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Tavakoli Structured Finance, Inc.

The Financial Report

By Janet Tavakoli

Bernanke’s Deposition: AIG, Goldman, Merrill and Bailouts

For years before the 2008 financial crisis, I issued specific warnings about credit derivatives, mortgage backed securities, collateralized debt obligations, misrated structured financial products, and leverage.

I wrote books and published articles in professional journals. In 2007, I specifically warned risk managers at Merrill Lynch (among others), to get out. Risk managers had responsibility without authority, so why should they go down for malfeasance at senior levels in their organizations? (See: “Subprime Mortgages: The Predators Fall,” GARP Risk Review, March 2007.)

My 2003 book, Collateralized Debt Obligations & Structured Finance, warned about the dangers of junk collateral—chiefly corporates at that time—and misrated CDOs. The warnings included the “Magnetar” CDO structure.

In December 2007, WSJ’s Serena Ng and Carrick Mollenkamp quoted me in a story: “Wall Street Wizardry Amplified Credit Crisis.”  It was about a CDO called Norma, one of the infamous “constellation” deals named after stars, a classic situation for fraud, and a deal in which Magnetar invested. Merrill Lynch was the underwriter and seller.

“Only nine months after selling $1.5 billion in securities to investors, Norma is worth a fraction of its original value. Credit-rating firms, which once signed off approvingly on the deal, have slashed its ratings to junk status.

‘It is a tangled hairball of risk,’ Janet Tavakoli, a Chicago consultant who specializes in CDOs, says of Norma. ‘In March of 2007, any savvy investor would have thrown this…in the trash bin.’”

In January 2008, Mollenkamp and Ng wrote more specifically about Magnetar’s involvement in profiting as an investor in CDOs, in which other investors took heavy losses, and again quoted me (“A Fund Behind Astronomical Losses”):

“[Magnetar's] trading highlights the important role some hedge funds played in the great debt unwind that is now plaguing financial markets. Many hedge funds realized early on ‘that the loans and securities that went into CDOs were extremely toxic, and they designed structures to exploit that,’ says Janet Tavakoli, a structured-finance consultant.”

The trade was to go long equity—hiving the excess spread from a CDO—and short the mezzanine tranches. Although the equity is supposed to take the “first loss,” it was the least risky tranche and very lucrative. It earned the cash waterfall that used to be reserved for “investment grade” investors. (See Pp. 261-265 of my 2003 book: Collateralized Debt Obligations and Structured Finance, John Wiley & Sons, and further explanations in my 2008 2nd edition.)

Magnetar wasn’t the Underwriter, Marketer/Seller, or Manager

Today, there were two stories in the Wall Street Journal about securities fraud that seemed to be placed in the wrong order.  In “SEC’s Hunt for Crisis-Era Wrongdoing Loses Steam,” Jean Eaglesham explains that the SEC would not pursue charges against Magnetar, a hedge fund that participated in some Merrill deals. The article misses a key point. Magnetar was neither the underwriter nor seller. Merrill Lynch was both.

Hedge funds like Magnetar (and John Paulson’s funds) played a sharp game. They may have had a very good idea that other investors in the CDOs were suckers who didn’t understand where the cash waterfall would flow. As some tranches failed, others—including the “first loss” equity tranche—often had a windfall. Hedge funds didn’t act as whistleblowers in these CDOs, but they didn’t necessarily have the legal obligation to perform that function.

Underwriters, Sellers, and Alleged Fraud

In the case of deals like Norma, Merrill Lynch, now a part of Bank of America, was the underwriter and seller of those overrated tranches of CDOs. The legal responsibility for securities structuring and marketing belonged to the underwriters. Merrill Lynch knew or should have known the collateral was flawed and the tranches were overrated, and it was obliged to specifically disclose that information.

When it comes to not blowing whistles, the SEC takes the cake. As a regulator, it studiously looked the other way as alleged securities fraud ran rampant. Today, its lawsuits are few and far between and do not capture the magnitude of the fraud.

Moreover, no regulatory body has used moral suasion to give context to the genesis, magnitude or extent of the fraud.

Section C1 of today’s WSJ points out that BofA/Merrill Lynch is being sued by the U.S. government for alleged securities fraud in the sale of $850 billion worth of mortgage backed securities. Shayndi Raice’s story, “BofA Sued over 2008 Bond Deal,” deserved the front page, and the Magnetar story should have been shoved in back.

Fraud Allegations Should Be Much Wider and More Comprehensive

Merrill Lynch was far from alone in suspect activity, and Merrill’s suspect activity wasn’t limited to one or two or even half a dozen deals. More on that later.

Yesterday, HSBC was in the news admitting that it posted a 23% net profit increase, but that it may face $1.6 billion in damages for alleged improper selling of mortgage backed securities. You’ll recall that HSBC took a $6 billion write-down for subprime mortgages for the fourth quarter of 2006, while U.S. banks took no write-downs. Instead U.S. banks and investment banks claimed they had no clue until the fall of 2007.

Ponzi Schemes and Sarbanes-Oxley Violations

The SEC has lost steam in its already very weak push against mortgage lenders and the investment banks that supplied them with money for alleged fraudulent lending. The investment banks supplied funds by allegedly defrauding investors in residential mortgage backed securities (RMBS), collateralized debt obligations (CDOs), CDO-squared (and more).

