The Unnecessary Meltdown
A year ago today, Wall Street imploded. But as William Cohan reports, a little-known meeting two years earlier started the runaway snowball—and also could have prevented the catastrophe.
As we parse through the rubble of the one-year anniversary of the demise of what used to be known as Wall Street, is it possible to isolate the canary in the coalmine—the proverbial moment above all others when the magnitude of the growing carnage in the mortgage-securities market began to reveal itself, and could have been mitigated?
That moment was not the bankruptcy of Lehman Brothers, a year ago Monday, or the $85 billion government bailout of AIG or even the shotgun marriage between a near-bankrupt Bear Stearns and JPMorganChase. Rather, a relatively innocuous meeting held fifteen months earlier—in December 2006, in a conference room on the 30th floor of Goldman Sachs—would forever change Wall Street.
As the meeting was winding up, Viniar concluded by saying, "It feels like it’s going to get worse before it gets better."
The meeting, conducted by David Viniar, Goldman’s CFO, included the five people who were running the firm’s so-called FICC—fixed-income, currencies and commodities—group and the various controllers, auditors and risk managers that work with them in those divisions. In sum, about 20 people had collected around Viniar to review what to him was a disturbing short-term trend: Goldman’s mortgage-desk had lost money ten days in a row. Not a lot of money by Goldman’s standards—somewhere in the $5 million to $30 million range—but a pattern troubling to Viniar, and he wanted to know why. “So one day we lost money—you know, our business is to make money with money,” Viniar told me in a recent interview. “Two days, three days, four days, five days and you start saying to the controllers, ‘Guys, what’s going on? What do they have? What’s their positions?’ Seven days, eight days, by the 10th day I say, ‘Let’s just talk about this.’”
• Nomi Prins: The Next Meltdown The mortgage traders came to the meeting with a two-inch thick report detailing all the firm’s mortgage-related trading and credit positions. Viniar said the firm did not make big bets one way or the other, but rather had a series of bets that tilted toward prices going up or down. At that moment, Goldman’s bias was toward being “long” mortgages—betting the value of the trades and the underlying mortgages would increase. But even so, there were disputes about the value of the mortgage securities with some of Goldman’s trading partners. In some cases, Goldman had asked for more cash (as collateral) to buy these securities; they seemingly valued them less than the rest of the market (and of course would be proved right).
The meeting dragged on for close to three hours. Each position was reviewed and then reviewed again. The firm had lost money ten days in a row because, Viniar said, it was betting mortgage-based securities would rise, when “the market was going down.” As the meeting was winding up, Viniar concluded by saying, “It feels like it’s going to get worse before it gets better." Nobody there knew how bad it was going to get. We didn’t have a clue that things were going to go crashing down.” There was complete consensus in the room about Viniar’s conclusion.
So Viniar and his colleagues quickly decided to reduce Goldman’s risk in this area to as close to zero as possible. “The words we used were, ‘Let’s get closer to home,’” Viniar said. He figured the mortgage market would continue to fall—again he did not realize how far and how fast—but that by reducing the firm’s exposure in December 2006, Goldman would be in position to buy when others were forced to sell and would benefit in the long-run.
Goldman reduced its exposure to mortgages “early,” Viniar said, “before most people had a view that the world was getting worse.” At one point before the magnitude of the problem became crystalline, Viniar thought that Goldman had become too bearish, and insisted that the firm’s traders reverse course somewhat. That decision later cost the firm around $200 million. “They were 100 percent right,” he said. “I was 100 percent wrong.”
Curiously, other firms did not follow Goldman’s lead and, in fact, during the first quarter of 2007 used the perceived weakness in the market for mortgage securities as an opportunity to double-down on their already huge long bets. This was the turning point. If Bear Stearns, Lehman Brothers, Merrill Lynch, Citigroup and AIG had the same perception of risk as did Viniar and his colleagues at Goldman Sachs, there might have been a downturn, but there wouldn’t have been a meltdown.
In any event, Goldman’s decision that December 2006 day proved to be very savvy indeed. Rather than suffer the billions of dollars of devastating losses as did many of their Wall Street brethren, Goldman broke even or made money in the mortgage market. (The firm will not say whether it made or lost money because it does not break out its financial information publicly in that fine detail. “The market would be really disappointed if it saw our actual mortgage results [in 2007], because they think we made a lot of money,” is all Gary Cohn, Goldman’s president, would say about the firm’s results.)
More important than whether Goldman made or lost money, though, was the information Goldman started to communicate to the market about its views on the value of mortgage securities. Since most traders were obliged to value their assets (mark-to-market) on a daily basis, such a substantial change in outlook by one of the biggest dealers in the market was bound to have an effect.
And, sure enough, in April 2007, Goldman’s change in sentiment began to have serious implications for the rest of the market. The two Bear Stearns hedge funds, run by Ralph Cioffi and Matthew Tannin, traded with Goldman. One of the two funds—the Enhanced Leveraged Fund—published its Net Asset Value (NAV) for the month of April 2007 as down 6.5%—plenty bad, especially after months of increasing NAVs—but that was before the fund had received the month’s marks from Goldman, which came in to the fund a week after other marks had been received. When the marks from Goldman came in—after the original April NAV had been published—at 50 to 60 cents on the dollar—meaning that Goldman believed that was what the securities were now worth in market and had marked its own books the same way—rather than the 99 cents, 98 cents or 97 cents reported by other dealers, Cioffi and Tannin had no choice but to revise the fund’s NAV and report that new number for April to investors.
The new April NAV? Down a whopping 18.97%, after figuring in Goldman’s marks. “Let me see if I can make this clear for you,” one Bear Stearns executive told me last year during the writing of my book, House of Cards. “Minus 6 percent announced this week. Oops—19 percent announced next week. Number one, 19 percent is a pretty damn big number. So we announce minus 19 percent. So what happens? Two fundamental things. One, this thing is in freefall—19 percent down. Number two, these guys are fucking idiots—6 percent one week, 19 percent the next week. How could that be?” Harder to understand, he continued, was that Goldman’s marks had been at 98¢ the month before. “Ninety-eight to 50?” he asked, incredulous. “They were at 98 the month before. There were no cash trades to imply anything like that. Nothing. There was nothing. And you know what? The way the procedure works, all we could [do] was go, ‘But, but, but, but, but . . .’ ”
The sharp loss spooked investors, who wanted out of the Bear hedge funds in droves. Their redemption notices set off a chain reaction that resulted in the closing of the hedge funds, then their liquidation by the rapid selling in the market of the mortgage-related securities Cioffi and Tannin had bought, and a spiraling decrease in the value of these securities worldwide. The demise of the two Bear Stearns’ hedge funds and the loss of nearly $1.6 billion of investor cash revealed to the world at large for the first time the magnitude of the potential risk from those securities lurking on balance sheets around the globe.
The rest, as they say, is history. The tragedy of the situation was that by June 2007, in the wake of the implosion of the Bear hedge funds, the magnitude of the growing problem with these squirrelly mortgage securities should have been known to one and all (and probably was) but none of the firms that failed did nearly enough—selling assets, raising new equity, considering mergers—to mitigate the avoidable fate that was soon to arrive at their doorstep. And it all began with a fateful decision by a group of very smart people in a Goldman Sachs conference room on the lower tip of Manhattan. Happy anniversary.
William D. Cohan, a former senior-level M&A banker on Wall Street, is the author of The Last Tycoons: The Secret History of Lazard Freres & Co, and his new best seller House of Cards: A Tale of Hubris and Wretched Excess on Wall Street.