Clients Worried About Goldman’s Dueling Goals

“Questions have been raised that go to the heart of this institution’s most fundamental value: how we treat our clients.” — Lloyd C. Blankfein, Goldman Sachs’s C.E.O., at the firm’s annual meeting in May

As the housing crisis mounted in early 2007, Goldman Sachs was busy selling risky, mortgage-related securities issued by its longtime client, Washington Mutual, a major bank based in Seattle.

Goldman Sachs CEO Lloyd Blankfein
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Goldman Sachs CEO Lloyd Blankfein

Although Goldman had decided months earlier that the mortgage market was headed for a fall, it continued to sell the WaMu securities to investors. While Goldman put its imprimatur on that offering, traders in the same Goldman unit were not so sanguine about WaMu’s prospects: they were betting that the value of WaMu’s stock and other securities would decline.

Goldman’s wager against its customer’s stock — a position known as a “short” — was large enough that it would have generated at least $10 million in profits if WaMu collapsed, according to documents recently released by Congress. And by mid-May, Goldman’s bet against other WaMu securities had made Goldman $2.5 million, the documents show.

WaMu eventually did collapse under the weight of souring mortgage loans; federal regulators seized it in September 2008, making it the biggest bank failure in American history.

Goldman’s bets against WaMu, wagers that took place even as it helped WaMu feed a housing frenzy that Goldman had already lost faith in, are examples of conflicting roles that trouble its critics and some former clients. While Goldman has legions of satisfied customers and maintains that it puts its clients first, it also sometimes appears to work against the interests of those same clients when opportunities to make trading profits off their financial troubles arise.

Goldman’s access to client information can also give its traders an advantage that many of the firm’s competitors lack. And because betting against a company’s shares or its debt can create an atmosphere of doubt about a company’s financial standing, Goldman because of its size and its position in the market can help make the success of some of its wagers faits accomplis.

Lucas van Praag, a Goldman spokesman, declined to say how much the firm earned on its bets against WaMu’s stock. He said his firm lost money on its bets against the other WaMu securities. In an e-mail reply to questions for this article, he said there was nothing improper about Goldman’s wagers against any of its clients. “Shorting stock or buying credit protection in order to manage exposures are typical tools to help a firm reduce its risk.”

WaMu is not the only Goldman client the firm bet against as the mortgage disaster gained steam. Documents released by the Senate Permanent Subcommittee on Investigations show that Goldman’s mortgage unit also wagered against Bear Stearns and Countrywide Financial, two longstanding clients of the firm. These documents are only related to the mortgage unit and it is unknown what other bets the rest of the firm made.

Goldman also bet against the American International Group , which insured Goldman’s mortgage bonds, and National City, a Cleveland bank the firm had advised on a sale of a big subprime mortgage lender to Merrill Lynch.

While no one has accused Goldman of anything illegal involving WaMu, National City, A.I.G. or the other clients it bet against, potential conflicts inherent in Wall Street’s business model are at the core of many of the investigations that state and federal authorities are conducting. Transactions entered into as the mortgage market fizzled may turn out to have been perfectly legal. Nevertheless, they have raised concerns among investors and analysts about the extent to which a variety of Wall Street firms put their own interests ahead of their clients’.

“Now it’s all about the score. Just make the score, do the deal. Move on to the next one. That’s the trader culture,” said Cornelius Hurley, director of the Morin Center for Banking and Financial Law at Boston University and former counsel to the Federal Reserve Board. “Their business model has completely blurred the difference between executing trades on behalf of customers versus executing trades for themselves. It’s a huge problem.”

Goldman has come under particularly intense scrutiny on such issues since the financial and economic downturn began gathering momentum in 2007, in part because it has done so well, in part because of the power it wields in Washington and on Wall Street, and in part because regulators have taken a keen interest in its dealings.

The Securities and Exchange Commission filed a civil fraud suit against the firm last month, contending that it misled clients who bought a mortgage security that the regulators said was intended to fail. Goldman has said it did nothing wrong and is fighting the case. Legislators in Washington are also considering financial reforms that limit potential conflicts of interest in the way that firms like Goldman trade and invest their own money.

The 15th Principle

Still, Goldman’s many hats — trader, adviser, underwriter, matchmaker of buyers and sellers, and salesperson — has left some clients feeling bruised or so wary that they have sometimes avoided doing business with the bank.

During the early stages of the mortgage crisis, Goldman seems to have unnerved WaMu’s former chief executive, Kerry K. Killinger, according to an e-mail message that Congressional investigators released.

