[THS] How Goldman Secretly Bet on the US Housing Crash

[Peter Webster]

http://www.truthout.org/1101095

How Goldman Secretly Bet on the US Housing Crash

Sunday 01 November 2009

by: Greg Gordon   |  McClatchy Newspapers

photo
Goldman Sachs failed to disclose that they knew there appraisals of home values had
been inflated. (Photo Illustration: Jared Rodriguez / t r u t h o u t; Adapted from:
dandeluca, respres)

     Washington - In 2006 and 2007, Goldman Sachs Group peddled more than $40
billion in securities backed by at least 200,000 risky home mortgages, but never told
the buyers it was secretly betting that a sharp drop in U.S. housing prices would
send the value of those securities plummeting.

     Goldman's sales and its clandestine wagers, completed at the brink of the housing
market meltdown, enabled the nation's premier investment bank to pass most of its
potential losses to others before a flood of mortgage defaults staggered the U.S. and
global economies.

     Only later did investors discover that what Goldman had promoted as triple-A
rated investments were closer to junk.

     Now, pension funds, insurance companies, labor unions and foreign financial
institutions that bought those dicey mortgage securities are facing large losses, and a
five-month McClatchy investigation has found that Goldman's failure to disclose that it
made secret, exotic bets on an imminent housing crash may have violated securities
laws.

     "The Securities and Exchange Commission should be very interested in any
financial company that secretly decides a financial product is a loser and then goes
out and actively markets that product or very similar products to unsuspecting
customers without disclosing its true opinion," said Laurence Kotlikoff, a Boston
University economics professor who's proposed a massive overhaul of the nation's
banks. "This is fraud and should be prosecuted."

     John Coffee, a Columbia University law professor who served on an advisory
committee to the New York Stock Exchange, said that investment banks have wide
latitude to manage their assets, and so the legality of Goldman's maneuvers depends
on what its executives knew at the time.

     "It would look much more damaging," Coffee said, "if it appeared that the firm
was dumping these investments because it saw them as toxic waste and virtually
worthless."

     Lloyd Blankfein, Goldman's chairman and chief executive, declined to be
interviewed for this article.

     A Goldman spokesman, Michael DuVally, said that the firm decided in December
2006 to reduce its mortgage risks and did so by selling off subprime-related securities
and making myriad insurance-like bets, called credit-default swaps, to "hedge"
against a housing downturn.

     DuVally told McClatchy that Goldman "had no obligation to disclose how it was
managing its risk, nor would investors have expected us to do so ... other market
participants had access to the same information we did."

     For the past year, Goldman has been on the defensive over its Washington
connections and the billions in federal bailout funds it received. Scant attention has
been paid, however, to how it became the only major Wall Street player to extricate
itself from the subprime securities market before the housing bubble burst.

     Goldman remains, along with Morgan Stanley, one of two venerable Wall Street
investment banks still standing. Their grievously wounded peers Bear Stearns and
Merrill Lynch fell into the arms of retail banks, while another, Lehman Brothers,
folded.

     To piece together Goldman's role in the subprime meltdown, McClatchy reviewed
hundreds of documents, SEC filings, copies of secret investment circulars, lawsuits
and interviewed numerous people familiar with the firm's activities.

     McClatchy's inquiry found that Goldman Sachs:

     * Bought and converted into high-yield bonds tens of thousands of mortgages
from subprime lenders that became the subjects of FBI investigations into whether
they'd misled borrowers or exaggerated applicants' incomes to justify making hefty
loans.

     * Used offshore tax havens to shuffle its mortgage-backed securities to institutions
worldwide, including European and Asian banks, often in secret deals run through
the Cayman Islands, a British territory in the Caribbean that companies use to bypass
U.S. disclosure requirements.

     * Has dispatched lawyers across the country to repossess homes from bankrupt
or financially struggling individuals, many of whom lacked sufficient credit or income
but got subprime mortgages anyway because Wall Street made it easy for them to
qualify.

     * Was buoyed last fall by key federal bailout decisions, at least two of which
involved then-Treasury Secretary Henry Paulson, a former Goldman chief executive
whose staff at Treasury included several other Goldman alumni.

