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The Toxic Billion Dollar Goldman Sachs Bond Deal that the SEC Let Get Away

April 29, 2016, 10:00 AM UTC
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In early 2012, the Securities and Exchange Commission had Goldman Sachs, and perhaps the rest of Wall Street, in its sights.

SEC enforcement lawyers believed they had uncovered evidence showing that Goldman had defrauded investors, misleading them into thinking a particularly toxic subprime $1.3 billion mortgage bond, Fremont Home Loan Trust 2006-e, was a safe bet. Internal Goldman emails showed that one of the bankers on the deal knew that Fremont, the loan originator, had never verified the value of the homes on which the loans in the deal were based. Worse, many of the mortgages in the deal had previously been rejected by Goldman. But this time around, a supervisor at Goldman instructed a quality assurance staff member to make “liberal assessments.” What’s more, the SEC had evidence that Goldman knew it was likely that more than 10% of the loans in the deal were credits that Goldman classified as so-called EV3s—”unacceptable risks,” or “drops.” A third party reviewer, mortgage due diligence firm Clayton, had told the bank as much. Yet nearly all of the deficient loans were waived into the deal, including one where a borrower had a debt-to-income level of 91%.

In mid-February 2012, the SEC sent Goldman a Wells notice, formally notifying the firm that the SEC was drawing up a civil fraud suit based on the deal. It would have been the SEC’s second big case against Goldman (GS) in less than two years. The bank had paid $550 million to settle claims it defrauded investors in the Abacus CDO in July 2010. This second case had the potential to be a blueprint for other actions against the big banks. Goldman had 30 days to respond.

And then, nothing.

In August 2012, Goldman said in a securities filing that it had received word from the SEC that the regulator had closed its investigation and would not bring any action against the bank related to mortgage bonds. The fine Goldman had to pay? Exactly zero.

Four years later, the Goldman SEC case-that-never-was is a black eye for the SEC and offers further proof that Wall Street’s chief regulator failed to do its job in the wake of the financial crisis. Meanwhile, earlier this month, Goldman Sachs agreed to pay nearly $5.1 billion to settle claims from the Department of Justice that the bank defrauded investors in mortgage bond deals.

The DOJ settlement covers dozens of deals. But Colleen Kennedy, an assistant U.S. attorney in Sacramento and one of two government lawyers who led the DOJ’s Goldman mortgage investigation, says that one of the deals she and her colleagues looked at closely was Fremont Home Loan Trust 2006-e, the same deal the SEC had investigated. What’s more, according to a person with the knowledge of the SEC’s investigation and the DOJ’s eventual settlement with Goldman, the SEC largely had the same evidence the DOJ did. But rather than secure a billion-dollar settlement, as the DOJ did, or go to trial, the SEC dropped its case.

“There’s no question the DOJ took a much more stern stance with the banks starting in the last two years of [Eric] Holder’s tenure as U.S. Attorney General,” says John Coffee, a law professor at Columbia University. “The SEC hasn’t gotten billions from anyone.”

No one at the SEC has publicly explained what derailed the regulator’s Goldman mortgage bond investigation. And while there has been a fair amount of turnover at the SEC, the group that pursued the case and other complicated deals in the wake of the financial crisis remains largely intact.

Pointing fingers

In an email to Fortune, Mary Schapiro, the former SEC chairwoman who left the agency in late 2012, says despite the Wells notice and all the evidence that the SEC amassed against Goldman, the case never made it to her or the other commissioners. Schapiro essentially points the finger at Robert Khuzami, who was then the head of enforcement for the SEC, for dropping the ball. “You would have to ask the enforcement director at the time,” Schapiro responded. “If the staff doesn’t recommend charges, the Commission has nothing to vote on.”

Following the Wells notice, it looks like Khuzami killed the case and told Goldman it was off the hook. According to Kennedy, the case was never referred to the DOJ, which started looking at FHLT 2006-e and other deals when it began its own independent investigation of Goldman in January 2014. Khuzami left the SEC in 2013 and is now a partner at top law firm Kirkland & Ellis, where he has represented companies including Deutsche Bank.

Khuzami did not respond to Fortune’s requests for comment. Both the SEC and Goldman declined to offer comment for this story.

The SEC has levied a total of nearly $3.8 billion in fines against firms and individuals for conduct related to the financial crisis, including the $550 million settlement in the Goldman Abacus case. But that’s tiny compared to the nearly $45 billion in fines, penalties, and settlements dolled out by the government’s mortgage taskforce, which is a collaboration between the DOJ and a number of state attorneys generals, including New York’s Eric Schneiderman.

