EMAIL DETAILS

>
> Derivatives: A tricky pick
> By Jonathan Ford and Sam Jones
> Published: June 9 2010 20:58 | Last updated: June 9 2010 23:12
>
> It has become a familiar refrain up and down Wall Street. Whenever
> questions are raised about the complex subprime mortgage derivatives
> theinvestment banks sold during the credit boom, back comes the
> response: caveat emptor.
>
> Goldman Sachs rebutted the fraud charges brought against it recently
> by the Securities and Exchange Commission – the first case the US
> regulator has bought against issuers of these derivatives – by
> making just such an argument. The bank said that when it sold
> collateralised debt obligations (CDOs) that allowed investors to
> place bets on pools of subprime mortgages, it was dealing only with
> sophisticated investors who required no protection. They knew, or
> should have known, what they were doing. If they didn’t – well,
> buyer beware.
>
> Goldman has even referred to the investors who bought its CDOs as
> “among the most sophisticated mortgage investors in the world”.
>
> Wall Street’s finest have been bracing for the legal and regulatory
> backlash ever since regulators started poking around the CDO deals
> they sold. They have good reason to be nervous about the liabilities
> they may face. Between 2005 and 2007, investment banks issued about
> $1,100bn of CDOs. Huge losses from these products almost brought
> down the financial system the following year. If investment banks
> had to compensate buyers for even a fraction of these losses, the
> result would be financial carnage.
>
> But beyond the issue of legal liabilities, there are broader
> questions about the way investment banks behaved. Because they could
> deem buyers of CDOs to be “sophisticated” – a legal term dating back
> to the US Securities Act of 1933 and extended to over-the-counter
> derivatives in 2000 – they were free to treat them as
> counterparties, rather than customers to whom they owed a duty of
> care.
>
> As lawmakers and regulators look more closely at the CDO business,
> evidence is emerging of the way the investment banks used this
> freedom to take advantage of customers – many of whom they knew to
> be ignorant of the risks. This may come back to haunt the banks.
>
> The SEC case concerns a CDO – Abacus 2007-AC1 – created and sold in
> early 2007, just as the housing market was on the verge of melting
> down. Its allegation is that Goldman assisted John Paulson’s Paulson
> & Co hedge fund, which wanted to “short” (or bet against) the CDO,
> to influence its contents, some of which he picked for their
> toxicity. The investment bank then sold Abacus to its clients
> without telling them about Paulson’s true role. Indeed, it is
> claimed, the bank allowed those buyers to believe that it would be
> investing alongside them on the long side, an allegation that
> Goldman denies. Had they known the truth, the SEC claims, they might
> never have bought the CDO.
>
> Paulson was able to exert the influence it did because of the
> informal way in which Goldman and other investment banks put CDOs
> together. In spite of structuring and selling these products, they
> did not “sponsor” issues in the same way they would for an ordinary
> share offering (and consequently be obliged to endorse the quality
> of the investment).
>
> Their role was simply to co-ordinate a number of counterparties and
> agents that actually ran the CDO – and in the process, to take a
> fee. By 2007, CDO structuring was raking in billions of dollars for
> banks. It was the fastest growing and most lucrative area of most
> banks’ entire bond trading operations.
>
> Being at the centre of deals gave an investment bank great power. As
> it appointed the ratings agencies and managers, it could shop round
> for those that were likely to be the most compliant. It could
> promote the interests of favoured investors, use CDOs to hedge its
> own loan book or even take a trading position. This was a
> considerable edge.
>
> It was an edge the investment banks deployed against “long”
> investors on the other side of CDO trades. These were commercial
> banks, many from outside the US, that bought CDOs because new
> international capital rules let them hold highly-rated assets (even
> those backed by mortgages) off their balance sheets in special
> vehicles while setting aside only tiny slivers of capital against
> them. As this boosted returns, they piled in. By 2007, according to
> Merrill Lynch analysts, banks had vehicles containing close to
> $1,700bn worth of assets. One of these, Rhinebridge, a $15bn
> offshoot of the German bank IKB, was one of the main buyers of Abacus.
>
> Commercial banks such as IKB – which traditionally specialised in
> lending to small and medium-sized German businesses – did not
> adequately understand CDOs, it has since become clear. They relied
> too often on box-ticking due diligence procedures – ratings and the
> rubber stamp of CDO managers – to have purchases approved by their
> organisations’ credit committees.
