Rep. Darrell Issa (R-Calif.) (Louie Palu/ZUMA Press)

In April, the multibillion-dollar hedge fund Paulson & Co. was cited in a blockbuster Securities and Exchange Commission civil fraud suit against Wall Street investment bank Goldman Sachs. The SEC complaint alleged that Paulson helped build investment vehicles predicated on rising real-estate prices — and then bet against them, making more than $1 billion on the collapse of the subprime market and the nationwide housing market decline.

[Congress1] Now, Rep. Darrell Issa (R-Calif.), the ranking Republican on the House Oversight Committee, has opened an investigation into whether Paulson did much the same — blowing up the subprime bubble while standing to reap hundreds of millions when it burst — via a large donation to a nonprofit group.

In a May 26 letter to John Paulson, the head of Paulson & Co., Issa asks for documents relating to the firm’s $15 million July 2007 donation to the Center for Responsible Lending, an advocacy group that runs community banks to provide loans to low-income Americans, lobbies for stronger consumer protections on Capitol Hill and offers legal aid to victims of predatory lending, among other activities. The Issa letter implies that Paulson donated to the CRL to stoke the housing bubble and thereby increase its returns. (Ben White first posted the letter at Politico.)

The allegations in the Issa letter stem not from a congressional investigation or think tank report — but from Americans for Prosperity, the Koch family-funded conservative advocacy group famed for supporting the Tea Parties and rallying against health care and financial regulatory reform. CRL contends that AFP’s investigation misconstrues the way its lending programs work, and Paulson pushes back against the idea that it used charitable donations for business ends.

“According to reports,” the Issa letter reads, “CRL was involved in a strategy to ‘shake down and harass banks into making bad loans to unqualified borrowers.’ Central to CRL’s strategy were loans made under the Community Reinvestment Act, legislation designed to encourage banks to make loans to low-income borrowers using loosened underwriting standards.”

But the “reports” cited by Issa come from Americans for Prosperity. The quotation comes not from any independent study, but from a FoxNews.com op-ed by Phil Kerpen, the head of AFP. And the Issa letter is a product of AFP’s months-long grassroots campaign to convince Washington lawmakers to investigate the ties between Paulson, CRL and the Obama administration, alleging that Paulson used the CRL to stoke and then pop the property bubble and criticizing the “revolving door” between CRL and the administration.

AFP faults the CRL and other community lenders that do not require high down payments or take on borrowers with bad credit for blowing up the housing bubble. It also alleges that the CRL “harasses” big banks into making bad loans, by accusing them of redlining when they do not penetrate low-income or minority communities, for instance.

It makes sense, Kerpen told TWI, that Paulson would donate to CRL to help it fund bad loans or to convince it to make more of them — and then collect a profit once the bubble collapsed. In his op-ed, he argues that the CRL donation and the Goldman Sachs deal were two sides of the same coin.

“Paulson paid Goldman Sachs … $15 million to design collateralized-debt obligations comprised of specific subprime mortgages that he selected,” he wrote. “This bucket of investments may have included loans that he knew were unsound and were made only because banks were strong-armed by the CRL. Until there is a full investigation, we won’t know for sure, but it appears Paulson’s $30 million — split between the CRL and Goldman Sachs — financed a scheme that netted his fund a cool $1 billion dollars.”

Of course, Paulson & Co.’s true motivations are opaque. But the firm hit back against allegations that the donation had any business motivation whatsoever, saying the funds helped create an institute to provide legal assistance to homeowners, not to originate subprime loans.

“Paulson & Co’s donation was used exclusively to provide legal assistance to people facing foreclosure to help them stay in their homes,” the company’s spokesperson, Armel Leslie, wrote in an email. “The program has provided legal assistance to thousands of people facing foreclosure. It has distributed $10 million to 34 legal service organizations in 30 states through multi-year grants. [And the] CRL estimates that the program has saved more than 1,300 homes.”

Paulson himself has argued the same. In 2008, the hedge fund manager told the House Oversight Committee that he made the donation in the hope of slowing the foreclosure crisis, not stoking it. “As we saw the difficulty homeowners were having in making mortgage payments, in July 2007, prior to the initiation of any government support programs, Paulson & Co. made a $15 million charitable contribution,” Paulson said in November 2008. “The institute supports local groups across the country providing legal representation to families facing foreclosure.”

Michael Waldorf, a vice president at Paulson, has also defended the donation. “We decided to make a positive contribution in addressing a serious economic problem. People are being thrown out of their homes,” Waldorf told BusinessWeek’s Eamon Javers. “And if they don’t have enough money to pay their mortgages, then they don’t have enough money to pay a lawyer.”

(A person familiar with the hedge fund’s business also noted that the donation to CRL came at the end of Paulson’s property-bubble strategy, not the beginning or middle. The subprime bubble had already burst, with lenders declaring bankruptcy and foreclosures spiking, by the summer of 2007. Paulson’s millions had for the most part already been made.)