Around the same time that the SEC sent Goldman a Wells notice, it also began a similar investigation into the giant bank Wells Fargo (WFC). The SEC did get Wells Fargo to pay a $6.5 million fine for its mortgage misdeeds, which included $65,000 in illegally obtained profits. Earlier this month, Wells Fargo settled similar charges brought by the Department of Justice. This time, the bank had to shell out $1.2 billion in fines.

House Financial Services Committee Hearing On Financial Regulation
Robert Khuzami, when he served as director of the division of enforcement at the U.S. Securities Exchange Commission Photograph by Andrew Harrer — Bloomberg via Getty Images
Photograph by Andrew Harrer — Bloomberg via Getty Images


The SEC’s lackluster pursuit of Wall Street has been in the spotlight recently. A recent story in the New Yorker by ProPublica’s Jessie Eisinger detailed one SEC lawyer’s ultimately failed attempt to get the agency to pursue top officials at Goldman Sachs in the Abacus case. Instead, SEC officials, much like the Wall Streeters it regulates, seemed eager to label the financial crisis the result of stupidity and not fraud, looking to move on rather than hold bankers accountable. Last week, Senator Elizabeth Warren slammed the SEC for allowing Steven A. Cohen, the hedge fund manager whose former firm was accused of insider trading, to start running investment funds again.

The SEC may not be entirely at fault for its limited success with its financial crisis-related investigations. The DOJ, unlike the SEC, has the power to bring criminal cases. Experts say that gives it more leverage when negotiating settlements. In the past, the DOJ’s enforcement of financial crimes, like junk bonds and insider trading in the late 1980s and early 1990s, has been tougher than the SEC. What’s more, the DOJ does have more leeway than the SEC in the fines it can assess. And many have argued that the SEC lacks the financial resources to complete its mission. According to sources, the SEC asked Congress after the financial crisis for funding to hire 40 more staff attorneys to dedicate to mortgage cases. The request was denied.

“I absolutely think the SEC lacks anything resembling adequate enforcement capability,” says Brandon Garrett, a University of Virginia law professor and author of the book Too Big To Jail. “Nonetheless, the perception is that the SEC wasn’t all that invested in pursuing financial crisis cases.”

Still, legal experts say the civil statutes that the SEC and the DOJ can prosecute under are essentially the same and require the same level of proof. The main difference is that the DOJ enjoys a longer statute of limitations, but that didn’t come into play in the Goldman case.

The SEC may have ended up with smaller settlements because they opted to target individual bond deals. The DOJ, by contrast, has taken the stance that the banks’ conduct was serial and have gone after a number of deals at once.

A nasty bond from the start

From its birth, FHLT 2006-e was a pretty nasty bond, as I have written in the past. Launched in December 2006, just as the subprime mortgage market was showing signs of the trouble ahead, FHLT 2006-e was a collection of roughly 5,000 subprime home loans, wrapped up into a bond. Many of the home loans were made in California to borrowers with credit scores in the low 600s, but who had borrowed, on average, around $330,000 each.

In 2012, I noted that even by Goldman’s own admission about 13% of the borrowers in the pool had credit scores lower than 549—a score that would barely qualify for a cell phone contract, let alone a house. As Goldman began to package the loans into a bond, things started to get worse. According to previously unreported Goldman Sachs internal emails obtained by the SEC and the Department of Justice, in early November 2006, a Goldman employee in the quality control department sent an email to bankers putting together the Fremont deal to say that 296 of the loans in the proposed pool for FHLT 2006-e were mortgages that Goldman had already rejected and would probably have to reject again. According to the email, which Fortune has not seen but the existence of which and its contents have been verified by two different sources, some of the loans had been rejected because they had a loan-to-value ratio greater than 100%, meaning what the borrower owed was larger than what their house was worth. In other loans, borrowers claimed to be taking out mortgages against their primary residence, when in fact records showed that they lived in other states, often far away. Many of the mortgage files lacked proper documentation. And many of the borrowers had debt-to-income levels that exceeded 55%, much higher than typical accepted.

In response, the Goldman quality control employee got an email from his manager saying he and others should use a “liberal assessment” when deciding which loans would be allowed in FHLT 2006-e. And that’s what they did.

The next day, the finance employee emailed back with good news. Of the previously rejected 296 loans, a further examination found that 155 of them could be included in FHLT 2006-e. The response from the finance employee’s manager was disappointment. “155 not good,” the manager wrote in an email. “Calling Florida to go over in detail, but much higher than we discussed yesterday.”

Later that day, the finance employee emailed his manager to say he had even better news. It turned out that an additional 62 loans could make it into the deal. Eventually 236 of the previously rejected loans got included in FHLT 2006-e. It didn’t seem to matter that appraisals in 60 of the loans appeared to be inflated. Another 50 mortgages had loan-to-value ratios of over 100%, meaning the houses were already underwater.

