http://www.mcclatchydc.com/227/story/81465.html

NEW YORK — When financial titan Goldman Sachs joined some of its Wall Street rivals in late 2005 in secretly packaging a new breed of offshore securities, it gave prospective investors little hint that many of the deals were so risky that they could end up losing hundreds of millions of dollars on them.

McClatchy has obtained previously undisclosed documents that provide a closer look at the shadowy $1.3 trillion market since 2002 for complex offshore deals, which Chicago financial consultant and frequent Goldman critic Janet Tavakoli said at times met "every definition of a Ponzi scheme."

The documents include the offering circulars for 40 of Goldman's estimated 148 deals in the Cayman Islands over a seven-year period, including a dozen of its more exotic transactions tied to mortgages and consumer loans that it marketed in 2006 and 2007, at the crest of the booming market for subprime mortgages to marginally qualified borrowers.

In some of these transactions, investors not only bought shaky securities backed by residential mortgages, but also took on the role of insurers by agreeing to pay Goldman and others massive sums if risky home loans nose-dived in value — as Goldman was effectively betting they would.

Some of the investors, including foreign banks and even Wall Street giant Merrill Lynch, may have been comforted by the high grades Wall Street ratings agencies had assigned to many of the securities. However, some of the buyers apparently agreed to insure Goldman well after the performance of many offshore deals weakened significantly beginning in June 2006.

Goldman said those investors were fully informed of the risks they were taking.

These Cayman Islands deals, which Goldman assembled through the British territory in the Caribbean, a haven from U.S. taxes and regulation, became key links in a chain of exotic insurance-like bets called credit-default swaps that worsened the global economic collapse by enabling major financial institutions to take bigger and bigger risks without counting them on their balance sheets.

The full cost of the deals, some of which could still blow up on investors, may never be known.

Before the subprime crisis, the U.S. financial system had used securities for 40 years to help Americans finance their houses, cars and college educations, said Gary Kopff, a financial services consultant and the president of Everest Management Inc. in Washington. The offshore deals, he lamented, "became the biggest contributors to the trillions of dollars of losses" in 2008's global meltdown.

While Goldman wasn't alone in the offshore deal making, it was the only big Wall Street investment bank to exit the subprime mortgage market safely, and it played a pivotal role, hedging its bets earlier and with more parties than any of its rivals did.

McClatchy reported on Nov. 1 that in 2006 and 2007, Goldman peddled more than $40 billion in U.S.-registered 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. Many of those bets were made in the Caymans deals.

At the time, Goldman's chief spokesman, Lucas van Praag, dismissed as "untrue" any suggestion that the firm had misled the pension funds, insurers, foreign banks and other investors that bought those bonds. Two weeks later, however, Chairman and Chief Executive Lloyd Blankfein publicly apologized — without elaborating — for Goldman's role in the subprime debacle.

Goldman's wagers against mortgage securities similar to those it was selling to its clients are now the subject of an inquiry by the Securities and Exchange Commission, according to two people familiar with the matter who declined to be identified because of its sensitivity. Spokesmen for Goldman and the SEC declined to comment on the inquiry.

Goldman's defenders argue that the legendary firm's relatively unscathed escape from the housing collapse is further evidence that it's smarter and quicker than its competitors. Its critics, however, say that the firm's behavior in recent years shows that it's slipped its ethical moorings; that Wall Street has degenerated into a casino in which the house constantly invents new games to ensure that its profits keep growing; and that it's high time for tougher federal regulations.

In 2006 and 2007, as the housing market peaked, Goldman underwrote $51 billion of deals in what mushroomed into an under-the-radar, $500 billion offshore frenzy, according to data from the financial services firm Dealogic. At least 31 Goldman deals in that period involved mortgages and other consumer loans and are still sheltered by the Caymans' opaque regulatory apparatus.

Tavakoli, an expert in these types of securities, said it's time to start discussing "massive fraud in the financial markets" that she said stemmed from these offshore deals.

"I'm talking about hundreds of billions of dollars in securitizations," she said, without singling out Goldman or any other dealer. " . . . We nearly destroyed the global financial markets."

