Goldman vs. Magnetar: A Dozen Questions About the Subprime Scandals


If you're reading this, you're aware of the civil charges the SEC brought against Goldman Sachs (GS). But what does the whole thing mean in the broader context of the Goldman brand, that scary black hole hedge fund called Magnetar you've probably heard about, and that hot new Michael Lewis book, The Big Short? Here's our Socratic attempt to address -- if not fully answer -- these questions.

Seriously, how bad is Goldman Sachs?

Bad. Repulsive. Depraved. Satanic. Worse than the Vatican.

But what about compared with everyone else on Wall Street?

Yeah, everyone else is probably a lot worse than Goldman.

So why go after Goldman?

Well, there's a thing called "branding" in this country. It's apparently the only thing the public responds to anymore. So: Obama got elected because he had a good brand, his happy marriage to Michelle is a function of his larger brand strategy, he passed health care reform at a great risk to his brand, etc, etc.

So, the same way the Obamas and the Kardashians and Apple are all brands, Goldman Sachs is a brand. If you're on Wall Street, it absolutely goes without saying you've got acute Goldman envy. You'll pimp your own daughter to beat its earnings. You'll quadruple the salary of any of its genius junior traders willing to work for you -- and guarantee him a minimum $8 million bonus -- and then that trader will spill all your secrets to his buddies back at Goldman Sachs and you can't even get mad at him, it's just a testament to how great they are over there at instilling loyalty to the goddamn Goldman brand.

Meanwhile on Main Street, Goldman is to Wall Street as Abu Ghraib is to the military. So many bad apples! Goldman is the firm that brought you Hank Paulson, the guy who forked over a trillion dollars so bankers could take home $33 billion in bonuses in a year unemployment hit 10%. Then there's his heroically loathsome deputy Neel Kashkari, who pressed Paulson to start paying attention to the mortgage crisis only by deploying the profoundly warped analogy of the Iran hostage crisis, wherein if they failed to act to stave off the destruction Bush Administration plutonomics had wrought, Obama would be the guy who got credit for actually doing something about it (as Ronald Reagan had been credited with bringing home the hostages).

Aw, you don't think Hank Paulson is sincerely worried about the country? I read he spent the whole year on the verge of puking.

It doesn't matter what Paulson's real intentions were, this is about what they call "optics" over at Goldman, and I haven't even gotten to Steve Friedman, a guy who makes me want to puke. A former Goldman president, Friedman spent the crisis in one of the three "class B" spots on the nine-member board of the New York Fed charged with representing the interests of the "public" (motto: "ha ha ha, as if we give a crap about the public"). There Friedman turned out to be so comically oblivious to the existence of said public that he decided to start loading up on Goldman Sachs stock in January 2009. He had to get a special "conflict-of-interest" waiver to do it and everything. Great job representing the public interest in a turbulent time, Steve!

And that episode of course totally pales next to the rest of Bob Rubin's resume. Can I count the ways democracy would seem far less farcical right now if not for Goldman derivatives whiz turned Committee To Screw The World member turned senior zombie bankster Bob Rubin? No more easily than I could count the $500 trillion in unregulated derivatives trades accumulated wholly outside the purview of anyone with any authority to make sure they weren't, just for instance, being used to trick city treasurers and school board chiefs into signing contracts that would eventually put their already cash-strapped institutions on the hook for billions of dollars in collateral -- payable directly to the nation's most moneyed investment banks in a mind-bending wrinkle of the subprime mortgage collapse -- all thanks to Bob freakin' Rubin!

What was so brilliant about Goldman is that, in what they call "hedging," they never affiliated themselves with any particular brand of politician. Year after year they raked in the billions, with none of the gridlock and inertia you'd expect from an institution in which some bosses were Democrats, and some Republicans. This went over well in Washington, where "bipartisan" is like the Bentley of policy brands, until the scheme bilked so much wealth from the unsuspecting public that we had nothing left for them to steal.

Then writer Matt Taibbi -- who is employed by Jann Wenner, one of the decade's wealthiest profiteers of the side game of keeping the public doped up on celebrity ephemera -- found himself charged with the unenviable task of explaining the financial crisis to people who would rather be reading about Lady Gaga, and did the only thing he could in such a position: He eviscerated the Goldman Sachs brand.

I keep hearing that this is the very first time the SEC's new "structured finance" unit has sued anyone. Why go after Goldman if it's just about branding?

Branding, of course! The SEC has a terrible brand. If Toyota's braking system department had its own brand, the SEC's would still look worse. It isn't really the SEC's fault that Democrats and Republicans spent so many years falling all over one another to appoint SEC commissioners largely on the basis of their determination to undermine every public interest the agency was founded to protect. But they feel pretty bad about it anyway, especially since that Madoff whistleblower guy started going on television every night, talking in that unhinged way of his about how idiotic they are. So they did what you would if you had a job in the only business more disembowled, defunded and dysfunctional than journalism -- they went after Goldman.