>
> James Fairrie, a credit officer who formerly worked at IKB, says
> while due diligence was “extremely thorough on the face of it”, it
> did not ask the right questions. The order had “come down from on
> high that it was a good thing to buy CDOs”. Managers at the bank
> were often swept along by the pace of deals. “If I delayed things
> more than 24 hours, someone else would have bought the deal.”
>
> He attributes the pressure to “the extraordinary abilities of the
> American sales manager”, adding: “They are very insistent and
> persuasive. They made sure you were well looked after – entertained
> as well.”
>
> “IKB had an army of PhD types to look at CDO deals and analyse
> them,” says one CDO investor. “But Wall Street knew that they didn’t
> get it. When you saw them turn up at conferences there was always a
> pack of bankers following them.”
>
> . . .
>
> Nothing excuses the lack of savvy shown by the commercial banks.
> They took losses because of their own greed and ignorance. IKB, one
> of the first lenders to collapse in the credit crunch, was largely
> the author of its own misfortune. But that does not excuse
> investment banks if they took advantage of their clients’ credulity.
>
> A number of cases have come to light suggesting that this was going
> on. The Goldman case is all about “adverse selection” – putting
> risky assets into CDOs. This was not unique. As the mortgage market
> weakened, hedge funds eagerly sponsored CDOs to place negative bets
> – often seeking to push the most toxic debt they could into the
> structures.
>
> To win the hedge funds’ business, while also gaining the due
> diligence rubber stamp needed to mark the resultant CDOs fit for
> sale, investment banks recruited pliant CDO managers who signed off
> the hedge funds’ choices. “This adverse asset selection was going on
> a lot,” says one hedge fund investor. “Various CDO managers would be
> asked by banks if they would go along with this sort of thing. Those
> with integrity said no. You got paid a fee to tarnish your
> reputation.”
>
> Adverse selection was not the only dubious practice. Banks also
> structured CDOs that were seemingly designed to incur losses for
> long investors. In mid-2006, Morgan Stanley launched some CDOs –
> known as the Baldwin deals – that have puzzled observers.
>
> Rather than the risk in the deal reducing over time as the
> underlying loans in the structure were repaid – as is typical with
> CDOs – the Baldwin deals continued to take on new risks as old ones
> ran off – a fact that was disclosed to investors in the deal’s
> marketing documentation. This feature led to massive losses and
> would have done so, according to one CDO investor, even if the
> housing market had not collapsed. Significantly, Morgan Stanley
> chose to bet against its own product, and by extension against the
> customers to whom it was selling it. One investor describes Baldwin
> as “the most sinister trade of all”.
>
> But if one CDO exemplifies the conflicts inherent in the investment
> banks’ role, it was Vertical 2007-1. By the time UBS of Switzerland
> structured this $1.5bn product, the US property market was clearly
> turning. Vertical – which UBS staff referred to in internal e-mails
> as “vomit” and “crap” – was eventually sold. Barely two months
> later, Vertical collapsed. One of the buyers, Pursuit Partners, a
> hedge fund, has since sued the bank, alleging it knew before it sold
> the deal that it would fall apart.
>
> To get Vertical off the ground, UBS certainly bust a gut. Its
> relationship with Standard & Poor’s – a rating agency that had
> already awarded its top rating to hundreds of CDOs – was
> exceptionally fraught. E-mails from S&P released by the US Senate
> show how aggressively UBS bankers acted to get the rating they
> needed for Vertical. In one, a banker told an S&P executive he would
> spell her name correctly only when she did what he asked her to do.
>
> S&P was perhaps reluctant to sign off because of an unusual feature
> to the Vertical deal. “Vertical is politically closely tied to [Bank
> of America] – and is mostly a marketing shop – helping to take risk
> off books of BofA,” wrote James Halprin, an S&P analyst, to
> colleagues that year. He seemed to suggest that the purpose of
> Vertical was to help Bank of America hedge its mortgage risks.
>
> UBS did not return calls for comment on the connections alleged
> between it and Bank of America in the Vertical deal. In a statement
> earlier this year the bank said Pursuit was a “sophisticated
> investor” that was “fully aware that it was purchasing troubled
> securities at deep discounts in the summer of 2007” and that the
> hedge fund itself described the investments in unflattering terms.
> According to the bank, Pursuit has reduced its claim from $100m to
> $35m. The court hearing the case “found no probable cause for
> Pursuit’s core allegations”, it said, adding: “UBS is confident that
> it will prevail on the merits of the remaining claims.”