HEADS, I WIN; TAILS, YOU LOSE

Goldman's activities in the Caymans helped it unload some of its subprime-related risks on others and also amass tens of billions of dollars in protection against a U.S. housing crash that ultimately occurred. These deals have accounted for a sizeable share of the firm's $103 billion in revenues and more than $25 billion in profits since Jan. 1, 2007. At the end of 2009, Goldman had set aside more than $16 billion in cash and stock bonuses for its employees.

Many of Goldman's winning bets with other large U.S. banks raised the price tags of 2008's government bailouts of Citigroup, Bank of America, Morgan Stanley and others by sums that no one has yet determined because the contracts are private, according to people familiar with some of the transactions.

However, one billion-dollar transaction that Goldman assembled in early 2006 is illustrative. It called for the firm to receive as much as $720 million from Merrill Lynch and other investors if defaults surged in a pool of dicey U.S. residential mortgages, according to documents in a court dispute among the parties.

Securities experts said that deal is headed for a crash that's likely to cause serious losses for Merrill Lynch, which Bank of America acquired a year ago in a $50 billion government-arranged rescue.

Taxpayers got hit for tens of billions of dollars in the Caymans deals because Goldman and others bought up to $80 billion in insurance from American International Group on the risky home mortgage securities underlying the deals.

AIG, rescued in September 2008 with $182 billion from U.S. taxpayers, later paid $62 billion to settle those credit-default swap contracts. The special inspector general who's tracking the use of federal bailout money has reported that beginning in 2004, Goldman itself bought $22 billion in insurance from AIG for dozens of pools of unregistered securities backed by dicey types of home loans.

When the federal government saved nearly bankrupt AIG, Goldman got $13.9 billion of the bailout money, and it still holds more than $8 billion in protection from AIG.

Tavakoli said that Goldman's subprime dealings burned taxpayers a second way. She said that three foreign banks — France's Calyon and Societe Generale and the Bank of Montreal — bought protection against securities they purchased in Goldman's Caymans deals, using AIG as a backstop.

Those banks got a total of $22.6 billion from AIG (Societe Generale $16.9 billion, Calyon $4.3 billion and Bank of Montreal $1.4 billion), though not all of the money was related to investments in deals underwritten by Goldman.

Each of the 12 Goldman deals in 2006 and 2007 traced by McClatchy included credit-default swaps that reserved a chance for the firm to lay down modest wagers that could bring thousand-fold returns if a bundle of securities, in several cases risky home mortgages, cratered.

The investors wouldn't buy the securities, but would agree that the insurance would hinge on their performance. Goldman said that it or an affiliate would hold those bets, at least initially.

"This might look stupid in hindsight, but at the time the investors thought they were lucky to get a piece of low-risk (AAA-rated) bonds created by Goldman Sachs with above-market returns," said Kopff, the securities expert.

The Wall Street ratings agency Moody's Investors Service has lowered to junk status the bulk of the securities in all 12 of those deals, devaluing some positions that Moody's initially rated as investment grade by 80 percent.

One Wall Street market participant who watched the disaster unravel said that the bankers and traders who packaged subprime mortgage-related deals in the Caymans deals got paid based on volume and would "jam the stuff anywhere they had to close the deal."

This individual, who declined to be identified for fear it would hurt his career, said that the swaps gave the banks an unlimited supply of cash and the mistaken belief that they had "an infinite return on investment."

The insurance unit of ACA Capital Holdings Inc. wrote $65 billion in swaps coverage, mostly on the Caymans deals called collateralized debt obligations, or CDOs, before it folded and turned nearly all its assets over to the banks that had thought ACA would backstop them.

The documents obtained by McClatchy also reveal that:

* Goldman's Caymans deals were riddled with potential conflicts of interest, which Goldman disclosed deep in prospectuses that typically ran 200 pages or more. Goldman created the companies that oversaw the deals, selected many of the securities to be peddled, including mortgages it had securitized, and in several instances placed huge bets against similar loans.

* Despite Goldman's assertion that its top executives didn't decide to exit the risky mortgage securities market until December 2006, the documents indicate that Goldman secretly bet on a sharp housing downturn much earlier than that.

