By Greg Gordon | McClatchy Newspapers
NEW YORK — Inside the thick Goldman Sachs investment circular were the details of a secret, $2 billion deal channeled through a Caribbean tax haven.
The Sept. 26, 2006, document offered sophisticated U.S. and European investors an opportunity to buy into a pool of supposedly high-grade bonds backed by residential, commercial and student loans. The transaction was registered through a shell company in the Cayman Islands.
Few of the potential investors knew it, but the ratings of many of the mortgage securities hid their true risks and, in some cases, Goldman’s descriptions exaggerated their quality.
The Cayman offering — one of perhaps dozens made through the British territory — occurred as Goldman began to ditch the subprime mortgage business before the U.S. housing market collapsed under an avalanche of homeowner defaults.
In all, Goldman sold more than $57 billion in risky mortgage-backed securities during a 14-month period in 2006 and 2007, including nearly $39 billion issued from mortgages it purchased. Meanwhile, the firm peddled billions of dollars in complex deals, many of them tied to subprime mortgages, in the Caymans and other offshore locations.
Many of those securities later soured, but the sales allowed Goldman to become the only major U.S. investment bank to escape the brunt of the subprime meltdown.
One bond analyst who reviewed the 2006 Cayman deal dismissed it in a report to clients as “a not so cleverly disguised way for Goldman Sachs & Co. to unload its unwanted exposures to the subprime real estate market onto foreign investors.”
Goldman spokesman Michael DuVally said that the firm “sold mortgage securities only to sophisticated investors” and disclosed “all the appropriate information available.”
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McClatchy also found at least two instances in which Goldman appeared to mislead investors. In one, the firm said that $65.3 million in securities were backed by safe “prime” mortgages when the same loans had been labeled a cut below prime in a U.S. offering. In the other, Goldman listed $10 million as “midprime” loans when the underlying mortgages had been made to subprime borrowers with shaky finances.
DuVally said that the descriptions were consistent with the standards set by Moody’s, the bond-rating agency.
The secret Cayman Islands deals provide a window into one method that Goldman and other Wall Street firms used to draw European banks and other foreign financial institutions into investing hundreds of billions of dollars in securities tied to risky U.S. home loans.
Experts estimate that Wall Street investment banks sold 25 percent to 50 percent of these bonds and related securities overseas, resulting in massive losses in Europe and elsewhere when the market collapsed.
Last spring, the International Monetary Fund projected that global write-downs on “U.S.-originated assets” stemming from the subprime disaster could reach $2.7 trillion.
Underscoring the role of tax havens as a Wall Street marketing tool, a Treasury Department report found that as of June 30, 2008, $164 billion in U.S. mortgage-backed securities were held in the Cayman Islands and $22 billion more were held in Luxembourg, another tax-friendly zone.
Gary Kopff, a securitization expert who analyzed unpublished industry data, said that Goldman packaged or marketed offshore deals worth at least $83 billion from 2002 to 2008. These deals, called collateralized debt obligations, amounted to a $1.3 trillion global market, and Goldman reaped as much as $1.66 billion for assembling and selling them.
Some of Goldman’s subprime mortgage securities wound up in the hands of financially struggling Eastern European governments such as those in Romania, Bulgaria, Slovakia and Slovenia, said a Wall Street expert involved in trading those types of securities who declined to be identified because of the matter’s sensitivity. This person said that one Slovakian bank’s multimillion-dollar investment wound up worthless.
DuVally said the company could find no record of marketing the bonds in those countries, but that the securities may have gotten there through the resale market.
Subprime-backed mortgage securities that were sold at the crest of the housing market in 2006 and 2007 have shown the most precipitous drop in value, with default rates on the underlying mortgages exceeding 30 percent. For many cash-strapped borrowers, it was easy to walk away from soaring monthly payments when their mortgage balances exceeded the lower value of their homes.
The 2006 Cayman deal was part of a flurry of Goldman activity in the hidden, unregulated parts of the securities industry. Goldman’s traders also made huge bets that those securities would lose value by buying insurance-like contracts, called credit-default swaps, with private parties. Beginning early in 2007, they bought swaps on a London-based exchange.
Every Goldman bet on the exchange’s subprime index, which was run by the London-based financial services company Markit, was on a basket of bonds that included a bundle of its own subprime-related securities.
Germany’s Deutsche Bank, the trustee holding mortgages for scores of Goldman’s bond offerings, also lists more than 50 private Goldman deals on its Web site. Of those, 42 were backed by risky mortgages.
In marketing exotic deals that typically include subprime mortgage-backed securities, Goldman and other Wall Street firms have long used the Caymans as a gateway to European investors, said an official of a German bank, who wasn’t authorized to speak publicly and declined to be identified.