All right, but I represent the public, and I want the truth. I can handle the truth! Who is worse than Goldman?

There's this hedge fund just outside Chicago called Magnetar. Founded in 2005, big giver to Rahm Emanuel. Maybe you've heard about them from This American Life. I had been sitting on my own Magnetar story for a couple months when the radio show aired its episode on Magnetar last week (produced in conjunction with this new nonprofit mercenary investigative journalism outfit called ProPublica), because the rapacious "strategy" by which these guys made billions deliberately churning out subprime mortgage deals after the housing market started to fall, solely for the purpose of betting they would fail, is so diabolically hard to explain that the act of trying to explain it was starting to make "working out" seem appealing by comparison. (Not that I caved, but...)

But here I go. For the first five years of the decade, the subprime mortgage business was kept drowning in cash by a cabal of financial engineers who knew they could sell bonds backed by American mortgages to risk-averse investors, because American mortgage bonds had never widely defaulted, because the American housing market had never broadly collapsed.


Let's put it this way: It had never crashed the way it had in developing economies more vulnerable to the whims and manipulations of shadowy oligarchs in control of incomprehensibly vast sums -- which is to say, the developing economies which were spending the decade accumulating an ever-growing pile of cash to invest. Those mortgage bonds were pretty inscrutable by definition, but there were bigger fees to be had by making them even more inscrutable, by packaging them into theoretically less risky structures called collateralized debt obligations, or CDOs, which were then sliced into "tranches" that were assigned varying interest rates and levels of risk.

A side benefit of all this complexity was that it could be used to conceal all manner of scams and frauds, and so when American pension fund managers started looking askance at the lower-rated subprime tranches (slices) in response to losing another cleaning lady to full-time condo speculation -- this was about 2003 -- the CDO engineers formed a new type of vehicle, the "mezzanine CDO," in which they could dump all the riskiest slices of the mortgage bonds and magically produce a CDO that, sliced once more, would turn out to glean 80% triple-A ratings from the rating agencies.

Now, at this point there was literally no mortgage the Wall Street guys would not buy, which sent the housing market into overdrive, such that by 2005 it was getting harder and harder to find mortgages to buy, so a derivatives guy at Deutsche Bank and some of his friends invented something called "synthetic" mortgage securities, which weren't backed by actual mortgages but would pay the same interest rate and carry the same risks as a mortgage bond of your choosing.

Ahem . . .

I was just getting to the point! So by 2005 the whole CDO pyramid was toxic, fraud-ridden, shady, sustained by nothing but the myth of ever-rising housing prices. But the mezzanine CDO market, for all its AAA ratings, clearly comprised the filthiest corners of the worst mortgage deals to anyone who knew about CDOs.

And the filthiest section of the filthiest kind of CDO was the "equity" tranche of each deal. Every CDO structure is set up so the equity tranche on the bottom slice of every vehicle agrees to bear all the first defaults in exchange for a higher interest rate and some measure of control over the type of mortgages that go inside it. "Placing" the equity tranche was a big hurdle to getting CDO deals done, involving all manner of chicanery I won't get into here, but in mezzanine deals it was generally worth it for the banks to agree to front the first $10 million in losses as a good faith gesture to get investors to buy the rest of the crap.

Then came Magnetar . . .

Magnetar bought equity tranches of at least $40 billion of mezzanine CDOs in 2006 and 2007, all so they could bet the deals would fail. And because 80% of the mortgage bonds Magnetar chose to put into its deals were "synthetic," they basically succeeded in cloning four virtual versions of the crappiest mortgage bonds in the country for every one super crappy mortgage bond that was actually backed by a bunch of super crappy adjustable rate mortgages.

And by taking the other side of those bets -- agreeing to pay investors the modest interest rates on the Triple A mortgage securities the deals were concocting -- Magnetar was effectively buying up huge amounts of cut-rate default insurance that would pay them gazillions of dollars when the whole scam exploded in everyone's face. But none of this cheap insurance, nor any of those virtual crappy mortgage bonds, would have been there to buy had Magnetar not come in and pretended to be the biggest housing bulls on the block, the rare investor willing to play "greatest fool" in the whole pyramid scheme.

Totally appalling practices like Magnetar's are the reason a trillion dollars in mostly mortgage-backed CDOs got unleashed on the financial system in 2006 and 2007 -- and that's after the housing market started to fall. (In fact, more mortgage CDOs were issued in those two years than there were in the first six years of the decade.) Would it have happened the same way without Magnetar? It's tough to say.

Okay, so what did Goldman do?

