How Goldman profited from subprime meltdown

By The Wall Street Journal

The subprime-mortgage crisis has been a financial catastrophe for much of Wall Street. But at Goldman Sachs, thanks to a tiny group of traders, it has generated one of the biggest windfalls the securities industry has seen in years.

The group's big bet that securities backed by risky home loans would fall in value generated nearly $4 billion of profits during the year that ended Nov. 30, according to sources familiar with the firm's finances. Those gains erased $1.5 billion to $2 billion of mortgage-related losses elsewhere in the firm.

On Tuesday, despite a terrible November and some of the worst market conditions in decades, analysts expect Goldman Sachs (GS, news, msgs) to report a record net annual income of more than $11 billion.

Goldman's trading home run was blasted from an obscure corner of the firm's mortgage department -- the structured-products trading group, which now numbers about 16 traders.

Two of them, Michael Swenson, 40, and Josh Birnbaum, 35, pushed Goldman to wager that the subprime market was heading for trouble. Their boss, mortgage-department head Dan Sparks, 40, backed them during heated debates about how much money the firm should risk.

This year, the three men are expected to be paid between $5 million and $15 million apiece, people familiar with the matter say.

Under Chief Executive Lloyd Blankfein, Goldman has stood out on Wall Street for its penchant for rolling the dice with its own money. The upside of that approach was obvious in the third quarter: Despite credit-market turmoil, Goldman earned $2.9 billion, its second-best three-month period ever. Blankfein is set to be paid close to $70 million this year, according to one person familiar with the matter.

Goldman's success at wringing profits out of the subprime fiasco, however, raises questions about how the firm balances its responsibilities to its shareholders and to its clients.

Making a market

Goldman's mortgage department underwrote collateralized debt obligations, or CDOs, complex securities created from pools of subprime mortgages and other debt. When those securities plunged in value this year, Goldman's customers suffered major losses, as did units within Goldman itself, due to their CDO holdings.

The question now being raised: Why did Goldman continue to peddle CDOs to customers early this year while its own traders were betting that CDO values would fall? A spokesman for Goldman Sachs declined to comment on the issue.

The structured-products trading group that executed the winning trades isn't involved in selling CDOs minted by Goldman, a task handled by others. Its principal job is to "make a market" for Goldman clients trading various financial instruments tied to mortgage-backed securities. That is, the group handles clients' buy and sell orders, often stepping in on the other side of trades if no other buyer or seller is available.

The group also has another mission: If it spots opportunity, it can trade Goldman's own capital to make a profit. And when it does, it doesn't necessarily have to share such information with clients, who may be making opposite bets. This year, Goldman's traders did a brisk business handling trades for clients who were bullish on the subprime-mortgage-securities market. At the same time, they used Goldman's money to bet that market would fall.

Financial firms have good reason to keep a tight leash on proprietary traders. In 1995, bad bets by Nicholas Leeson, a young trader, led to $1.4 billion in losses and the collapse of Barings. Last year, the hedge fund Amaranth Advisors shut down after a young Canadian trader lost more than $6 billion on natural-gas trades. But big trading wins such as George Soros' 1992 bet against the British pound, which netted more than $1 billion for his hedge fund, tend to be talked about for years.

Continued: A more-bearish posture

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