But Goldman wasn’t finished. On top of reconsidering loans it had already rejected, the bank also called in Clayton, a third-party reviewer, to look at a sample of the loans in FHLT 2006-e. It’s common to use a sampling method to identify problems in mortgage securitizations rather than looking at all the loans in a given deal. When Goldman did its own deals, it typically sampled 30% of the loans to inspect for errors. In the Fremont deal, where Goldman didn’t own the loans (it was just underwriting the bond), it told Clayton to sample just over 10% of the loans in the deal, or 615.


Of the loans Clayton examined, 71 were deemed to be EV3, or loans that did not meet the standards of the deal. Nonetheless, Goldman ended up including 67 of the loans flagged by Clayton in the deal anyway. But the bigger problem was this: By the time Goldman was marketing FHLT 2006-e to potential investors, Fremont had developed a reputation for lax lending, and investors were growing wary of home values in general. As a result, according to the DOJ’s settlement, Goldman in late 2006 launched an effort to brush up Fremont’s image, presenting its officials to investors to tout the mortgage broker’s improved lending guidelines. According to the DOJ’s settlement with Goldman, Fremont promised investors that it would tighten its underwriting standards. This included conducting independent appraisals of the properties in the loan pool to make sure that the homes values hadn’t been inflated, according to a source familiar with the matter.

But when Clayton examined the 615 loans in FHLT 2006-e, it found that not a single one of the files attached to the mortgages included the promised appraisal reviews. On November 22, 2006, a Clayton employee emailed an employee in Goldman’s due diligence department to inform them of this, and the fact that the lack of appraisal reviews may force Clayton to find that all of the loans in the pool should be rejected. A little while later, the Goldman employee wrote in a reply email, “We are OK with the missing appraisals reviews.” Two weeks later, Goldman sold off FHLT 2006-e, and its roughly 5,000 subprime loans, to investors, raising $1.3 billion.

The fallout

By the time the SEC issued its Wells notice in February 2012, it was clear that FHLT 2006-e was a disaster. Investors had already lost over $400 million on the deal. As for the borrowers, 10% had lost their houses to foreclosure. Another 20% hadn’t made a mortgage payment in over a month.

Sources have told Fortune that shortly after the SEC issued its Wells notice, lawyers from Sullivan & Cromwell, which has long defended Goldman, showed up at the SEC’s offices. The lawyers from Sullivan & Cromwell argued that the terms of the Fremont deal were different than those in an earlier Goldman deal, which is why the previously rejected loans made it into FHLT 2006-e. The lawyers also argued that all of the loans Clayton flagged but were later waived into the deal had mitigating factors that made them sound. Sullivan & Cromwell lawyers wanted to take the SEC through the 5,000 loans in the Fremont deal one by one, and said they would do the same thing with a jury. Shortly thereafter, the SEC dropped the case.

A year and a half later in January 2014, the DOJ’s Kennedy and Kelli Taylor, another assistant U.S. attorney in Sacramento, fresh off a $13 billion settlement with J.P. Morgan, began to look at mortgage deals underwritten by Goldman in the run up to the financial crisis. They quickly landed on FHLT 2006-e along with a number of other Goldman deals that they thought suggested the bank may have done something wrong.

According to a source familiar with the Goldman mortgage investigation, the SEC’s lawyers had not conducted a loan-by-loan analysis, a standard practice in DOJ investigations of such deals.

Kennedy and Taylor say the case was not referred to them by the SEC, but they declined to comment on anything else related to Goldman and the SEC.

The SEC is part of the government’s residential mortgage backed securities working group. But the agency was not a part of the recent $5 billion settlement with Goldman. The losses to investors in FHLT 2006-e alone have come to a total of $558 million. Of the remaining loans in the deal, 20% are either delinquent or in foreclosure proceedings.

On the day the DOJ settlement with Goldman Sachs was announced on April 11, Rene Febles, who is the Deputy Inspector General for Investigation at the government housing authority FHFA-OIG, said in a release, “Goldman Sachs had a fiduciary responsibility to investors, which they blatantly side stepped … one can only hope that Goldman Sachs has learned the difference between risk and deceit.”

Phil Angelides, who led the Financial Crisis Inquiry Commission, is not convinced big banks, including Goldman, have changed their ways. Last month, newly unsealed documents from the FCIC showed that the commission had referred evidence to the Justice Department to pursue investigations against a number of former high ranking Wall Street executives, including Robert Rubin. The DOJ, though, never brought cases against any of those individuals.

“The people who are responsible for the financial crisis have still not been called to account,” says Angelides, who notes that the DOJ did not name any individual bankers in its settlement with Goldman. “It’s fair to say that the Department of Justice has been better. But both the SEC and the DOJ have been lagging and lacking.”