News that the SEC and federal prosecutors are further investigating Wall Street firms involved in the structuring and distribution of CDOs (collateralized debt obligations) is not a surprise. Although Goldman Sachs (GS) has been targeted initially for its marketing of an Abacus transaction in conjunction with Paulson and Co., the simple fact is Goldman was not anywhere close to the largest player in this space. Who was? Well, I should more appropriately ask, “Who wasn’t?” All of Wall Street jumped on the CDO gravy train.
The Wall Street Journal sheds some insights on this story by writing, Wall Street Probe Widens:
Federal prosecutors, working with securities regulators, are conducting a preliminary criminal probe into whether several major Wall Street banks misled investors about their roles in mortgage-bond deals, according to a person familiar with the matter.
The banks under early-stage criminal scrutiny—J.P. Morgan Chase & Co., Citigroup Inc.,Deutsche Bank AG and UBS AG—have also received civil subpoenas from the Securities and Exchange Commission as part of a sweeping investigation of banks’ selling and trading of mortgage-related deals, the person says. Under similar preliminary criminal scrutiny are Goldman Sachs Group Inc. and Morgan Stanley, as previously reported by The Wall Street Journal.
The Manhattan U.S. Attorney’s office and SEC are working hand-in-hand. At issue is whether the Wall Street firms made proper representations to investors in marketing, selling and trading pools of mortgage bonds called collateralized debt obligations, or CDOs.
Many major Wall Street banks created CDOs at the behest of players that made bets against the deals—and banks themselves sometimes bet against the deals. Bearish bets paid off when the mortgage market crashed.
The challenge for investigators and regulators in this investigation is melting the materials down to the point where they themselves can understand the intricate nuances and subtleties of the deals. Will these investigators and regulators comprehend the concept of a waterfall, overcollateralization, subordinate cash flows, credit supports, super-senior cash flow, equity, a trigger?
Why do you think members of Congress looked like such buffoons while questioning the representatives from Goldman Sachs? The crowd from Goldman was talking a foreign language. Do you really think legal eagles from the DOJ, or regulators from the SEC or FINRA stand a chance in discussing the nature of these transactions with CDO structurers? Not a chance.
As I write this piece, I recall the oft heard conversation from salespeople themselves who would engage those structuring the CDOs. The conversation would go something along these lines:
Salesperson: “Can you give me the breakdown in the collateral behind this deal? How about the geographic dispersion in the collateral? Please also tell me the level of credit supports?
Structurer: (rolls his eyes in a condescending and disparaging fashion): “Why so many questions? This deal is cheap.”
Salesperson: “Well, my client would like to know this information.”
Structurer: “OK, try telling your client that we are still pooling the collateral, but it looks to be good and we have a lot of interest in the deal. If he persists, then try telling him it is like this other deal.”
Salesperson: “What? What do you mean, try telling him….How about we try this, ‘You don’t lie to me.’ How about you start by telling me the truth, and then I’ll figure out how to sell the bonds. Got it? How can I figure out what to tell my client if you’re lying to me?”
Structurer: “I hate dealing with you. Where are the dumb salespeople?”
Although this exchange is a bit of a parody, it is not all that far removed from what would often happen. The point being is that the individuals structuring deals were often mathematical geniuses who could figure out how to bury and disguise risk so it was not easily detected. The risks would then be exposed during periods of extreme volatility, much like what occurred during 2007-2008.
Not all of Wall Street was operated in this manner. Many market sectors were highly commoditized and transparent. The world of CDOs was not one of those markets.