REPRESENTATIVE PETERS RENEWS CALL FOR WALL STREET CRACKDOWN
Today’s Reports on new SEC Investigations Shed further Light on the Greed and Duplicity that Led to Global Financial Crisis
Washington, D.C. – April 20, 2010 – (RealEstateRama) — News reports on SEC investigations today illustrate what the Wall Street Journal calls “an open secret on Wall Street”: investment banks created products it knew would fail just to give hedge funds an opportunity to bet against them. The fact that these products were being created solely as a way for hedge funds to bet against the housing market was never disclosed to those who invested in them. Banks profited by taking fees for moving these investments, and then got bailed out by taxpayers when the investments went bad. Pension funds, mutual funds, local governments and other investors on Main Street lost heavily.
Following today’s reports, Representative Peters, who helped shape Wall Street Reform legislation that passed the House in December, issued the following statement (for a recent op-ed column Congressman Peters wrote on this issue, click here):
“New reports are shedding even more light on how greed and duplicity on Wall Street contributed to a financial collapse that rippled through our entire economy. The hedge funds that helped design these investment vehicles have profited handsomely by their collapse. The banks that participated in this scam made exorbitant profits, and then when the investments turned out to be worthless were bailed out by taxpayers. The only ones who have lost are the American people who have seen retirement accounts decimated, credit for small businesses dry up and jobs lost—and have had to use their tax dollars to bail out those responsible for the mess.
“The Senate must stop delaying and pass Wall Street reform legislation similar to the bill the House passed to protect our economy from future crises and ensure taxpayers will never again be required to bailout Wall Street. The Senate bill should include the measure I authored to require the financial sector to pay back taxpayers for every dime of the Wall Street bailout initiated in 2008. The extent of the deceptive greed that wrecked our economy should persuade remaining holdouts that tougher safeguards for Wall Street are extremely necessary and that requiring the financial sector to payback the bailout is more than fair.”
Last December, the House of Representatives passed the Wall Street Reform and Consumer Protection Act (H.R. 4173), a bill Representative Peters helped shape as a Member of the House Financial Services Committee. Representative Peters helped shape this bill as a member of the House Financial Services committee. The legislation included an amendment Representative Peters authored that would require large institutions across the financial sector to pay the cost of any shortfall in the TARP program so taxpayers would be repaid every cent of the bailout.
This Act would ensure an end to taxpayer bailouts in the future and finally provide oversight of the risk posed by “too big to fail” financial firms. Firms whose reckless risk threatened the larger economy would be required to take steps to reduce that risk. And rather than taxpayers bailing out failing firms (such as AIG), failed institutions would be responsibly dissolved using a safety fund paid for by large banks themselves, the same way the FDIC now unwinds failed banks. The bill also contains tough new consumer protections to stop credit cardholders or those securing an auto loan or mortgage from being ripped off or deceptively pushed into a bad investment.
APRIL 19, 2010
By CARRICK MOLLENKAMP, SERENA NG, GREGORY ZUCKERMAN and SCOTT PATTERSON
The Securities and Exchange Commission, after having hit Goldman Sachs Group Inc. with a civil fraud charge, is investigating whether other mortgage deals arranged by some of Wall Street’s biggest firms may have crossed the line into misleading investors.
The SEC’s case against Goldman Friday has exposed an open secret on Wall Street: As the housing market began to wobble a few years back, some big financial firms designed products aimed at allowing key clients, such as hedge funds, to bet on a sharp housing downturn.
Among the firms that created mortgage deals that soon went sour were Deutsche Bank AG, UBS AG and Merrill Lynch & Co., now owned by Bank of America Corp. It isn’t known what deals the SEC is investigating.
Further cases could hinge on whether the SEC sees what it considers misrepresentation, and not just questions such as whether a deal favored one client over another. A critical part of the SEC’s case against Goldman is that the firm allegedly misled investors by not notifying them of the role of hedge-fund investor John Paulson—who was dubious of the housing boom—in selecting what went into the mortgage deal Goldman sold. Goldman said it fully disclosed the investments and didn’t need to reveal the Paulson connection.
