Category Archives: CDOs, Collateralized Debt Obligations

The Securities and Exchange Commission (SEC) has charged investment firm Goldman Sachs with fraud in connection to sales of synthetic collateralized debt obligations (CDOs).

According to the SEC’s complaint, Goldman Sachs failed to disclose critical information about the CDOs to investors, including their ties to a major hedge fund whose investments Goldman allegedly was betting against. Meanwhile, as investors suffered huge financial losses totaling billions of dollars, Goldman itself profited.

The hedge fund, Abacus 2007-AC1, contained mortgage investments that were most likely to lose value, says the SEC. Abacus was then marketed and sold to investors such as pension funds, insurance companies and other hedge funds.

As reported April 16 by the New York Times, the SEC’s lawsuit against Goldman marks the first time that regulators have taken action against a Wall Street deal that helped investors capitalize on the collapse of the housing market.

“The product was new and complex, but the deception and conflicts are old and simple,” Robert Khuzami, director of the SEC’s division of enforcement, said in a statement.

“Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party,” Khuzami said.

An obscure hedge fund called Magnetar offers new details into the world of collateralized debt obligations (CDOs) and how the instruments cost investors billions while yielding a payday bonanza for Magnetar. And that’s the irony. What Magnetar did appears to be legal.

Magnetar and the toxic deals it created and then bet against are the subject of an investigative story by ProPublica and co-produced with Chicago Public Radio’s This American Life and NPR’s Planet Money.

The short version of Magnetar – which was started up by former Citadel trader Alec Litowitz – begins with the Chicago hedge fund buying up the riskiest portion of CDOs. At the same time, Magnetar placed bets that portions of its own deals would fail. Meanwhile, Magnetar ended up reaping a massive fortune.

Magnetar worked with most of Wall Street’s top banks in its deals – deals that ultimately produced $40 billion worth of extremely toxic, high-risk CDOs. Among the banks that helped sell those toxic assets to investors: Merrill Lynch, Lehman Brothers, Citigroup, UBS and JPMorgan Chase.

“Along the way, it did something to enhance the chances of that happening, according to several people with direct knowledge of the deals. They say Magnetar pressed to include riskier assets in their CDOs that would make the investments more vulnerable to failure. The hedge fund acknowledges it bet against its own deals but says the majority of its short positions, as they are known on Wall Street, involved similar CDOs that it did not own. Magnetar says it never selected the assets that went into its CDOs.”

ProPublica offers an excellent slideshow of how Magnetar orchestrated its CDO deals. Entitled The Anatomy of the Magnetar Trade, the slides provide a straightforward and simple account of the players involved in the CDO market and how when the instruments ultimately collapsed, Magnetar profited.

The complete (5,900 words) story on Magnetar is well worth the read. You can view the story in its entirety here.

Synthetic collateralized debt obligations, or CDOs, are complex mortgage-linked debt products that have been blamed for bringing Wall Street to its knees and pummeling millions of investors in the process. It was in the fall of 2007, when the financial markets first started to become unhinged, that these high-risk instruments found their way into the public’s eye.

Today, CDOs are a hot topic on Capitol Hill, where members of Congress and regulators like the Securities and Exchange Commission (SEC) are trying to determine exactly how and why synthetic CDOs created the financial tsunami that they did.

As reported Dec. 24 in an article by Gretchen Morgenson and Louise Story for the New York Times, regulators are said to be looking at whether current securities laws or rules of fair dealing were violated by the investment firms and banks that created and sold CDOs and then turned around to bet against clients who purchased them.

“One focus of the inquiry is whether the firms creating the securities purposely helped to select especially risky mortgage-linked assets that would be most likely to crater, setting their clients up to lose billions of dollars if the housing market imploded,” the article says.

Pension funds and insurance companies are some of the institutional investors that lost billions of dollars on synthetic CDOs – investments they thought were safe investments.

The New York Times article devotes space mainly to the synthetic collateralized debt obligation business of Goldman Sachs and, specifically, mortgage-related securities called Abacus synthetic CDOs. Abacus CDOs were developed by Goldman trader Jonathan Egol, who had the idea that they would protect Goldman from investment losses if the housing market ever collapsed.

According to the article, when the market did tank, Goldman created even more of these securities, enabling it to pocket huge profits. Meanwhile, clients of Goldman who purchased the CDOs – and who thought they were solid investments – lost big.

One can easily infer from the article and other news reports on the subject that Goldman put the best interests of clients in harm’s way with Abacus because it not only served as the structurer of the deals involving the product, but also held onto the short side of those same deals. In other words, the company would be advising clients to buy assets that, in turn, it was betting to fail.

