Sunday, September 4, 2011


Subcommittee what he meant by that comment, Mr. Steffelin said that he believed the Abacus
2742 SEC v. Tambone, 550 F.3d 106, 135 (1st Cir. 2008) [citations omitted].
2743 SEC Study on Investment Advisers and Broker-Dealers at 63 [citations omitted].
2744 Id. at 61.
2745 See Goldman response to Subcommittee QFR at PSI_QFR_GS0048.
2746 See, e.g., 1/23/2007 email from Fabrice Tourre to Marine Serres, GS MBS-E-003434918, Hearing Exhibit
4/27-62 (Tourre wrote: “[S]tanding in the middle of all these complex, highly levered, exotic trades he [Mr.
Tourre] created without necessarily understanding all the implications of these monstruosities [sic] !!!”).
2747 See discussion of Abacus in section C(5)(b)(ii)DD, above.
2748 12/18/2006 email from Fabrice Tourre, “Paulson,” GS MBS-E-003246145, Hearing Exhibit 4/27-107.
2749 SEC deposition of Paolo Pellegrini (12/3/2008). PSI-Paulson-04 (Pellegrini Depo)-0001, at 175-76.
2750 April 23, 2010 Subcommittee Hearing Transcript at 64.
2751 2/27/2007 email from Ed Steffelin to Peter Ostrem, GS MBS-E-009209654.
CDO created “reputational risk” for the collateral manager industry and the whole market.2752
When Mr. Tourre later sought to book two CDS contracts referencing the Abacus securities, a
Goldman salesman wrote: “seems we might have to book these pigs.”2753
As planned, once issued, the Abacus securities quickly lost value. In October 2007, six
months after the Abacus securities were issued, the credit rating agencies downgraded them, and
a Goldman salesperson noted: “This deal was number 1 in the universe of CDO’s that were
downgraded by Moody’s and S&P. 99.89% of the underlying assets were downgraded.”2754 The
three investors that bought Abacus securities together lost more than $1 billion, while the
Paulson hedge fund, as the sole short party, recorded a corresponding $1 billion profit.2755 In
July 2010, Goldman agreed to settle a securities fraud complaint brought by the SEC by paying a
fine of $550 million and “acknowledging it was a mistake for the Goldman marketing materials
to state that the reference portfolio was ‘selected by’ ACA Management, LLC without disclosing
the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson’s economic
interests were adverse to CDO investors.”2756
With respect to Hudson, Goldman designed the CDO from its inception as a way to
transfer the risk of loss associated with ABX assets from Goldman’s inventory to the Hudson
investors.2757 Goldman documents state, for example, that Hudson was “initiated by the firm as
the most efficient method to reduce long ABX exposures,”2758 and the CDO was an “exit for our
long ABX risk.”2759 Goldman created and took the short side of $2 billion in single name CDS
contracts referencing RMBS securities that it wanted to short, and sold them to the Hudson
CDO. The end result was that Goldman wrote 100% of the CDS contracts that made up
Hudson’s assets and took 100% of the short side of the CDO, which meant that Goldman would
profit if the CDO fell in value. Goldman marketed the CDO without disclosing its status as the
sole short party, instead telling investors that its interests were “aligned” with theirs. The
Hudson securities immediately began losing value. Within a year, while the holders of the
Hudson securities lost virtually their entire investments, Goldman’s profits reached $1.7 billion,
which it then used to offset other mortgage related losses.
In both CDOs, Goldman took actions that disguised that the transactions were designed to
lose value. In Abacus, Goldman omitted mention of the Paulson hedge fund’s involvement in
the asset selection process and hired a well known third party portfolio agent, ACA
2752 Subcommittee interview of Ed Steffelin (12/10/2010).
2753 4/15/2007 email from Cactus Raazi to Daniel Chan, “Dan: ABACUS 07-AC1,” Hearing Exhibit 4/27-82.
2754 10/26/2007 email from Goldman salesman to Michael Swenson, “ABACUS 2007-AC1 – Marketing Points
(INTERNAL ONLY) [T-Mail],” GS MBS-E-016034495.
2755 Error! Main Document Only.Securities and Exchange Commission v. Goldman Sachs, Case No. 10-CV-
3229 (S.D.N.Y.), Complaint (April 16, 2010).
2756 SEC v. Goldman, Sachs & Co. and Tourre, Case No. 10-CV-3329 (BSJ) (S.D.N.Y.), Consent of Defendant
Goldman, Sachs & Co (July 14, 2010).
2757 See discussion of Hudson CDO in section C(5)(b)(ii)AA, above.
2758 Goldman response to Subcommittee QFR at PSI_QFR_GS0249.
2759 9/20/2006 email from Arbind Jha to Josh Birnbaum, GS MBS-E-012685289.
Management, to “leverage ACA’s credibility.”2760 In Hudson, Goldman omitted that it had
written all of the CDO’s CDS contracts and it referenced $1.2 billion in ABX assets in
Goldman’s own inventory, and instead told investors that Hudson’s assets were “sourced from
the Street” and Hudson was “not a Balance Sheet CDO.”2761
Goldman marketed the Abacus and Hudson securities to clients knowing that each CDO
had been designed to lose value and produce a profit for the short party. Given that information,
Goldman marketed CDOs that it knew or should have known were not suitable for any investor.
Selection of Poor Quality Assets. Similar concerns apply to Goldman’s origination and
marketing of the Anderson and Timberwolf CDOs, which contained such poor quality assets that
Goldman knew or should have known that they would perform poorly or fail. Yet Goldman
recommended them to investors anyway. The issue is whether, by recommending that investors
purchase the Anderson and Timberwolf securities, Goldman violated its fair dealing obligation
and recommended investments that were not suitable for any investor.
With respect to Anderson, Goldman personnel knew before marketing its securities that
the CDO had poor quality assets that were losing value. Nearly 45% of the referenced RMBS
securities in Anderson were dependent upon loans issued by New Century, while another 7%
depended upon loans issued by Fremont, two subprime lenders known, including by Goldman
personnel, for issuing poor quality loans and poorly performing RMBS securities.2762 On
February 24, 2007, Goldman personnel calculated that the assets in the Anderson warehouse
account had already lost $60 million in value from the time they were purchased.2763 In
response, Mr. Sparks, the Mortgage Department head, decided to cancel the CDO.2764 Later, he
changed his mind and rushed Anderson to market with only $305 million of the $500 million in
assets that had been planned. Goldman was the largest short party, with 40% of the short interest
in Anderson.
Anderson issued its securities on March 20, 2007. Goldman knew at the time that both
New Century and Fremont were in financial distress.2765 In addition, the week before, Goldman
had conducted reviews of both a New Century and a Fremont loan pool on the firm’s books, and
found that 26% of the New Century loans2766 and 50% of the Fremont loans2767
2760 3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transactions sponsored by
ACA,” GS MBS-E-002406025, Hearing Exhibit 4/27-118.
reviewed had
2761 10/2006 Hudson Mezzanine Funding 2006-1, LTD., GS MBS-E-009546963, at 978, Hearing Exhibit 4/27-87.
2762 See discussion of Anderson CDO in section C(5)(b)(ii)BB, above. Another 8% were dependent upon loans
issued by Countrywide.
2763 2/24/2007 email from Deeb Salem to Michael Swenson and others, GS MBS-E-018936137.
