Marco Onado

1. Marco Onado 8196 Comparative Financial Systems April 28, 2010 Goldman and its sisters The new world of investment banking

2. Agenda • The Sec action against Goldman Sachs • The Senate investigations • The possible regulatory consequences • The investment banking is dead. Long live the investment banking

3. The SEC complaint • The Commission brings this securities fraud action against Goldman, Sachs & Co and a GS&C employee, Fabrice Tourre , for making materially misleading statements and omissions in connection with a synthetic collateralized debt obligation ("CDO") GS&Co structured and marketed to investors. • This synthetic CDO, ABACUS 2007ACI, was tied to the performance of subprime residential mortgage-backed securities and was structured and marketed by GS&Co in early 2007 when the United States housing market and related securities were beginning to show signs of distress. Synthetic CDOs like ABACUS 2007-ACI contributed to the recent financial crisis by magnifying losses associated with the downturn in the United States housing market.

4. The SEC complaint • GS&Co marketing materials for ABACUS 2007-ACI- including the term sheet, flip book and offering memorandum for the CDO-all represented that the reference portfolio of RMBS underlying the CDO was selected by ACA Management, a third-party with experience analyzing credit risk in RMBS. • Undisclosed in the marketing materials and unbeknownst to investors, a large hedge fund, Paulson & Co. Inc., with economic interests directly adverse to investors in the ABACUS 2007-ACI CDO, played a significant role in the portfolio selection process.,

5. The SEC complaint • After participating in the selection of the reference portfolio Paulson effectively shorted the RMBS portfolio it helped select by entering into credit default swaps ("CDS") with GS&Co to buy protection on specific layers ofthe ABACUS 2007-ACI capital structure. Given its financial short interest, Paulson had an economic incentive to choose RMBS that it expected to experience credit events in the near future~ GS&Co did not disclose Paulson's adverse economic interests or its role in the portfolio selection process in the term sheet, flip book, offering memorandum or other marketing materials provided to investors.

6. The Sec complaint • In sum, GS&Co arranged a transaction at Paulson's request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors, as part of the description of the portfolio selection process contained in the marketing materials used to promote the transaction, Paulson's role in the portfolio selection process or its adverse economic interests.

7. The Sec complaint • Tourre was principally responsible for ABACUS 2007-ACI. Tourre devised the transaction, prepared the marketing materials and communicated directly with investors. Tourre knew of Paulson's undisclosed short interest and its role in the collateral selection process. Tourre also misled ACA into believing that Paulson invested approximately $200 million in the equity of ABACUS 2007-ACI (a long position) and, accordingly, that Paulson's interests in the collateral section process were aligned with ACA's when in reality Paulson's interests were sharply conflicting.

8. The Sec complaint • The deal closed on April 26, 2007. Paulson paid GS&Co approximately $15 million for structuring and marketing ABACUS 2007-ACl. By October 24,2007,83% of the RMBS in the ABACUS 2007-AC1 portfolio had been downgraded and 17% were on negative watch. By January 29,2008,99% of the portfolio had been downgraded. As a result, investors in the ABACUS 2007-AC1 CDO lost over $1 billion. Paulson's opposite CDS positions yielded a profit of approximately $1 billion for Paulson.

9. The hot issue • The crux of the suit is that the ultimate long investors were not informed about Paulson’s role in selecting the reference portfolio. • And it appears, according to the SEC’s complaint, that Paulson did indeed suggest securities to include, and that Paulson’s role in this was not disclosed to IKB

10. The partiesinvolved Goldman Sachs • Investors • IKB • Abn Amro Paulson’s hedge fund ACA Cap Mgmt

11. The structureof the trade Notionalequity ca. 20% of total

12. The layers • Notional equity 20% = $360 mn (synthetic CDO: a pure convention between the two parties) • Next layer: 440 Credit Linked Notes (IKB and ACA) • Super Senior Layer: $90 mn (Goldman Sachs) • Super Senior Tranche: $910 mn

13. The CDS part of the deal • In turn, because of the size of the credit exposure that this implied for the central counterparty, Goldman, ACA entered into a Credit Default Swap that served to substitute ABN Amro risk (later Royal Bank of Scotland) for that of ACA (see next slide).

15. The rationaleof the Cds • GS was the central counterparty, facing off against both the long and the short side, and protecting against credit risk of its counterparties with a combination of CDS and collateral posting. • A key reason to have a broker/ dealer at the center of the structure is to allow the buyer and seller in a transaction to maintain their identities private; another is to allow each to have exposure to an institution known to them rather than maintaining a direct exposure to a counterparty or counterparties it is less familiar with, or whose credit it does not want to take

16. Senator Carl Levin, Apr 27 2010 • Goldman Sachs and other investment banks, when acting properly, play an important role in our economy. They help channel the nation’s wealth into productive activities that create jobs and make economic growth possible, bringing together investors and businesses and helping Americans save for retirement or a child’s education. • Why does this matter? Surely there is no law, ethical guideline or moral injunction against profit. But Goldman Sachs didn’t just make money. It profited by taking advantage of its clients’ reasonable expectation that it would not sell products that it didn’t want to succeed, and that there was no conflict of economic interest between the firm and the customers it had pledged to serve. Goldman’s actions demonstrate that it often saw its clients not as valuable customers, but as objects for its own profit