The 2006 Cayman deal was outside the reach of U.S. tax laws and free of U.S. regulation. Goldman circulated the deal under the names of Cayman-based Altius III Funding Ltd., and a sister firm registered in Delaware, both created for the sole purpose of facilitating the transaction.
The offering drew a scornful reaction from the bond analyst who warned investment clients to stay away. The analyst’s report, a copy of which was obtained by McClatchy, described Goldman as “a single underwriter solely interested in pushing its dirty inventory onto unsuspecting and obviously gullible investors.”
“. … In this case, it is a foregone conclusion that many relatively senior bondholders will suffer severe losses,” said the analyst’s report, which was made available on the condition of anonymity because the offering barred unauthorized disclosure.
McClatchy also learned of a second private Goldman deal, in which it sought in May 2007 via another Cayman company to sell $44.6 million in bonds related to subprime loans written by New Century Financial, a mortgage lender that weeks earlier had careened into bankruptcy after California regulators closed it.
For foreign banks, the lure was spelled AAA. Under both public and private deals, experts said, 80 percent or more of the bonds carried top grades from financial rating companies, assuring investors that the securities were among the safest plays in the financial world.
The triple-A rating was “the clincher,” said an official of another German bank, who also wasn’t authorized to speak publicly and requested anonymity.
Few investors, however, knew that Goldman and other Wall Street dealers were paying the biggest U.S. financial ratings firms for grading the risky bonds.
Sylvain Raynes, a former analyst for Moody’s Investors Service, the largest U.S. rating firm, likened the Wall Street firms’ relationships with the rating agencies to hiring “a high-class escort service.”
Typically, he said, an investment banker would meet with analysts for a ratings agency, describe a mortgage pool “and propose his dream result.”
“The agency would call back after the meeting and intimate that they ‘could get there’ sight unseen,” Raynes said. “Both parties understood what that meant, and the agency would be hired to rate the deal.”
After bestowing untold numbers of triple-A ratings on subprime-backed bonds, Moody’s and the second- and third-largest rating agencies, Standard & Poor’s and Fitch, began to downgrade hundreds of pools of the securities in the summer of 2007, including the offshore deals known as collateralized debt obligations.
That set off a chain reaction that culminated in last year’s Wall Street meltdown. Since then, both Moody’s and S&P have downgraded slices of the Altius III deal several times.
U.S. pension funds that have lost money on subprime mortgage-backed bonds have filed suits accusing Goldman, Morgan Stanley and Merrill Lynch of failing to inform them of the bonds’ true risks. (Merrill is now part of Bank of America.)
Many European institutions that lost money on the securities, however, have fewer legal options.
Few of them are pointing fingers at Goldman or other U.S. investment banks. McClatchy contacted several European banks about their subprime losses and got similar responses when the banks were asked where they’d bought them.
Germany’s IKB Deutsche Industriebank, whose 2007 near-collapse from subprime losses awakened Europe to the impending financial crisis, has written off about $19 billion (in current U.S. dollars) related to U.S. mortgages. A spokeswoman for the bank declined to say which investment banks sold it bonds.
Several of Germany’s seven regional “landesbanks,” or land banks, also took a pounding. With $7.2 billion in aid from the state of Bavaria, Munich-based Bayern LB, Germany’s sixth-largest bank, has reserved $8.95 billion for losses in its asset-backed securities portfolio, which includes subprime loans. A Bayern spokesman declined to say who sold the bank the risky bonds.
Spokespeople for the Royal Bank of Scotland, which bought a Dutch subprime subsidiary and has reported tens of billions of dollars in losses, and the French bank Societe General, which lost more than $6 billion, also declined to identify any U.S. investment banks as the source of their problems.
“Are we angry against the U.S. banks?” a German bank official said, requesting anonymity because of the matter’s sensitivity. “We looked at the triple A’s like the other banks, and we bought this, yeah. It doesn’t help much to be angry.”
(Tish Wells contributed to this article.)
Story Transcript
PAUL JAY, SENIOR EDITOR, TRNN: Welcome back to The Real News Network. We’re with Greg Gordon, coming from the McClatchy offices and the Real News studio in Washington, DC. Thanks for joining us again, Greg.
GREG GORDON, INVESTIGATIVE JOURNALIST, MCCLATCHY NEWSPAPERS: Glad to be here.
JAY: So in part three of your series on Goldman Sachs and the subprime mortgage orgy—okay, that’s my word, not yours—you talk about the way Goldman Sachs and other banks went offshore to the Caribbean, to tax havens, to give their clients tax shelters, but also to shelter themselves from potential repercussions of selling such junk. Tell us the story.