The deals generated about $1 billion in total fees for the firms, traders say. Investors that bought them often lost heavily. Now private lawsuits, along with the SEC’s case against Goldman, are shedding light on how some of these mortgage deals were put together.
Soured mortgage investments helped trigger the near-collapse of American International Group Inc., which had insured at least $1 billion of bond deals issued by Wall Street firms in 2005 that reflected hedge funds’ input, according to documents reviewed by The Wall Street Journal and people familiar with the matter. Taxpayers had to foot the bill for AIG’s rescue.
Ultimately, the problems landed at American doorsteps. Losers in the mess included, for instance, a county in Washington state.
On Friday, SEC enforcement director Robert Khuzami said the agency will look closely at mortgage deals similar to the Goldman one that is the focus of the SEC action.
At the center of the scrutiny are instruments called collateralized debt obligations. These are typically instruments backed by bundles of mortgage bonds and other assets, including complex derivatives based on the bonds’ performance.
In the late stages of the housing boom, some hedge funds that doubted its staying power worked with banks to create CDOs that would provide them with a way to bet against the mortgage market. Often the hedge funds bought insurance-like contracts, called credit-default swaps, that would rise in value if the bonds, and thus the CDOs, weakened.
In the Goldman structure at the center of the SEC complaint, credit-rating firms downgraded 99% of the underlying mortgage securities by January 2008. Some CDOs created by Deutsche Bank, Merrill and UBS also suffered downgrades to most of their assets by early 2008, according to analyst reports.
Deutsche Bank’s traders and bankers were on alert for problems in the housing industry as early as September 2005, well before the market cracked, when a top-ranked mortgage-securities analyst at the bank issued a report warning of pending losses in subprime loans. That report, issued after the analyst visited firms that service mortgages in California, said it would be “sensible” to buy credit protection against mortgage-bond defaults.
From 2005 through late 2006, the U.S. securities arm of Deutsche Bank created several CDOs that sold credit protection on mortgage bonds that the firm’s hedge-fund clients bet against, according to people familiar with the matter. Deutsche Bank facilitated the deals, earning fees, by selling credit-default swaps to the hedge funds and clients. To offset its risk, the bank itself bought swaps that would pay off if mortgages backing the CDOs weakened.
Among the hedge-fund clients was one run by Mr. Paulson, the investor the SEC says helped pick the assets for a Goldman CDO. His firm, Paulson & Co., which reaped billions on the mortgage meltdown, helped choose about 100 mortgage assets for some of Deutsche Bank’s CDOs, traders say. Deutsche Bank used some but not all of his recommendations, according to people familiar with the transactions.
Investors who bought slices of the CDOs weren’t explicitly told about the bets by the hedge funds, though they were shown a list of mortgage bonds on which swaps had been written, according to people familiar with the matter and marketing documents reviewed by The Journal.
The Deutsche Bank CDOs were called Static Residential CDOs (nicknamed “START”). Those CDOs took bullish positions on mortgage bonds that hedge-fund clients bet against.
Many mortgage bonds underlying the Deutsche START deals were downgraded by rating agencies and tumbled in value after loan delinquencies rose. Deutsche Bank’s hedge-fund clients profited when insurance on those bonds rose in value.
A spokesman for Deutsche Bank said all participants in the deals, not just Paulson, provided input on which mortgage securities backed its CDOs. A spokesman for Mr. Paulson said, “Every single synthetic CDO has a party on the long and short side.”
Some sophisticated traders and Wall Street firms were early to spot the impending end of the housing boom. In January 2007, a New York money manager, Tricadia Capital, told investors in a hedge fund it managed of “serious cracks” beginning to appear. In a letter to investors reviewed by The Wall Street Journal, it said 2007 “may well be the year in which the great structured credit trade unwinds with profound implications for markets around the world.” The fund, the firm’s officials said, was positioned “to benefit from a dislocation in the credit markets.”