In that message, Mr. Killinger noted that he had avoided retaining Goldman’s investment bankers in the fall of 2007 because he was concerned about how the firm would use knowledge it gleaned from that relationship. He pointed out that Goldman was “shorting mortgages big time” even while it had been advising Countrywide, a major mortgage lender.

“I don’t trust Goldy on this,” he wrote. “They are smart, but this is swimming with the sharks.”

One of Mr. Killinger’s lieutenants at Washington Mutual felt the same way. “We always need to worry a little about Goldman,” that person wrote in an e-mail message, “because we need them more than they need us and the firm is run by traders.”

Mr. Killinger does not appear to have known that Goldman was selling short his company’s shares. His lawyer did not respond to requests for comment. But because Bear Stearns, National City, Countrywide and WaMu all were hammered by the mortgage crisis, any bets Goldman made against each of those firm’s shares were likely to have been profitable.

Even though Goldman had frequently shorted the shares of other firms, it, along with another bank, Morgan Stanley, successfully lobbied the S.E.C. in 2008, at the height of the mortgage collapse, to forbid traders from shorting financial shares, sparing its own stock.


As Trading Arm Grows, a Clash of Purpose

When new hires begin working at Goldman, they are told to follow 14 principles that outline the firm’s best practices. “Our clients’ interests always come first” is principle No. 1. The 14th principle is: “Integrity and honesty are at the heart of our business.”

But some former insiders, who requested anonymity because of concerns about retribution from the firm, say Goldman has a 15th, unwritten principle that employees openly discuss.


It urges Goldman workers to embrace conflicts and argues that they are evidence of a healthy tension between the firm and its customers. If you are not embracing conflicts, the argument holds, you are not being aggressive enough in generating business.

Mr. van Praag said the firm was “unaware” of this 15th principle, adding that “any business in any industry, has potential conflicts and we all have an obligation to manage them effectively.”

But a former Goldman partner, who spoke on condition of anonymity, said that the company’s view of customers had changed in recent years. Under Lloyd C. Blankfein, Goldman’s chief executive, and a cadre of top lieutenants who have ramped up the firm’s trading operation, conflict avoidance had shifted to conflict management, this person said. Along the way, he said, the firm’s executives have come to see customers more as competitors they trade against than as clients.

In fact, Mr. Blankfein and Goldman are quick to remind critics that Wall Street deals with sophisticated investors, who they say can protect themselves. At the bank’s shareholder meeting earlier this month, Mr. Blankfein said, “We deal with the most demanding and, in some cases, cynical clients.”

Even Goldman’s mortgage department compliance training manual from 2007 acknowledges the challenges posed by the firm’s clients-come-first rule. Loyalty to customers “is not always straightforward” given the multiple financial hats Goldman wears in the market, the manual notes.

In addition, the manual explains how Goldman uses information harvested from clients who discuss the market, indicate interest in securities or leave orders consisting of “pretrade information.” The manual notes that Goldman also can deploy information it receives from a wide range of other sources, including data providers, other brokerage firms and securities exchanges.

“We continuously make markets and take risk based on a unique window on the market which is a mosaic constructed of all of the pieces of data received,” the manual said.

Mr. van Praag, the Goldman spokesman, said that the “manual recognizes that like many businesses, and certainly all our competitors, we serve multiple clients. In the process of serving multiple clients we receive information from multiple sources.”

Creative destruction

“This policy and the excerpt cited from the training manual simply reflects the fact that we have a diverse client base and give our sales people and traders appropriate guidance,” he added.


Fostering a Market Then Abandoning It

Even now, two years after a dispute with Goldman, C. Talbot Heppenstall Jr. gets miffed talking about the firm.

As treasurer at the University of Pittsburgh Medical Center, a leading nonprofit health care institution, Mr. Heppenstall had once been pleased with Goldman’s work on the enterprise’s behalf.

Beginning in 2002, Goldman had advised officials at U.P.M.C. to raise funds by issuing auction-rate securities. Auction-rate securities are stock or debt instruments with interest rates that reset regularly (usually weekly) in auctions overseen by the brokerage firms that sell them. Municipalities, student loan companies, mutual funds, hospitals and museums all used the securities to raise operating funds.

Goldman had helped to develop the auction-rate market and advised many clients to issue them, getting an annual fee for sponsoring the auctions. Between 2002 and 2008, U.P.M.C. issued $400 million; Goldman underwrote $160 million, while Morgan Stanley and UBS sold the rest.