Basically, it allowed massively rich hedge fund client John Paulson to copy Magnetar's ingenious trade on a deal in 2007, thus totally screwing other clients. I learned about it originally from this book about John Paulson written by Greg Zuckerman at The Wall Street Journal called The Greatest Trade Ever. Zuckerman said Paulson bought equity tranches of $5 billion in CDO deals like that, set up by a few banks, not just Goldman. But one trader at Bear Stearns told Zuckerman that the whole thing smelled funny to him and he found it unethical. Yes, bad enough that a Wall Street trader found it unethical -- what does that tell you?

But weren't big investment banks letting Magnetar get away with what they did, too?

Of course! You think your local Bank of America can just sell you a credit default swap? The difference was that, unlike Paulson, Magnetar didn't go around telling everyone how much money he was going to make when the housing bubble exploded, how he was about to make the biggest one-time fortune in the history of money. With Magnetar, the most disturbing thing about it comes down to this: Before the Pro Publica investigation, I had thought Magnetar had sponsored $30 billion in deals. That number appeared in some Wall Street Journalstories on the fund, and I picked it up from EConned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism, a new (and infuriating) book by "Yves Smith," founder of the blog Naked Capitalism (and former Goldman Sachs insider!).

Smith, former insurance executive Tom Adams and a team of industry insiders who shall go unnamed here had undertaken their own investigation into Magnetar's 2006-2007 deal flow -- and come up with a number that fell $10 billion short of ProPublica's more intensive count of $40 billion. That is how completely scary and secretive and accountable to no one the hedge fund industry is. Smith's team had identified billions of dollars worth of deals that seemed to have Magnetar's fingerprints on them, of course -- and EConned says some estimates of Magnetar's CDO footprint run as high as $60 billion, but it was so hard to know for sure, and resources for mounting legal battles are so conspicuously weighted in Magnetar's favor, that the publisher went with the lower number.

Well, isn't that why Michael Lewis makes the argument that the guys who figured all this out in time to profit from it were actually sort of heroes?

The fact that John Paulson, Michael Burry, Kyle Bass, Andrew Lahde, Steve Eisman and even that jerk who printed up those "I'm Short Your House" T-shirts have all been willing to speak extensively to the media about their most profitable investment strategy should tell you something, because hedge funds don't generally have any interest in public disclosure.

Maybe some hedge fund guys even have motives not directly related to greed, such that they feel the story of "how selling houses to people who would never be able to afford the payments became, for a time, the most profitable business America had ever known" is something more people ought to know about. But if they have motives unrelated to greed, if the profiteers helping to assemble the first rough draft of this sordid chapter in history feel comfortable speaking openly about how they amassed their winnings, it's probably pretty safe to assume that they aren't the worse scoundrels of the bunch.

Until EConned, I had seen only one other financial crisis book reference Magnetar, Scott Patterson's The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It, which characterizes Magnetar's strategy as "possibly diabolical" -- but devotes only a page to exploring that possibility. All of which is to say, we probably have a lot left to hear from the real scoundrels in this tale -- but we aren't gonna hear it until we get a lot more indictments.

But why would the guys with nothing to hide protect the villains? Couldn't they all be playing the media just so they can fake us out again?

That's my fear. There's a tendency among financial journalists to blame bad things on stupidity, hubris, recklessness, delusion, etc., because a good old-fashioned conspiracy theory would undermine all the hard work we just did wading through all the unbearable complexity that got us this far.

In reading The Big Short, I got a queasy feeling when I got to the chapter on AIG, which chronicles the desperate efforts of a plucky executive named Gene Park to get the company out of the catastrophic business of "insuring" dodgy mortgage CDOs that would eventually put taxpayers $183 billion in hock to the Magnetars on the other side of those bets. Reprinted almost word for word from Lewis's Vanity Fair investigation into AIG, the chapter recalls how Park first began sniffing around his company's subprime insurance business after reading a Wall Street Journal story on a subprime lender's big dividend yield, and recounts in great detail his months-long effort to convince the notorious AIG Financial Products chief Joe Cassano to pull the plug on the business, which he eventually did at the end of 2005.

Reading about it a second time, I was struck by the fact that Park isn't actually quoted. It's clear he cooperated with Lewis, but also that he made an attempt to distance himself from the story, for reasons unclear to me. Gene Park, I thought. Where have I heard that name...

And then it hit me. When Magnetar formed a little-known Connecticut subsidiary called Quadrant Structured Credit Products in mid-2007, with $400 million and Lehman Brothers as a minority stakeholder, it named a former AIG structured finance executive named Gene Park as its CEO. I can't confidently explain at this point what Quadrant does or what it was intended to do, and what I do know could fill another 3,000 words. But Lewis paints Park as "The Most Hated Man On Wall Street" and the man who single-handedly tried to shut down the entire business, without explaining how exactly he ended up working for a hedge fund wholly devoted to keeping the bubble machine in business for another year and a half after AIG got out of it.

That's pretty impressive. Can I get in on this Magnetar genius?

Doubtful. But you can buy Goldman Sachs stock! And I'm afraid that's about all I've got for you right now.