Goldman certainly is not the only investment firm that employed this strategy. Others banks created similar securities that they sold to clients and then bet against the future performance of those assets.

Goldman and other investment banks will soon have to answer tough questions about accountability and fiduciary duty. In the meetings being held on Capitol Hill, the Financial Crisis Inquiry Commission – a group that has been compared to the 9/11 Commission – plans to call several panels of investment banks to appear as witnesses. Among them: CEOs of Goldman Sachs, Morgan Stanley, JP Morgan Chase, and Bank of America.

Federal prosecutors say former Credit Suisse Group AG broker Eric Butler used bait-and-switch tactics to fraudulently steer institutional and retail clients into millions of dollars worth of auction-rate securities, collateralized debt obligations (CDOs) and other risky debt instead of the safe, conservative investments the investors initially asked for. On Aug. 14, after only two hours of jury deliberations, Butler was found guilty of conspiracy to commit securities fraud, securities fraud and conspiracy to commit wire fraud. He faces a maximum sentence of 20 years in prison on the most serious count.

Butler’s co-defendant is Julian Tzolov, who had fled the country earlier this year. He was returned to the United States on July 20 and has since pleaded guilty to conspiracy, wire fraud and securities fraud. His is awaiting sentencing.

Butler and Tzolov were charged in September of lying to clients about their purchases of nearly $1 billion of auction-rate securities and CDOs from 2004 to 2007. Reportedly, the two men had told customers their investments were backed by federally guaranteed student loans.

During Butler’s trial, Tzolov served as a witness for the prosecution, providing testimony against his former partner.

“We did it together,” Tzolov told jurors. “We were sitting right next to each other. We were meeting with clients together.”

Already facing hundreds of arbitration claims and lawsuits over a group of collapsed mutual bond funds, Morgan Keegan & Company is now the subject of Well Notice by the Securities and Exchange Commission (SEC). The notice typically signals the likelihood that the SEC could file civil charges in the near future for possible violations of federal securities laws. 

As reported July 16 by the Memphis Daily News, Morgan Keegan’s parent company, Regions Financial Corp., disclosed in a regulatory filing on July 15 that its investment subsidiary, Morgan Asset Management and three unidentified employees received a Wells Notice from the SEC last week.

“We knew it was just a matter of time before the SEC and probably other state regulators (brought) the hammer down,” said Indianapolis attorney Mark Maddox, in the Memphis Daily News article. Maddox is one of dozens of attorneys across the country who has won arbitration cases against Morgan Keegan in the past year for investor losses connected to the mutual funds.

The claims against Morgan Keegan involve at least seven bond funds (collectively known as the “RMK Funds”) that the Memphis-based company formerly managed and which plummeted in value because of the underlying investments made by Morgan Keegan. The investments included untested types of subprime mortgage securities, collateral debt obligations (CDOs) and other risky debt instruments. Losses in the funds entailed more than $2 billion between March 31, 2007, and March 31, 2008.

Meanwhile, investors in the RMK funds say Morgan Keegan misrepresented the funds as corporate bonds and preferred stocks, giving them the illusion of diversification and low risk levels. 

For too long, the idea of “anything goes” on Wall Street was the norm, as investment banks concocted and sold individual and institutional investors exotic baskets of untested and speculative financial instruments like subprime mortgage securities, credit default swaps and collateral debt obligations (CDOs). The products themselves were born out of process known as securitization, and critics say abuses in that market have proven to be a main contributor behind the mortgage market meltdown and the credit crisis that followed.

Securitization is everywhere today. Mortgages are securitized. Car loans are securitized. So are credit cards and student loans. Essentially, securitization occurs anytime an interest-earning pool of assets is packaged together and sold as securities.

Lenders were the first to make securitization mainstream when they decided to “sell” home mortgages to big investment banks, which then converted the mortgages into securities. That was more than four decades ago. During that time, investment banks began to securitize many other kinds of debt and lining up retail and institutional investors, pension funds, and others as their buyers.

For a while, the securitization business thrived beyond all expectations. Demand for mortgage-backed securities was so huge that lenders found they could sell almost any type of security, even the most risky and toxic form of debt.

Whatever the securitization market had in demand, however, it lacked in transparency, disclosures and due diligence. Ultimately, the absence of this much-needed regulation led to financial disaster for investors and the nation as a whole. As reported in a July 6 story by NPR, many critics now contend the housing collapse and the recession itself would never have materialized if the securitization market had been better regulated.

