FedUpUSA

Archive for the ‘Collateralized Debt Obligations’ Category

Courtesy of reszatonline, who brings us the following allegory by way of Tim Coldwell, we are happy to distill (no pun intended) all of modern economics and finance in a narrative that is 500 words long, and involved booze and broke alcoholics: in other words everyone should be able to understand the underlying message. And while the immediate application of this allegory is to explain events in Europe, it succeeds in capturing all the moving pieces of modern finance.

From reszatonline

Helga is the proprietor of a bar.

She realizes that virtually all of her customers are unemployed alcoholics and, as such, can no longer afford to patronize her bar.

To solve this problem, she comes up with a new marketing plan that allows her customers to drink now, but pay later.

Helga keeps track of the drinks consumed on a ledger (thereby granting the customers’ loans).

Word gets around about Helga’s “drink now, pay later” marketing strategy and, as a result, increasing numbers of customers flood into Helga’s bar. Soon she has the largest sales volume for any bar in town.

By providing her customers freedom from immediate payment demands, Helga gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages. Consequently, Helga’s gross sales volume increases massively.

A young and dynamic vice-president at the local bank recognizes that these customer debts constitute valuable future assets and increases Helga’s borrowing limit.

He sees no reason for any undue concern, since he has the debts of the unemployed alcoholics as collateral!!!

At the bank’s corporate headquarters, expert traders figure a way to make huge commissions, and transform these customer loans into DRINKBONDS.These “securities” then are bundled and traded on international securities markets.

Naive investors don’t really understand that the securities being sold to them as “AA” “Secured Bonds” really are debts of unemployed alcoholics.

Nevertheless, the bond prices continuously climb!!!, and the securities soon become the hottest-selling items for some of the nation’s leading brokerage houses.

One day, even though the bond prices still are climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Helga’s bar.

He so informs Helga.

Helga then demands payment from her alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts.

Since Helga cannot fulfil her loan obligations she is forced into bankruptcy.

The bar closes and Helga’s 11 employees lose their jobs.

Overnight, DRINKBOND prices drop by 90%. The collapsed bond asset value destroys the bank’s liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community.

The suppliers of Helga’s bar had granted her generous payment extensions and had invested their firms’ pension funds in the BOND securities. They find they are now faced with having to write off her bad debt and with losing over 90% of the presumed value of the bonds.

Her wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers. Fortunately though, the bank, the brokerage houses and their respective executives are saved and bailed out by a multibillion dollar no-strings attached cash infusion from the government.

The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers who have never been in Helga’s bar.

ZeroHedge

From Bloomberg:

Mark Mobius, executive chairman of Templeton Asset Management’s emerging markets group, said another financial crisis is inevitable because the causes of the previous one haven’t been resolved.

“There is definitely going to be another financial crisis around the corner because we haven’t solved any of the things that caused the previous crisis,” Mobius said at the Foreign Correspondents’ Club of Japan in Tokyo today in response to a question about price swings. “Are the derivatives regulated? No. Are you still getting growth in derivatives? Yes.”

The total value of derivatives in the world exceeds total global gross domestic product by a factor of 10, said Mobius, who oversees more than $50 billion. With that volume of bets in different directions, volatility and equity market crises will occur, he said.

Let that sink in.  TEN TIMES GLOBAL GROSS DOMESTIC PRODUCT.  In other words, banks have created enough ‘financial weapons of mass destruction’ to wipe out every human being’s production….ten times over.

For those who don’t quite understand what a derivative is, it is a financial instrument the value of which depends upon other, more basic, underlying variables.  Such a variable is called an ‘underlying’ and can be a traded asset, such as an economic index (like the S&P 500) or even the unemployment rate.  People may know the most popular of these, which are the stock market futures.  People place ‘bets’ on which way the market will go and if they are right, they make money, if they are wrong, they lose money.

In the above example, the ‘underlying’ is the actual stock market value.  This is something that has a tangible, measurable value.  The stock market value at any given time is completely transparent and available for anyone to see.  However, the prevailing derivatives over the past decade were not something that could be readily and transparently measured.  They were derivatives on collateralized debt obligations.  These were the other weapons of financial destruction designed by our favorite investment banks on Wall Street to capitalize on the bad mortgages they were peddling and shoving down people’s throats.  It was never about the quality of the loans; it was instead, about the quantity of loans they could make, so that they could be bundled into these CDOs, slapped with a nice AAA rating (by the agencies the banks themselves owned), and re-sold to unsuspecting investors (suckers), the majority of which happen to be your retirement plans.

