The government's civil-fraud allegation against Goldman Sachs centers on a deal the company crafted so that hedge-fund king John Paulson could bet on a collapse in U.S. housing prices.
It was a dizzyingly complex transaction, involving 90 bonds and a 65-page deal sheet. But it all boiled down to whether people like Stella Onyeukwu, Gheorghe Bledea and Jack Booket could pay their mortgages.
They couldn't, and Paulson made $1 billion as a result.
Booket, a 44-year-old heating and air-conditioning repairman, owed $300,000 on his three-bedroom home in Aberdeen Township, N.J. His house was one of thousands that wound up in a pool of mortgages that were referenced in the so-called collateralized debt obligation, or CDO, which Goldman created for Paulson. The hedge-fund manager invested heavily in a form of insurance that could yield huge gains if the borrowers grew unable to pay.
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In 2006, Booket got hit by a car while riding a motorcycle from a late-night party, was unable to find much work and couldn't pay the bank. In October 2008, he lost the house to foreclosure and plans to move out by next week. He says he bears no grudge against Paulson and Goldman.
"The man came up with a scheme to get rich, and he did it," says Booket, who had refinanced his mortgage just months before the accident. "So more power to him."
More than half of the 500,000 mortgages from 48 states contained in the Goldman deal -- known as Abacus 2007-AC1 -- are now in default or foreclosed. (See slides of some of the homes backed by the Abacus mortgages.)
Paulson didn't have any direct involvement in the mortgages contained in the Goldman deal under scrutiny by the Securities and Exchange Commission. And the bets that Paulson placed on Abacus didn't affect whether or not homeowners defaulted. Rather, he used Wall Street to help structure hugely lucrative side bets that homeowners such as Booket couldn't make their monthly mortgage payments.
One loser in the deal, German bank IKB Deutsche Industriebank, saw most of its $150 million Abacus investment evaporate. It had believed that borrowers broadly could afford the loans. The bank says it is cooperating with the SEC's inquiry.
"There's no question we made money in these transactions," said a Paulson spokesman in a statement. "However, all our dealings were through arms-length transactions with experienced counterparties who had opposing views based on all available information at the time. We were straightforward in our dislike of these securities but the vast majority of people in the market thought we were dead wrong and openly and aggressively purchased the securities we were selling."
Some of the people whose mortgages underpinned Paulson's wager were themselves taking a gamble -- that U.S. housing prices would continue to march upward, making it possible for them to eventually pay off loans they couldn't afford.
The Wall Street Journal identified homeowners in the Abacus portfolio by taking the 90 bonds listed in a February 2007 Abacus pitch book and matching them with court records, foreclosure listings, title records and loan servicing reports. The bonds contained nearly 500,000 mortgage loans.
Nonetheless, she took out an even bigger loan from Fremont, which lent her $786,250 at an initial interest rate of 7.55% -- but that would begin to float as high as 13.55% two years later. She says the monthly payment on the new loan came to a bit more than $5,000.
She defaulted in early 2008 and was evicted from the house in early 2009.
Fremont didn't respond to requests for comment.
In early 2007, Paulson's company was identifying different bonds from across the country that it wanted to place bets against. Paolo Pellegrini, Paulson's right-hand man, began working with Goldman trader Fabrice Tourre to choose bonds for the Abacus portfolio, say people familiar with the deal.
Abacus was a "synthetic" CDO, meaning that it didn't contain any actual bonds. Rather, it allowed Paulson's company to buy insurance on bonds it didn't own. If the bonds performed well, Paulson would make a steady stream of small payments -- much like insurance premiums. If they performed poorly, Paulson would receive potentially large payouts.
According to the SEC complaint, Paulson especially wanted to find risky subprime adjustable-rate mortgages that had been given to borrowers with low credit scores who lived in California, Arizona, Florida, and Nevada -- states with big spikes in home prices that he reckoned would crash.
Pellegrini and a colleague had purchased an enormous database capable of tracking the characteristics of more than six million mortgages in various parts of the country. They spent long hours scouring it all, according to people familiar with the matter.
Continued: Limited English-speaking skills
