Main St. paid for Wall St. maneuvers

NEW YORK —  The doomed deal at the heart of the government’s civil fraud suit against Goldman, Sachs & Co. was designed for sophisticated investors.

But one of the main buyers of the complex toxic securities issued by the Goldman vehicle, a German bank known as IKB, paid for its share of the deal with money it collected from a number of relatively unsophisticated investors including King County in Washington state.

In 2007, the county bought $100 million of commercial paper, a type of short-term debt, from Rhineland, a special fund created by IKB that in turn snapped up nearly $150 million of the securities created by the Goldman vehicle known as Abacus 2007-AC1.

When the huge financial apparatus devised by Goldman went down in flames, taking Rhineland with it, King County was saved from a loss only because IKB had agreed to insure Rhineland’s debt.

But the local government wasn’t so lucky with a similar, $50-million purchase it also made in 2007 from another IKB fund, dubbed Rhinebridge.

The county lost $19 million when Rhinebridge collapsed -- and an additional $54 million when other similar funds defaulted. About 100 county agencies in the Seattle area, including some that deal with libraries and schools, saw their budgets cut as a result. The county has sued IKB and the rating firms that put their stamps of approval on Rhinebridge.

“They invested in commercial paper that they thought was as safe as Treasury bonds,” said James Cox, a professor of securities law at Duke University. “They undoubtedly thought they were investing in something much more secure.”

“We got caught up in the ... disruptions caused by this sort of slick, extremely high-level shenanigans that were going on,” said Larry Gossett, a member of the King County council.

The case illustrates how complicated schemes created by Wall Street toward the end of the mortgage boom depended ultimately on Main Street’s money.

The relationships were so tangled that some parties have since been labeled both victims and perpetrators. In the Abacus deal, the Securities and Exchange Commission suit says, IKB was misled by Goldman about the nature of the deal. King County’s suit, however, claims IKB was smart enough to realize it was buying toxic assets and hid their risk from Rhinebridge’s investors.

“What we define as sophisticated is turning out to be not all that sophisticated after all,” said Lynn Stout, a professor of securities law at UCLA. “A lot of people -- sophisticated and unsophisticated -- had come to trust regulators to make sure that investments were honestly marketed. They came to assume that if something was being sold, it was probably reasonably OK.”

Rhineland and Rhinebridge, both named after the German river that runs near IKB’s headquarters in Dusseldorf, were designed to earn a profit by collecting more in income on mortgage-backed securities like Abacus than the funds were paying in interest to investors such as King County.

The county bought its Rhinebridge commercial paper in the summer of 2007, when the investment pool opened. By November, according to the county’s suit, the fund was insolvent because of the collapsing mortgage market, making it “perhaps the shortest-lived ‘triple A’ fund in the history of corporate finance.”

IKB has called the suit “entirely without merit,” saying Rhinebridge investors were given “proper and complete disclosure.”

The suit, filed in federal court in Manhattan, lays much of the blame on the three big rating firms that gave Rhinebridge top grades, saying they ignored the fact that the housing market had already peaked, spelling trouble for mortgage securities.

“The music stopped at the latest in 2006, but the rating agencies kept dancing,” the suit says. “They pretended to hear the music because defendant IKB, among others, paid them handsomely to make believe nothing had changed.”

A spokesman for McGraw-Hill Cos., which owns Standard & Poor’s, said the King County suit had no merit. Lawyers for the other rating firms named in the suit, Moody’s Investors Service and Fitch Ratings, didn’t return phone calls seeking comment.

Other lawsuits against rating firms have struggled to pass muster with judges, getting thrown out before reaching trial. But this month the judge overseeing the King County case rejected requests by the defendants to dismiss it. The suit has been certified as a class action representing all Rhinebridge investors. A trial is set for next year.

After Rhinebridge defaulted, its assets were auctioned off. King County got back 55 cents for each dollar it had invested. At another fund, called Mainsail II, the county received 35 cents on the dollar. The county is pursuing litigation in the Mainsail case. The county’s mortgage-related losses cut its 2008 investment earnings in half, forcing budget cuts including the suspension of the county library system’s building program.

Since those direct hits, King County continued to struggle during the recession and its aftermath. Last week, days before Goldman announced another strong quarterly profit, county officials announced that they were looking at laying off hundreds of police officers and prosecutors.

Gossett, the county council member, said the county invested in Rhinebridge because the commercial paper paid a higher interest rate than money market funds.

“We had no way of knowing or having a deep understanding of how it was working,” he said. “We just knew that early on it was providing better returns.”

nathaniel.popper @latimes.com