But in the fall of 2007, as the credit crisis deepened, investors began exiting the $330 billion market, causing interest rates on the securities to drift upward. By mid-January 2008, U.P.M.C. was concerned about the viability of the market and asked Goldman if the hospital should get out. Stay the course, Goldman advised U.P.M.C. in a letter, a copy of which Mr. Heppenstall read to a reporter.

On Feb. 12, less than a month after that letter, Goldman withdrew from the market — the first Wall Street firm to do so, according to a Federal Reserve report. Other firms quickly followed suit.

With the market in disarray, the interest rates that U.P.M.C. and other issuers had to pay investors skyrocketed. Rather than pay the rates, U.P.M.C. decided to redeem the securities.

Although Goldman had fled the market, it refused to allow a redemption to proceed, Mr. Heppenstall said, warning that its contract with the hospital barred U.P.M.C. from buying back the securities for at least another month.

U.P.M.C. had to continue paying lofty interest rates — as well as Goldman’s fees, even though the firm was no longer sponsoring the auctions, according to Mr. Heppenstall.

Goldman had been U.P.M.C.’s investment banker for about six years, Mr. Heppenstall noted in an interview, but this incident marked the end of that relationship. He said that the other Wall Street firms that had underwritten U.P.M.C.’s auction-rate securities, Morgan Stanley and UBS, had allowed it to redeem them. Goldman was the only firm that did not.

“This conflict was the last straw in our relationship with Goldman Sachs and we no longer do any business with them,” he said.

Mr. van Praag, the Goldman spokesman, declined in his e-mail message to respond in detail to U.P.M.C.’s complaints, other than to say that a contract is a contract and that governed how Goldman interacted with the hospital.

“The legal agreements that governed U.P.M.C.’s A.R.S. securities did not allow U.P.M.C. to bid for its own securities in the auctions,” he said.


Brokering State Debt and Advising Against It

A state assemblyman in New Jersey named Gary S. Schaer also has had unsettling encounters with Goldman.

Mr. Schaer, who heads the New Jersey Assembly’s Financial Institutions and Insurance Committee, said he became wary in 2008 when he learned that Goldman, one of the state’s main investment bankers, was encouraging speculators to bet against New Jersey’s debt in the derivatives market. (At the time, a former Goldman chief executive, Jon Corzine, was New Jersey’s governor).

Closing the ranks

Goldman had managed $4.2 billion in debt issuance for the state since 2004, receiving fees for arranging those deals.

A 59-page collection of trading ideas that Goldman put together in 2008, and which was reviewed by The New York Times, shows the firm recommending that customers buy insurance to protect themselves against a debt default by New Jersey. In addition to New Jersey, Goldman advocated placing bets against the debt of eight other states in the trading book. Goldman also underwrote debt for all but two of those states in 2008, according to Thomson Reuters.

Mr. Schaer complained to Mr. Blankfein in a letter in December 2008. A response came back from Kevin Willens, a managing director in Goldman’s public finance unit; he argued that Goldman maintained impermeable barriers between its unit that had helped New Jersey raise debt and another unit that was urging investors to bet against the state’s ability to repay that debt. Mr. Schaer replied that he doubted the barriers were impenetrable.

Goldman Sachs CEO Lloyd Blankfein
Goldman Sachs CEO Lloyd Blankfein

“New Jersey taxpayers cannot be expected to pay tens of millions of dollars in investment banking fees while another department of the very same firm — albeit one clearly and strategically walled off — actively or aggressively advocates the sale of the very same or similar bonds in the aftermath,” Mr. Schaer wrote.

Mr. Schaer said in an interview that he tried to get regulations passed to prevent banks from playing such dual roles in state finances, but has made little headway.

“I hope the federal government will undertake this problem, and it is a problem,” he said. “It’s unrealistic to think the wall — no matter how thick or how tall — will be effective.”

Goldman’s many financial roles have raised concerns well beyond the state level. Over the years, it has played the role of adviser and fund-raiser for a diverse range of countries, while occasionally drawing criticism for simultaneously betting against the ability of some countries, like Russia, to repay their debts.


As Client Positions Sour, Goldman Defends Own

Goldman’s powerful and nimble trading desk has become a reliable fountain of profits for the firm. But it has also instilled fear among some clients who say they believe, as Mr. Killinger and others at Washington Mutual did, that Goldman trades against the interests of some of its clients.

Trading desks make big bets using the firm’s and clients’ money. Goldman’s trading operation has grown so pivotal and influential that many analysts say the firm as a whole now operates more like a hedge fund than an investment bank — another benchmark of the firm’s internal evolution that can create new friction with clients.

For example, if Goldman makes a proprietary bet in a particular market, as it did in early 2007 when it amassed a huge wager against mortgages, what stops it from positioning itself against clients who operate in that market?

