Copyright © 2010 by Suzanne McGee All rights reserved. Published in the United States by Crown Business, an imprint of the Crown Publishing Group, a division of Random House, Inc., New York. www.crownpublishing.com CROWN BUSINESS is a trademark and CROWN and the Rising Sun colophon are registered trademarks of Random House, Inc. Originally published in slightly different form in hardcover in the United States by Crown Business, an imprint of the Crown Publishing Group, a division of Random House, Inc., New York, in 2010. Library of Congress Cataloging-in-Publication Data McGee, Suzanne. Chasing Goldman Sachs/Suzanne McGee. p. cm. 1. Goldman, Sachs & Co. 2. Investment banking—United States—History—21st century. 3. Financial crises—United States—History—21st century. 4. Finance—United States—History— 21st century. I. Title. HG4930.5.M38 2010 332.660973—dc22 2009053440 eISBN: 978-0-30746012-7 Cover design by Pete Garceau Cover photographs: Reuters/Landov (building); Getty Images (sky) v3.1 In memory of my grandfather James R. Burchell CONTENTS Cover Title Page Copyright Dedication Foreword Dramatis Personae Introduction: The Chase PART I Dancing to the Music 1 From Utility to Casino: The Morphing of Wall Street 2 Building Better—and More Profitable—Mousetraps 3 What’s Good for Wall Street Is Good for … Wall Street: How Wall Street Became Its Own Best Client 4 To the Edge of the Abyss—and Beyond: Flying Too Close to the Sun PART II Greed, Recklessness, and Negligence: The Toxic Brew 5 “You Eat What You Kill” 6 The Most Terrifying Four-Letter Word Imaginable 7 Washington Versus Wall Street PART III The New Face of Wall Street 8 Wanted: A New Model for Wall Street 9 Chasing Goldman Sachs? Glossary Notes Acknowledgments About the Author FOREWORD W e think we’re number one, but we’ll leave that for others to decide.” Back in 1983, when John Whitehead, then cochairman of Goldman Sachs & Co. made that statement to a reporter from New York magazine, the investment bank was already well on the way to becoming one of Wall Street’s iconic firms. Its bankers proclaimed that they were “long- term greedy”; the denizens of Goldman weren’t the type, they declared regally, to try to capture every fraction of a penny of fees and profits, particularly if there was even a question that they might be doing so at the expense of a client relationship. Goldman Sachs even felt itself to be above some businesses—no advising hostile bidders on takeover strategies, for instance; that was far too messy. Then there were some potential clients that a Goldman Sachs banker didn’t want to be seen lunching with, much less transacting business with. Goldman’s clients were the crème de la crème; preserving the firm’s name and reputation by choosing who to deal with and what deals to do was more critical than grabbing at an extra few thousand dollars in fees. Occasionally, something unpleasant would happen to remind Goldman bankers of the solid business reasons behind those lofty principles, such as the firm’s brief but damaging relationship with Robert Maxwell. Many Goldman partners had felt skittish about accepting the media tycoon as a client; his checkered past included his being dubbed by a British government inquiry as “not a person who can be relied on to exercise proper stewardship” of a public company. But the allure of earning big fees overrode those concerns—that is, until Maxwell vanished off his yacht into the sea near the Canary Islands and a new investigation revealed that he had looted a billion pounds from his employees’ pension funds. British regulators hit Goldman with a fine for its role in the fiasco in 1993; the size of the fine was somewhat less important than the public humiliation, however. Partners vowed that never again would Goldman Sachs be named and shamed in such a manner. And yet, in the summer of 2010, Robert Khuzami, head of the enforcement division of the Securities and Exchange Commission, stood triumphantly in front of a group of reporters and an array of television cameras broadcasting his words globally. He announced that Goldman Sachs had agreed to pay a fine of $550 million—the largest penalty the SEC had ever imposed on a Wall Street firm—to settle a civil fraud case the agency had filed only months earlier. But Khuzami and the SEC had won more than their $300 million share of that settlement: Goldman had agreed to acknowledge publicly that the “fundamental basis” of the agency’s lawsuit was accurate. Goldman had failed to live up to its own standards and disclose everything that German bank IKB might have wanted to know about the mortgage securities deal, dubbed Abacus, that lay at the heart of the suit. Specifically, the SEC had claimed Goldman hadn’t fully explained to IKB and other potential investors buying the Abacus package of synthetic mortgage-based securities that hedge fund manager John Paulson had played a key role selecting the specific securities in that transaction—indeed, that the deal was being done at his initiative because he wanted to find a way to profit from what he expected would be a big decline in the value of the securities he chose. That’s precisely what happened: Paulson walked away a billion dollars richer, while IKB became one of the first financial institutions to fall victim to the global financial crisis and require a bailout. Goldman Sachs, the envy of Wall Street, now found itself under scrutiny for all the wrong reasons. Instead of its peers and rivals trying to figure out what it was doing to earn the astonishing rates of return it delivered like clockwork to its investors, regulators and legislators were putting its business under a microscope. To insiders, it seemed