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July 30, 2008
A Letter to Certain Investment Banks and CDO Managers
Some market pundits say that “disclosure’ is the answer to the “dead calm” of a securitization market adrift in the doldrums. That is not it guys. It is one thing to have documents that disclose risks—many of the documents of death spiral collateralized debt obligations (CDOs backed by private-label residential mortgage backed securities) in 2007 disclosed eye-popping risks—it is quite another to bring deals to market that you knew or should have known were overrated and deeply troubled the day the deal closed.
The real issue is timely, complete and continuing disclosure. If you knew or should have known your “triple-A” tranches deserved a junk rating on the day the deal closed, that should have been specifically disclosed, no matter what the rating agencies, or your attorneys, said. As the investment bank securitizing the deal and selling the securities, it was down to you. You thought the disclaimers in the documents protected you—well how is that working out? You are now suffering some of the consequences. The SEC may say you were within the “rules” (let’s see what happens), but the market is holding you responsible. Investors shun you.
The reason no one trusts securitizations is not “disclosure” of loan data. The reason is that you, the securitization departments of several investment banks and the “friendly” CDO “managers,” that “managed” their death spiral CDOs, have no credibility. If securitization professionals failed to perform appropriate due diligence, they have a problem. If they performed due diligence, but suppressed the reports, they also have a problem. Going forward, investors may not even trust “disclosures” of due diligence, because loan data can be manipulated. Your current lack of credibility means your former customers will be reluctant to believe your data and your documents in future.
Investment banks have a huge credibility problem when trying to explain that they “didn’t know the gun was loaded,” because people like me began putting their concerns in print early in 2007. You may recall that I wrote an article for GARP Risk Review1 saying risk managers who had a hard time doing their jobs should get out and short these deals. I used Merrill as an example, but the same applies to many other investment banks.
So, how did the CDOs that Merrill Lynch brought to market in 2007 perform? As expected, they are dreadful. (See Table 1) All of the deals I captured are in serious trouble at the “triple-A” level. All have one or more originally “triple-A” rated tranches downgraded below investment grade (junk) by one or more rating agencies. Of the 30 CDOs shown, 27 have even the topmost original “triple-A” tranche now ranked as junk by one or more rating agencies.
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, yet I could find no record of a declared event of default (EOD). The remaining CDO has “triple-A” tranches downgraded to junk, but the two topmost tranches are still rated investment grade (the topmost is Aa1 neg/ AAA neg and the formerly “triple-A” tranche below that is Baa2 neg/ BBB+ neg). The EOD may be undeclared due to documents that avoid that declaration so that investors cannot trigger acceleration or liquidation (or the declaration may be pending).
Other investment banks deserve to be in the Hall of Shame, but the most they can hope for is to match Merrill’s 2007 record; they cannot beat it. (And if I inadvertently missed a Merrill CDO in this 2007 cohort, and if it is performing well, we would all like to hear about it. Inquiring minds would love to know.)
Merrill had pieces of other investment banks’ deals embedded in many of the CDOs, and likewise other investment banks had pieces of Merrill’s CDOs in their deals. And, of course, their credit derivatives desks bought and sold protection on each other’s CDOs.
If I knew there was a serious problem with buying and selling these securitizations, then investment banks knew or should have known. I run a boutique consulting firm in Chicago. My intellectual capital is the product. If I can figure this out, how is it that the army of securitization professionals and their management did not? Or did they?
As far as I can tell, disclosing loan data is not the problem. The problem is that investment banks knew or should have known they packaged damaged product to sell to unwary investors. Granted, some of these investors were sophisticated and should have known better; investment banks and “sophisticated” investors, like the bond insurers can slug it out with each other. But there is a difference between an account with a lot of money and a “sophisticated” investor. Many smaller municipalities and other retail-like accounts may have been saddled with dodgy products.
Investment banks and the rings of highly paid managers, securitization professionals, and lax CDO managers have an enormous amount of responsibility for the collateral damage done to the U.S. housing market and “insured” bond markets.
One can argue that the bond insurers were willing victims, but municipalities paying higher funding costs were not. One can argue that some homeowners knowingly overextended themselves, but many others were victims of predatory lending practices. U.S. taxpayers are unwilling victims, paying either directly or indirectly for housing market assistance, turmoil in municipal bond markets, frozen auction rate securities, and bailouts of errant mortgage lenders and investment banks.
The Federal Reserve Bank is now providing liquidity for many investment banks either directly or indirectly. Investment banks may not be “borrowing,” but the Fed’s willingness to accept “triple-A” assets in exchange for treasuries is a back-door bailout.
Investment banks — and their all-powerful lobbyists, including the Mortgage Bankers Association and the American Securitization Forum —should be told: you helped break it; you help pay for it.
1 Janet Tavakoli, “Subprime Mortgages: The Predators’ Fall,” GARP Risk Review, March/April 2007 Issue 35.
Note from Janet Tavakoli: The 2008 edition, Structured Finance & Collateralized Debt Obligations, brings readers up to date with widespread fraud in securitizations. My financial crisis expose, Dear Mr. Buffett: What an Investor Learns 1,269 Miles from Wall Street, (Wiley Finance, 2009), explains the culpability of rating agencies, monolines, mortgage loan underwriters, lax regulators, accountants, so-called CDO managers, and most of all, the investment banks that underwrote deals and were obliged to adhere to securities laws, but often didn’t.
See also: “The Elusive Income of Synthetic CDOs,” Journal of Structured Finance, Winter 2006 Volume 11, Number 4
For more in depth analysis, read Structured Finance & Collateralized Debt Obligations, 2nd Edition, by Janet Tavakoli, Wiley 2003, 2008.
Read finance articles by Janet Tavakoli