2764 2/24/2007 email from Mr. Sparks to Mr. Ostrem and others, GS MBS-E-001996601, Hearing Exhibit 4/27-95.
2765 See, e.g., 2/8/2007 email from Craig Broderick to Mr. Sparks and others, GS MBS-E-002201486 (calling New
Century’s announcement that it would restate its earnings “a materially adverse development”); 3/14/2007
Goldman email, “NC Visit,” GS MBS-E-002048050 (stating Fremont still has cash “but not for long”); 3/13/2007
email from Mr. Ostrem to Scott Wisenbaker and Matthew Bieber, GS MBS-E-000898410, Hearing Exhibit 4/27-
172 (providing talking points for selling Anderson securities to customers).
2766 3/13/2007 email from Manisha Nanik, “New Century EPDs,” GS MBS-E-002146861, Hearing Exhibit 4/27-
deficiencies and should be returned to the lender for refunds. Goldman nevertheless continued to
market the Anderson securities. When some potential investors expressed concerns about
Anderson’s underlying assets, in particular the New Century loans, Goldman tried to dispel those
concerns even while harboring its own low opinion of New Century loans.2768 Goldman
managed to sell approximately $102 million in Anderson securities to nine investors who lost
virtually their entire investments within a year.2769
With respect to Timberwolf, Goldman personnel knew that the CDO’s assets had begun
losing value almost from the time they were acquired.2770 Timberwolf was a CDO2 transaction
comprised of 56 different CDO assets with over 4,500 unique underlying securities.2771 In
February 2007, Mr. Sparks told a senior Goldman executive that it was a deal “to worry about,”
and that its assets had already incurred such significant losses that they had exhausted the share
of the warehouse risk held by Goldman’s partner in the transaction.2772 Despite that loss in
value, Goldman continued with the issuance of the Timberwolf securities in March 2007. By
May, a special CDO valuation project undertaken by the Mortgage Department found that the
Timberwolf’s assets had lost still more value.2773 Despite its lower internal valuation, Mr.
Sparks advised Goldman senior executives that his CDO pricing strategy was to “take the writedown,
but market at much higher levels” to avoid “leaving some money on the table.”2774
During the spring and summer of 2007, Goldman aggressively marketed Timberwolf
securities to investors around the world, eventually selling about $853 million in Timberwolf
securities to 12 investors.2775 Goldman sold the securities at prices substantially above its
internal book values for the Timberwolf securities. After making a sale, Goldman then,
sometimes only days or weeks later, marked down the value of the securities it had sold,
resulting in investors realizing losses and sometimes requiring the investor to post additional
cash margin or collateral.2776 In September 2007, an internal Goldman analysis found that, in
just six months, Timberwolf’s AAA rated securities had lost 80% of their value. One of
Goldman’s senior executives monitoring Timberwolf pronounced it “one shitty deal.”2777 The
CDO was liquidated in October 2008, and the investors who purchased Timberwolf securities
lost virtually their entire investments.
2767 3/14/2007 Goldman email, “NC Visit,” GS MBS-E-002048050.
2768 See, e.g., 3/6/2007 email from Joshua Bissu to Mr. Ostrem and Mr. Bieber, GS MBS-E-014597705 (talking
points for Goldman personnel to respond to investor concerns about the New Century loans).
2769 See e.g., Goldman response to Subcommittee QFR at PSI_QFR_GS0223.
2770 See, e.g., 9/17/2007 email from Christopher Creed, “Timberwolf,” GS MBS-E-000766370, Hearing Exhibit
4/27-106 (showing price for Timberwolf securities dropped from $94 on 3/31/2007 to $87 on 4/30/2007).
2771 8/23/2007 email from Jay Lee to Mr. Lehman and others, GS MBS-E-001927784.
2772 2/26/2007 email exchange between Mr. Sparks and Mr. Montag, GS MBS-E-019164799, Hearing Exhibit
2773 5/20/2007 email from Paul Bouchard, “Materials for Meeting,” GS MBS-E-001863725.
2774 5/14/2007 email from Mr. Sparks to Mr. Montag and Mr. Mullen, GS MBS-E-019642797.
2775 See, e.g., Goldman response to Subcommittee QFR at PSI_QFR_GS0223.
2776 See, e.g., example involving Basis Capital in discussion of Timberwolf in section C(5)(b)(ii)CC, above.
2777 6/22/2007 email from Mr. Montag to Mr. Sparks, “Few Trade Posts,” GS MBS-E-010849103, Hearing Exhibit
Goldman CEO Lloyd Blankfein said publicly about the firm’s securities: “If we believed
it would fail … the security wouldn’t work, we would not sell it.”2778 But Goldman marketed
the Anderson and Timberwolf securities to clients knowing that each CDO had poor quality
assets that were continually losing value. It marketed them at the same time it was investing on
the short side of the CDOs and the subprime mortgage market as a whole, and its Mortgage
Department head was telling his staff that it was “Game Over” and time to “get out of
everything.”2779 Within a year, the Anderson and Timberwolf securities were virtually
worthless. Given what Goldman knew when marketing Anderson and Timberwolf, Goldman
was recommending investments that were most likely not suitable for any investor.
This analysis examines Goldman’s conduct in the context of the law prevailing in 2007.
Since then, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 has
established new conflict of interest prohibitions that would apply to this type of conduct,
including Section 621 which bars any underwriter or placement agent of an asset backed security
from engaging in any transaction “that would involve or result in any material conflict of interest
with respect to any investor in a transaction arising out of such activity.”
(7) Goldman’s Proprietary Investments
When reviewing the conflict of interest issues related to Goldman’s mortgage related
activities in 2006 and 2007, another issue examined by the Subcommittee was the extent to
which Goldman’s Mortgage Department was engaged in proprietary trading.2780
In 2007, Goldman was not a commercial bank, and proprietary trading was not illegal.
The issue that concerned the Subcommittee was the extent to which its proprietary activities may
have contributed to the conflicts of interest that affected how Goldman operated.2781
2778 April 30, 2010 transcript of The Charlie Rose Show, at 14.
In a
2779 3/12/2007 Goldman Firmwide Risk Committee, “March 7th FWR Minutes,” GS MBS-E-00221171, Hearing
Exhibit 4/27-19; 3/3/2007 email from Mr. Sparks, “Call,” GS MBS-E-010401251, Hearing Exhibit 4/27-14.
2780 Until its repeal in 1999, the Glass-Steagall Act prohibited banks from engaging in proprietary trading. Glass-
Steagall Act, Section 16. The Act’s prohibition on proprietary trading was weakened over the years and finally
repealed by the Financial Services Modernization Act of 1999, P.L. 106-102 (1999). Since Goldman did not
become a bank holding company until 2008, neither the Glass-Steagall prohibition nor its repeal affected its
activities during the time period examined by the Subcommittee.
2781 Financial institutions that trade for their own accounts at the same time that they conduct trades on behalf of
their clients may experience conflicts of interest. See, e.g., 4/23/2010 letter from John Reed, former Chairman and
CEO of Citigroup, to Senators Merkley and Levin (“When a firm is focused on market gain through proprietary
trading, it too often will employ every available device to achieve those gains B including take advantages of clients
and putting the firm at risk.”); In re Merrill Lynch, Pierce, Fenner & Smith, Incorporated, Exchange Act Rel. No.
