Goldman Sachs’s Role in Crisis at Stake in Question Over Marks

By Christine Harper
July 2 (Bloomberg) -- Goldman Sachs Group Inc. executives sought to defend the firm’s pricing of illiquid mortgage derivatives during two days of hearings as investigators questioned whether the firm accelerated the financial crisis.
Gary Cohn, Goldman Sachs’s president and chief operating officer, and Chief Financial Officer David Viniar argued that the firm’s prices in 2007 and 2008 reflected what it saw in the market. Financial Crisis Inquiry Commission members questioned whether the investment bank deliberately discounted prices to push markets lower because it had bet on a decline in the value of subprime mortgage-backed debt.
"You guys are net short and you’re driving down prices, are you creating a self-fulfilling prophecy?" Philip N.
Angelides, chairman of the FCIC, asked Viniar during yesterday’s hearing. "Were you in fact pushing the market down?"
Viniar, 54, replied that "we never instruct people to mark things down. We mark where the market is."
The dispute is at the heart of whether Goldman Sachs had a role in the near-bankruptcy of American International Group Inc.
or was a careful risk manager whose focus on marking assets to fair value helped the securities firm prepare for the credit contraction earlier than rivals. Goldman Sachs, whose record
2007 profit was helped by bets against securities backed by subprime mortgages, was one of the biggest buyers of AIG’s insurance covering such debt and increased demands for collateral from AIG as prices fell.

‘Smoking Gun’

Goldman Sachs might have the power to drive down prices in an illiquid market like the one that existed in mid-2007, said David Killian, a fixed-income portfolio manager at Sterling Asset Management LLC. Still, he said there’s no evidence that the firm intentionally pushed down marks for its own benefit.
"Unless someone’s going to come up with some smoking gun and e-mails that show they did conspire to do that, I think that would be incredibly difficult to prove because managing risk is in fact what they do for a living," said Killian, whose King of Prussia, Pennsylvania-based firm owns Goldman Sachs stock and bonds. "If that’s proven, that’s bad news."
Chief Executive Officer Lloyd C. Blankfein, 55, was castigated at a Senate subcommittee hearing in April for selling securities linked to subprime home loans while the firm’s traders were betting against the market. The Securities and Exchange Commission sued the company that same month, claiming it sold a collateralized debt obligation without disclosing that a hedge fund helped pick underlying securities and bet against the vehicles. Goldman Sachs has denied wrongdoing.

More Art Than Science

The FCIC is investigating what caused the credit crisis, and will report findings to Congress and President Barack Obama by December. Derivatives are contracts whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events.
The commission released e-mails between Goldman Sachs employees that show that setting prices for some of the little- traded derivatives on CDOs may have been more art than science -
- less a matter of reacting to market moves and more a matter of anticipating them. CDOs pool assets such as mortgage bonds, bank capital notes and buyout loans into new securities with varying risks.
In an e-mail on July 26, 2007, a Goldman Sachs employee in New York informed some of the bank’s executives that it had demanded $2 billion in margin from AIG because of a "massive remarking" by Goldman Sachs "ahead of other dealers in the street, which have not yet remarked this type of underliers."
‘Very Unhappy, Even Mad’
"This remarking is independent from today’s market move and reflective of the desk’s view that marks were stale," he wrote. "In their views, marks at only a small discount to par (as they were) do not reflect the increased risk in this market."
In another e-mail on July 31, 2007, a Tokyo-based employee explained that Japanese insurer AIOI Insurance Co. was angry at Goldman Sachs’s change in the mark to market, or MTM, of the super-senior portion of a CDO containing asset-backed securities.
"Aioi is very unhappy and even mad at our MTM," the employee wrote. "Our MTM is more than twice as bad as others."
David Lehman, co-head of Goldman Sachs’s structured products group trading desk, told the FCIC that the firm’s prices "always represented our best view of market prices based on the information we had at the time."
Angelides said that Goldman Sachs lowered its demand for collateral from AIG to $1.2 billion from $1.8 billion because it "refined" the pricing over a few days, calling into question the method behind the initial request.

‘Stab in the Dark’

"You ask for 50 percent more initially than your quote- unquote refined estimate," Angelides said. "Seems to me that’s pretty much a stab in the dark."
Lehman said the firm changed prices and collateral demands as it received more information from AIG about some of the contracts.
In an e-mail to executives on July 26, 2007, Goldman Sachs trader Ram Sundaram described how the firm had increased efforts to determine prices for derivatives in the so-called negative basis book, which led to a substantial decline in the prices the firm established. In the message, Sundaram called for a new process for marking prices.
"The extent of the collateral calls being generated overnight is embarrassing for the firm ($1.9Bn from AIG-FP alone)," he wrote. "We need to focus on developing a process for ensuring accuracy for all marks."

Ulterior Motives

Sean Egan, president of Egan-Jones Ratings Co. in Haverford, Pennsylvania, said the episode demonstrates the need for a "neutral, independent source for deriving prices for illiquid securities" that can be accepted by both sides of a transaction and free from the perception that they’re driven by ulterior motives.
Goldman Sachs prices could have been tainted by "subjectivity and self-dealing, because it’s in their interest to mark those prices as low as possible in this case," Egan said. "Goldman was not only protecting their own position but actually benefiting."
Viniar, in his testimony, disputed such a view.
"There’s a big misconception that we just decide to mark things and then move the market," he said. "We mark based on where the market is."