Derivatives were the key to not only maximizing their return profits, but also off-setting the massive risk in writing these bad loans.  Matter of fact, the worse the loan, the more the profit, because while they were busy bundling and selling the CDOs, the investment banks were also placing bets that these loans would fail – i.e. in market parlance, taking a short position against what they were selling and, in some cases, against the very firms to which they were selling the CDOs. 

While hedging or mitigating risk is certainly a legitimate investment practice (everyone should do so with their investments), the problems here were:  (1) there was absolutely no transparent way to gauge the value of the asset being traded; they were all dependent upon the rating the agencies gave to them, and as mentioned above, the ratings agencies were and still are owned by the banks themselves; and (2) none of the banks selling these instruments ever disclosed whether or not they themselves had a position for or against these investments they were selling.

In many cases, these instruments had no true underlying value at all.  Still, the little bundles of CDOs were sold and re-sold and sold again, each time it changed hands, the seller pocketed a profit and passed it off to the next unsuspecting investor.   Since the underlying value was only as much or as good as the original mortgage loan, one can see exactly how the collapse began in late 2007.  With all these ‘easy credit’ mortgages being bought and sold, and Wall Street’s insatiable appetite for the CDOs, this pushed up home prices to the point at which the majority of people could not afford them.  At the peak of the housing boom, many markets had average home prices at SIX TIMES the average income.  Historically speaking, it has never been possible to sustain home prices over three times average income.  Collapse was inevitable when the majority of people could no longer sustain monthly mortgage payments even with ‘creative financing.’ 

So, as we have been saying here at FedUpUSA, the homeowners are not to blame.  You did exactly as the banks planned you should do: took a loan you couldn’t afford.  The world has been scammed, defrauded, robbed and it is now all over but the big kaboom.  These derivatives are still out there, lurking under the bed like the monster from your childhood.  Nothing has been fixed.   Many of these derivatives are worthless because a great majority of the CDOs are, in reality (as opposed to the falsified balance sheets banks are allowed to have) worth pennies on the dollar at best, or absolutely nothing.  All it will take is one big bank to be unable to pay out on its bets.  The monster must be fed, which is why governments around the world are using taxpayer money to support the banks and it is also why we have quantitative easing (i.e. money printing), which is causing the massive price increases in everything we need to buy.  Governments will keep trying to cover up the lies and they’ll keep stealing money from you to do it.  The question now is, how long will you let them?  I know what this guy would do.

STOP THE LOOTING AND START PROSECUTING!

Litigation may be slowly doing the job missed or only partially completed by various governmental investigations into the financial crisis. The Valukas report on the Lehman bankruptcy was revealing, and numerous foreclosure defense attorneys have opened cans of worms that the powers that be would rather pretend simply don’t exist.

The New York Times reports tonight that a case filed last year was unsealed last week. It plumbs a continuing sore point with the public, namely the generous terms of the AIG bailout, both to the company (which defied the government and insisted on remaining largely intact when the plan had been to sell its various units to repay the government funding) and to its credit default swap counterparties. The litigation has the potential to be revealing, particularly if it goes into discovery (various depositions are likely to become public in pre-trial jousting, um, motions). The Times gives an overview:

The lawsuit, filed by a pair of veteran political activists from the La Jolla area of San Diego, asserts that A.I.G. and two large banks engaged in a variety of fraudulent and speculative transactions, running up losses well into the billions of dollars. Then the three institutions persuaded the Federal Reserve Bank of New York to bail them out by giving A.I.G. two rescue loans, which were used to unwind hundreds of failed trades.

The loans were improper, the lawsuit says, because the Fed made them without getting a pledge of high-quality collateral from A.I.G., as required by law.

“To cover losses of those engaged in fraudulent financial transactions is an authority not yet given to the Fed board,” said the plaintiffs, Derek and Nancy Casady, in their complaint, filed in Federal District Court for the Southern District of California.

The lawsuit names A.I.G., Goldman Sachs and Deutsche Bank as defendants, but not the Fed.