34-63760, Admin. Proc. 3-14204 (Jan. 25, 2011) (settling allegations that Merrill Lynch’s proprietary traders
misused information about their customers’ trading); 7/19/2005 speech by Annette Nazareth before the Securities
Industry Association Compliance and Legal Division Member Luncheon (discussing increased potential for
conflicts of interest). In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act, P.L. 111-603,
restored the prohibition on proprietary trading by banks, subject to certain exceptions. See Section 619, amending
the Bank Holding Company Act of 1956, to be codified at 12 U.S.C. §1851. Regulations implementing Section 619,
also known as the Merkley-Levin provisions after the Senators who authored them or the Volcker Rule after former
Federal Reserve Chairman Paul Volcker who championed the ban, are due by October 2011.
recently issued “Report of the Business Practices Committee,” Goldman reaffirmed as its first
business principle: “Our clients’ interests always come first.”2782 Contrary to that statement,
however, Goldman documents showed its employees repeatedly expressing concern about the
firm’s interests, but rarely mentioning or placing a priority on the interests of its clients. In fact,
after Goldman announced record profits for its Mortgage Department in the third quarter of
2007, when many of its clients were suffering substantial losses from the mortgage investments
they purchased from Goldman, Peter Kraus, co-head of the Investment Banking Division, wrote
the following to Goldman CEO Lloyd Blankfein: “I met with 10+ individual prospects and
clients . . . since earnings were announced. The institutions don’t and I wouldn’t expect them to,
make any comments like ur good at making money for urself but not us. The individuals do
sometimes, but while it requires the utmost humility from us in response I feel very strongly it
binds clients even closer to the firm, because the alternative of take ur money to a firm who is an
under performer and not the best, just isn’t reasonable. Clients ultimately believe that
association with the best is good for them in the long run.”2783
The tension between Goldman’s efforts to make money on behalf of itself versus on behalf of its
clients raises a number of conflict of interest concerns, particularly when its efforts to profit from
shorting the mortgage market or particular RMBS or CDO securities occurred simultaneously
with its efforts to market mortgage related securities to its clients.
Goldman’s Proprietary Activities. Until recently, when asked about the extent of the
firm’s proprietary activities, Goldman generally claimed that its proprietary investments
contributed only approximately 10% of the firm’s profits.2784 In January 2011, however,
Goldman announced in an SEC filing that it was changing the categories under which it reported
income. Goldman added a new category called “Investments and Lending” to segregate the
firm’s proprietary investment income from the income it derived from activities undertaken on
behalf of clients.2785 Based on earnings reported in January 2011 for Goldman=s full fiscal year
2010, the proprietary investment income recorded under “Investments and Lending” accounted
for $7.5 billion, or about 20% of Goldman’s net revenues.2786
2782 1/2011 “Report of the Business Standards Committee,” at 1. In May 2010, at Goldman’s annual shareholders’
meeting, CEO Lloyd Blankfein announced the formation of a Business Standards Committee to conduct an
extensive review of the firm’s business standards and practices to determine the extent to which the firm was
adhering to its own written “Business Principles,” and to make appropriate recommendations. Id. The Committee’s
January 2011 report provided recommendations in the areas of Client Relationships and Responsibilities, Conflicts
of Interest, Structured Products, Transparency and Disclosure, Committee Governance, and Training and
Professional Development.
Goldman did not specify how it
defined proprietary investments and lending for purposes of its earnings report, nor what desks
2783 9/26/2007 email to Mr. Blankfein, “Fortune: How Goldman Sachs Defies Gravity,” GS MBS-E-009592726,
Hearing Exhibit 4/27-135.
2784 See, e.g., 1/21/2010, The Goldman Sachs Group Inc., 4Q 2009 Earnings Call Transcript, Q&A (David Viniar
states that, in most years, proprietary trading accounts for “10% roughly plus or minus a couple of percent.”),
2785 1/11/2011 Goldman Form 8-K filed with the SEC (announcement of change in reporting categories).
Goldman’s change in its reporting categories implemented one of the recommendations outlined in Goldman’s
“Report of the Business Standards Committee” published in January 2011.
2786 See 1/19/2011 Goldman press release on 2010 earnings, available at
or activities contributed to the total, how it calculated the reported amount, or why it was double
the amount cited a year earlier.
To date, three Goldman units have been identified as engaging explicitly in investments
on behalf of the firm. One, based in New York, is called Goldman Sachs Principal Strategies or
“GSPS,” which Goldman is reportedly in the process of dismantling.2787 The second is the
Global Macro Proprietary Trading Desk, which had traders in New York and London and
reportedly invested in foreign exchange markets, interest rate markets, stocks, commodities and
other fixed income markets.2788 The third, according to Goldman, is the Special Situations
Group or SSG, which is reportedly engaged primarily in long term investments on behalf of the
firm and clients, with little short term trading or sales activities.2789
Proprietary Activities in the Mortgage Area. In the mortgage area, until 2005,
Goldman had a dedicated proprietary investment desk in the Mortgage Department called the
Principal Finance Group, often referred to as Principal Investments.2790 According to Goldman
personnel, that desk specialized in long term investments on behalf of Goldman in assets such as
distressed mortgages and credit card and energy receivables, but only rarely engaged in short
term trading.2791 In 2005, Principal Investments was folded into the Special Situations Group
(SSG), which was then a Goldman business unit located in Asia and not part of the Mortgage
Department.2792 After Principal Investments personnel moved to SSG, the Mortgage Department
operated without a desk that was explicitly dedicated to proprietary trading during 2006 and
When asked whether the Mortgage Department engaged in proprietary activities during
2006 and 2007, Goldman executives and traders in the Mortgage Department generally resisted
providing a direct answer, declined to identify any proprietary trades or investments, and
declined to estimate or calculate how much of the Mortgage Department=s 2007 revenues or
profits were proprietary.
2787 Subcommittee interview of David Viniar (4/13/2010). See also “More Goldman Traders to Exit for Funds,”
Financial Times (1/9/2011). Goldman may be eliminating the desk in response to the Dodd-Frank prohibition on
proprietary trading.
2788 See “Goldman to Shut Global Macro Trading Desk,” New York Times (2/16/2011). Goldman may be
eliminating this desk in response to the Dodd-Frank prohibition on proprietary trading.
2789 Subcommittee interview of Darryl Herrick (10/13/2010). To the extent that its activities are limited to long
term investments, the SSG unit would not be affected by the Dodd-Frank prohibition on proprietary trading which
applies only to trading accounts used “principally for the purpose of selling in the near term (or otherwise with the
intent to resell in order to profit from short-term price movements),” and does not affect long term investments. See
Section 619(h)(6). Under Section 620 of the Dodd-Frank Act, banking regulators are also conducting an 18-month
review of all permitted bank investment activities, both long and short term, to gauge the risk of each activity, any
negative effect the activity may have on the safety and soundness of the banking entity or the U.S. financial system,
and the “appropriateness” of each activity for a federally insured bank.
2790 Subcommittee interview of Darryl Herrick (10/13/2010).
2791 Id.
2792 Id.
When asked about particular transactions, Goldman executives or traders often described
them as examples, not of “proprietary trading,” but “principal trading” in which Goldman acted
as a market maker. Goldman personnel told the Subcommittee that to fulfill the firm’s role as a
market-maker, Goldman used its own capital to amass an inventory of assets in anticipation of
customer demand, and acted as a “principal” when building that inventory. They indicated that
the mortgage related assets were acquired for the purpose of accommodating existing or
anticipated client buy and sell orders and not to produce proprietary profits for the firm.
