Has Goldman Set a Dangerous New Precedent By Folding on Subprime Lending in Boston?

Includes: CFC, FMCC, FNMA, GS
by: Bruce Krasting

There are approximately 1.2 million register lawyers in the United States. 1.1 million of them saw this headline yesterday. The 100,000 lawyers who did not see it were on vacation and will be aware of it soon enough.

The net of this story is that Goldman Sachs (NYSE:GS) has agreed to pay the state of Massachusetts $60 million to settle a dispute regarding Goldman’s “predatory lending” practices in and around Boston. $50 million will be made available to reduce the loan principle on 714 individual mortgages. Of note is that the agreement called for reductions in principal of as much as 30% for traditional mortgages and up to 50% on second mortgages. Also of note is that the State of Massachusetts gets to keep $10mm for their efforts. Not bad for Attorney General Martha Coakley.

This means next to nothing for Goldman Sachs. However, a very dangerous precedent has been set. In the critical years 2005-2007 Goldman was ranked 15th in the League Tables for sub prime and Alt-A origination/securitization. Goldman’s management must be pleased as punch with that poor showing today. Those that ranked high on that list are no doubt consulting with their attorneys.

If Goldman gets its hand slapped for $60mm over 714 mortgages what does this mean for Countrywide Financial (CFC)? They were very big in Boston. Merrill Lynch was at the top of those securitization tables. That is what got Stan O’Neal fired. If the settlement in Boston is representative of what will be forthcoming then Bank of America (NYSE:BAC) is going to be facing a very big number. And that is just Massachusetts. The AGs in the all of the other states, especially Florida, Nevada, Arizona and California must be licking their chops at this news.

One hears a lot about loan modifications these days. So far there are two basic approaches:

I) The borrower is given relief in the form of a lower interest rates and stretched-out maturities. The homeowner stays in the home.

II) The bank will accept a deed in lieu of the mortgage. The homeowner is out of the home.

There have been very few cases where a homeowner is allowed to stay in the home and achieve a principal reduction. The Boston settlement opens the floodgate for principal reduction. It is the essence of the agreement. All 714 borrowers are now eligible for principal reduction and the money is just sitting there waiting to be collected.

One can imagine the conversations between neighbors in Boston:

A: “Good news finally! I just got 35% net off my first and second mortgage.”

B: “Wow! How did you manage that?”

A: “I was lucky enough to get my mortgages through Goldman Sachs. They did a deal with the Mass AG and I win the lotto!

B: “I have my mortgages with Indy Mac Bank (OTCPK:IDMCQ) can I get reduction too?

A: Sure. Here is the number to call. Now lets party!

This is lining up badly for the banks. The States are broke. They will see this as a source of revenue. Politicians will also like it. They will be able to claim that they are helping their constituents. Word on this will spread quickly from borrower to borrower. Every one of them will be looking for a break.

The settlement makes an important distinction between first and second mortgages. The rights of the second mortgages are clearly subordinated in the deal. This is how a bankruptcy court would treat the two classes of debt. This provides a clue on how these ‘seconds’ will be treated in the future.

One of the largest sources of these second mortgages is the Mortgage Insurance Industry. They provide a guaranty of payment on the first loss of 20%. This product competed with the second mortgage industry. It created the same result for the borrower, the ability to buy a home with no money down. Precisely what Goldman is paying up for. In this case what quacks, walks and swims like a duck is likely to be treated like a duck.

Fannie Mae (FNM) and Freddie Mac (FRE) hold tens of billions of these insured or ‘enhanced’ mortgages. FHFA recently reported that the Agencies collectively held or guaranteed 30.2 million mortgages. Of that amount 16%, or 4.8 million are identified as “Non Prime”. Put differently, the Agencies hold 6,000 times more non-prime mortgages then Goldman originated in Boston.

At this point it is not at all clear what the broader implications of the Goldman settlement will be. This development has put the issues of lender liability and principal reduction on the table. It is unlikely they will come off the table anytime soon.

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