The lawsuit itself names other defendants, including Merrill and its successor Bank of America, SocGen, and “Does 1 through 100.”

White shoe types will likely look down their noses at the filing. It makes rather eccentric use of graphics (for instance, including company logos) and includes charts, some of which are very helpful (tables with tabulations and timelines), while others are visual representations of arguments made in the text and hence would be deemed by style snobs to be redundant. It also is somewhat sensationalistic, even heated at points in tone (which does make for more lively reading) and does not unpack its arguments as much as appears to be typical in court filings.

Nevertheless, despite the rough style, there’s some intriguing reading, and the case does a clever job of juxtaposing e-mails and Congressional testimony by AIG executives with various disclosures of the AIG bailout process and the terms of the loan facilities.

To my non-expert eye, the case appears to hinge on the argument that begins on p. 43, that the Fed loans were in violation of the Fed’s authority under the widely-cited “unusual and exigent circumstances” clause. I had taken the reading of former central banker, now Citigroup economist Willem Buiter on this, that it gave the Fed the authority to lend against a dead dog if it chose to.

That appears to be inaccurate, and I wonder if the focus upon this section will embolden the Audit the Fed crowd to have another go at the central bank.

Specifically, the “unusual and exigent” language includes other restrictions, which I read as all being operative:

1. The central bank can lend against “notes, bills, and other drafts of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal reserve bank

2. The “notes, bills, and other drafts of exchange” must be discounted

3. The Federal reserve bank making the loan must obtain evidence that the non-bank party seeking the loan can’t get credit from other banks

4. “….five or more members of the Board of Governors must affirmatively vote to authorize the discount prior to the extension of credit.”

The case focuses on allegedly fraudulent representations made by AIG and the various major dealers in the course of obtaining the financing. But the part I find interesting is the Fed’s evident non-compliance with the requirements of this section, particularly the fact that the central bank lent 100% against the face value of the AIG CDOs, between taking out the CDS and then lending the bailout vehicle Maiden Lane III the funds to buy the CDOs. Interestingly, the SIGTARP investigation missed this issue. If this was at all considered, the argument may have been that the AIG equity in MLIII was tantamount to a discount, but the lawsuit argues that notion is bogus. Since AIG was broke, any money for the AIG equity came from the outside (in fairness, it’s a bit more complex, thanks to reserves set aside over the collateral dispute).

The suit argues that the initial loan was made under false premises, since the loan was secured by all assets of AIG, when the assets were already pledged (all the regulated subs have prior claims on them, both to creditors and policy-holders). The understanding, as depicted in various less-than-official accounts, like the Andrew Ross Sorkin Too Big Too Fail, is that the loans were secured by the equity of the subs. Fine in theory, but in practice, that isn’t what the loan document says, and as important (although not argued in the case) is the amount of the loan was based on what AIG needed to stay afloat, not on any effort to find a market value of the assets pledged and discount that.

In addition, the notion that it was acceptable to lend against stock appears to be based on the discount schedule that the Fed posts and revises from time to time as to the types of collateral that are accepted for lending and the various discount rates established for them. But note that schedule is for depositary institutions. The Fed acted as if it could simply lend against the same assets held by non-depositaries, but the language of the germane section does not appear to support that idea.

The various disclosures of how the Fed lent against pretty much anything the banks could round up, including defaulted securities, is troubling. Defenders of the central bank argue no harm was done since the securities have recovered from crisis lows (well save the ones that went to zero). The problem is that the logic is circular. In many cases, the value of the securities now depends on the fact that the Fed is willing to lend at super low interest rates. So the “market” values are fictive and dependent upon Fed intervention, which is coming at the expense of savers. The interdependence between the Fed’s rescue facilities and its continued interventions is given a free pass, but those of us who are not at the top of the food chain are continuing to pay the cost.

Naked Capitalism

Of course nobody will be listening….

In an earlier post, I wrote that Congress should act immediately to abolish credit default swaps on the United States, because these derivatives will foment distortions in global currencies and gold. Credit defaults swaps on the United States currently settle in euros, but there is talk of creating new contracts calling for settlement in gold. Congress should immediately ban all credit derivatives on the United States, since the opportunities for mischief making outweigh the hedging value.