* Goldman pegged at least 11 of its Caymans deals in 2006 and 2007 on swaps tied in some cases to the performance of a bundle of securities that it neither owned nor sold, but used as markers to coax investors into covering its bets on a housing downturn.

* If Goldman opted to buy the maximum swap protection cited in the 12 deals in which McClatchy found that it sold both swaps and mortgage-backed securities, and if the securities underlying the swaps defaulted, its clients would owe the firm $4.1 billion. If all 31 deals were similarly structured, investors could be on the hook to Goldman for as much as $10.6 billion, according to Kopff, who assisted McClatchy in analyzing the documents.

From 2005 to 2007, Goldman says it invited only sophisticated investors to act as its insurers. In those CDOs, Kopff said, Goldman appears to have created "mini-AIGs in the Caymans," arranging for investors to post the money that would cover the bets up front.

Kopff charged that Goldman inserted the credit-default swaps into CDO deals "like a Trojan Horse — secret bets that the same types of bonds that they were selling to their clients would in fact fail."

Goldman's chief financial officer, David Viniar, has said that the firm purchased the AIG swaps only as an "intermediary" on behalf of its clients, first writing protection on their securities, and then buying its own protection to eliminate those risks.

If that were true of all of the swaps contracts, however, Goldman would have earned only the lucrative investment fees on the deals and any gains from selling protection to its clients.

In a Dec. 24 letter to McClatchy, Goldman said it sold those products only to sophisticated investors and fully informed them of which securities would be the basis of any swap bets. The investors, it said, "could simply decide not to participate if they did not like some or all the securities."

'WHY YOU HAVEN'T SEEN A LOT OF COMPLAINING'

It's impossible to tell without Goldman opening its books how much the firm bet against the housing market using only its own money.

Goldman said it disclosed $1.7 billion in residential mortgage losses in 2008, and that the losses "would have been substantially higher" without its contrary bets, or "hedges." It called those hedges "the cornerstone of prudent risk management."

The company declined, however, to reveal what share of its recent profits came from those secret bets and how much it stands to make if its Caymans deals continue to implode.

The new Caymans documents obtained by McClatchy, however, help peel back some of the shroud of secrecy around the market for more than 2,000 CDOs, the bulk of them peddled by six American and four European major banks, according to Dealogic.

As of Nov. 2, more than half of the 766 CDOs backed by risky mortgages and other consumer loans had experienced an "event of default," signaling a possible collapse, according to a report by Wells Fargo Securities. The default rate soared to 77 percent for 114 deals struck as the subprime mortgage market deteriorated in the second half of 2006, and to 86 percent for 148 deals in 2007, it reported.

Securities experts said that regardless of whose money Goldman used, investors on the losing end of the deals suffered the same effects.

Whether Goldman deceived investors with its secret bets depends partly on whether the courts or investigators conclude that disclosing the swaps would have dissuaded potential buyers from purchasing its registered mortgage securities, the experts said. Separate questions of disclosure could apply to clients who invested in the Caymans deals.

The Wall Street figure who insisted upon anonymity said that despite all the hoopla, there were few private investors in CDOs, and that banks have suffered most of the losses, one reason "why you haven't seen a lot of complaining."

Indeed, a computer match conducted for McClatchy by the National Association of Insurance Commissioners found no records of any insurance company investing in the 12 identifiable Goldman hybrid deals containing credit-default swaps.

However, other experts said that many of Wall Street's victims have chosen to remain silent. Douglas Elliott, a former investment banker at J.P. Morgan Chase who's a fellow at The Brookings Institution, a center-left policy organization in Washington, said that pension funds are loath to discuss investments that "blow up" because "it could potentially lead to lawsuits against them."

Christopher Whalen, a senior vice president and managing director of California-based Institutional Risk Analysis, said that foreign banks "got stuffed" in the Caymans deals, but that Wall Street dealers typically averted litigation by buying back failed securities at a discount to avoid court fights. Any investors who sued would face the threat of being "blackballed" — shunned by Wall Street firms, he said.

The CDO devastation, Whalen said, underscores the need to close a "disclosure loophole" that allows Wall Street to avoid publicly reporting these deals.