17. SenatePermanentSubcommittee on Investigationsfindings on Goldman Sachs • Securitizing high riskmortgages • Magnifyingrisk • Shorting the mortgage market • Conflictbetween client and proprietart trading • Abacustransaction • UsingnakedCredit Default Swaps

18. Securitising high riskmortgages • GS contributed to securitize loans for bad lenders such as Washingon Mutual • WaMu, Long Beach, and Goldman Sachs collaborated on at least $14 billion in loan sales and securitizations, even though Long Beach originated some of the worst performing subprime mortgages in the country. • In 2005, Long Beach saw a surge of early payment defaults and had to repurchase over $875 million of nonperforming loans from investors, as well as book a $107 million loss. Internal audits of Long Beach and examinations by the Office of Thrift Supervision repeatedly identified lax lending standards, poor controls over loan officers. Long Beach securitizations had among the worst credit losses in the industry from 1999-2003, and in 2005 and 2006 Long Beach securities were among the worst performing in the market

19. Securitising high riskmortgages • Nevertheless, in May 2006 Goldman Sachs acted as co-lead underwriter with WaMu to securitize about $532 million in subprime second lien, fixed rate mortgages originated by Long Beach issued about $495 million in RMBS securities backed by the Long Beach high risk mortgages. • The top three tranches, representing 66 percent of the principal loan balance, received AAA ratings from S&P, even though the pool contained high risk, subprime second lien mortgages—loans for which there was little prospect of recovering collateral in the event of a housing downturn—issued by one of the nation’s worst mortgage lenders

20. Securitising high riskmortgages • Goldman Sachs then sold the Long Beach securities to investors. • In less than a year, the Long Beach loans started to become delinquent. By May 2007,the cumulative net loss on the underlying mortgage pool jumped to over 12 percent, wiping out asignificant amount of the deal’s loss protection and causing S&P to downgrade 6 out of 7 of themezzanine tranches of the securitization. The Long Beach securities plummeted in value.

21. Goldman Sachs owned some of the mezzanine securities, but had also placed a bet against themby purchasing a credit default swap that paid off if the securities incurred loss. One Goldmanemployee, upon learning of the Long Beach losses, wrote in an email to management: “badnews… [the loss] wipes out the m6s and makes a wipeout of the m5 imminent… costs us about2.5[million dollars]… good news… we own 10[million dollars] protection at the m6… we make$5[million].” Ultimately, in this transaction, Goldman Sachs profited from the decline of thevery security it had earlier sold to clients. By May 2008—only two years later—even the AAAsecurities in LBMLT 2006-A had been downgraded to default status. By March 2010, thesecurities recorded a cumulative net loss of over 66 percent.

22. Goldman Sachs shorting the mortgage market • Goldman Sachs senior management closely monitored the holdings and the profit and loss performance of its mortgage department. • In late 2006, when high risk mortgages began showing record delinquency rates, and the value of RMBS and CDO securities began falling generally, Goldman Sachs Chief Financial Officer • David Viniar convened a meeting on December 14, 2006, to examine the data and consider how to respond.

23. Goldman Sachs shorting the mortgage market • Beginning in early 2007, Goldman Sachs initiated an intensive effort to not only reduce its mortgage risk exposure, but profit from high risk RMBS and CDO securities incurring losses. • A presentation to the Goldman Sachs Board of Directors identified a number of actions taken during the year, including: “Shorted synthetics” and “Shorted CDOs and RMBS

24. Senator Levin’s position • But Goldman Sachs did more than earn fees from the synthetic instruments it created. Goldman also bet against the mortgage market, and earned billions when that market crashed. In December 2006, Goldman decided to move away from its “long” positions in the mortgage market in what began as prudent hedging against the firm’s large exposure to that market, exposure that sparked concern on the part of the firm’s senior executives. The edict from top management after a Dec. 14, 2006 meeting was “get closer to home,” meaning get to a more neutral risk position. But by early 2007, the company blew right past a neutral position on the mortgage market and began betting heavily on its decline, often using complex financial instruments, including synthetic collateralized debt obligations, or CDOs.

25. Senator Levin’s position • Goldman took large net short positions throughout 2007. This chart, which is based upon data supplied to the Subcommittee by Goldman Sachs, tracks the firm’s ongoing huge net short positions throughout the year. These short positions at one point represented approximately 53% of the firm’s risk as measured by the most relied upon risk measure, “Value at Risk” or “VaR.” And these short positions did more than just avoid big losses for Goldman. They generated a large profit for the firm in 2007.

26. Possibleregulatoryactions • Tighter capital requirements • Separation (Volcker rule) • From Otc to regulated markets • Stricter fiduciary duties

27. The strengths and weaknessesof the investmentbanks’ businessemodel • Two drivers of profitability • Leverage • Rotation (earnings per volume of assets) • Leverage can mean fragility • Rotation can mean • Aggressive search for fees • Insufficient liquidity support for positions

28. The 4 livesofinvestment banking accordingto a researchfromNatixis. Returns