In my opinion Congress should ban any and all securities for trading by any regulated entity (such as banks, hedge funds, mutual funds and similar) that are not exchange-traded.  Not clearinghouse-listed, exchange traded.

Why?

Because it is my considered opinion that such instruments as CDOs and custom, bespoke CDS have as one of their key elements to their marketability obfuscation of who holds what risk, why they hold the risk, and under what terms they will need to pay.

How much mayhem could “creative” minds generate in the credit default swap markets, the currency markets, and the gold market? Quite a bit, since customized credit default swaps can be embedded in all manner of financial investments, and they can be written to offload unexpected risks on naïve investors.

The Dodd-Frank “financial reform” bill doesn’t address customized over-the-counter credit default swaps, and the bill doesn’t do anything at all to reign in speculation in the currency markets or the commodities markets.

That “omission” was intentional.  The simple fact of the matter is that these highly-customized contracts are extremely profitable for the banks and other large financial institutions.  But the basic laws of business balance prohibit these artifices from being profitable unless someone is able to hide their true characteristics. 

The clear and obvious fact is that nobody works for free.  Therefore, the more-complex a security is, and the more hands it touches, the worse the deal for the customer.  There is no way around this.  The only way you can have these deals be “better” for the customer is if someone gets rooked or the customer is wrong about what he thinks the “better deal” constitutes. 

You always have a right to take a less-advantageous deal for yourself, but nobody does of their own free will.  The only time this sort of thing ever happens is if someone is deceived.  That is, they take a risk they didn’t know they had, or they’re convinced to lend someone money at terms that look attractive but that’s only true because the risk they believe they’re accepting is different – and less - than the risk they actually accept.

This is what made loans like OptionARMs, the custom Abacus CDOs and similar instruments possible.  Were the customers to understand what they were buying they would have never bought.  Customers were mollified by worthless “ratings”, the pronouncements of various actors such as lending officers and other alleged “professionals” and in some cases outright fraud such as the cases where a consumer had his or her income changed by a lending officer to pass some computer-driven ratio.

One can argue that these acts should be prosecuted, and I both have and will continue to.  But looking forward rather than in the rear-view mirror the only way to stop this is to bar the creation and trading of these instruments.  If whatever we trade is forced onto an exchange then there is no chain risk and there is no hiding of the sausage.  With exchange trading everyone can see the best bid and offer, we know what open interest is, and there is never a question as to the mark on that instrument – it’s right there, “in your face” every trading day.

Janet talks about Central Bankers having a “bubble deflator”, and that the financial industry has once again found a way to play without adult supervision.  She’s right in her analysis of the implications, but the better option is to not allow instruments to be offered that are intentionally-complex for the purpose of deceiving people in the first place.

The Market-Ticker

On Our Rotten Financial System

Posted by Karl Denninger

So today Goldman will come before the Senate Permanent Committee on Investigations – with Lloyd himself, along with “Fabulous Fab” on the witness panel.

Blankfein’s prepared testimony makes some interesting claims:

“We didn’t have a massive short against the housing market, and we certainly did not bet against our clients,” Blankfein says in prepared remarks released by the company. “Rather, we believe that we managed our risk as our shareholders and our regulators would expect.”

Uh, Lloyd, are you sure?

Carl Levin, a Michigan Democrat who leads the Senate’s Permanent Subcommittee on Investigations, released documents that he said showed the company “put its own interest and profit ahead of the interests of its clients,” a conflict he called on Congress to end. Lloyd Blankfein, Goldman Sachs’s chairman and chief executive officer, will dispute that assertion and argue the firm was merely managing its own risk.

Yep. 

It’s amusing how Goldman claims it “lost money” on some of these deals.

So what?

The question is not whether there were residual pieces of trash that Goldman wound up (unwillingly) eating when they couldn’t sell them.  The question is whether or not Goldman (and everyone else) should have had the ability to put these deals together in the first place, and how it came to be that trillions of dollars of alleged “AAA” paper was better suited for use in the men’s bathroom stalls!

Levin said:

“This market is not free until it is free of self-dealing and until it is free of conflict of interest,” Levin, 75, said at a press briefing yesterday. “It is not free until it ends the gambling operation that results in gambling debts that the public ends up paying.”

That can’t happen until we see handcuffs Senator. 

