In 2006 and 2007, Goldman Sachs Group sold over $40 billion in residential mortgage backed securities (RMBS) 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 cause those securities to plummet in value. (“How Goldman Secretly Bet on the U.S. Housing Crash,” Greg Gordon, McClatchy Washington Bureau.)
As a result, pension funds, insurance companies, labor unions and foreign financial institutions that bought those RMBS have suffered large losses. According to the article:
“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.”
“It would look much more damaging,” Columbia University law professor John Coffee said, “if it appeared that the firm was dumping these investments because it saw them as toxic waste and virtually worthless.”
A Goldman spokesman, Michael Duvally, said that the firm decided in December 2006 to reduce its mortgage risks by selling subprime-related securities and related credit-default swaps, to “hedge” against a housing downturn.
Previously, scant attention had been paid to how Goldman was the only major Wall Street bank to exit the subprime securities market before the housing bubble burst.
However, McClatchy reportedly reviewed hundreds of documents, including SEC filings, copies of “secret” investment circulars, and legal pleadings, conducted interviews, and made the following findings:
- That Goldman Sachs bought and securitized thousands of mortgages from subprime lenders that were investigated for misleading borrowers or exaggerated applicants’ incomes to justify making hefty loans.
- That Goldman Sachs used offshore tax havens to avoid U.S. disclosure requirements when selling its mortgage-backed securities worldwide.
- That Goldman Sachs repossessed 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.
For decades, Goldman, founded in 1869, has cultivated an elite reputation. It has come to be regarded as home to the best and brightest of graduates of Ivy League schools.
Goldman has also become a revolving door to and from Washington. For example, last October, a Goldman vice president, Adam Storch, was named managing executive of the SEC’s enforcement division.
Several pension funds, including Mississippi’s Public Employees’ Retirement System, have filed putative class-actions against Goldman Sachs, alleging that it made “false and misleading” representations regarding true risks of the RMBS it sold them.
California’s public employees’ retirement system (CALPERS), reportedly purchased $64.4 million in subprime mortgage-backed bonds from Goldman in March 2007. By July, CALPERS listed the bonds’ value at $16.6 million, a drop of nearly 75 percent.
Suits filed by the pension funds allege that Goldman Sachs 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.
Massachusetts Attorney General Martha Coakley (the unsuccessful candidate for Edward Kennedy’s seat in the U.S. Senate) said that foreclosed homes in Boston and other Massachusetts cities has resulted in blight. She blames investment banks because they provided a market for loans that mortgage lenders “knew or should have known were destined for failure.”
Insurance companies, whose annuities provide income for many retirees, have reportedly invested $2 billion in Goldman’s risky high-yield mortgage-backed bonds.
In 2007, Goldman paid a discounted price of $8.8 million to repurchase subprime mortgage bonds that Prudential had bought for $12 million, as concerns about the housing market grew.
Goldman Sachs sold approximately $83 billion of complex securities, most of them backed by subprime mortgages, through the Caymans and other offshore sites. In at least one of these offshore deals, Goldman reportedly described the underlying mortgages as “prime” or “midprime,” when they were actually lower grades.
While DuVally has said that Goldman executives “had no way of knowing how difficult housing or financial market conditions would become,” Goldman anticipated the subprime mortgage disaster and knew how to limit its subprime mortgage risk.
New York hedge fund manager John Paulson 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.”
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.
Goldman Sachs reportedly bought $20 billion of credit default swaps from AIG in 2005 and 2006 to cover mortgage defaults or ratings downgrades on subprime-related securities it offered offshore. Since most swaps are private contracts that are not traded on public exchanges, however, Goldman has been able to conceal details of most of its other swaps trades.
In early 2007, Goldman traders reportedly used a private London swap exchange to bet heavily against the housing market.
DuVally admitted that Goldman Sachs has entered into other similar transactions to hedge its own subprime risks and to take positions against the housing market for its clients.
DuVally claims that until the end of 2006, Goldman Sachs was still betting on a strong housing market. But Goldman sold nearly $28 billion of risky mortgage securities it had issued in the U.S. in 2006, including $10 billion in October 2006, and dumped another $11 billion in February 2007.
Goldman never revealed its secret bets against the housing market.
Interestingly, Dan Sparks, 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 heightened disclosure burden on principal underwriters of securities. Goldman Sachs was an underwriter of the approximately $39 billion of risky mortgage-backed securities that it sold from March 2006 to February 2007.
“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,” said Frank Partnoy, a University of San Diego law professor who specializes in securities. “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.”
If Goldman had disclosed the contrary bets, “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,” said James Cox, a Duke University law professor who also has served on the NYSE advisory panel.
“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?”
Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 30 occasions. Page Perry’s attorneys are actively involved in representing institutional and corporate investors that lost money in CDOs and other structured finance instruments. For further information, please contact us.