the mortgage market,
and earned billions when that market crashed. In December 2006, Goldman
decided to move away from its “long” positions in the mortgage market
in what began as prudent hedging against the firm’s large exposure to
that market, exposure that sparked concern on the part of the firm’s
senior executives. The edict from top management after a Dec. 14, 2006
meeting was “get closer to home,” meaning get to a more neutral risk
position. But by early 2007, the company blew right past a neutral
position on the mortgage market and began betting heavily on its
decline, often using complex financial instruments, including synthetic
collateralized debt obligations, or CDOs.

Goldman took large net short positions throughout 2007. This chart,
which is based upon data supplied to the Subcommittee by Goldman Sachs,
tracks the firm’s ongoing huge net short positions throughout the year.
These short positions at one point represented approximately 53% of the
firm’s risk as measured by the most relied upon risk measure, “Value at
Risk” or “VaR.” And these short positions did more than just avoid big
losses for Goldman. They generated a large profit for the firm in 2007.

Goldman says these bets were just a reasonable hedge. But internal
documents show it was more than a reasonable hedge – it was what one
top executive described as “the big short.”

Listen to a top Goldman mortgage trader, Michael Swenson, who touted
his success in 2007, what he called his “proudest year” because of what
he called “extraordinary profits” – $3 billion as of September 2007 –
that came from bets he recommended the firm take against the housing
market. Mr. Swenson told his superiors, “I was able to identify key
market dislocations that led to tremendous profits.”

Another Goldman mortgage trader, Joshua Birnbaum, wrote in his
performance evaluation about the billions of dollars in profits earned
in 2007 betting against the mortgage market. “The prevailing opinion
within the department was that we should just ‘get close to home’ and
pare down our long,” he wrote. He then touted the fact that he had
urged Goldman Sachs “not only to get flat, but get VERY short.” He
wrote that after convincing his superiors to do just that, “we
implemented the plan by hitting on almost every single name CDO
protection buying opportunity in a 2-month period. Much of the plan
began working by February as the market dropped 25 points and our very
profitable year was under way.” When the mortgage market collapsed in
July, he said: “We had a blow-out [profit and loss] month, making over
$1Bln that month.”

These facts end the pretense that Goldman’s actions were part of its
efforts to operate as a mere “market-maker,” bringing buyers and
sellers together. These short positions didn’t represent customer
service or necessary hedges against risks that Goldman incurred as it
made a market for customers. They represented major bets that the
mortgage securities market – a market Goldman helped create – was in
for a major decline.

Goldman continues to deny that it shorted the mortgage market for
profit, despite the evidence. Why the denial? My best estimate is that
it’s because the firm cannot successfully continue to portray itself as
working on behalf of its clients if it was selling mortgage related
products to those clients while it was betting its own money against
those same products or the mortgage market as a whole. The scope of
this conflict is reflected in an internal company email sent on May 17,
2007, discussing the collapse of two mortgage-related instruments, tied
to WaMu-issued mortgages, that Goldman helped assemble and sell. The
“bad news,” a Goldman employee says, is that the firm lost $2.5 million
on the collapse. But the “good news,” he reports, is that the company
had bet that the securities would collapse, and made $5 million on that
bet. They lost money on the mortgage related products they still held,
and of course the clients they sold these products to lost big time.
But Goldman Sachs also made out big time in its bet against its own
products and its own clients. Goldman CEO Lloyd Blankfein summed it up
this way: “Of course we didn’t dodge the mortgage mess. We lost money,
then made more than we lost because of shorts.” The conflict of
interest that lies behind that statement is striking.

The Securities & Exchange Commission has filed a civil complaint
alleging that in another transaction, involving a product called Abacus
2007-AC1, Goldman violated securities law by misleading investors about
a mortgage-related financial instrument.