“The SEC and the courts will resolve the legal question of whether Goldman’s actions broke the law,” Levin said. “The question for us is whether Goldman’s actions in 2007 were appropriate and whether we should act, legislatively, to bar similar actions in the future.”

17 pages Senator.  They’re called “Glass Steagall”, and that law absolutely barred the conduct that led to and caused this crisis.

Let’s be frank: Creating these sorts of toxic deals is, for these institutions, simply a reach for fees.  They don’t care if they perform so long as they don’t get stuck with the trash.  A particular transaction was even referenced as “one shi&&y deal” by Goldman employees, according to some internal emails:

“Boy that timberwo[l]f was one shi**y deal,” Montag, who is now Bank of America Corp.’s president of global banking and markets, said in a June 22, 2007, e-mail to Daniel Sparks, who ran Goldman Sachs’s mortgage business at the time, according to the panel’s statement. Within five months of Timberwolf’s debut, the CDO had lost 80 percent of its value, and it was liquidated in 2008, according to the panel.

The CDO was among securities that Goldman Sachs sold to clients after deciding the New York-based firm needed to reduce its mortgage holdings, Carl Levin, a Michigan Democrat who leads the panel, said in the statement. Chief Executive Officer Lloyd Blankfein and six other current and former executives will testify tomorrow in front of the panel about practices in mortgage securities markets before they collapsed.

And of course such conduct, and the people who commit it, aren’t fired.  Mr. Montag is now Bank of America’s president of Global Banking and Markets.  “Market discipline” doesn’t, it appears, extend to forcing people to eat their own cooking and when they sell things they know smell like dead fish to clients, it’s all ok.

Perhaps it is under the law, but whether it should be is another matter.

It is often argued that if we don’t permit this sort of “innovation” that our economy and businesses will suffer.  Really?  Who suffers?  Wall Street?  Can we reasonably have an economy where 1/3rd of all profits made in the nation are “earned” by asset-stripping other people?  That’s what even the good deals do – they turn over a part of the transactional flow of some business to the wall street banks, which then keep it for themselves. 

The bad deals, like this one referenced, are even worse in that they siphon off fees from someone who later loses all their money!

This is not restricted to Goldman, by the way.  Indeed, let’s examine another deal that the government was intimately involved in, this first reported by Zerohedge in the form of the Fannie Mae Preferred offering that was foisted on the market just weeks before the firm blew up.

The underwriters, who coincidentally received 3.15% of $2 billion, or $63 million bucks, include Merrill Lynch (now absorbed), Citibank (rescued), Morgan Stanley, UBS (who has a running spat with the IRS about assisting Americans in illegally evading taxes) and Wachovia (which collapsed in a ball of fire that was contained only by forced marriage to Wells Fargo.) 

Why was this deal so insanely toxic?  It was issued on May 19th of 2008, and paid exactly one coupon before Fannie was absorbed into conservatorship. 

And unlike the “sophisticated investors” who bought CDOs and other similar trash from the big banks, this deal was bought by literal widows and orphans, along with community banks.

I would argue that it should have never been brought to the market in the first place, as before it was offered I had opined (in public in fact) that Fannie and Freddie were both insolvent.

Indeed, on March 8th of 2008 I called out the games in a letter written to President Bush and others in which I said (among other things):

Mr. Bernanke and The Fed have lowered the Fed Funds Target from 5.25% to 3% over the last few months and the “slosh”, or free funds available in the Fed Banking System, has nearly doubled over that time. Yet this additional liquidity has done nothing to address the problem and won’t because the issue is not one of inadequate liquidity; rather it is a desperate move to hide the fact that a significant number of financial institutions in our nation are, if forced to mark all their paper to the market and recognize their exposure to off balance sheet vehicles, insolvent.

At the root of the matter, Mr. President, is a lack of trust caused by the intentional acts of these institutions, and lack of regulatory enforcement by both the Federal Reserve and other agencies such as the OTS and OCC.

We have fixed exactly nothing since then.  We have only papered over the insolvencies with government fiat currency, claiming they’re “loans” – and they are in a sense – they’re forced purchases of bankrupt companies by the taxpayer which we are now liable for.

Wall Street created this monster with the full knowledge and permission of the government. 