Bear Stearns, a now defunct investment bank, is a case in point.

With the housing crisis gathering steam in March 2007, Goldman created and sold to clients a $1 billion package of mortgage-related securities called Timberwolf. Within months, investors lost 80 percent of their money as Timberwolf plummeted.

Arguing is pointless

Bear bought a $300 million slice of Timberwolf through some of its funds, and the investment was disastrous. The funds collapsed under the weight of Timberwolf and other errant investments, beginning a downward spiral for Bear itself that ended a year later with the firm forced into the arms of JPMorgan Chase to prevent a bankruptcy.

Goldman, however, benefited from the problems its securities helped to create, Congressional documents show. Around the same time that Bear was investing in Timberwolf, Goldman was placing a bet that Bear’s shares would fall. Goldman’s short position in Bear was large enough that it would have generated as much as $33 million in profits if Bear collapsed, according to the documents.

Mr. van Praag, a Goldman spokesman, declined in the e-mail message to say how much the firm earned on those bets or whether they were still on when Bear finally collapsed.

Goldman was busy with other clients as well during 2007, including Thornburg Mortgage, a high-end lender. Goldman was one of 22 financial companies that lent money to Thornburg; it was using about $200 million of a Goldman credit line backed by mortgage loans.

In August 2007, Goldman was the first firm to begin aggressively marking down the value of Thornburg assets used as collateral for the loan. Goldman said the assets were not valuable enough to repay the loan if Thornburg defaulted. Goldman demanded more cash to shore up the account.

According to five people briefed on the relationship who requested anonymity because they didn’t want to damage continuing business relationships, Goldman told Thornburg that the request was justified because the value of similar mortgages traded by other parties had been priced at lower levels. But Goldman, according to two people with knowledge of the situation, had not actually seen such trades.

Thornburg officials, however, pushed back on Goldman’s request, questioning the values the firm put on Thornburg’s portfolio. “When we tried to negotiate price, they argued that they were aware of transactions that were not broadly known on the Street,” said a former Thornburg employee briefed on the talks with Goldman. “That was their justification for why they were marking us down as aggressively as they were — that they were aware of things that others were not.”

Even as Goldman pressured Thornburg for cash, a Goldman banker pitched Thornburg to hire the firm to help it raise new funds. Thornburg turned elsewhere.

Thornburg wasn’t the only firm Goldman pressured this way. It made similar demands — using similar arguments — of A.I.G., the insurer that stood behind many of Goldman’s mortgage securities. Ultimately, Goldman’s demands drained the insurer of so much cash that a hobbled A.I.G. required a taxpayer bailout in September 2008. Meanwhile, Goldman had been buying protection against a possible debt default by A.I.G. at the same time that it was pressuring A.I.G. to pay it additional cash. Because Goldman’s own cash demands were weakening A.I.G., Goldman had a front-row seat to the distress the company was experiencing — giving Goldman added insight that buying default insurance on A.I.G. was probably a shrewd investment.

Although Goldman’s financial insight derived from proprietary dealings with A.I.G., and included facts that others in the market most likely didn’t have, Mr. van Praag, the Goldman spokesman, said that his firm was not capitalizing on nonpublic information.

Like A.I.G., Thornburg found that arguing with Goldman was fruitless, because the firm had favorable contracts with Thornburg governing disputes. So Thornburg accepted Goldman’s valuations, but then established credit lines with other banks.

Although Goldman lost a customer, its mortgage unit had gained a victory: the firm could cite the valuations that Thornburg accepted as proper pricing for mortgage securities when it got into similar disputes with other clients.

“If they could move our positions, they could then argue with A.I.G. or some of their other big positions that our marks were where the market was,” the former Thornburg employee said. “They could have this sort of client arbitrage going on.”

Mr. van Praag, the Goldman spokesman, said his firm’s dispute with Thornburg was about differing standards for valuing collateral, nothing more.

“We are a ‘mark to market’ institution and we mark our positions on a daily basis to reflect what we believe is the current value for a security if we decided to sell it,” he said. “Those marks are verified by our controllers department, which is independent from the securities division.”

Goldman said that the mortgage collapse and Thornburg’s financial problems vindicate the posture it took on how to value Thornburg’s collateral. “Subsequent events clearly indicated that our marks were accurate and realistic,” Mr. van Praag said.

Indeed, soon after Goldman demanded more funds from Thornburg, analysts began downgrading its shares on news of the collateral calls. Beaten down by the broader mortgage collapse, Thornburg filed for bankruptcy protection on May 1, 2009.