February 6, 2009 10:06AM
Inside Wall Street’s Subprime Bond Factory
By Elizabeth MacDonald
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Third in the Crackdown on Wall Street series
What exactly went on behind the scenes in Wall Street’s subprime bond factory?
A behind the scenes, inside look at three asset-backed bond deals on Wall Street, deals that eventually imploded, shows exactly the danger investors were put in.
Law enforcement officials now say arrests on Wall Street will be made not just of those who hawked predatory subprime loans, but those who pushed predatory securities built on those loans, according to Fox Business’s interviews with David Cardona, head of the criminal division at the Federal Bureau of Investigation’s New York offices as well as other top law enforcement officials at the FBI.
The FBI is investigating, from top to bottom, Wall Street executives who participated in Wall Street’s financial engineering factory, where executives compulsively minted and fraudulently pushed on investors dangerous securities built on bad mortgages, bad credit card payments, bad auto loans, bad student loans, you name it.
All stuffed through Wall Street’s underwriting pipeline, and all magically emerging as Triple-A rated securities, safe as a US Treasury.
Bonds and derivatives that were then sold by companies Wall Street purposely set up offshore in places like the Cayman Islands or Guernsey, away from the prying eyes of market regulators.
Counter-terrorism Agents Enlisted
The FBI has enlisted agents specialized in al Qaeda and terrorism financing, overseen by special agent Rachel Rojas.
The agents are needed here, because the task of following the money trail in the pools of loans Wall Street assembled to back these securities is similar to following the paper trail in the usury-forbidden Muslim world’s anonymous money transfer network in the Middle East, Asia and Africa, called hawala.
The credit rating agencies are under scrutiny, too, as they hungered after fees and fell prey to the push to get these radioactive securities goldplated Triple A, meaning safe and virtually risk-free.
Both Wall Street and the credit rating agencies knew full well that investment portfolios around the world, notably pension funds, by the very dint of their own regulations, were only allowed to invest in safe, Triple-A rated securities.
It’s clear now that Wall Street went wild. It manufactured trillions of dollars in asset-backed bonds and derivatives that dwarfed the value of the underlying mortgages, auto loans, and student loans upon which they were based, investment experts say.
But what really happened?
Bucket Shop Bonds
When you invest your money, you expect a competent money manager who will protect your investments, right?
However, too many investors in these mortgage-backed and other asset-backed bonds invested on autopilot, without checking who was watching their money.
Specifically, the securities and derivatives under scrutiny were supposed to be overseen by competent investment managers to ensure investor money was protected and returns were being paid.
Anything less is a breach of fiduciary duty, and potentially securities laws, says Janet Tavakoli, derivatives expert and author of “Dear Mr. Buffett: What An Investor Learns 1,269 Miles From Wall Street” (John Wiley & Sons, 2009).
So who were these guys who oversaw these jerry rigged bonds?
Executives you wouldn’t want managing your local McDonald’s, notes Fox Business’s Joanna Ossinger.
An Unregulated Bond Factory
The mayhem was notable inside the offices of the Wall Street underwriters of what are called collateralized debt obligations (CDOs), pools of bonds which are backed by pools of mortgages, and so on.
Derivatives expert Tavakoli says that in November 2006, she warned a Wall Street shop that “their CDO managers are unregulated,” that “most do not have the expertise or the resources to perform CDO management or surveillance,” and that “many cannot build a CDO model.”
She also noted that “rating agencies rarely ask for background checks on CDO managers.”
In fact, many investor prospectuses for these securities offerings read like “finance comic books,” Tavakoli says she wrote in a letter to legendary investor Warren Buffett in December 2007.
A Rotten Deal for Investors
Tavakoli says one notably rotten deal came across her radar screen in late 2006. Back then, she read the prospectus for a mortgage-backed security that took hundreds of mortgage loans, shoved them into a portfolio, and sold the risk on to investors.
The portfolio included negative amortization loans and interest-only loans, the most combustible mortgages bought from some of the worst mortgage mills that have since flopped.