Despite laws prohibiting executives from signing off on fraudulent financial statements – that is, any financial statement that does not make a full and fair exposition of the firm’s financial position (Sarbanes-Oxley) these executives have not been prosecuted.  “I didn’t know” is not a defense under Sarbox – if you’re in the executive suite of a public firm you have an affirmative duty to know. 

So why have not the former CEOs of Bear Stearns and Lehman been indicted?  Why have not the CEOs of the other big banks that failed, all of whom proclaimed that everything was fine right up until they blew sky high? 

As for all these hinky deals that the big banks did, if this crisis has taught us one thing it is that if there’s a way to game a rule or regulation it will be gamed.  So long as these firms can find a way to play “heads we win, tails taxpayers lose” they will do so.  So long as they can effectively force companies to forfeit 30% of every dollar of GDP produced in this nation to them, they will do so.

So long as firms with access to federal assistance of any sort, whether it be The Fed window, overnight repo loans from or by firms with Fed Clearing access, or the privilege of deposit-taking and fractional loan-making exists, these firms will leverage government-provided backstops to their own benefit for the purpose of fee extraction. 

These fees do not benefit society as a whole.  They are in fact a tax on top of all other taxes that firms and thus individuals pay.  This burden is, today, roughly 30% of GDP, and our nation and its economy simply cannot afford to redirect this vast amount of wealth to a handful of rich and powerful people on Wall Street, whether their acts are founded in illegal conduct or not.

17 pages Senator.  That’s all it takes.

Reinstate Glass-Steagall and force all these banks to spin off the parts of their organizations that are in conflict.  All institutions that want access to any sort of public safety net, whether it be Fed Discount loans or FDIC insurance may not trade in or on the securities and insurance markets – OTC or otherwise – period.

Force all instruments onto a public exchange, including all CDS, without exception.  This immediately forces nightly margin supervision which prevents the sort of detonations that happened with AIG and others, and absolutely bars contagion, as no firm can maintain a position that it cannot back with capital.

It is often said that if we do this firms will “flee” to other nations that don’t have such restrictions.  No they won’t – not if we refuse to grant them access to our securities markets and the firms in them unless they comport with these rules worldwide no matter where they are headquartered. 

America is a vast economy.  Yes, China is growing, but we’re still a plurality of world GDP. 

Firms will threaten Senator, but if the law is crafted such that if they want access to our markets in any form or fashion they must comply worldwide with separation of function and exchange clearing, they will comply.

Yes, they’ll make “less money”, and that’s their argument against such changes. 

But let’s be frank – every dollar Wall Street “makes” it in fact extracts.  That is, Wall Street creates nothing.  It siphons off capital from other production – that’s all it can do, since it creates not one car, television, or cellular phone.  Indeed, every dollar of fees extracted by Wall Street and every dollar of interest paid to those firms is one dollar that cannot be returned to the economy in the form of innovation for the production of goods and services.

The essential functions of clearing payments and matching those who wish to loan capital with those who wish to borrow it is ministerial.  All the hinky deals alleged to “spread risk” have now been proved to do no such thing, but instead are complex simply so as to be difficult to understand and thus easy to intentionally misprice. 

That mispricing is fraud Senator, whether it can be legally labeled as such or not, and until we put a stop to it we will continue to have these bouts of crisis, each worse than the last.

Our government and society cannot withstand another banking system attack run, and it is imperative that The Senate, along with prosecutors, put a stop to it both through legislation and prosecution.

We have one last chance to stop it.  If we do not at this time do so, and another ”market failure” occurs, our economy and even our political system – that is, our society and republican form of government – will fall.

Those are the stakes, and the question before you now is whether the bribery that is rampant in Washington (although we call it “lobbying”) will win, or whether you will rise to the occasion and uphold the oath of office that you, along with every other member of Congress, took before being seated.

Secret AIG Document Shows Goldman Sachs Minted Most Toxic CDOs

Feb. 23 (Bloomberg) — When a congressional panel convened a hearing on the government rescue of American International Group Inc. in January, the public scolding of Treasury Secretary Timothy F. Geithner got the most attention.

Lawmakers said the former head of the New York Federal Reserve Bank had presided over a backdoor bailout of Wall Street firms and a coverup. Geithner countered that he had acted properly to avert the collapse of the financial system.