At the same time, several Goldman executives and traders told the Subcommittee that all
of Goldman’s trading desks, including those in the Mortgage Department, were given discretion
to trade some amount of the firm’s capital within certain limits.2793 Daniel Sparks told the
Subcommittee: “We told [the Firmwide Risk Committee] what we wanted to do, and they told
us how much we could do.”2794 Joshua Birnbaum said that the amount of proprietary trading that
a desk was allowed to do depended upon certain risk limits, but could not recall a specific or
typical dollar amount of any risk limit assigned to the Mortgage Department as a whole or to any
of its trading desks for proprietary trading purposes.2795 Goldman’s Chief Risk Officer Craig
Broderick told the Subcommittee that the firm did not distinguish between “proprietary” versus
other types of risk, because the aggregate risk levels would be the same.2796 Mr. Broderick said
that the firm’s proprietary trading, outside of GSPS, was “embedded” in the routine business
conducted by various trading desks and was not specifically segregated as “proprietary.”2797
Until enactment of the Dodd-Frank Act in 2010, federal securities law contained no
statutory or regulatory definition of proprietary trading by banks and generally did not require
firms to identify or monitor their proprietary investments.2798 The Subcommittee investigation
found that the terms “proprietary” and “prop” were commonly used in the financial services
industry to describe business performed on behalf of, or for the benefit of, a financial firm itself,
while the term “flow” was used to refer to market-making transactions involving, or for the
benefit of, the firm’s customers.2799
2793 Subcommittee interviews of Mr. Sparks (4/15/2010); Mr. Birnbaum (4/22/2010); and Mr. Broderick (4/9/2010).
See also 12/17/2007 email from Michael DuVally to Mr. Sparks, “WSJ Responses,” GS MBS-E-013821884 (“Some
traders are allowed to express their own market views using the firm’s capital.”).
2794 Subcommittee interview of Daniel Sparks (4/15/2010).
2795 Subcommittee interview of Joshua Birnbaum (4/22/2010).
2796 Subcommittee interview of Craig Broderick (4/9/2010).
2797 Id. Goldman’s Chief Financial Officer David Viniar provided similar information in response to questions from
the Financial Crisis Inquiry Commission, indicating that Goldman did not specifically “break out” its proprietary
trading from its other business results. See FCIC Hearing, Testimony of David Viniar (7/2/2010),
2798 The Dodd-Frank Act defines “proprietary trading” as “engaging as a principal for the trading account of [a]
banking entity . . . in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, any
derivative, any contract of sale of a commodity for future delivery, any option on any such security, derivative, or
contract or any other security or financial instrument that the appropriate Federal banking agencies ... may, by rule ...
determine.” 12 U.S.C. ' 1851(h)(4). The Act further defines “trading account” as one used for “near term” trading
or for capturing profits from “short term price movements.” Section 1851(h)(6). These provisions are subject to
further refinement through implementing regulations.
2799 See, e.g., description of proprietary trading in Deutsche Bank’s 3/26/2008 Form 20-F filed with the SEC at 24
(“Within Corporate Banking & Securities, we conduct proprietary trading, or trading on our own account, in
addition to providing products and services to customers. Most trading activity is undertaken in the normal course
A number of internal Goldman documents in 2006 and 2007, used the terms “prop” and
“flow” when referring to mortgage related activities. In a 2006 email to Goldman senior
executives, for example, Mr. Sparks, the Mortgage Department head, used the terms when
criticizing a decision by Morgan Stanley to move its most experienced mortgage traders from its
mortgage department’s “franchise” desk to a dedicated proprietary desk.2800 Mr. Sparks argued
against Goldman=s doing the same by claiming exposure to customer trades or “flows” made
mortgage traders “more effective” in their proprietary trades:
“Morgan Stanley is going overboard by taking most of their experienced and known
traders out of the franchise. We should keep our franchise leaders in the seats and
continue to allow them to take prop views B the customer flows they see make them more
This email shows, not only that Mr. Sparks and other Goldman executives used the terms “prop”
and “flow,” but they also knew Goldman mortgage traders were handling both customer and
proprietary transactions at the same time.
In November 2007, Mr. Sparks received an email from the Mortgage Department’s
business manager, John McHugh, indicating that proprietary trades made up a substantial portion
of the Department’s activities.2802 In the email, Mr. McHugh provided Mr. Sparks with a draft of
the Department=s 2008 business plan which included a description of the projected business
activities of the Structured Product Group – the Mortgage Department trading desk that then
handled RMBS, CDO, and other mortgage related trading activities. Under the heading, “Prop
vs. Flow,” the draft plan stated: “Prop/flow components of SPG Trading will be roughly
equal.”2803 Under another section entitled, “Assumptions/ Initiatives in ABS [Asset Backed
Security] p&l [profit and loss],” the draft business plan stated:
$ “Good prop opportunity capitalizing on selling pressure, selective distressed asset
$ Expect prop flow split to be roughly 50/50.”2804
of facilitating client business. For example, to facilitate customer flow business, traders will maintain long positions
(accumulating securities) and short positions (selling securities we do not yet own) in a range of securities and
derivative products, reducing this exposure by hedging transactions where appropriate. While these activities give
rise to market and other risk, we do not view this as proprietary trading. However, we also use our capital to exploit
market opportunities, and this is what we term proprietary trading.”).
2800 4/13/2006 email from Mr. Sparks to Messrs. Cohn, Sobel, and Mullen, “Morgan Super Traders Worry Hedge
Funds,” GS MBS-E-016187625.
2801 Id. See also Glenn Bedwin, International Research Director, Thomson Financial, Trading for Investors Forum,
Financial News Supplement at 14 (2004) (noting the value of “information [banks] gain from looking at the flow
going through their desk”).
2802 11/16/2007 email from John McHugh to Mr. Sparks, “FICC 2008 business plan presentation to Firm,” GS
2803 Id.
2804 Id.
The draft business plan suggests that fully half the 2008 SPG and ABS activities were expected
to involve proprietary investments.
When the Subcommittee asked Mr. Sparks about the “prop/flow components of SPG
Trading” in the Department’s 2008 draft business plan, Mr. Sparks indicated that he was not sure
what his business manager meant and was unable to estimate what percentage of the SPG
Trading Desk’s activities was spent on proprietary trades.2805 In a later written response to
Subcommittee questions about the email, Mr. Sparks wrote: “‘Prop’ or ‘proprietary’ can mean
different things to different people.” He continued that Mr. McHugh=s email appeared to use
“prop” to refer to investments made with a longer holding period, such as months or years, while
“flow” seemed to refer to investments with a shorter holding period:
“Defined this way, both ‘prop’ and ‘flow’ trades can involve customers, although
sometimes the term ‘proprietary’ is used to describe business that does not involve a
customer. (Sometimes proprietary is used to describe any activity that involves use of a
firm’s own capital.).”2806
Goldman’s Net Shorts As Proprietary Investments. Goldman’s practice of embedding
its proprietary trading activities within the ordinary trading conducted on its market-making
mortgage trading desks, together with its unwillingness to estimate its proprietary activities,
made it difficult to determine the extent of the proprietary trading that took place within the
Mortgage Department from 2006 to 2007.2807 Nonetheless, many of the transactions undertaken
by the Mortgage Department from late 2006 to late 2007 appear to have been undertaken to
advance the financial interests of the firm, rather than primarily to make markets for clients.
