April 18, 2016
The news reports about Goldman’s $5 billion settlement over its boom-time securitization practices have focused on whether Goldman would really have to pay all $5 billion at the end of the day. It is important to focus on the size of the deal: does it do justice? I am not sure whether I have an answer to that question though. With these billion dollar settlements, it is hard to tell whether the punishment fits. Should it have been a billion more? A billion less? What is the right metric?
I leave these questions for others to wrestle with and turn to something a bit more prosaic: what exactly did Goldman do that was so wrong? The Settlement Agreement incorporates a Statement of Facts, attached as Annex 1 to the agreement. The answer, contained in the Statement of Facts, is that “Goldman received information indicating that, for certain loan pools, significant percentages of the loans reviewed did not conform to the representations made to investors about the pools of loans to be securitized, and Goldman also received certain negative information regarding the originators’ business practices.” (1) More specifically,
In various RMBS offerings, Goldman provided representations, or otherwise disclosed information, in certain offering documents, about the loans it securitized, telling investors that:
- Certain loan originators applied underwriting guidelines that were intended primarily to assess the borrower’s ability and, in some cases, willingness to repay the debt and the adequacy of the mortgage property as collateral for the loans;
- Loans in the securitized pools were originated generally in accordance with the loan originator’s underwriting guidelines;
- Exceptions to those underwriting guidelines had been made when the originator identified “compensating factors” at the time of origination; and
- The securitization sponsor or originator (which, in many instances, was Goldman) represented that the loans had been originated in compliance with federal, state, and local laws and regulations. (2, emphasis added)
This is what it told investors, but in fact, Goldman was accepting many, many mortgages that were rated EV3 — an unacceptable risk — into its mortgage-backed securities. In one proposed MBS transaction,
Although Goldman dropped 25 percent of the loans in the due diligence sample because they were graded as EV3s, including all the loans graded as EV3s for unreasonable stated income, which comprised at least 2.5 percent of the loans in the due diligence sample, Goldman did not review the portion of the pool not sampled for credit or compliance due diligence, which comprised approximately 70 percent of the total pool, to determine whether there were similar exceptions in the unsampled portion. (8)
In other words, Goldman knew that it had serious problems in the sample mortgage files it reviewed, but ignored the fact that those same problems were likely to be found in the files that were not sampled. That amounts to willful ignorance if the problem.
It seems that every big financial crisis lawsuit has that embarrassing note that management wishes had never seen the light of day. Here, “Goldman’s head of due diligence, who had just overseen Goldman’s due diligence on six Countrywide pools that closed during a two-day period at the end of March, responded to [a] research report by saying: “If they only knew . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .” (11) Turns out, they did find out — just much later than the Goldman folks.