In these mortgages, because the loan’s principal is not being paid down, the loan amount steadily increases as the interest rate shoots up. The resulting, massive balloon payment has the same effect on consumers’ wallets as the levees breaking in New Orleans, Tavakoli says.
More than 60% of the loans backing this security were purchased from New Century Capital, which in turn bought them from New Century Mortgage Corp., a unit of New Century Financial Corp., an incestuous stew of a company that restated its financials in February 2007 and then filed for bankruptcy on April 2, 2007, under a cloud of fraud allegations, Tavakoli says.
Another Dangerous Deal for Investors
From 2004 to mid 2007, Merrill Lynch was Wall Street’s biggest underwriter of CDO deals built on shaky assets such as loans from places that were essentially mortgage mills. CDOs again are pools of bonds, they are typically made up of dozens of bonds backed by hundreds, even thousands of loans.
Merrill reaped hundreds of millions of dollars in fees by assembling and selling these eventually soured securities.
For example, Merrill Lynch made a lot of money as a part owner of California-based Ownit Mortgage Solutions, a mortgage mill that eventually collapsed in December 2006, Tavakoli points out. Merrill built and sold securities backed by Ownit’s loans.
Ownit issued crazy 45-year ARMs and no-income-verifications loans. In the words of William D. Dallas, its founder and CEO: “The market is paying me to do a no-income-verification loan more than it is paying me to do the full documentation loans.”
Michael Blum, Merrill Lynch’s head of global asset-backed finance, sat on the board of Ownit Mortgage Solutions. When Ownit imploded in December 2006, Blum faxed in his resignation, Tavakoli says.
Full Steam Ahead
But Merrill continued to sell securities, or derivatives, based on Ownit’s loans well into 2007, even after Ownit collapsed, Tavakoli says.
For example, in early 2007, Merrill created a package of securities deals backed by loans issued by Ownit, Tavakoli says.
However, the securities were built on sand. Around 70% of the borrowers of these Ownit loans had not provided full documentation of either their income or assets, Tavakoli says.
Most of the loans were for the full appraised value of homes, meaning they were no down payment loans, loans given at a time when home prices were already starting to crumble.
But in her read of the deal documents, Tavakoli says Merrill only disclosed that Ownit went bankrupt, and did not mention it was Ownit’s largest creditor.
Can Merrill say it did an “arms-length” transaction with Ownit when a Merrill officer sat on the Ownit’s board and Merrill was Ownit’s largest creditor, Tavakoli asks?
In early 2007, both Moody’s Investors Service and Standard and Poor’s, the credit rating agencies, downgraded the Triple-A rated tranche of this Merrill deal to junk status, “an investment they had previously rated as ‘super safe’ with almost no possibility of loss. That meant investors were “likely to lose their shirts,” Tavakoli says.
Moody’s later forecasted that 60% of the original portfolio value could eventually be lost, Tavakoli says.
However, the SEC as a regulator of the investment banks had the power to stop this nonsense, but it did nothing to halt this securitization activity.
“Instead, investment banks accelerated securitization activity in the first part of 2007,” Tavakoli says.
One of the Worst Deals of All
Take a look at another deal to see the serious dangers investors were unaware of.
After an Evanston, Illinois hedge fund called Magnetar pushed Merrill to set up “a tailor-made bet on subprime mortgages,” Merrill cooked up a CDO deal and nicknamed it “Norma,” according to an important but overlooked Wall Street Journal article by Carrick Mollenkamp and Serena Ng on December 27, 2007.
Norma was pushed onto investors as a Triple-A rated, diversified investment with yields of 10% or more, the Journal says. Moody’s, Standard & Poor’s and Fitch Ratings all gave Norma their highest, triple-A rating–implying it had as little risk as Treasury bonds of the U.S. government.
It Was Anything But Safe
Within eight months of selling $1.5 bn in bonds to investors, Norma dropped to a fraction of its original value, the Journal says. Credit-rating firms, “which had signed off approvingly on the CDO, slashed its ratings to junk,” the paper says.
Rather than diversifying risk, Norma instead “bet heavily on subprime mortgages, typically made to borrowers with poor or patchy credit histories,” the paper says.