Several factors suggest that transactions undertaken to build and profit from Goldman’s
two large net short positions in 2007 were completed for Goldman’s own benefit, rather than on
behalf of its clients. First, the two net short positions – totaling $10 billion in February and
$13.9 billion in June 2007 – were far larger than a financial institution would establish simply to
meet anticipated client demand.2808
2805 Subcommittee interview of Daniel Sparks (10/3/2010).
Second, the magnitude of the risk attached to those short
positions was also outsized. As indicated earlier, the Mortgage Department typically contributed
2806 Daniel Sparks response to Subcommittee QFR at PSI-QFR_GS0452.
2807 The difficulties associated with distinguishing between proprietary trading and market making activities are
examined in a recent study by the new Financial Stability Oversight Council (FSOC), an intra-governmental council
established by the Dodd-Frank Act, comprised of ten regulators in the financial services sector, and charged with
identifying risks and responding to emerging threats to U.S. financial stability. See FSOC FAQs,; 1/2011 “Study & Recommendations on Prohibitions on Proprietary Trading & Certain
Relationships with Hedge Funds & Private Equity Funds” (hereinafter “FSOC Study”), at 22-44. The FSOC Study
observed: “Absent robust rules and protections, banking entities may have the opportunity to migrate existing
proprietary trading activities from the standalone business units that are presently recognized as ‘proprietary
trading” into more mainstream ‘sales and trading’ or other operations that engage in permitted activities.” Id. See
also “Proprietary Trading Goes Under Cover: Michael Lewis,” Bloomberg, (10/27/2010) (quoting a bank trader
who reportedly said “from here on out, if he wants to take a proprietary position ... he will argue that he bought the
position because a customer wanted to sell the position, and he was providing liquidity”).
2808 These totals include Goldman’s net shorts from both its mortgage trading and CDO securitization activities.
only about 2% of Goldman’s total net revenues, yet in 2007, it was allowed to continually exceed
its permanent Value-at-Risk (VAR) limit and incur up to 52% of firmwide risk. The
Subcommittee uncovered no evidence to suggest that Goldman incurred and sustained that
disproportionately high level of risk to accommodate client demands or to hedge positions taken
on to accommodate clients.
A third factor indicating the net short positions were proprietary in nature was how long
Goldman held onto them. For example, the Mortgage Department maintained a $9 billion ABX
AAA short for six to nine months in 2007. While that short was initially used to hedge certain
long positions held by various Mortgage Department desks, it was retained even after those long
positions were sold off or written down. Mr. Sparks later described the ABX AAA short as
“disaster insurance” in case the subprime market collapsed.2809 The Subcommittee found no
evidence indicating that the $9 billion short was maintained over such a long period of time to
accommodate client demand.
A fourth factor indicating Goldman’s net short positions were proprietary in nature was
the Mortgage Department’s affirmative effort to solicit clients to buy RMBS and CDO assets in
its inventory.2810 The Subcommittee saw no evidence that this sales activity was undertaken to
accommodate client demand; to the contrary, the documents show that the Mortgage
Department’s sales efforts took place amid a deteriorating mortgage market and waning investor
interest in mortgage related products.2811
Still another indicator that the Mortgage Department’s net shorts were proprietary was
that, when clients expressed interest in acquiring certain short positions, Goldman at times
refused to accommodate their requests. For example, in June 2007, when Goldman began
building its second large net short position, its Mortgage Department refused client requests to
purchase the short side of CDS contracts with Goldman: “Really don=t want to offer any [shorts
to customers]” and “too late!”2812
2809 Subcommittee interview of Daniel Sparks (4/15/2010).
On another occasion in March 2007, a Goldman employee
told Goldman’s Chief Risk Officer Mr. Broderick that the Mortgage Department was no longer
buying subprime assets: “Just fyi not for the memo, my understanding is that desk is no longer
2810 See, e.g., documents cited in Section C(4)(b) (sales efforts to reduce Goldman’s $6 billion long position) and
Section C(5)(a)(iii) (sales efforts to reduce Goldman-originated RMBS and CDO securities), above.
2811 See, e.g., emails noting difficult sales environment. 1/31/2007 email from Mr. Sparks to Mr. Montag,
“MTModel,” Hearing Exhibit 4/27-91 (making “lemonade out of some big old lemons”); 3/9/2007 email from Mr.
Sparks to Mr. Schwartz and others, GS MBS-E-010643213, Hearing Exhibit 4/27-76 (“team is working incredibly
hard and is stretched”); 3/27/2007 email from Mr. Ostrem to Mr. Bieber, GS MBS-E-000907935, Hearing Exhibit
4/27-172 (congratulating Mr. Bieber for “an excellent job pushing to closure these deals in a period of extreme
difficulty”); 6/11/2007 email from Mr. Montag, GS MBS-E-001866144 (after a sale of Timberwolf securities,
telling the sales team they had done an “incredible job B just incredible”).
2812 6/10/2007 email from Michael Swenson, “CDS on CDOs,” GS MBS-E-012568089; 6/13/2007 email from
sales, “CDO protection,” GS MBS-E-012445931. See also 9/7/2007 Fixed Income, Currency and Commodities
Annual Individual Review Book, Salem 2007 Self-Review, GS-PSI-03157 at 71 (in his self-evaluation Mr. Salem
wrote that his desk sold short positions on single name CDS contracts only to customers that could provide Goldman
with useful information: “We were very aggressive with pricing and only shared risk [short positions] with smart
guys if they gave us insight on names to go short or go long in return.”).
buying subprime. (We are low balling on bids.).”2813 Refusing client requests and lowballing
bids to avoid purchases indicate that the Goldman Mortgage Department was not acting as a
market maker to accommodate client demand.
Perhaps the strongest indicator that Goldman’s large net short positions were proprietary
investments are the statements made by Goldman’s own executives and traders. Goldman’s head
ABX trader, Joshua Birnbaum, described the Department’s decisions in February and June to
build and profit from its net short positions, not as efforts to accommodate anticipated client
demand, but as investments made on behalf of the firm to produce large profits:
“Whereas execution of strategies has clearly been a concerted team effort, I consider
myself the initial or primary driver of the macro trading direction for the business. I
would highlight 3 major calls here:
1. Dec-Feb: ... The prevailing opinion within the department was that we should just
‘get close to home’ and pare down our long. ... I concluded that we should not only get
flat, but VERY short. ... [W]e all agreed the plan made sense. ... [W]e 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 when the market dropped 25
points and our profitable year was underway. ...
3. Jun-Jul: the BSAM [Bear Stearns Asset Management failure] changed everything. I
felt that this mark-to-market event for CDO risk would begin a further unraveling in
mortgage credit. Again, when the prevailing opinion in the department was to remain
close to home, I pushed everyone on the desk to sell risk aggressively and quickly. We
sold billions of index and single name risk such that when the index dropped 25pts in
July, we had a blow-out p&l [profit & loss] month, making over $1Bln that month. ...
We made money: a) taking large directional views, the direction of which we changed
several times, b) ... betting the bad names would get much worse vs. the good ones, c)
shorting CDOs, d) capturing the index to single name basis ... among other things.”2814
2813 3/2/2007 email exchange between Mr. Broderick and Patrick Welch, GS MBS-E-009986805, Hearing Exhibit
2814 9/26/2007 EMD Reviews, Joshua Birnbaum Self-Review, GS-PSI-01975, Hearing Exhibit 4/27-55c. Mr.
