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An Unsavory Slice of Subprime

By Allan Sloan
Tuesday, October 16, 2007

It's getting hard to wrap your brain around subprime mortgages, Wall Street's fancy name for junk home loans. There's so much subprime stuff floating around -- more than $1.5 trillion of loans, maybe $200 billion of losses, thousands of families facing foreclosure, umpteen politicians yapping -- that it's like the federal budget: It's just too big to be understandable.

So let's reduce this macro story to human scale. Meet GSAMP Trust 2006-S3, a $494 million drop in the junk-mortgage bucket, part of the more than half-a-trillion dollars of mortgage-backed securities issued last year. We found this issue by asking mortgage mavens to pick the worst deal they knew of that had been floated by a top-tier firm, and this one's pretty bad.

It was sold by Goldman Sachs. GSAMP originally stood for Goldman Sachs Alternative Mortgage Products but has become a name itself, like AT&T and 3M. This issue, which is backed by ultra-risky second-mortgage loans, contains all the elements that facilitated the housing bubble and bust. It's got speculators searching for quick gains in hot housing markets, it's got loans that seem to have been made with little or no serious analysis by lenders, and finally, it's got Wall Street, which churned out mortgage "product" because buyers wanted it. As they say on the Street, "When the ducks quack, feed them."

Alas, almost everyone involved in this duck-feeding deal has had a foul experience. Less than 18 months after the issue was floated, one-sixth of the borrowers had already defaulted on their loans. Investors who paid face value for these securities have suffered heavy losses. That's because their securities have either defaulted (for a 100 percent loss) or been downgraded by credit-rating agencies, which has depressed the securities' market prices. (Check out one of these jewels on a Bloomberg machine, and the price chart looks like something falling off a cliff.) Even Goldman may have lost money on GSAMP, but being Goldman, the firm has more than covered its losses by betting successfully that the price of junk mortgages would drop. Of course, Goldman knew a lot about this market: GSAMP was just one of 83 mortgage-backed issues totaling $44.5 billion that Goldman sold last year.

Now let's take it from the top.

In the spring of 2006, Goldman assembled 8,274 second-mortgage loans originated by Fremont Investment & Loan, Long Beach Mortgage and assorted other players. More than one-third of the loans were in California, then a hot market. It was a run-of-the-mill deal, one of the 916 residential-mortgagebacked issues totaling $592 billion that were sold last year. Most of the information in this article is based on our reading of various public filings.

The average equity the second-mortgage borrowers had in their homes was 0.71 percent. (No, that's not a misprint: The average loan-to-value of the issue's borrowers was 99.29 percent.) It gets even hinkier. Some 58 percent of the loans were no-documentation or low-documentation. This means that though 98 percent of the borrowers said they were occupying the homes they were borrowing on -- "owner-occupied" loans are considered less risky than loans to speculators -- no one knows if that was true. And no one knows whether borrowers' incomes or assets bore any serious relationship to what they told the mortgage lenders.

You can see why borrowers lined up for the loans, even though they carried high interest rates. If you took out one of these second mortgages and a typical 80 percent first mortgage, you got to buy a house with essentially none of your own money at risk. If house prices rose, you'd have a profit. If house prices fell and you couldn't make your mortgage payments, you'd get to walk away with nothing (or almost nothing) out of pocket. It was go-go finance, very 21st century.

Goldman acquired these second-mortgage loans and put them together as GSAMP Trust 2006-S3. To transform them into securities it could sell to investors, it divided them into tranches -- which is French for "slices," in case you're interested.

There are trillions of dollars of mortgage-backed securities in the world for the same reason that Tyson Foods offers you chicken pieces rather than insisting you buy an entire bird. Tyson can slice a chicken into breasts, legs, thighs, giblets -- and Lord knows what else -- and get more for the pieces than it gets for a whole chicken. Customers are happy because they get only the pieces they want.

Similarly, Wall Street carves mortgages into tranches because it can get more for the pieces than it would get for whole mortgages. Mortgages have maturities that are unpredictable, and they require all that messy maintenance like collecting the monthly payments, making sure real estate taxes are paid, chasing slow-pay and no-pay borrowers, and sending out annual statements of interest and taxes paid. Securities are simpler to deal with and can be customized.

Someone wants a safe, relatively low-interest, short-term security? Fine, we'll give him a nice AAA-rated slice that gets repaid quickly and is very unlikely to default. Someone wants a risky piece with a potentially very rich yield, an indefinite maturity, and no credit rating at all? One unrated X tranche coming right up. Interested in legs, thighs, giblets, the heart? The butcher -- excuse us, the investment banker -- gives customers what they want.

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.

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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