U.S. News

A Routine Deal Became an $840 Million Mistake

Landon Thomas, Jr.|The New York Times

To the bankers here, it seemed like a chance to make a quick $7 million — risk free.

Instead, their sweet deal turned into a $840.1 million debacle.

In May 2007, a handful of bankers in London agreed to take a role in a complex mortgage investment being devised by Goldman Sachs.

The Royal Bank of Scotland Headquarters
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That decision set off a chain of events that left the Royal Bank of Scotland Group — to many Britons, a symbol of the excesses that brought the financial world to its knees — as the biggest loser in the deal that has now drawn Goldman into a legal maelstrom.

How R.B.S. became entangled in this investment, Abacus 2007-AC1, is a story of these financial times. What is perhaps most unusual about the deal, and the London bankers’ role in it, is that it was so routine. Abacus, which is now at the center of accusations that Goldman defrauded investors, was one of countless mortgage deals that ricocheted between Wall Street and Europe during the heady days of the boom.

Indeed, after R.B.S., the biggest loser in Abacus was IKB Deutsche Industriebank of Germany, which was a big player in such mortgage investments.

Executives involved in the transaction say that while the fine print was scoured intently, the larger question of why the bank was increasing its exposure to an increasingly tenuous American housing market was given short shrift.

The $840.1 million that Abacus cost R.B.S. represented a small part of the crippling losses that led the British government to rescue the bank in the costliest bailout of any bank worldwide. Today R.B.S. is all but nationalized; the British government owns about 84 percent of it.

Gordon Brown, Britain’s prime minister, has called for an investigation into the Abacus deal, as has the German chancellor, Angela Merkel.

But R.B.S. became involved in Abacus almost by accident. Bankers working in London for ABN Amro, a big Dutch bank that was later acquired by R.B.S., agreed to stand behind a portfolio of American mortgage investments that were used in the deal. ABN Amro shouldered almost all of the risks for what, in retrospect, might seem like a small reward: that $7 million. When the housing market fell and Abacus collapsed, R.B.S. ended up on the hook for most of the losses.

For ABN Amro, Abacus was just another product on the Wall Street assembly line. Like its counterparts in the United States, the Dutch bank seized on the mortgage mania to expand what was, at the time, a highly lucrative business.

How much its bankers earned, in salaries and bonuses, is not known. But at many banks, bonuses were often based on profits that turned out to be ephemeral, much like the profits that ABN Amro initially reaped on Abacus.

When the Abacus investment soured, Royal Bank of Scotland, under the terms of the deal, was obligated to cover the $840.1 million in losses. The British bank paid that sum to Goldman Sachs, which, in turn, paid John A. Paulson, the hedge fund manager who had bet against the deal. According to the Securities and Exchange Commission, Goldman had devised the investment to fail from the start so that Mr. Paulson could wager against it. Goldman has vowed to fight the claims, which it has called baseless.

Mr. Paulson was not named in the S.E.C.’s civil fraud suit.

The ABN Amro executives who were involved in the Abacus deal were, like Abacus itself, largely unknown. Many focused on “exotics,” that is, complex instruments that are virtually unheard of outside of financial circles.

These executives included Mitchell Janowski, the head of credit trading exotics at ABN; Richard Whittle, global head of credit and alternatives trading; and Stephen Potter on the trading desk, whose job it was to present the trade to ABN’s credit and risk committee.

At the furthest remove from the trade was Robert McWilliam, who was in charge of assessing the credit quality of ABN’s trading counterparties.

According to people involved in the transaction, Goldman and ACA Capital, a bond insurance company that also played a central part in Abacus, contacted ABN Amro because they needed a big bank to offset ACA’s risk in the deal.

Some at ABN Amro questioned ACA’s second-tier status in the industry, as well as signs that the housing market was in trouble. But the Dutch bank was happy to take the easy $7 million upfront fee for what its executives concluded was a relatively small risk. The bank’s credit committee signed off.

In its role, ABN Amro essentially agreed to pay off bets on the mortgage investments linked to Abacus in the event hard-pressed homeowners defaulted on their mortgages and the investments declined in value. In return, the bank would collect its $7 million.

But, almost from the start, Abacus began to fall apart. More than 80 percent of the mortgage securities behind the deal were soon downgraded as the crisis in the housing market spread. Goldman itself claims that it lost about $100 million on the deal.

Some inside ABN Amro were leery of Abacus early on. Indeed, several traders there immediately bought credit default swaps — insurance-like instruments — from Goldman Sachs to hedge their exposure to ACA.

After R.B.S.’s purchase of ABN Amro became official in 2008, most of the ABN team went their separate ways. Only Mr. McWilliam, who focuses on counterparty risk, remains at the bank.

Mr. Janowski lives in Boulder, Colo., where he trades independently. He declined to comment on his role. Mr. Potter and Mr. Whittle could not be reached. A spokesman for R.B.S. said Mr. McWilliam declined to comment.

Former ABN executives were divided on the merits of the case against Goldman. One person involved in the deal said that if ABN Amro executives had known of Mr. Paulson’s role in Abacus they might have had second thoughts about the deal.

But another former executive insisted that ACA, as an expert in this area, had a chance to reject the securities that Mr. Paulson had chosen for the deal.

“These guys were experts,” this person said. “If they were so good and thought the market was going to go to hell, they should not have put their name to it.”