Birnbaum’s comments indicate that Goldman’s proprietary activities extended to its CDO activities. As explained
earlier, while Abacus 2007-AC1 was undertaken in response to a client request, Hudson 1 was conceived by the
Mortgage Department as a way to transfer risk associated with poorly performing ABX assets in its inventory.
Goldman supplied 100% of the CDS contracts that made up Hudson’s assets, took 100% of the short side, and
profited at the expense of the Hudson investors. In October 2006, Mr. Ostrem, head of the CDO Origination Desk,
wrote to Mr. Sparks that a client was upset, because it knew “Hudson Mezz (GS prop deal) is pushing their deal
back,” clearly identifying Hudson as a “prop” or proprietary transaction. 10/16/2006 email from Mr. Ostrem to Mr.
Sparks, GS MBS-E 010916991, Hearing Exhibit 4/27-59. See also 2/25/2007 email exchange between Peter Ostrem
and Matthew Bieber, at GS MBS-E-001996601, Hearing Exhibit 4/27-95 (Mr. Ostrem proposed allowing a hedge
fund to include assets in Anderson and then short them, but Mr. Bieber thought Mr. Sparks would want to “preserve
that ability for Goldman”); 12/29/2006 email from Mr. Birnbaum to Mr. Lehman, GS MBS-E-011360438, Hearing
Exhibit 4/27-5 (when discussing certain proposed CDO deals that would generate $1 to $3 billion in short positions
and reference certain RMBS securities, Mr. Birnbaum stated: “On baa3 [RMBS securities with credit ratings of
In a later presentation put together to propose a new compensation arrangement for the SPG
Trading Desk’s trading activities, Mr. Birnbaum was unequivocal that the net shorts the desk had
acquired were not hedges to offset risk, but “outright” short investments to produce profits:
“By June, all retained CDO and RMBS positions were identified already hedged. ... SPG
trading reinitiated shorts post BSAM [Bear Stearns Asset Management] unwind on an
outright basis with no accompanying CDO or RMBS retained position longs. In other
words, the shorts were not a hedge.2815
In his 2007 self-evaluation, Michael Swenson, head of the Mortgage Department=s SPG
Trading Desk, described the net short positions undertaken by the firm in this way:
“It should not be a surprise to anyone that the 2007 year is the one that I am most proud
of to date. ... extraordinary profits (nearly $3bb [billion] to date). … I directed the ABS
desk to enter into a $1.8 bb short in ABS CDOs that has realized approx. $1.0bb of p & l
[profit and loss] to date. … [W]e aggressively capitalized on the franchise to enter into
efficient shorts in both the RMBS and CDO space.”
Mr. Swenson’s description of the net short position he “directed” to be built in CDOs and
the resulting $1 billion in profit makes no reference to client demands. Mr. Salem, a trader on
the ABS Desk, was equally clear in his 2007 self-evaluation that the desk made a deliberate bet
on the direction of the mortgage market: “Mike, Josh, and I were able to learn from our bad long
position at the end of 2006 and layout the game plan to put on an enormous directional
short.”2816 Each of these three Mortgage Department employees played a key role in building
the firm’s net short positions. Their own statements indicate that they perceived acquiring the
2007 net short positions to be for the benefit of the firm, and not to build an inventory of assets
to respond to anticipated client demand.
Other internal documents also portray the net short positions as decisions made by the
firm to advance its own financial interests. In an internal presentation to the Goldman Board of
Directors regarding the “Subprime Mortgage Business,” for example, the Mortgage Department
wrote that, in the first quarter of 2007, “GS reverse[d] long market position through purchase of
single name CDS and reductions of ABX.”2817
BBB-], I’d say we definitely keep it for ourselves. On baa2 [RMBS securities with BB ratings], I’m open to some
sharing to the extent that it keeps these customers engaged with us.”).
In September 2007, the Goldman Board of
Directors summarized its mortgage business this way: “Although broader weakness in the
mortgage markets resulted in significant losses in cash position, we were overall net short the
2815 10/3/2007 “SPG Trading B 2007,” presentation prepared by Joshua Birnbaum with input from other SPG
employees, but which was not ultimately provided to senior management, GS MBS-E-015654036, at 44 [emphasis
in original]. Mr. Birnbaum reaffirmed his analysis in a 2010 written response to Subcommittee questions. See Mr.
Birnbaum’s response to Subcommittee QFR at PSI_QFR_GS0509.
2816 9/7/2007 Fixed Income, Currency and Commodities Annual Individual Review Book, Salem 2007 Self-Review,
GS-PSI-03157, at 71.
2817 3/26/2007 Presentation to Goldman Board of Directors, “Subprime Mortgage Business,” GS MBS-E-
005565527, Hearing Exhibit 4/27-22.
mortgage market and thus had very strong results.”2818 Talking points prepared for CFO David
Viniar prior to a March 2007 earnings call with analysts stated: “The Mortgage business’
revenues were primarily driven by synthetic short positions.”2819 In an October 2007 letter sent
to the SEC, Goldman wrote:
“[W]e are active traders of mortgage securities and loans and ... we may choose to take a
directional view of the market .... For example, during most of 2007, we maintained a net
short sub-prime position and therefore stood to benefit from declining prices in the
mortgage market.”2820
In an October 2007 internal presentation to another Goldman unit, Chief Risk Officer Craig
Broderick wrote:
“So what happened to us? ... In market risk B you saw in our 2nd and 3rd qtr results that
we made money despite our inherently long cash positions. – because starting early in ‘07
our mortgage trading desk started putting on big short positions ... and did so in enough
quantity that we were net short, and made money (substantial $$ in the 3rd quarter) as the
subprime market weakened.”2821
In a November 2007 email to his colleagues, Goldman CEO Lloyd Blankfein wrote: “Of course
we didn’t dodge the mortgage mess. We lost money, then made more than we lost because of
shorts.”2822 None of these internal documents suggests that the Mortgage Department’s net short
transactions were undertaken to accommodate existing or anticipated client trades.
In January 2011, the new Financial Stability Oversight Council (FSOC) issued a study
that focused, in part, on criteria that can be used to distinguish between proprietary and market
making activities.2823
2818 9/17/2007 Board of Directors Meeting Financial Summary, GS MBS-E-009776907, Hearing Exhibit 4/27-42.
Applying those recently developed criteria to the Mortgage Department’s
2007 activities also supports viewing that activity as the result of proprietary rather than market
making activities. For example, the Mortgage Department was building its net shorts with the
expectation that they would appreciate in value rather than provide assets to facilitate customer
transactions; the position created risks out of proportion to those necessary to accommodate
2819 3/9/2007 email from Sheara Fredman to David Viniar and others, GS MBS-E-009762678, Hearing Exhibit
4/27-16. When preparing a later internal presentation, in October 2007, Dan Sparks was even more blunt: “The desk
benefitted from a proprietary short position in CDO and RMBS single names.” 10/5/2007 draft of “Business Unit
Townhall Presentation, Q3 2007,” prepared by Mr. Sparks, Hearing Exhibit 4/27-47. Mr. Sparks removed this
phrase from the final version of the presentation and told the Subcommittee he had been mistaken to include it in the
earlier draft.