     The firm benefited when Paulson elected not to save rival Lehman Brothers from
collapse, and when he organized a massive rescue of tottering global insurer
American International Group while in constant telephone contact with Goldman chief
Blankfein. With the Federal Reserve Board's blessing, AIG later used $12.9 billion in
taxpayers' dollars to pay off every penny it owed Goldman.

     These decisions preserved billions of dollars in value for Goldman's executives and
shareholders. For example, Blankfein held 1.6 million shares in the company in
September 2008, and he could have lost more than $150 million if his firm had gone
bankrupt.

     With the help of more than $23 billion in direct and indirect federal aid, Goldman
appears to have emerged intact from the economic implosion, limiting its subprime
losses to $1.5 billion. By repaying $10 billion in direct federal bailout money Ñ a 23
percent taxpayer return that exceeded federal officials' demand Ñ the firm has
escaped tough federal limits on 2009 bonuses to executives of firms that received
bailout money.

     Goldman announced record earnings in July, and the firm is on course to surpass
$50 billion in revenue in 2009 and to pay its employees more than $20 billion in year-
end bonuses.

     The Bluest of the Blue Chips

     For decades, Goldman, a bastion of Ivy League graduates that was founded in
1869, has cultivated an elite reputation as home to the best and brightest and a
tradition of urging its executives to take turns at public service.

     As a result, Goldman has operated a virtual jobs conveyor belt to and from
Washington: Paulson, as Treasury secretary, sent tens of billions of taxpayers' dollars
to rescue Wall Street in 2008, and former Goldman employees populate some of the
most demanding and powerful posts in Washington. Savvy federal regulators have
migrated from their Washington jobs to Goldman.

     On Oct. 16, a Goldman vice president, Adam Storch, was named managing
executive of the SEC's enforcement division.

     Goldman's financial panache made its sales pitches irresistible to policymakers and
investors alike, and may help explain why so few of them questioned the risky
securities that Goldman sold off in a 14-month period that ended in February 2007.

     Since the collapse of the economy, however, some of those investors have
changed their opinions of Goldman.

     Several pension funds, including Mississippi's Public Employees' Retirement
System, have filed suits, seeking class-action status, alleging that Goldman and other
Wall Street firms negligently made "false and misleading" representations of the
bonds' true risks.

     Mississippi Attorney General Jim Hood, whose state has lost $5 million of the $6
million it invested in Goldman's subprime mortgage-backed bonds in 2006, said the
state's funds are likely to lose "hundreds of millions of dollars" on those and similar
bonds.

     Hood assailed the investment banks "who packaged this junk and sold it to
unwary investors."

     California's huge public employees' retirement system, known as CALPERS,
purchased $64.4 million in subprime mortgage-backed bonds from Goldman on
March 1, 2007. While that represented a tiny percentage of the fund's holdings, in
July CALPERS listed the bonds' value at $16.6 million, a drop of nearly 75 percent,
according to documents obtained through a state public records request.

     In May, without admitting wrongdoing, Goldman became the first firm to settle
with the Massachusetts attorney general's office as it investigated Wall Street's
subprime dealings. The firm agreed to pay $60 million to the state, most of it to
reduce mortgage balances for 714 aggrieved homeowners.

     Attorney General Martha Coakley, now a candidate to succeed Edward Kennedy
in the U.S. Senate, cited the blight from foreclosed homes in Boston and other
Massachusetts cities. She said her office focused on investment banks because they
provided a market for loans that mortgage lenders "knew or should have known were
destined for failure."

     New Orleans' public employees' retirement system, an electrical workers union
and the New Jersey carpenters union also are suing Goldman and other Wall Street
firms over their losses.

     The full extent of the losses from Goldman's mortgage securities isn't known, but
data obtained by McClatchy show that insurance companies, whose annuities provide
income for many retirees, collectively paid $2 billion for Goldman's risky high-yield
bonds.