The CRL says that Paulson’s donation did not go to capitalize its community banking arm, and therefore never funded subprime loans. CRL spokesperson Kathleen Day says that while the CRL does originate subprime mortgages, it provides vanilla 30-year mortgages. The organization expects higher-than-average default rates because of its low-income lending mission. Additionally, she notes that the CRL itself takes on losses from loans it repackages or originates.

“Every bit of that money went to help people facing foreclosure try to save their homes,” she says. “I’ll say it over and over and over again. It led to fewer foreclosures. If anything, it would have cost Paulson money by easing [the foreclosure crisis]. And the CRL, since 1999, has been arguing for changes to the regulatory and bankruptcy laws to prevent the foreclosure crisis.”

Still, Kerpen and the Issa letter fault the CRL for stoking the housing bubble through low-income mortgage lending. And Kerpen wants a broader investigation into the CRL and its lending, advocacy and lobbying practices. He wrote in his opinion piece that the CRL has “[escaped] the spotlight of investigation, but under [Sen. Chris Dodd's (D-Conn.) financial regulatory reform bill] the CRL is poised to accomplish most of its longtime goals and achieve sweeping new powers.” (The Dodd bill does not give consumer advocates new powers beyond creating, in the form of a new Consumer Financial Protection Agency, a new rule-making entity to consider their concerns.)

And on Friday, Kerpen reiterated the broad concern behind his argument about the Paulson donation to CRL. “We think that the financial crisis is being used as a pretext for vast new regulations that have nothing to do with what went wrong,” he told TWI. “We’re particularly concerned that the Consumer Financial Protection Act was attached to the Dodd bill, and CRL was the advocacy group that was responsible for making that happen.”

The CRL argues that it advocates only for the interests of those afflicted by predatory lending and underserved low-income and minority communities — and that its political mission is sound. “These are all the same charges that have been dredged up for the past two and a half years by organizations that are against reform,” said Day. “It’s the payday lenders and financial services industry groups and others getting fronts to oppose us and bringing up bogus charges. [This is part of] an effort to try to torpedo legislation that will benefit consumers.”

On Friday, Kerpen said that he does not know Paulson’s motivations, but is happy that the government is finally investigating. “It is possible it was a coincidence. And it is possible that [Paulson made the donation] to assuage his guilt about the Goldman deal,” Kerpen says. “But it is also possible that [Paulson and the CRL] were sharing information.”

Lewis and BoA have been in hot water over their government-backed deal to acquire the failing Merrill Lynch in December. At the time of the deal, Merrill was set to pay $5.8 billion in employee bonuses — bonuses that BoA executives didn’t reveal to their shareholders, who approved the buyout.

The saga didn’t escape Democratic leaders on the House Oversight and Government Reform Committee, whose ongoing investigation of the deal has gained public prominence with several Capitol Hill hearings. Rep. Edolphus Towns (D-N.Y.), who chairs the panel, issued a statement Wednesday warning Lewis’s that the probe will continue despite the changing of the guard.

Our investigation has uncovered troubling facts about Bank of America’s acquisition of Merrill Lynch, and Mr. Lewis was at the center of this controversy. We hope that Bank of America’s new leadership will quickly repay American taxpayers and help us finally resolve unanswered questioned about this merger.

Bank of America purchased Merrill Lynch in December, even after then-BoA CEO Ken Lewis voiced reservations that the buyout would be a bad move for BoA shareholders due to the bad financial shape of Merrill.

Lewis later told New York’s attorney general that federal officials, notably Bernanke and Paulson, had pressured him to go through with the sale. To sweeten the pot, the White House eventually put up $20 billion of Wall Street bailout dollars to catalyze the deal.

Appearing before Towns’ panel last week, Bernanke defended his role in the saga. Paulson will have his chance  July 16.

AIG Tower, Hong Kong (flickr: Marc Oh!)

Three weeks after the Federal Reserve threw an $85-billion lifeline to the American International Group, the Fed gave another loan Wednesday to the world’s biggest insurer. This extra money could total $37.8 billion. An AIG spokesman said the second lifeline is necessary to deal with an “extraordinary situation in the markets.”

Former company CEOs insisted at a congressional hearing this week that it was these larger market forces, rather than any decisions made by executives, that caused AIG to unravel.

Neither Martin Sullivan, who ran the company from 2005 to 2008, nor Robert Willumstad, his successor who was fired a week before AIG’s government bailout, admitted any misjudgment or apologized for any company decision. These included giving a $1-million-a-month consulting job to the executive most responsible for the company’s collapse.

Asked how AIG got into such dire financial straits, Sullivan and Willumstad both blamed a “financial tsunami” beyond their control. When questioned about the company’s decision to rely so heavily on the secondary mortgage market, the source of AIG’s principal troubles, each CEO pointed the finger at the other.

The AIG hearing, held Tuesday by the House Committee on Oversight and Government Reform, was the second of five scheduled House oversight hearings into the financial crisis. The first, on Monday, probed the collapse of the investment bank Lehman Bros., whose bankruptcy filling on Sept. 15 may have ignited the credit crisis. At that hearing, CEO Richard Fuld Jr. infuriated committee members by portraying Lehman as a victim of what he also called a “financial tsunami.”