2820 10/4/2007 letter from Goldman to the SEC, GS MBS-E-009758287, Hearing Exhibit 4/27-46.
2821 10/29/2007 presentation by Craig Broderick to the Tax Department, GS MBS-E-010018512, Hearing Exhibit
4/27-48. See also 10/5/2007 draft presentation by Mr. Sparks, for a Business Unit Townhall meeting, GS MBS-E-
013703468, Hearing Exhibit 4/27-47 (“The desk benefited from a proprietary short position in CDO and RMBS
single names.”).
2822 11/18/2007 email from Mr. Blankfein, “NYT,” GS MBS-E-009696333, Hearing Exhibit 4/27-52.
2823 1/2011 “Study & Recommendations on Prohibitions on Proprietary Trading & Certain Relationships with
Hedge Funds & Private Equity Funds,” at 22-44.
customer demand; the Mortgage Department actively and aggressively solicited clients to build
its short positions; the Mortgage Department accumulated an unpredictable inventory profile in
terms of volume and in relation to customer demand; and it had a relatively low inventory
turnover with the bulk of the profits derived from inventory appreciation when Goldman covered
its shorts.
Advocating More Proprietary Trading. One last set of documents shines additional
light on the role of proprietary investments in the Goldman Mortgage Department in 2006 and
2007. As indicated earlier, for several years, Goldman’s Mortgage Department had a proprietary
trading desk, Principal Investments, that was explicitly and exclusively dedicated to engaging in
transactions for the benefit of the firm. In 2005, it was moved to the SSG unit. Internal
Goldman documents show that some in the Mortgage Department wanted to revive that desk,
increase the amount of proprietary trading in the mortgage area, or claim a greater share of the
proprietary profits created by the Mortgage Department for the firm.
In August 2006, for example, the CDO Origination Desk proposed that Goldman
establish a formal proprietary trading fund or proprietary trading operation within the Mortgage
Department to conduct mortgage related transactions on behalf of the firm. In an August 2006
email, Peter Ostrem, the CDO Origination Desk head, made the proposal to Mr. Sparks, the
Mortgage Department head:
“Let’s do our own fund. SP [Structured Product] CDO desk. Big time. GS [Goldman
Sachs] commits to hold proportion of equity outright. This could be big. ... I need real
leverage. Got some structured ideas too. When can we talk strategy for an hour or
Mr. Sparks responded: “Next week. In the meantime calm the blank down.”2825 Later the same
day, he later wrote to Mr. Ostrem: “Not going to happen.”2826 When asked about these emails,
Mr. Sparks told the Subcommittee that Goldman decided not to allow the Mortgage Department
to set up its own hedge fund or explicit proprietary trading desk.2827
In March 2007, after a series of large trades with the Harbinger hedge fund on the ABS
Desk, Deeb Salem, an ABS trader, emailed Mr. Birnbaum, Mr. Swenson, and Mr. Chin with a
proposal for a proprietary CDO:
“Am I crazy to be thinking we might want to grow the harbinger trade and do our own
abs desk cdo. There’ll be so much juice in it. It would blow out. We could sell
supersenior and maybe some equity. Then the remaining mezz would be a cover of a
couple hundred million of our cdo short. Haven’t crunched the numbers, but I’m
2824 8/10/2007 email from Mr. Ostrem to Mr. Sparks, “Leh CDO Fund,” GS MBS-E-010898470.
2825 Id.
2826 8/10/2007 email from Mr. Sparks to Mr. Ostrem, “Leh CDO Fund,” GS MBS-E-010898476.
2827 Subcommittee interview of Daniel Sparks (10/4/2010).
guessing we’d effectively cover well north of 1000 plus own some call rights. Or we also
keep the equity and own it for free.
To select the portfolio, we look at the underlying rmbs deals in our cdo shorts. And
replicate that as best as possible.”2828
Mr. Birnbaum replied: “I like it.”2829 Mr. Swenson responded: “Love it we will give dan
[Sparks] a heart attack.”2830 Two months later, in June 2007, Mr. Swenson wrote Mr. Salem:
“Talk to me now things are developing - dan wants you to be the epicenter of the subprime
universe which is not a bad position to be in.”2831 Mr. Salem replied:
“That’s fine. My number 1 concern is that it[’]s traded by the right people bc [because]
the opportunity is huge. It’s a product that needs to be traded as a prop product. ... U
need to be in charge and we need prop minded guys involved.”2832
That same month, however, the Bear Stearns’ hedge funds collapsed due to losses from their
subprime holdings. In July, the mass ratings downgrades took place, and the RMBS subprime
market began to shut down as well. The Subcommittee saw no evidence that the proprietary
CDO proposed by Mr. Salem was carried out.
In July 2007, Mr. Birnbaum, Goldman’s head ABX trader, remarked that Goldman was
giving John Paulson, the head of the Paulson Partners hedge funds, “a run for his money” in
shorting the mortgage market, and claimed Goldman was “No. 2” behind the Paulson hedge
funds in profiting from a massive net short position.2833 In October 2007, Mr. Birnbaum drafted
a proposal that the SPG Trading Desk be compensated in accordance with a hedge fund model,
rather than through Goldman’s bonus pool, so the desk could obtain a portion of the proprietary
profits it was generating.2834 He discussed the proposal with other Mortgage Department
personnel, but did not present it to senior management.2835 The Mortgage Department personnel
who helped build the net shorts nevertheless received substantial compensation for their 2007
Proprietary trading was not prohibited by law in 2007, and Goldman was free to and did
engage in billions of dollars in mortgage related trades for its own account. The Goldman case
2828 3/3/2007 email from Mr. Salem, “Another idea . . .,” GS MBS-E-012511081.
2829 Id.
2830 Id.
2831 6/7/2007 email from Mr. Swenson to Mr. Salem, “Fyi,” GS MBS-E-012444245.
2832 Id.
2833 7/12/2007 email from Mr. Birnbaum, GS MBS-E-012944742, Hearing Exhibit 4/27-146 (“He’s definitely the
man in this space, up 2-3 bil on this trade. We were giving him a run for his money for a while but now are a
definitive #2.”).
2834 See slides prepared by Mr. Birnbaum, “SPG Trading B 2007,” GS MBS-E-015654036 -50.
2835 Mr. Birnbaum response to Subcommittee QFR at PSI_QFR_GS0509.
2836 Mr. Birnbaum, for example, received $17 million in 2007. Subcommittee interview of Joshua Birnbaum
study also demonstrates how proprietary trading, when undertaken at the same time as trading on
behalf of clients, can give rise to conflicts of interest between the bank’s financial interests and
those of its clients. The new proprietary trading and conflict of interest restrictions in the Dodd-
Frank Act are designed to address and reduce these conflicts.
D. Preventing Investment Bank Abuses
Developments over the past two years offer a number of ways to address problems
identified in the Goldman Sachs and Deutsche Bank case studies. The success of those
alternatives will depend in large part upon how they are implemented, and the degree to which
the market disruptions caused by the financial crisis convince investment banks to realign their
use of structured finance products, curb their proprietary trading, and respect the interests of their
clients. Success will also depend upon sensible implementation of the measures enacted into law
by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).
(1) New Developments
The Dodd-Frank Act contains several measures that affect investment banking practices.
Three key provisions involve proprietary investments, conflicts of interest, and a new study of
permitted banking activities.
