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The subprime trading gains notched by Birnbaum and Swenson and their Goldman associates are large by recent Wall Street standards. Traders at Deutsche Bank (DB, news, msgs) and Morgan Stanley (MS, news, msgs) also bet against the subprime-mortgage market this year, but in each case, their gains were essentially wiped out because their firms underestimated how far the markets would fall.
New York hedge-fund company Paulson also turned a considerable profit on the subprime meltdown this year, as did Hayman Capital Partners, a Dallas hedge-fund firm, say people familiar with the matter.
As recently as a year ago, few on Wall Street thought that the market for home loans made to risky borrowers, known as subprime mortgages, was heading for disaster. At that point, Goldman was bullish on bonds backed by such loans.
Last December, Sparks, a longtime trader of bond-related products, was named head of Goldman's 400-person mortgage department. That gave him a seat on the firm's risk committee, which numbers about 30 and meets weekly to hash out the firm's risk profile. It also gave him authority over the structured-products trading group, which then had just eight traders and was run jointly by Swenson and David Lehman, 30, a former Deutsche Bank trader.
Swenson, known as Swenny on the trading desk, is a former Williams College hockey player with four children and an acid wit. A veteran trader of asset-backed securities, he joined Goldman in 2000. In late 2005, he helped persuade Birnbaum, a Goldman veteran, to join the group. Birnbaum had developed and traded a new security tied to mortgage rates.
Swenson and Sparks, then No. 2 in the mortgage department, wanted Birnbaum to try his hand at trading related to the first ABX index, which was scheduled to launch in January 2006. Because securities backed by subprime mortgages trade privately and infrequently, their values are hard to determine. The ABX family of indexes was designed to reflect their values based on instruments called credit-default swaps.
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A more bearish posture
These swaps, in essence, are insurance contracts that pay out if the securities backed by subprime mortgages decline in value. Such swaps trade more actively, with their values rising and falling based on market sentiments about subprime default risk.Swenson and Sparks told Birnbaum the ABX was going to be a hot product, according to people with knowledge of their pitch.
They were right. On the first day of trading, Goldman netted $1 million in trading profits. But the index was tough to trade. In comparison to huge markets like Treasury bonds, there wasn't much buying and selling. That meant that Swenson's team nearly always had to use Goldman's capital to complete trades for clients looking to buy or sell.
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During a discussion with Sparks and others, Viniar noted that Goldman had big exposure to the subprime mortgage market because of CDOs and other complex securities it was holding. Emerging signs of weakness in the market meant that Goldman needed to hedge its bets, the group concluded.
Swenson and his traders began shorting certain slices of the ABX, or betting against them, by buying credit-default swaps. At that time, new subprime mortgages still were being pumped out at a rapid clip, and gloom hadn't yet descended on the market. As a result, the swaps were relatively cheap.
Continued: Leaving money on the table
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