Illustration by: Matt Mahurin

The stated purpose of the hearings is to determine what the federal government can do to monitor the historic financial bailout bill, that became law last Friday, and prevent another crisis.

What distinguishes the hearings so far is the lack of contrition on the part of the financial-services executives testifying before the committee. They have deflected questions from both Republican and Democratic representatives, who seem equally infuriated about the crisis.

“It seems you have these company’s cultures and then the larger culture,” said Rep. John Sarbanes (D-Md.) during the Lehman hearing. “In June 2008, Richard Fuld actually said Lehman was doing well.

“What happens to make him think he can make such statements?” Sarbanes continued, “Is it the parties he’s going to? Is it the analysts who got paid to say he’s doing a good job?”

This line of questioning continued during the testimony of AIG’s Sullivan and Willumstad.

“Do you acknowledge that you are part of what triggered the financial tsunami?” Rep. Mark Souder (R-Ind.) asked the CEOs. “Do you bear any responsibility? You said you were making profits, but you had a shell [unit] that was anchored in less than secure mortgages. Why weren’t you warning your stockholders?”

“It’s not just us,” Sullivan responded. “The U.S. is in a financial Pearl Harbor.”

Former AIG CEO Martin Sullivan (flickr)

Nonetheless, Sullivan made decisions that would be a stretch to blame on overwhelming market forces. AIG has 116,000 employees in 130 countries. But it was AIG’s London-based Financial Products office, with 377 employees, that brought the entire company down.

By 2007, Joseph Cassano, head of that London office, had built a $500-billion portfolio in a mortgage-market derivative called credit default swaps — essentially insurance policies for bonds and loans. But Cassano never backed these assets with either capital or collateral.

As the mortgage-backed securities markets collapsed, it became clear that the credit default swaps insuring them were losing value as well.

The Treasury Dept. became alarmed. In a Mar. 10 letter to AIG, made public Tuesday, the Treasury’s Office of Thrift Supervision said that the failure to monitor AIG’S financial products constituted a “material weakness within corporate management’s oversight.”

The next day, March 11, Sullivan fired Cassano. But he handed him a $1-million-a-month consulting job. The only caveats were that Cassano would not take work with other companies and that Sullivan could terminate the contract on a monthly basis.

Even as AIG reported further losses, Sullivan did not end the relationship with Cassano. Sullivan’s successor, Willumstad, also kept him on.

“Why didn’t you fire Cassano?” Rep. Henry A. Waxman (D-Calif.), chairman of the oversight committee, asked Willumstad at the hearing. “This is the man who went out on his own and made the derivative deals that brought down AIG.”

Illustration by: Matt Mahurin

“During the unwinding of the company,” Willumstad replied, “you want to make sure you retain the intellectual knowledge of the key players.”

Strange as that may sound, consider this. In March 2008, Sullivan successfully lobbied the board to change AIG’s executive pay system in a way that would give him greater compensation.

Sullivan wanted the performance pay of 70 executives, including himself, not to “reflect the extraordinary market conditions” that he viewed as leading to AIG’s 2007 losses. So the board’s compensation committee decided to average the company’s 2007 losses with its spectacular gains from 2005 and 2006.

Sullivan reportedly received a bonus this year of close to $5.7 million, which is what he received in 2007. He told the oversight committee he has no plans to return the money.

The most embarrassing decision brought to light Tuesday was the weeklong, company-paid vacation for some high-performing insurance agents at the St. Regis Resort, in Monarch Beach, Calif., after the government bailed out AIG. The cost was $440,000, including a $23,000 bill for for spa services.

On questioning, Sullivan and Willumstad said that the vacation would not have happened on their watch. Both had left the company before the agents were feted.

As for the reasons behind the collapse of AIG, Willumstad blamed the company’s credit default swaps, which were started when Sullivan was CEO. Sullivan, for his part, largely fingered Maurice Greenberg, AIG’s founder and CEO from 1969-2005. Greenberg had said he was too sick to appear before the committee. But in written testimony, he largely blamed Sullivan.

On Monday, Lehman CEO Fuld also passed blame to someone else. “What happened to Lehman Bros. could have happened to any firm on Wall Street,” Fuld told the committee. “Lehman was a casualty of the crisis of confidence.”

But committee members were unsympathetic to this argument, focusing on the compensation that Fuld and other Lehman top executives received. “You [Fuld] made $480 million over the last eight years,” Waxman said to Fuld. “Is that fair?”

Waxman kept repeating the question, and Fuld kept deflecting it by contesting the accuracy of the $480-million figure. He said he earned less, closer to $350 million.

The committee wrapped up its two days of hearings Tuesday by firing off a letter off to Treasury Sec. Henry Paulson Jr. about excessive executive compensation at AIG.

Over the next two weeks, Waxman plans hearings on hedge funds, credit-rating agencies and — in all likelihood — Fannie Mae and Freddie Mac. The final hearing, scheduled for Oct. 23, will look at the role of federal regulators in policing Wall Street.

If the hearings go as planned, lawmakers will progress from excoriating Wall Street executive to figuring out what they — and the Bush administration — did to enable their behavior.