The SEC’s complaint alleges that Goldman Sachs in effect helped
stack the deck against the buyers of the instrument it sold. The hedge
fund that bought the short position in the transaction – in other
words, that bet that the product would not perform well – helped select
the mortgages that were to be referenced in the product that Goldman
sold to investors. The SEC alleges that Goldman Sachs knew of the hedge
fund’s selection role and failed to disclose it to the other Abacus
investors, who thought the package had been designed to succeed, not
fail. We learned in last week’s hearing that Goldman also failed to
disclose the hedge fund’s role to the credit rating agency that rated
the Abacus deal. Eric Kolchinsky, who oversaw the ratings process at
Moody, testified before the Subcommittee, “It just changes the whole
dynamic on the structure, where the person who is putting it together,
choosing it, wants it to blow up.”

The SEC and the courts will resolve the legal question of whether
Goldman’s actions broke the law. The question for us is one of ethics
and policy: Were Goldman’s actions in 2007 appropriate, and if not,
should we act to bar similar actions in the future?

Abacus may be the best-known example of conflicts of interest
revealed in the Goldman documents, but it is far from the only example.
Anderson Mezzanine Funding 2007-1 was a synthetic product assembled by
Goldman. According to company documents, a Goldman client had expressed
interest in taking a short position in the transaction, but an
executive noted that Dan Sparks, the head of Goldman’s mortgage
department, might “[want] to preserve that ability for Goldman.” This
suggests that not only was Goldman going to bet against the instrument
that it was selling, but it wanted to make that bet badly enough that
it took the bet for itself instead of letting an interested client have
it. It then sold Anderson securities to its clients, without disclosing
that it would profit if those securities suffered losses.

Client loyalty fell so far that one Goldman employee cited his
refusal to assist Goldman clients facing losses from a Goldman
financial product as performance that should be rewarded. Mr. Swenson
wrote to his superiors in his performance review: “I said ‘no’ to
clients who demanded that GS should ‘support the GSAMP program,”
Goldman Sachs’ subprime mortgage-backed security program. Mr. Swenson
wrote that saying “no” to clients who asked Goldman to support a
security it had sold them were “unpopular positions but they saved the
firm hundreds of millions of dollars.”

Most investors make the assumption that people selling them
securities want those securities to succeed. That’s how our markets
ought to work, but they don’t always. The Senators who in the 1930s
investigated the causes of the Great Depression stated the principle

[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 must never make the mistake of
offering investments to his clients which he does not believe to be

Goldman documents make clear that in 2007 it was betting heavily
against the housing market while it was selling investments in that
market to its clients. It sold those clients high-risk mortgage-backed
securities and CDOs that it wanted to get off its books in transactions
that created a conflict of interest between Goldman’s bottom line and
its clients’ interests.

These findings are deeply troubling. They show a Wall Street culture
that, while it may once have focused on serving clients and promoting
commerce, is now all too often simply self-serving. The ultimate harm
here is not just to clients poorly served by their investment bank.
It’s to all of us. The toxic mortgages and related instruments that
these firms injected into our financial system have done incalculable
harm to people who had never heard of a mortgage-backed security or a
CDO, and who have no defenses against the harm such exotic Wall Street
creations can cause.

Running through our findings and these hearings is a thread that
connects the reckless actions of mortgage brokers at WaMu with
market-driven credit rating agencies and the Wall Street executives
designing the next synthetic. That thread is unbridled greed, and the
absence of a cop on the beat to control it.

As we speak, lobbyists fill the halls of Congress, hoping to weaken
or kill legislation aimed at reforming these abuses. Wall Street is on
the wrong side of this fight. It insists that reining in its excesses
would unduly restrict a free market that is the engine of American
progress. But this market isn’t free of self-dealing or conflict of
interest. It is not free of gambling debts that taxpayers end up paying.

I hope the executives before us today, and their colleagues on Wall
Street, will recognize the harm that their actions have caused to so
many of their fellow citizens. But whether or not they take
responsibility for their role, I hope this Congress will follow the
example of another Congress, eight decades ago, and enact the reforms
that will put a cop back on the Wall Street beat.

I would like to thank my ranking member, Sen. Coburn, who is
carrying out a very important responsibility at the White House this
morning and who will join us later, for his support and that of his
staff, and I recognize the acting ranking member, Sen. Collins, and
welcome her remarks.

Crossposted from Huffington Post


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