Proprietary Trading Restrictions. Commercial banks, their holding companies, and
affiliates, including any investment banks,2837 are prohibited by the Dodd-Frank Act from
engaging in proprietary trading, subject to certain provisions allowing them to continue to serve
clients and reduce risks. 2838 The proprietary trading ban will still allow banks, for example, to
continue to engage in transactions as market makers for clients, hedge their risks, and maintain
very limited investments in private funds they sponsor or manage for others.2839
The proprietary trading provision also addresses conflicts of interest and high risk
activities. It explicitly bars any proprietary trading activity that “would involve or result in a
material conflict of interest … between the banking entity and its clients, customers, or
counterparties,” or that would result “in a material exposure by the banking entity to high-risk
assets or high-risk trading strategies.” 2840 Those express limitations are intended to reduce not
only the risk of proprietary trading losses, but also the conflicts of interest that arise when a
bank-affiliated investment bank enters into an activity that allows it to profit at the expense of its
Investment banks that have no bank affiliation are not subject to the law's proprietary
trading prohibition. If, however, an investment bank is designated by the newly-created
2837 Two of the largest U.S. investment banks, Goldman Sachs and Morgan Stanley, are currently structured as bank
holding companies and so are subject to the ban on proprietary trading.
2838 Section 619 of the Dodd-Frank Act (creating a new §13(a) in the Banking Holding Company Act of 1956).
2839 Id. at §13(d)(1).
2840 Id. at §13(d)(2).
Financial Stability Oversight Council as a systemically critical firm, the Dodd-Frank Act would
subject its proprietary trading to additional capital requirements and quantitative limits. Those
restrictions are intended to ensure large investment banks have sufficient safeguards in place
when engaging in risky proprietary activities to prevent them from damaging the U.S. financial
system as a whole or necessitating a taxpayer bailout if they get into financial trouble.
Private Fund Restrictions. To ensure that the proprietary trading restrictions are
effective, the Dodd-Frank Act prohibits banks and their affiliates, including any investment
banks, from bailing out any private fund they advise or sponsor, including an affiliated hedge
fund or private equity fund. 2841 This prohibition would apply, for example, to Deutsche Bank
and its affiliated hedge fund, Winchester Capital, which made a large proprietary investment in
mortgage related products. 2842 These restrictions would not apply to investment banks that are
not affiliated with a bank. If, however, the investment bank is designated as a systemically
critical firm, it would become subject to additional capital charges to account for the risk that it
may end up bailing out a private fund. The private fund provision also addresses the issue of
eliminating any unfair advantage that banks may have from being able to rely on the special
privileges of being a bank to implicitly guarantee a private fund, and ensures that a federally
insured bank will not be put at risk if an affiliated private fund suffers losses.2843
Conflict of Interest Prohibitions. In 2009, one well known investment adviser
described the link between proprietary trading and conflicts of interest as follows:
“Proprietary trading by banks has become by degrees over recent years an egregious
conflict of interest with their clients. Most if not all banks that prop trade now gather
information from their institutional clients and exploit it. In complete contrast, 30 years
ago, Goldman Sachs, for example, would never, ever have traded against its clients. How
quaint that scrupulousness now seems. Indeed, from, say, 1935 to 1980, any banker who
suggested such behavior would have been fired as both unprincipled and a threat to the
partners’ money.”2844
The Dodd-Frank Act contains two conflict of interest prohibitions to restore the ethical
bar against investment banks and other financial institutions profiting at the expense of their
clients. The first is a broad prohibition that applies in any circumstances in which a firm trades
for its own account, as explained above.2845
2841 Id. at §13(d)(1)(G) and (I); (d)(4); and (f).
The second, in Section 621, imposes a specific,
explicit prohibition on any firm that underwrites, sponsors, or acts as a placement agent for an
asset backed security, including a synthetic asset backed security, from engaging in a transaction
“that would involve or result in any material conflict of interest” with an investor in that
2842 Id. See section discussing Deutsche Bank, above.
2843 Id. See, e.g., 6/12/2010 Cambridge Winter Center report, “Test Case on the Charles,” (explaining how State
Street Bank bailed out the funds it managed, but then itself needed several emergency taxpayer-backed programs).
2844 “Lesson Not Learned: On Redesigning Our Current Financial System,” GMO Newsletter Special Topic, at 2
(10/2009), available at
2845 Section 621 of the Dodd-Frank Act (creating a new § 27B(a) in the Securities Act of 1933).
security.2846 Together, these two prohibitions, if well implemented, will protect market
participants from the self-dealing that contributed to the financial crisis.
Study of Banking Activities. Section 620 of the Dodd-Frank Act directs banking
regulators to review what types of banking activities are currently allowed under federal and
state law, submit a report to Congress and the Financial Stability Oversight Council on those
activities, and offer recommendations to restrict activities that are inappropriate or may have a
negative effect on the safety and soundness of a banking entity or the U.S. financial system. This
study could evaluate, for example, the use of complex structured finance products that are
difficult to understand, have little or no track record on performance, and encourage investors to
bet on the failure rather than the success of financial instruments.
Structured Finance Guidance. In connection with provisions in the Dodd-Frank Act
related to approval of new products and standards of business conduct,2847 the banking agencies,
SEC, and CFTC may update and strengthen existing guidance on new structured finance
products. In 2004, after the collapse of the Enron Corporation, the banking regulators and SEC
proposed joint guidance to prevent abusive structured finance transactions. 2848 This guidance,
which was not finalized until January 2007, was issued in a much weaker form.2849 The final
guidance eliminated, for example, warnings against structured finance products that facilitate
deceptive accounting, circumvention of regulatory or financial reporting requirements, or tax
evasion, as well as detailed guidance on the roles that should be played by a financial institution's
board of directors, senior management, and legal counsel in approving new products and on the
documentation they should assemble.
(2) Recommendations
To prevent investment bank abuses and protect the U.S. financial system from future
financial crises, this Report makes the following recommendations.
1. Review Structured Finance Transactions. Federal regulators should review the
RMBS, CDO, CDS, and ABX activities described in this Report to identify any
violations of law and to examine ways to strengthen existing regulatory prohibitions
against abusive practices involving structured finance products.
2. Narrow Proprietary Trading Exceptions. To ensure a meaningful ban on
proprietary trading under Section 619, any exceptions to that ban, such as for marketmaking
or risk-mitigating hedging activities, should be strictly limited in the
implementing regulations to activities that serve clients or reduce risk.
2846 Id. at § 621.
2847 Section 717 and Title IX of the Dodd-Frank Act.
2848 “Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities,” 69 Fed. Reg.
97 (5/19/2004).
2849 “Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities,”
72 Fed. Reg. 7 (1/11/2007) (issued by the Office of the Comptroller of the Currency; Office of Thrift Supervision;
Federal Reserve System; Federal Deposit Insurance Corporation; and Securities and Exchange Commission).
3. Design Strong Conflict of Interest Prohibitions. Regulators implementing the
conflict of interest prohibitions in Sections 619 and 621 should consider the types of
conflicts of interest in the Goldman Sachs case study, as identified in Chapter VI(C)(6)
of this Report.
4. Study Bank Use of Structured Finance. Regulators conducting the banking
activities study under Section 620 should consider the role of federally insured banks
in designing, marketing, and investing in structured finance products with risks that
cannot be reliably measured and naked credit default swaps or synthetic financial
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