     Among the bigger buyers: Ambac Assurance purchased $923 million of Goldman's
bonds; the Teachers Insurance and Annuities Association, $141.5 million; New York
Life, $96 million; Prudential, $70 million; and Allstate, $40.5 million, according to the
data from the National Association of Insurance Commissioners.

     In 2007, as early signs of trouble rippled through the housing market, Goldman
paid a discounted price of $8.8 million to repurchase subprime mortgage bonds that
Prudential had bought for $12 million.

     Nearly all the insurers' purchases were made in 2006 and 2007, after mortgage
lenders had lifted most traditional lending criteria in favor of loans that required little
or no documentation of borrowers' incomes or assets.

     While Goldman was far from the biggest player in the risky mortgage
securitization business, neither was it small.

     From 2001 to 2007, Goldman hawked at least $135 billion in bonds keyed to risky
home loans, according to analyses by McClatchy and the industry newsletter Inside
Mortgage Finance.

     In addition to selling about $39 billion of its own risky mortgage securities in 2006
and 2007, Goldman marketed at least $17 billion more for others.

     It also was the lead firm in marketing about $83 billion in complex securities,
many of them backed by subprime mortgages, via the Caymans and other offshore
sites, according to an analysis of unpublished industry data by Gary Kopff, a
securitization expert.

     In at least one of these offshore deals, Goldman exaggerated the quality of more
than $75 million of risky securities, describing the underlying mortgages as "prime" or
"midprime," although in the U.S. they were marketed with lower grades.

     Goldman spokesman DuVally said that Moody's, the bond rating firm, gave them
higher grades because the borrowers had high credit scores.

     Goldman's securities came in two varieties: those tied to subprime mortgages and
those backed by a slightly higher grade of loans known as Alt-A's.

     Over time, both types of mortgages required homeowners to pay rapidly rising
interest rates. Defaults on subprime loans were responsible for last year's housing
meltdown. Interest rates on Alt-A loans, which began to rocket upward this year, are
causing a new round of defaults.

     Goldman has taken multiple steps to put its subprime dealings behind it, including
publicly saying that Wall Street firms regret their mistakes. Last winter, the company
cancelled a Las Vegas conference, avoiding any images of employees flashing wads
of bonus cash at casinos.

     More recently, the firm has launched a public relations campaign to answer the
criticism of its huge bonuses, Washington connections and federal bailout. In late
October, Blankfein argued that Goldman's activities serve "an important social
purpose" by channeling pools of money held by pension funds and others to
companies and governments around the world.

     Knowing When to Fold Them

     For investment banks such as Goldman, the trick was knowing when to exit the
high-stakes subprime game before getting burned.

     New York hedge fund manager John Paulson was one of the first to anticipate
disaster. He told Congress that his researchers discovered by early 2006 that many
subprime loans covered the homes' entire value, with no down payments, and so he
figured that the bonds "would become worthless."

     He soon began placing exotic bets Ñ credit-default swaps Ñ against the housing
market. His firm, Paulson & Co., booked a $3.7 billion profit when home prices tanked
and subprime defaults soared in 2007 and 2008. (He isn't related to Henry Paulson.)

     At least as early as 2005, Goldman similarly began using swaps to limit its
exposure to risky mortgages, the first of multiple strategies it would employ to reduce
its subprime risk.

     The company has closely guarded the details of most of its swaps trades, except
for $20 billion in widely publicized contracts it purchased from AIG in 2005 and 2006
to cover mortgage defaults or ratings downgrades on subprime-related securities it
offered offshore.

     In December 2006, after "10 straight days of losses" in Goldman's mortgage
business, Chief Financial Officer David Viniar called a meeting of mortgage traders
and other key personnel, Goldman spokesman DuVally said.

     Shortly after the meeting, he said, it was decided to reduce the firm's mortgage
risk by selling off its inventory of bonds and betting against those classes of securities
in secretive swaps markets.

     DuVally said that at the time, Goldman executives "had no way of knowing how
difficult housing or financial market conditions would become."

     In early 2007, the firm's mortgage traders also bet heavily against the housing
market on a year-old subprime index on a private London swap exchange, said
several Wall Street figures familiar with those dealings, who declined to be identified
because the transactions were confidential.