A potentially more important development slipped by with less notice, Bloomberg Markets reports in its April issue. Representative Darrell Issa, the ranking Republican on the House Committee on Oversight and Government Reform, placed into the hearing record a five-page document itemizing the mortgage securities on which banks such as Goldman Sachs Group Inc. and Societe Generale SA had bought $62.1 billion in credit-default swaps from AIG.

These were the deals that pushed the insurer to the brink of insolvency — and were eventually paid in full at taxpayer expense. The New York Fed, which secretly engineered the bailout, prevented the full publication of the document for more than a year, even when AIG wanted it released.

That lack of disclosure shows how the government has obstructed a proper accounting of what went wrong in the financial crisis, author and former investment banker William Cohan says. “This secrecy is one more example of how the whole bailout has been done in such a slithering manner,” says Cohan, who wrote “House of Cards” (Doubleday, 2009), about the unraveling of Bear Stearns Cos. “There’s been no accountability.”

CDOs Identified

The document Issa made public cuts to the heart of the controversy over the September 2008 AIG rescue by identifying specific securities, known as collateralized-debt obligations, that had been insured with the company. The banks holding the credit-default swaps, a type of derivative, collected collateral as the insurer was downgraded and the CDOs tumbled in value.

The public can now see for the first time how poorly the securities performed, with losses exceeding 75 percent of their notional value in some cases. Compounding this, the document and Bloomberg data demonstrate that the banks that bought the swaps from AIG are mostly the same firms that underwrote the CDOs in the first place.

The banks should have to explain how they managed to buy protection from AIG primarily on securities that fell so sharply in value, says Daniel Calacci, a former swaps trader and marketer who’s now a structured-finance consultant in Warren, New Jersey. In some cases, banks also owned mortgage lenders, and they should be challenged to explain whether they gained any insider knowledge about the quality of the loans bundled into the CDOs, he says.

‘Too Uncanny’

“It’s almost too uncanny,” Calacci says. “If these banks had insight into the underlying loans because they had relationships with banks, originators or servicers, that’s at the least unethical.”

The identification of securities in the document, known as Schedule A, and data compiled by Bloomberg show that Goldman Sachs underwrote $17.2 billion of the $62.1 billion in CDOs that AIG insured — more than any other investment bank. Merrill Lynch & Co., now part of Bank of America Corp., created $13.2 billion of the CDOs, and Deutsche Bank AG underwrote $9.5 billion.

These tallies suggest a possible reason why the New York Fed kept so much under wraps, Professor James Cox of Duke University School of Law says: “They may have been trying to shield Goldman — for Goldman’s sake or out of macro concerns that another investment bank would be at risk.”

Poor Performers

Goldman Sachs spokesman Michael DuVally declined to comment.

Schedule A also makes possible a more complete examination of why AIG collapsed. Joseph Cassano, the former president of the AIG Financial Products unit that sold the swaps, said on a December 2007 conference call that his firm pulled back from selling swaps on U.S. subprime residential CDOs in late 2005. The list shows that the $21.2 billion in CDOs minted after 2005, mostly based on prime and commercial mortgages, performed as badly as or worse than the earlier subprime vintages.

A lawyer for Cassano declined to comment.

As details of the coverup emerge, so does anger at the perceived conflicts. Philip Angelides, chairman of the Financial Crisis Inquiry Commission, at a hearing held by his panel on Jan. 13, questioned how banks could underwrite poisonous securities and then bet against them. “It sounds to me a little bit like selling a car with faulty brakes and then buying an insurance policy on the buyer of those cars,” he said.

‘Part of the Coverup’

Janet Tavakoli, founder of Tavakoli Structured Finance Inc., a Chicago-based consulting firm, says the New York Fed’s secrecy has helped hide who’s responsible for the worst of the disaster. “The suppression of the details in the list of counterparties was part of the coverup,” she says.

E-mails between Fed and AIG officials that Issa released in January show that the efforts to keep Schedule A under wraps came from the New York Fed. Revelation of the messages contributed to the heated atmosphere at the House hearing.

“What date did you know there was a coverup?” Republican Congressman Brian Bilbray of California demanded of Geithner. Lawmakers used the word coverup more than a dozen times as they peppered Geithner with questions.

Geithner said that he wasn’t involved in matters of disclosure and that his former colleagues did the best they could. In a Jan. 19 statement, the New York Fed said, “AIG at all times remained responsible for complying with its disclosure requirements under the securities laws.”

