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In Goldman, Sachs We Trust

photo: Carrie Sloan via Flickr

photo: Carrie Sloan via Flickr

That’s the title of Chapter IV of John Kenneth Galbraith’s book The Great Crash 1929. The description of the activities of GS in the months prior to October, 1929, are eerily similar to those of GS in the run-up to the great crash of 2008, as described by McClatchy.

Galbraith tells us that GS was late to the investment trust game. Investment trusts were similar to the mutual funds of today, except that they created leverage by selling bonds and preferred stock as well as common stock. The returns to bonds and preferred stock are fixed, so the benefit of increases in asset values flowed to the common shareholders. GS formed Goldman Sachs Trading Corporation in December, 1928, and bought 1mn shares of its stock at $100 each. It immediately sold 90% of them to the public at $104. It sold more stock, and in February, 1929, the stock was selling for $222.50, which was about twice the value of the assets of GSTC.

Then it merged with the Financial and Industrial Securities Corporation. The assets of the merged company were about $235mn. GSTC bought over $57mn worth of its own stock, which helped the price considerably. Some of that stock was sold to William Crapo Durant, a speculator, who bled it back into the market as conditions would allow.

GSTC then organized a pair of investment companies that took leverage to new heights, first Shenandoah Corporation, which had common and preferred stock. Shenandoah sponsored Blue Ridge Corporation. The combined entities bought another large investment corporation, financed in part with more sales of stock. The total raise from the public was over $250mn. A lot of people paid a lot more than that in the open market. When the crash came a few weeks later, the stocks of all these Trusts collapsed.

In a tag line to Chapter IV, Galbraith quotes from testimony of Mr. Sachs in a Senate hearing several years later that the stock originally sold at $104 was then selling for a split-adjusted $3.50. . . .

Flash forward to 2002. Goldman Sachs, now a powerful corporation, decides to enter the securitized residential mortgage business, and partners with New Century Financial Corp., among others. McClatchy’s Greg Gordon explains what happened:

In at least nine deals from 2002 to 2007, Goldman sold bonds backed by more than $5 billion of New Century’s mortgages, one even after the California lender’s underwriting criteria all but disintegrated and a cash squeeze paralyzed its operation. Goldman also marketed at least three secret offshore deals bearing New Century’s name.

Separately, a GS mortgage subsidiary made a warehouse loan of $450mn to New Century. This is a revolving loan; it funded mortgage loans, and was repaid by transferring the note and mortgage to the GS sub.

Gordon gives a well-written description of New Century’s business, a sad and sordid tale of every kind of corrupt and predatory lending practice. He also describes the gradual deterioration of the standards of review by the mortgage buyers, like GS. For example, buyers examined 100% of the loans in the 90s, but that dropped to “probably less than 10% in 2006”….

GS denies that its standards were weaker in 2006 than 2007, but Gordon doesn’t take this on faith like a typical political writer would:

Goldman Sachs Mortgage, however, published guidelines in early 2007 indicating that it would accept a “stated income, stated asset” loan for a person with a subpar credit score of 600 who was borrowing 90 percent of his or her home’s value. The designation meant that although the borrower had poor credit, his or her claimed income and financial background would go unchecked.

In December, 2006, GS jerked the warehouse line, and other firms called their loans, and New Century spiraled into bankruptcy in April, 2007.

In February, 2007, GS sold for $1.7bn a pool of 9,800 notes and mortgages originated by New Century. Gordon gives us a taste of the disclosures in the prospectus:

· 3,422 of the borrowers had credit scores below 600, levels that experts say could include applicants with past bankruptcies.
· 3,688 of the borrowers were required only to state their incomes, not to document them — mortgages that became known as “liars’ loans.”
· More than a quarter of the borrowers had combined first and second mortgage balances that equaled or exceeded 90 percent of their homes’ values at the time.

Several weeks after the bankruptcy, GS “… started selling securities backed by New Century mortgages in a secret deal based in the Cayman Islands, a tax haven for U.S. companies.” This may refer to the notorious ABACUS securities, which I described here. I’m guessing these led to some of the AIG credit default swaps held by GS that were eventually paid off by the taxpayer. If so, taxpayer money bailed GS out of its lousy New Century subprime loans.

And here’s the first draft of a tag line like Galbraith’s for the story of GS involvement in the great crash of 2008, from SEC filings on one of the last pools of New Century mortgages:

“… You should consider … the risk that your investment in the offered certificates may perform worse than you anticipate.”

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I read a lot of books.