Moving forward, it’s likely there will be a substantial overhaul of the securitization market, including implementing key changes to the manner in which investment banks participate. One proposal is to require securitizers to hold on to a piece of whatever financial product they’re selling to investors. In sharing the risk, they may be a little more careful about what they’re selling, according to the NPR story.

On June 26, 2009, a Washington, D.C., arbitration panel of the Financial Industry Regulatory Authority (FINRA) ruled in favor of investor David Cutler and his claim (FINRA No. 09-00300) against Charles Schwab & Company and its Schwab YieldPlus Fund.

The panel awarded Cutler $11,400.

Cutler’s complaint against San Francisco-based Charles Schwab is similar to hundreds of other arbitration claims filed with FINRA by investors who allege that Charles Schwab misrepresented the risks of the Schwab YieldPlus fund by failing to disclose important information about the risky securities it held.

Specifically, the Schwab YieldPlus fund was marketed and sold as a safe and conservative alternative investment to money market funds. Later, investors learned the YieldPlus fund was heavily concentrated in high risk and toxic subprime mortgage-backed securities and in even more risky collateral debt obligations (CDOs). Ultimately, Schwab’s failure to diversify the fund’s portfolio caused investors to collectively lose approximately $1.3 billion in 2008.

In 2008, approximately 74% of customer claimant cases filed with FINRA resulted in monetary settlements or awards for the investor.

More investors are scoring legal victories in their claims against Morgan Keegan & Company and a group of proprietary mutual funds. As reported June 7, 2009, by The Birmingham News, 16 of investors’ 20 wins came in the past 25 arbitration hearings with the Financial Industry Regulatory Authority (FINRA). In April, the Memphis-based investment firm suffered six consecutive losses in arbitration negotiations with investors.

Many investors who have filed claims with FINRA lost up to 95% of their money the Morgan Keegan mutual funds.

The claims against Morgan Keegan involve several collapsed bond funds that plummeted in value following the onset of the mortgage loan crisis. The common theme in the majority of investors’ claims is that Morgan Keegan misrepresented the mutual funds as corporate bonds and preferred stocks, giving the illusion of diversification and low risk levels.

Later, losses in the funds – which entailed more than $2 billion between March 31, 2007, and March 31, 2008 – were traced back to the underlying investments made by Morgan Keegan. The investments included risky and untested types of subprime mortgage securities, collateral debt obligations (CDOs) and other debt instruments.

Hyperion Brookfield Asset Management now manages the funds at the center of the ongoing litigation.

The arbitration scorecard keeps getting bigger for investors and their arbitration cases against Memphis-based Morgan Keegan & Co. At the heart of the legal disputes: Seven mutual bond funds that aggrieved investors say Morgan Keegan and fund managers led them to believe were invested in conservative preferred stocks and corporate bonds. Instead, the funds, collectively known as the RMK Funds, took high-risk bets on speculative and toxic financial products such as collateralized debt obligations and derivatives.

Other troubled RMK funds at the center of the ongoing litigation were tied to the credit default swaps business, an investing strategy that essentially entails a “bet” between two parties on the likelihood a bond or similar type of investment will default. When the housing market crashed and burned in the summer of 2007, that’s exactly what happened, and certain RMK funds subsequently were forced to pay off huge losses.

Ultimately, Morgan Keegan’s investing gambles, along with the company’s alleged deception to keep the credit risks of the funds’ investments a secret, would cost investors dearly. Some of the RMK funds lost more than 90% of their value following the collapse of the housing market. In turn, investors suffered more than $2 billion in losses in just 2007 alone.

Since then, hundreds of arbitration cases have been filed by investors against Morgan Keegan for losses in the funds. Now, after months of waiting to tell their story, it appears momentum is building on the side of investors.  As reported June 7, 2009, by The Birmingham News, 16 of investors’ 20 wins came in the last 25 hearings with the Financial Industry Regulatory Authority (FINRA). In just the month of May 2009, FINRA announced eight arbitration decisions in favor of investors.

As for Morgan Keegan, the legal battle over its collapsed bond funds has played havoc with its stock price. The company’s shares plummeted more than 70% in the past year.

In 2008, management responsibilities for the seven RMK funds were handed off to Hyperion Brookfield Asset Management. Meanwhile, the former Morgan Keegan manager of the funds, Jim Kelsoe, no longer manages any Morgan Keegan funds, according to The Birmingham News article, and has been “reassigned” to an unspecified role within the company.