Goldman “Shorted” Mortgages Because World Wouldn’t Expect It

Washington – A key Goldman Sachs trading manager indicated in his personnel performance review that he could use the “fear” in the market of a coming collapse in the nation’s mortgage market to make profits for the Wall Street firm, documents released Tuesday show.

Former trader Joshua Birnbaum wrote that because “the world would think” Goldman Sachs would invest in the mortgage market for the long term, the firm should “flip our risk” and bet on an impending crisis.

“We could use that fear to our advantage if we could flip our risk,” he wrote.

The disclosure was among hundreds of documents the Senate Permanent Subcommittee on Investigations, chaired by Michigan Democrat Carl Levin, released at the beginning of a hearing into the role of investment banks – and particularly Goldman Sachs – in the nation’s recent economic collapse.

The Birnbaum memo also suggests that Goldman executives were creating a strategy to profit from risky mortgages at the same time they were selling similar products to unsuspecting clients.

Birnbaum began testifying about 11 a.m. Goldman chief executive Lloyd Blankfein is scheduled to testify later today, the last of seven Goldman officials due to testify under oath.

In his testimony, Birnbaum said there was a vigorous debate within Goldman about which way the housing market was headed. He said that nobody from senior management told him to make an overall “directional bet” against the subprime market, but simply to reduce risk overall.

He said he is “very proud” of his tenure at Goldman. “We provided significant liquidity to our customers in a difficult and challenging market while also managing to post a profit during this period,” he said.

Comparing his panel’s investigation to inquiries into the causes of the Great Depression, Levin said that what investigators see now is similar to what they saw in the 1930s. “The parallels are unmistakable to today’s events,” Levin said.

Held before a packed, standing-room only Senate room, the hearing met all the criteria of a Washington zoo, with protesters in prison uniforms demanding that Goldman executives do jail time and dozens of cameras trailing witnesses as they walked into the room.

When four current and former Goldman traders took seats at the witness table, they quickly learned what it means to be in the middle of a Washington scandal. A crush of photographers encircled them, setting off a rat-a-tat of clicking cameras.

In his opening statement, Levin directly took on Goldman’s contention – made repeatedly in recent weeks – that it did not profit at its clients’, or the nation’s, expense.

“The evidence also shows that repeated public statements by the firm and its executives provide an inaccurate portrayal of Goldman’s actions during 2007, the critical year when the housing bubble burst and the financial crisis took hold,” Levin said. “The firm’s own documents show that while it was marketing risky mortgage-related securities, it was placing large bets against the U.S. mortgage market.”

He later added that the actions Goldman took undermine the pretense that it was acting as a mere “market-maker” on Wall Street _ or simply working to match buyers and sellers. “They represented major bets that the mortgage securities market – a market Goldman helped create – was in for a major decline,” Levin said.

The hearing put under a microscope the firm’s contention that it was only responsibly managing its risk by making negative bets on the housing market as it crested in late 2006 and 2007. Levin and his team of subcommittee investigators found that instead, many of those negative bets exploited clients, who had a reasonable expectation that Goldman would not sell products to them that would later drop in value.

In his opening statement, the Goldman executive at the heart of a fraud case brought by the Securities and Exchange Commission offered a spirited defense.

“I deny – categorically – the SEC’s allegation. And I will defend myself in court against this false claim,” said Fabrice Tourre, a London-based executive director of a Goldman unit that prepares complex deals.

The SEC contends that Tourre, and Goldman, failed to disclose to investors that a prominent hedge fund manager, John Paulson, helped pick mortgages that he believed would fail in order to bet against the complex security being put together by Goldman.

Eric Kolchinsky, a former executive from Moody’s Investors Service, told the subcommittee last Friday that he was not made aware of this information and it could have changed the way the ratings agency would have rated the deal that was eventually offered to investors as investment grade.

Tourre told Levin’s panel today that others involved in the deal were sophisticated investors and that he did in fact disclose key information about the hedge fund manager Paulson, whose firm famously made more than $1 billion betting against the U.S. housing market.

Tourre denied that the complex deal being probed by the SEC was designed to fail, and said that the securities referenced in the deal “did not underperform” other securities in the same ratings class and year of the transaction.