Another Tricadia unit, whose job was to manage CDOs, was working with banks, including UBS, to create new asset pools predicated on the housing market’s doing well. Tricadia had responsibility for selecting the mortgage assets.
A document for one $2.25 billion CDO, called “TABS 2007-7,” underwritten by UBS, did warn that other funds managed by Tricadia or its affiliates might make bearish bets on the same assets, an offering document shows. Less than a year after it was formed, the deal was liquidated, after the downgrade of most of its underlying assets. Losing investors included a bank in California and UBS itself. But in 2007, the hedge fund Tricadia managed reaped strong gains.
A spokesman for Tricadia said it “has always acted in the best interests of its clients and investors” and did not make negative bets on the same assets backing the TABS 2007-7 deal.
Hedge fund Pursuit Partners LLP, which lost money on several UBS-underwritten CDOs, including TABS, alleges in a pending lawsuit against UBS in state court Stamford, Conn., that UBS knew assets backing the CDOs were souring when it was marketing the deals in the summer of 2007. A lawyer for Pursuit says it was contacted about the suit by the SEC and Justice Department. Both declined to comment. UBS, which has denied wrongdoing in the suit, declined on Sunday to comment.
Among investors in Abacus, the Goldman transaction the SEC focused on, was an affiliate of Germany’s IKB Deutsche Industriebank AG, which put in $150 million. The affiliate, Rhineland Funding Capital Corp., issued its own short-term IOUs, to investors such as King County in Washington State and a suburban Minneapolis school district.
Just months after Abacus closed, the investment by the IKB affiliate was nearly worthless and the affiliate couldn’t renew maturing IOUs. That ultimately harmed U.S. towns and cities that had invested in debt sold by Rhineland.
Washington state’s King County has sued IKB claiming that unknown to the county, an IKB affiliate held many “toxic, low-quality mortgage-backed securities.” IKB is fighting the suit, pending in federal court in New York. An IKB spokeswoman declined to comment on the case.
Another hedge fund, Magnetar Capital in Evanston, Ill., worked in 2005 and 2006 with Merrill, Deutsche Bank and other firms to set up CDOs. One was a CDO called Norma, underwritten by Merrill. That deal, the subject of a page one Wall Street Journal article in December 2007, was a $1.5 billion assemblage of mortgage securities and credit-default swaps on subprime assets. Magnetar, a Merrill client, bought the riskiest slice of Norma and made bearish bets against slightly less risky layers of CDOs.
A money manager Merrill had hired to pick the assets to put in Norma told the Journal in 2007 that most had been pre-selected. A review of the assets showed they included swaps bets opposite to the negative wager Magnetar made. As losses increased, Magnetar profited.
The Dutch bank, commonly known as Rabobank, sued Merrill last year in a New York state court, alleging that Merrill misrepresented the safety of Norma, which it called a “dumping ground” for impaired subprime assets, structured with the help of Magnetar. Merrill denied wrongdoing and has sought dismissal of the suit. On Friday, Rabobank asserted in court that Merrill and Magnetar effectively had engaged in the “same type of fraudulent conduct” the SEC accused Goldman of.
A Merrill spokesman said Sunday it provided all information required by Rabobank in the Dutch bank’s decision to invest in the CDO. The spokesman added that Rabobank had access to information about the bonds underpinning the CDO, and disclosures were provided.
A spokesman for Magnetar said that it hadn’t seen the Friday court filing and that the original complaint “made a variety of false and inaccurate statements about Magnetar and its investment in CDOs.” The spokesman added that “Magnetar’s investments in CDOs were based on a statistical strategy and expressed no fundamental view on the direction of the market. Any characterization to the contrary is incorrect.”
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