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An Unsavory Slice of Subprime

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How is a buyer of securities like these supposed to know how safe they are? There are two options. The first is to do what we did: Read the 315-page prospectus, related documents and other public records with a jaundiced eye and try to see how things can go wrong. The second is to rely on the underwriter and the credit-rating agencies -- Moody's and Standard & Poor's. That, of course, is what nearly everyone does.

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In any event, it's impossible for investors to conduct an independent analysis of the borrowers' credit quality even if they choose to invest the time, money and effort to do so. That's because Goldman, like other assemblers of mortgage-backed deals, doesn't tell investors who the borrowers are. One Goldman filing includes more than 1,000 pages of individual loans -- but they're listed by code number and Zip code, not name and address.

Even though the individual loans in GSAMP looked like financial toxic waste, 68 percent of the issue, or $336 million, was rated AAA by both agencies -- as secure as U.S. Treasury bonds. Twenty-five percent of the issue, or $123 million, was rated investment grade, at levels from AA to BBB--. Thus, a total of 93 percent was rated investment grade. That's despite the fact that this issue is backed by second mortgages of dubious quality on homes in which the borrowers (most of whose income and financial assertions weren't vetted by anyone) had less than 1 percent equity and on which GSAMP couldn't effectively foreclose.

In a public analysis of the issue, Moody's projected that less than 10 percent of the loans would ultimately default. S&P, which gave the securities the same ratings Moody's did, almost certainly reached a similar conclusion but hasn't filed a public analysis and wouldn't share its numbers with us. As long as housing prices kept rising, it all looked copacetic.

Goldman peddled the securities in late April 2006. In a matter of months, the mathematical models used to assemble and market this issue -- and the models that Moody's and S&P used to rate it -- proved to be horribly flawed. That's because the models were based on recent performances of junk-mortgage borrowers, who hadn't defaulted much until last year thanks to the housing bubble.

Through the end of 2005, if you couldn't make your mortgage payments, you could generally get out from under by selling the house at a profit or refinancing it. But in 2006, we hit an inflection point. House prices began stagnating or falling in many markets.

Interest rates on mortgages stopped falling. Way too late, as usual, regulators and lenders began imposing higher credit standards. If you had borrowed 99 percent-plus of the purchase price (as the average GSAMP borrower did) and couldn't make your payments, couldn't refinance, and couldn't sell at a profit, it was over. Lights out.

As a second-mortgage holder, GSAMP couldn't foreclose on deadbeats unless the first-mortgage holder also foreclosed. That's because to foreclose on a second mortgage, you have to repay the first mortgage in full, and there was no money set aside to do that. So if a borrower decided to keep on paying the first mortgage but not the second, the holder of the second would get bagged.

If the holder of the first mortgage foreclosed, there was likely to be little or nothing left for GSAMP, the second-mortgage holder. Indeed, monthly reports issued by Deutsche Bank, the issue's trustee, indicate that GSAMP has recovered almost nothing on its foreclosed loans.

By February 2007, Moody's and S&P began downgrading the issue. Both agencies dropped the top-rated tranches all the way to BBB from their original AAA, depressing the securities' market price substantially. In March, less than a year after the issue was sold, GSAMP began defaulting on its obligations. By the end of September, 18 percent of the loans had defaulted, according to Deutsche Bank.

Nicolas Weill, chief credit officer for structured finance at Moody's, said that in hindsight, the firm probably would not have rated GSAMP had it realized what was going on in the junk-mortgage market. Low credit scores and high loan-to-value ratios were taken into account in Moody's original analysis, of course, but the firm now thinks there were things it didn't know about. Weill doesn't lay blame on any particular party, though in a Sept. 25 special report posted on Moody's Web site, he called for "additional third-party oversight that reviews the accuracy of the information provided by borrowers, appraisers, and brokers to originators" when it comes to junk issues. Or, as he calls them, "non-prime."

S&P, by contrast, says it considers both its original rating and subsequent downward revisions correct. "We used the best information available at the time," says Vickie Tillman, S&P's chief rating officer.

If you read documents that Goldman filed with the SEC in connection with this offering, you discover that they warn about pretty much everything we've discussed so far and some things we haven't: the impact of falling house prices, the difficulty of foreclosing, the possible changes in credit ratings, the fact that more than half the mortgages were in California, Florida, and New York, all of which were overheated markets. It's all disclosed. In capital letters. So no buyer -- and this is aimed at sophisticated investors -- can say he wasn't warned.

Even though many of its mortgage-backed customers were getting stomped, Goldman still made money on mortgages in the third quarter. The company said its profits came from shorting an index of mortgage-backed securities. "Although we recognized significant losses on our non-prime mortgage loans and securities, those losses were more than offset by gains on short mortgage positions," Goldman said in a recent SEC filing.

As we interpret this -- the firm declined to elaborate -- Goldman made more on its hedges than it lost on its inventory because junk mortgages fell even more sharply than Goldman thought they would.

What is there to take away from our course in Junk Mortgages 101? Two things. First, you have to pay at least some attention to all those "risk factors" that issuers forever warn you about, especially when you're dealing with a whole new thing like junk mortgages issued en masse instead of by specialists. Second, when you rely on the underwriter and the rating agencies to do all your homework for you, you don't have safety. You have only the illusion of safety.

Doris Burke provided research assistance for this column. Allan Sloan is Fortune magazine's senior editor at large. His e-mail address isasloan@fortunemail.com.


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