     The swaps contracts would pay off big, especially those with AIG. When
Goldman's securities lost value in 2007 and early 2008, the firm demanded $10
billion, of which AIG reluctantly posted $7.5 billion, Viniar disclosed last spring.

     As Goldman's and others' collateral demands grew, AIG suffered an enormous
cash squeeze in September 2008, leading to the taxpayer bailout to prevent
worldwide losses. Goldman's payout from AIG included more than $8 billion to settle
swaps contracts.

     DuVally said Goldman has made other bets with hundreds of unidentified
counterparties to insure its own subprime risks and to take positions against the
housing market for its clients. Until the end of 2006, he said, Goldman was still
betting on a strong housing market.

     However, Goldman sold off nearly $28 billion of risky mortgage securities it had
issued in the U.S. in 2006, including $10 billion on Oct. 6, 2006. The firm unloaded
another $11 billion in February 2007, after it had intensified its contrary bets.
Goldman also stopped buying risky home mortgages after the December meeting,
though DuVally declined to say when.

     I've Got a Secret

     Despite updating its numerous disclosures to investors in 2007, Goldman never
revealed its secret wagers.

     Asked whether Goldman's bond sellers knew about the contrary bets, spokesman
DuVally said the company's mortgage business "has extensive barriers designed to
keep information within its proper confines."

     However, Viniar, the Goldman finance chief, approved the securities sales and the
simultaneous bets on a housing downturn. Dan Sparks, a Texan who oversaw the
firm's mortgage-related swaps trading, also served as the head of Goldman Sachs
Mortgage from late 2006 to April 2008, when he abruptly resigned for personal
reasons.

     The Securities Act of 1933 imposes a special disclosure burden on principal
underwriters of securities, which was Goldman's role when it sold about $39 billion of
its own risky mortgage-backed securities from March 2006 to February 2007.

     The firm maintains that the requirement doesn't apply in this case.

     DuVally said the firm sold virtually all its subprime-related securities to Qualified
Institutional Buyers, a class of sophisticated investors that are afforded fewer
protections than small investors are under federal securities laws. He said Goldman
made all the required disclosures about risks.

     Whether companies are obliged to inform investors about such contrary trades, or
"hedges," is "a very hot issue" in cases winding through the courts, said Frank
Partnoy, a University of San Diego law professor who specializes in securities. One
issue is how specific companies must be in disclosing potential risks to investors, he
said.

     Coffee, the Columbia University law professor, said that any potential violations of
securities laws would depend on what Goldman executives knew about the risks
ahead.

     "The critical moment when Goldman would have the highest liability and
disclosure obligations is when they are serving as an underwriter on a registered
public offering," he said. "If they are at the same time desperately seeking to get out
of the field, that kind of bailout does look far more dubious than just trading
activities."

     Another question is whether, by keeping the trades secret, the company withheld
material information that would enable investors to assess Goldman's motives for
selling the bonds, said James Cox, a Duke University law professor who also has
served on the NYSE advisory panel.

     If Goldman had disclosed the contrary bets, he said, "One would have to believe
that a rational investor would not only consider Goldman's conduct material, but likely
compelling a decision to take a pass on the recommendation to purchase."

     Cox said that existing laws, however, don't require sufficient disclosures about
trading, and that the government would do well to plug that hole.

     In marketing disclosures filed with the SEC regarding each pool of subprime
bonds from 2001 to 2007, Goldman listed an array of risk factors that grew over time.
Among them was the possibility of a pullback in overheated real estate markets,
especially in California and Florida, where the most subprime loans had been made.

     Suits filed by the pension funds, however, allege that Goldman made materially
false or misleading statements in its public offerings, failing to disclose that many
loans were based on inflated appraisals and were bought from firms with poor
lending practices.

     DuVally said that investors were fully informed of all known risks.

     "What's going to happen in the next few years," said San Diego's Partnoy, "is
there's going to be a lot of lawsuits and judges will have to decide, should Goldman
have disclosed more or not?"