>
> Vertical was not the only example of a CDO constructed by one bank
> to the apparent benefit of another. In a CDO named Jackson
> Segregated Portfolio, built in 2006 by Citigroup, parts of its
> portfolio were selected by Morgan Stanley, according to a person
> familiar with the deal. Just as with Abacus, Morgan Stanley’s role
> was not disclosed to investors in the CDO. Morgan Stanley profited
> from the collapse of the deal.
>
> “We expressly disclosed in marketing the Jackson CDOs that the
> collateral selection may have included factors adverse to
> investors,” a Citigroup spokesperson said on Wednesday. “Having said
> that, we remain committed to enhancing the transparency of all
> financial transactions in which we are involved.” Though investors
> were unaware of Morgan Stanley’s short position in the Jackson deal,
> the transaction differed from Abacus markedly because it did not
> involve a third-party selection agent. In the Jackson CDO marketing
> materials, Citigroup explicitly stated that it did not act “in a
> fiduciary capacity in the selection of the reference portfolio”.
>
> . . .
>
> Certainly, investment banks were interested in the possibility of
> using CDOs to offload the toxic risks in rivals’ balance sheets on
> to clients. As Goldman’s Fabrice Tourre put it in an e-mail to his
> superiors at the end of 2006, one of the big opportunities lay in
> “Abacus-rental strategies ... [where] we ‘rent’ our Abacus platform
> to counterparties focused on putting on macro short [sic] in the
> sector”. Decoded: Goldman would sell CDOs stuffed with other
> investment banks’ toxic waste, allowing them to short it.
>
> “The banks didn’t want to look as if they were short themselves,”
> says one subprime investor. “So bank A helped bank B get short and
> then bank B helped bank C and so on. Unless you were very close to
> the market you wouldn’t get it.”
>
> Banks were not blind to the risks their reputations were running.
> “Real bad feeling across European sales about some of the trades we
> did with clients,” one Goldman salesman wrote to Daniel Sparks, who
> headed the bank’s mortgage department, in October 2007. “The damage
> this has done to our franchise is very significant,” he added,
> before listing five trades and the hundreds of millions Goldman had
> collected from them at the expense of clients within months of their
> closing.
>
> Whether or not the banks broke securities laws, their pious mission
> statements stress their commitment to the client. Goldman’s, for
> instance, says simply: “Our clients’ interests always come first.”
> The contrast with the banks’ behaviour in the CDO market could
> hardly be more striking.
>
>
> The long and the short of a strange synthetic product
>
> The product at the heart of the US Securities and Exchange
> Commission’s civil charges against Goldman Sachs is a synthetic
> collateralised debt obligation. This complex structure comprises a
> bet from a set of “long” investors that a given pool of mortgage-
> backed bonds will pay off; and another from a set of “short”
> investors who believe it will default. The CDO simply reconciles
> these opposing bets, much as a bookmaker would.
>
> The structure issues both bonds and insurance. The bonds, secured
> against financial insurance contracts (credit default swaps) taken
> out against the pool of mortgage bonds on which investors wish to
> bet, are sold to long investors. The short investors, who believe
> the bonds in the pool will fail, buy the insurance. Their premiums
> pay the long investors’ coupons. In return, the long investors’
> principal payments for the bonds are set aside to cover insurance
> claims in the event of a default.
>
> To assemble and sell a synthetic CDO such as Goldman’s Abacus, an
> investment bank must co-ordinate counterparties and agents carefully
> – not least because it must reconcile two opposing views of the
> market without spooking either side.
>
> During the market’s heyday, counterparties willing to go short were
> two a penny. The trick came in persuading investors to go long.
> Banks were therefore at pains to stress the safety of CDO bonds, and
> the robustness of the processes that gave birth to them. For the
> sake of propriety, they employed a third-party CDO manager or
> selection agent to select and watch over the pool of mortgage bonds.
> In the case of Abacus, Goldman chose a company called ACA.
>
> In addition, to make the bonds saleable, rating agencies were
> appointed to adjudge their creditworthiness. These had a habit –
> largely because of their poorly calibrated property market models –
> of awarding synthetic CDOs their highest badges of security: triple-
> A status. For Abacus, Goldman used Moody’s and Standard & Poor’s.
>
> The involvement of third parties allowed Goldman and its peers to
> stress that their own roles were akin to that of marketmakers,
> bringing together willing buyers and sellers. When he testified to
> Congress in April, Lloyd Blankfein, Goldman chief executive, was
> clear about this distinction. “The thing customers are buying [with
> CDOs] is exposure,” he observed. “They’re not coming to us because
> of what our views are.”
>
>