First of four parts

WASHINGTON – In 2006 and 2007, Goldman Sachs Group Inc. peddled more than $40 billion in securities backed by at least 200,000 risky home mortgages but never told the buyers that it was secretly betting that a sharp drop in U.S. housing prices would send the value of those securities plummeting.

Goldman's sales and its clandestine wagers, completed at the brink of the housing market meltdown, enabled one of the nation's premier investment banks to pass most of its potential losses to others before a flood of mortgage loan defaults staggered the U.S. and global economies.

Only later did investors discover that what Goldman promoted as triple-A investments were closer to junk.

Now, pension funds, insurance companies, labor unions and foreign financial institutions that bought those dicey mortgage securities are facing large losses, and a five-month McClatchy Newspapers investigation has found that Goldman's failure to disclose that it made secret, exotic bets on an imminent housing crash may have violated securities laws.

"The Securities and Exchange Commission should be very interested in any financial company that secretly decides a financial product is a loser and then goes out and actively markets that product or very similar products to unsuspecting customers without disclosing its true opinion," said Laurence Kotlikoff, a Boston University economics professor who has proposed a massive overhaul of the nation's big banks. "This is fraud and should be prosecuted."

John Coffee, a Columbia University law professor who served on an advisory committee to the New York Stock Exchange, said that investment banks have wide latitude to manage their assets, and so the legality of Goldman's maneuvers hinges on what its executives knew at the time.

"It would look much more damaging," Coffee said, "if it appeared that the firm was dumping these investments because it saw them as toxic waste and virtually worthless."

Lloyd Blankfein, Goldman's chairman and chief executive, declined to be interviewed for this story.

A Goldman spokesman, Michael DuVally, said that the firm decided in December 2006 to reduce its mortgage risks and did so by selling off subprime-related securities and making myriad insurance-like bets, called credit-default swaps, to "hedge" against a housing downturn.

Although the company had secretly bet on a downturn, DuVally told McClatchy that Goldman "had no obligation to disclose how it was managing its risk, nor would investors have expected us to do so. … Other market participants had access to the same information we did."

Managing the meltdown

For the past year, Goldman's been on the defensive over its Washington connections and the billions it received in federal bailout funds. Yet, scant attention has been paid to how it became the only major Wall Street player to extricate itself from the subprime securities market before the housing bubble burst.

In piecing together Goldman's role in the subprime meltdown, McClatchy reviewed hundreds of documents, SEC filings and copies of secret investment circulars and lawsuits. It also interviewed numerous people familiar with the firm's activities.

McClatchy's inquiry found that Goldman Sachs:

• Bought and converted into high-yield bonds tens of thousands of mortgages from subprime lenders that became the subjects of FBI investigations into whether the lenders had misled borrowers or exaggerated applicants' incomes to justify making hefty loans.

• Used offshore tax havens to shuffle its mortgage-backed securities to institutions worldwide, including European and Asian banks, often in secret deals run through the Cayman Islands, a British territory in the Caribbean used by companies to bypass U.S. disclosure requirements.

• Dispatched lawyers across the country to repossess homes from bankrupt or financially struggling individuals, many of whom lacked sufficient credit or income but got subprime mortgages anyway because Wall Street made it easy for them to qualify.

MONDAY: Since the economic collapse that swept millions of Americans out of their jobs and homes, Goldman Sachs has moved aggressively to recover losses. The firm is pursuing marginally qualified borrowers into federal bankruptcy and state courts across the country and seeking to seize their homes. McClatchy examines one couple's multi-year attempt to get Goldman to admit that it had purchased their mortgage. Call Greg Gordon, McClatchy Washington Bureau, (202) 383-0005.