as if everything for which Goldman was once famous and lauded—its creativity in devising and structuring new products; its risk management prowess; the market insight displayed by traders deploying the firm’s own capital to generate returns; the firm’s ability to develop relationships with power players in Washington as well as on Wall Street —now rendered it infamous. Suddenly, everyone was asking what Goldman Sachs had done to earn the gargantuan profits in recent years; profits that had left other Wall Street CEOs green-eyed with envy and fuming at their own inability to measure up. But this book—conceived in early 2008, as Bear Stearns collapsed and Wall Street waited, holding its breath, for the next shoe to fall—is not the story of the transformation of Goldman Sachs from Wall Street’s most envied to its most reviled power. Rather, it’s the tale of the ways in which Goldman and the other Wall Street firms that sought to emulate its success underwent a fundamental transformation, and the impact of those changes for Wall Street, its clients, and the financial system as a whole. That transformation—which led to Wall Street being run solely in the interests of Wall Street entities themselves, with clients now viewed as counterparties—paved the way for the financial crisis whose ripple effects continue to reverberate on both Wall Street and Main Street. For the latter—indeed, for most of us—Wall Street’s value lies in its role as a financial utility or intermediary. But as the financial results of Goldman and its rivals demonstrated all too clearly, that’s not where the profit lay. And ever-bigger profits were what Wall Street’s own investors—the shareholders who bought stock in Goldman Sachs, Merrill Lynch, Lehman Brothers, and other firms—demanded, loud and clear. The SEC’s fraud lawsuit against Goldman Sachs simply made public what many Wall Street insiders had long known: clients need to be able to look out for themselves. Wall Street firms are dealing cards from the bottom of the deck to their friends, while saving the low-value cards for other clients. In case there was any doubt of what Goldman bankers really thought of the deals they were taking to their clients, investigators rapidly made public a series of embarrassing e-mails and other documents. In one, top Goldman banker Tom Montag wrote of another mortgage-backed securities transaction—Timberwolf—that it was “one shitty deal.” Certainly by the time John Paulson came knocking on its door, Goldman knew that being “long” subprime real estate in the spring of 2007 was likely to be a risky bet for anyone agreeing to take the other side of the trade that Paulson wanted to do; after all, the firm was pushing its team to unload their own exposure to others as rapidly as possible. In an e-mail to a friend, Fabrice Tourre, the banker who structured the deal (and who has not yet been able to settle the SEC’s charges against him) wrote of the CDO transactions he was crafting, “the whole business is about to collapse any time now … Only potential survivor, the fabulous Fab!” In another e-mail, the head of Goldman’s structured products correlation trading desk warned Tourre that “the cdo biz is dead” and that “we don’t have a lot of time left.” None of that gave Goldman Sachs bankers a reason to stop, it seems. Even Bear Stearns had turned away John Paulson, concerned at the ethical implications of allowing a hedge fund manager to choose which securities he would bet against and thus which securities Bear would have had to coax a client to buy outright. “In the old days, we would never have done business with just anyone who showed up on our doorstep,” insists one former Goldman Sachs partner, who says the revelations left him “shocked and dismayed.” In the old days, before Goldman Sachs sold stock to the public and its culture began to change irrevocably, “the question would have been ‘John Who? Do we know this guy? What is he asking us to do? What are the consequences of this? Is this someone we want and need a relationship with?’ Above all, we were always prepared to say ‘no.’ ” But by the dawn of the twenty-first century, saying “no” to deals wasn’t how Wall Street worked anymore. From the mortgage brokers who underwrote the now-notorious “no income, no-docs” home loans all the way up to the investment bankers who just couldn’t turn away a John Paulson, even when they had ethical reservations or, as Fabrice Tourre admitted, the securities that they were creating for their investors were “monstrosities”; the very word “no” seemed to have vanished from the lexicons of those toiling within the financial system. And the pressure was on to say “yes” to any deal that could generate a few pennies a share in quarterly earnings, because each and every investment bank and commercial bank was well aware of the extent to which its own return on equity fell short of that being generated by the Midas-like bankers at Goldman Sachs. Swiss banking giant UBS hired a consulting firm to advise it on the best way to generate profits; Goldman alumnus Robert Rubin, who had moved on to work for Citigroup, only reluctantly acknowledged to colleagues that his new firm had neither the trading skills nor the risk management prowess to beat Goldman at its own game. (That didn’t stop Citigroup from trying, of course.) Top bankers at Merrill Lynch & Co. knew to steer clear of their temperamental CEO Stan O’Neal on days that Goldman Sachs released its earnings. “Why can’t we earn numbers like that?” he demanded of one subordinate in mid-2005. The problem for Wall Street wasn’t what Goldman Sachs did. It was the attitude that lay behind those actions, combined with the fact that its