The alleged securities fraud in the sale of mortgage backed securities, CDOs, and related credit derivatives, is only one part of a widespread Ponzi scheme. Mortgage lenders made multi-billion dollar settlements after allegations of fraudulent lending, while producing phony documents that disguised violations of lending standards. They could not have continued this alleged fraud without funding from investment banks.

Banks and Investment Banks Lost Money Due to Control Fraud

Some banks claimed that they are innocent, because they lost money. But as William K. Black explains, in a control fraud, banks and investment banks can lose money, because bonus-seeking officers prosper in the same way that parasites eat their host.

Banks supplied credit lines, IPOs, bond offerings, securitization, and other fee-generating services to corrupt mortgage lenders. For example, JPMorgan Chase had credit lines to mortgage-lender Ownit that it yanked in November 2006, a month before Ownit’s bankruptcy. Merrill’s Mike Blum was on Ownit’s board. Countrywide, a large mortgage lender that settled fraud allegations is now owned by BofA. There are many more examples of suspect interconnected relationships.

Officers of TBTF banks and investment banks signed off on accounting statements for their mortgage-related businesses that suggested the activity was more honest and healthier than it was, and they were off by a very wide margin. Yet they have not faced responsibility for Sarbanes-Oxley violations.

Instead, investment banks sought new investors to supply money for old investors. In this case, money from new investors allowed soon-to-collapse mortgage lenders to buy back fraud-riddled loans. This funding kept the Ponzi scheme going far longer than it otherwise would have.

Even worse, investment banks leveraged against doomed-to-fail mortgage backed securities.

For example, in 2007, Merrill Lynch accelerated CDO activity, and MBIA wrote protection against some of its fraud-riddled CDOs.

Bernanke’s Potential Deposition: AIG, Goldman Sachs, Merrill and More

Hank Greenberg’s lawyers are trying to get U.S. Federal Reserve Chairman Ben Bernanke to testify in his lawsuit over the U.S. taxpayer bailout of American International group Inc. (AIG). As a sophisticated investor, AIG had responsibility for due diligence on the CDOs against which it sold protection. The underwriters of the CDOs had responsibility for alleged securities fraud. But wait. Those allegations have not even yet been made by the SEC.

Now that taxpayer money has been used to bailout AIG, the ballgame has changed. This is no longer a case of two big dogs in a brawl. It is now a matter of public interest.

The SEC sued Goldman Sachs for alleged securities fraud involving an Abacus CDO. AIG wrote protection against several Abacus CDOs, yet the SEC hasn’t investigated those deals. Likewise it hasn’t investigated the fact that Goldman Sachs was a key beneficiary of the AIG bailout. This was revealed by the SIGTARP’s November 17, 2009 report.

Five years ago, I publicly challenged AIG’s representation that it would take no losses against super senior CDO tranches. See: “In Subprime, AIG Sees Small Risk; Others See More,” WSJ, August 13, 2007. Within months, AIG was cited for “material weakness” in its accounting. AIG’s officers have not been held accountable for this accounting travesty.

Moreover CDOs that Goldman Sachs either underwrote, or against which it bought protection from AIG, were a chief cause of AIG’s distress in September 2008, and were the primary cause of the U.S. taxpayer’s bailout. Goldman’s cronies included Calyon, Societe General, Merrill and more. (See: “Goldman’s Undisclosed Role in AIG’s Distress,” TSF, November 10, 2009.)

Goldman’s list of negative basis trades featured many of Merrill’s CDOs as underlying risk. Merrill’s own list of deals with AIG amounted to around $9.9 billion as of November 2007. Merrill Lynch was also a beneficiary of the AIG bailout. In September 2008. Bank of America had just agreed to merge with Merrill, which had $6 billion in suspect super senior risk hedged with AIG.

Merrill’s nonsense didn’t begin and end with AIG. Merrill’s CDOs issued in 2007—and many before that—were a classic situation for fraud. See: “Dead Calm: No One Trusts You,” TSF, July 30, 2008:

“As of June 10, 2008, of 30 CDOs totaling more than $32 billion in notional amount, 19 have declared an event of default, are in acceleration, or have been liquidated. Ten others are “toast,” as evidenced by downgrades of their “triple A” tranches to junk status…”

Merrill Lynch is being sued for some CDOs, but not for the CDOs involved in the AIG mess.

If Ben Bernanke is made to testify, perhaps he can explain why the names of AIG’s counterparties and the names of the CDOs were kept from the public eye and redacted from SEC filings. He might also explain why it was denied for so long that Goldman Sachs was a beneficiary of the AIG bailout. He might also explain why Goldman Sachs was made a bank holding company without a thorough investigation into these matters.

Likewise, the allowed merger of Bank of America and Countrywide, and the quick merger of BofA and Merrill Lynch, deserve further scrutiny.

A few CDO lawsuits should merely be the small beginning of investigations into a much wider pattern of problematic activity combined with taxpayer bailouts. The Fed and the SEC have not yet provided needed investigations or proper context to the global financial crisis, accounting obfuscation, or to the ongoing bailouts.

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