GORDON: We don’t exactly know when Goldman Sachs joined this frenzy of offshore wheeling and dealing with respect to subprime mortgages. Goldman was a latecomer to the subprime game on Wall Street, and it was the first to get out and the only one to get out safely. But in the middle of the height of all this, Goldman was doing a lot of deals. According to a calculation by a securitization expert named Gary Kopff, Goldman had about $83 billion in offshore deals, many of which were or included subprime-related mortgage securities. These are very complex deals, because in many instances there are no mortgages directly underlying the securities. You might be buying a security that rises or falls in value based on another underlying security. And these deals are really a Wall Street creation that I guess would be characterized as ingenious. But the foreign bankers now say privately that these offshore deals, and particularly those in the Caymans, were sort of the platform for selling subprime-related assets or passing subprime-related risks off to foreigners who saw a AAA rating on the bulk of the securities and felt safe.
JAY: Just say again what “subprime” is. This is probably an ordinary person who gets a loan to buy a house with a salary level that doesn’t justify that loan, or a student who probably is not going to have the real possibilities of repaying this loan, and they’re just throwing money at people, assuming [an] underlying “the housing market’s going to go up forever”. And then you have layer after layer of speculation insurance and reinsurance that everybody’s making money on at every step of the way. Have I got it right?
GORDON: Essentially, yes. The other thing about—.
JAY: And then they’re going to hide it in the Caribbean. Go on.
GORDON: The other thing about a subprime is it’s a trick name: “subprime” makes it sound like it’s a lower interest rate, but the subprime loans were always higher interest rates. And a subprime, after two years, adjusted generally upward every six months. And so these people who would move into a home with $1,000 payment might have $2,000 payment three years later.
JAY: Now, I’ve been told by some of the economists I’ve interviewed that some analysts believe as much as a third of the world global capital flows are offshore in tax havens, unregulated and untaxed. So this is where a lot of the subprime went.
GORDON: That’s right. And the estimates of these instruments that I describe (they’re known as CDOs, collateralized debt obligations) reached $1.3 trillion. There also have been estimates that 25 to 50 percent of the subprime mortgage securities that were packaged and sold by Wall Street firms ended up in foreign hands. The International Monetary Fund has estimated that global losses from the subprime meltdown could reach $2.7 to $2.8 trillion. Now, bear in mind, just the basic good old subprime bonds (or there’s a related group that’s slightly less risky) were also sold to foreigners. But one of the interesting things we discovered is that the foreign banks don’t even want to say where they bought these bonds or more exotic securities sold out of the Caymans. They won’t even acknowledge them. And we asked whether Goldman Sachs had sold them to them, and nobody is pointing any fingers.
JAY: Why is that?
GORDON: Well, I’m not able to assess motives other than guess, but Goldman Sachs is a really big and really powerful company. It’s the most prestigious investment bank in the world.
JAY: And far more powerful now, post subprime crisis.
GORDON: It appears so. And I talked to a German bank official, who will remain unnamed. He said that the AAA rating was the clincher for us. And if you think about how these AAA ratings were bestowed on these securities, the Wall Street rating agencies, the big three, Moody’s, S&P’s, and Fitch, would have a meeting, according to Wall Street bond experts, they’d have a meeting with Goldman Sachs or another big investment bank, and there’d be a discussion about what was going to be in this bundle of subprime mortgages. And then they would part company and there’d be a phone call made, and the ratings agency might say, “We think we can handle this.” And what the Wall Street investment bank wanted to know, of course, is: “Can you give us AAA ratings on the bulk of the securities?” And I’ve had one expert say to me basically they were like a high-priced escort service who were just haggling over the price.
JAY: There’s no quote-unquote “due diligence”. It almost seems oxymoronic to use the word in this whole case. There’s no diligence being taken. It’s all wink-wink, nudge-nudge, let’s get in on the feeding frenzy.
GORDON: The Wall Street firms did hire due-diligence contractors to go through the mortgages before they bought them, but the problem was the mortgage bankers, subprime lenders, had adopted such loose guidelines that—when they were reviewing loans, all the loan had to do was fit the guideline. And if the guideline was—it’s what they called a stated-income loan, which later became known as a liars loan, there was no verification of the applicant’s income. And so if there was any kind of a protest by one of the due-diligence contractors saying this loan should be rejected, a supervisor would step in and say, “We have to follow the mortgage lender’s guidelines.”
JAY: Well, in the next segment of our interview, let’s dig into this, ’cause you’ve analyzed one specific case, in fact, where some of those people doing this diligence were told, “We’re not very interested in what you’re saying.” And more than that, a competition amongst Wall Street banks to get at these subprime mortgages, and one way to get at them is not to ask for any due diligence, and in fact the less you wanted, the more you got. So in the next segment of our interview, let’s dig into how all of that worked. Please join us with Greg Gordon on The Real News Network.
DISCLAIMER:
Please note that TRNN transcripts are typed from a recording of the program; The Real News Network cannot guarantee their complete accuracy.