The government has committed more than $182 billion to AIG and owns almost 80 percent of the company.

Document Withheld

In late November 2008, the insurer was planning to include Schedule A in a regulatory filing — until a lawyer for the Fed said it wasn’t necessary, according to the e-mails. The document was an attachment to the agreement between AIG and Maiden Lane III, the fund that the Fed established in November 2008 to hold the CDOs after the swap contracts were settled.

AIG paid its counter­parties — the banks — the full value of the contracts, after accounting for any collateral that had been posted, and took the devalued CDOs in exchange. As requested by the New York Fed, AIG kept the bank names out of the Dec. 24 filing and edited out a sentence that said they got full payment.

The New York Fed’s January 2010 statement said the sentence was deleted because AIG technically paid slightly less than 100 cents on the dollar.

Paid in Full

Before the New York Fed ordered AIG to pay the banks in full, the company was trying to negotiate to pay off the credit- default swaps at a discount or “haircut.”

By March 2009, responding to a request from Christopher Dodd, chairman of the Senate Committee on Banking, Housing and Urban Affairs, AIG released the names of the counterparty banks. In a filing later that month, AIG included Schedule A, showing bank names while withholding all identification of the underlying CDOs and the amounts of collateral each bank had collected. The document had more than 800 redactions.

In May 2009, AIG again filed Schedule A, this time with about 400 redactions. It revealed that Paris-based Societe Generale got the biggest payout from AIG, or $16.5 billion, followed by Goldman Sachs, which got $14 billion, and then Deutsche Bank and Merrill Lynch. It still kept secret the CDOs’ identification and information that would show performance.

‘Right to Know’

“This is something that belongs in the public domain because it was done with public money,” Issa says. “The public has the right to know what was done with their money and who benefited from it.” Now, thanks to Issa, the list is out, and specific information about AIG’s unraveling can be learned from it.

At the Jan. 27 hearing, the New York Fed was still arguing that the contents of Schedule A shouldn’t be fully disclosed. Thomas Baxter, the New York Fed’s general counsel, testified that divulging the names of the CDOs could erode their value: “We will be hurt because traders in the market will know what we’re holding.”

Tavakoli calls that wrong. With many CDOs, providing more information to the market will give the manager a greater chance of fetching a realistic price, she says.

Jack Gutt, a spokesman for the New York Fed, declined to comment, as did AIG’s Mark Herr.

Bad to Worse

Tavakoli also says that the poor performance of the underlying securities (which are actually specific slices or tranches of CDOs) shows they were toxic in the first place and were probably replenished with bundles of mortgages that were particularly troubled. Managers who oversee CDOs after they are created have discretion in choosing the mortgage bonds used to replenish them.

“The original CDO deals were bad enough,” Tavakoli says. “For some that allow reinvesting or substitution, any reasonable professional would ask why these assets were being traded into the portfolio. The Schedule A shows that we should be investigating these deals.”

Among the CDOs on Schedule A with notional values of more than $1 billion, the worst performer was a tranche identified as Davis Square Funding Ltd.’s DVSQ 2006-6A CP. It was held by Societe Generale, underwritten by Goldman Sachs and managed by TCW Group Inc., a Los Angeles-based unit of SocGen, according to Bloomberg data. It lost 77.7 percent of its value — though it isn’t in default and continues to pay.

SocGen spokesman James Galvin and TCW spokeswoman Erin Freeman declined to comment.

Documentation Needed

Ed Grebeck, CEO of Tempus Advisors, a global debt market strategy firm in Stamford, Connecticut, agrees that more digging is necessary. “You need all the documentation and more than that, all the e-mails,” he says. “That would allow us to understand what went wrong and how to fix it going forward.”

Neil Barofsky, the special inspector general for the Troubled Asset Relief Program, who delivered a report on the AIG bailout in November, says he’s not finished. He has begun a probe of why his office wasn’t provided all of the 250,000 pages of documents, including e-mails and phone logs, that Issa’s committee received from the New York Fed.

Schedule A provides some answers — and raises questions that need to be tackled to avoid the next expensive bailout.

To contact the reporter on this story: Richard Teitelbaum in New York at rteitelbaum1@bloomberg.net