And Norma even held ice-chunks of other derivative contracts that let the Norma bond managers bet on mortgage-backed bonds they didn’t own.
“It is a tangled hairball of risk,” Tavakoli, was quoted at the time. “In March of 2007, any savvy investor would have thrown this . . . in the trash bin.”
How Norma Was Born
Norma “was nurtured in a small office building on a busy road in Roslyn, on the north shore of New York’s Long Island, the Journal reports.
There, a stocky, 37-year-old money manager named Corey Ribotsky ran a company called N.I.R. Group LLC, the Journal says.
Ribotsky came not from the world of mortgage securities, “but from the arena of penny stocks, shares that trade cheaply and often become targets of speculation or manipulation,” the paper says.
Who was the N.I.R. Group?
N.I.R. and its affiliates invested stakes in 300 companies, some little-known, including a brewer called Bootie Beer Corp., lighting firm Cyberlux Corp. and water-purification company R.G. Global Lifestyles, the paper says.
However, Ribotsky’s firms were also in litigation at the time in New York federal court with all three companies, which claimed that N.I.R. had manipulated their share prices, the Journal says. N.I.R. denied wrongdoing through its lawyer, the paper says.
How did Ribotsky come across Merrill’s radar screen?
A Country Club Connection
To keep rich underwriting fees flowing, Merrill recruited outside companies to manage its pools of bonds, called CDOs.
In turn, Merrill helped these recruits raise funds, procure the assets for their CDOs and find investors.
The managers picked the assets and were charged with monitoring the CDOs’ collateral, earning rich annual management fees.
Ribotsky’s entrance into the world of CDO managers began at Engineers Country Club on Long Island, the Journal reports.
There, in 2005, he met Kenneth Margolis, then a high-profile CDO salesman at Merrill, the paper says.
Margolis, who in February 2006 became co-head of Merrill’s CDO banking business, was looking for recruits to manage CDOs at that time.
He put Ribotsky in contact with two former Wachovia Corp. bankers, and the three then launched a company called N.I.R. Capital Management, which over the following year or so took on the management of three CDOs underwritten by Merrill, the Journal reports.
Ribotsky then came to manage Merrill’s risky CDO called Norma, a company that was domiciled offshore, in the Cayman Islands. Norma was loaded with shaky derivatives. mostly credit default swaps, which are insurance contracts Norma sold on its securities.
A credit default swap is an insurance contract on a security, much like you’d buy insurance on your house. It pays out if the security goes bellyup.
The buyer of the insurance or the swap gets a payout if his or her underlying security drops in value.
The seller of the insurance, or the swap, gets the premium payments from the buyer of the swap.
Ribotsky’s firm earned fees of some 0.1% on about $1.5 bn in investments in Norma, the Journal says.
However, Norma only had about $90 mn, or 6% of its overall holdings, in actual mortgage-backed securities. The rest were shaky derivatives.
Your Head Exploded Yet?
Now this is how absurd this deal gets.
Remember, a credit default swap is an insurance contract on a security, much like you’d buy insurance on your house. It pays out if the security goes bellyup.
The buyer of the insurance or the swap gets a payout if his or her underlying securities drop in value.
The seller of the insurance, or the swap, gets the premium payments from the buyer of the swap.
But watch how the payments got made in Merrill’s Norma deal.
Norma sold these insurance contracts, or swaps, to Merrill. So Norma was the insurer for these swaps.
Merrill Lynch was the insured.
So Merrill paid Norma the insurance premiums, which Norma would then pay out to investors.
If the insured securities dropped in value, Norma would pay Merrill for the coverage.
Sounds like round-tripping of revenues to make each other’s numbers look good, doesn’t it?
Mine Has
Wall Street went nuts here.
It pumped out an unlimited number of these bond pools, called CDOs, that were loaded with these swaps, even though the bond pools were linked to the same amount of mortgage-backed bonds, even though the number of these bonds didn’t increase, even though the number of loans underneath these bonds didn’t increase.
At one point, CDOs sold credit protection on around three times the actual face value of triple-B-rated subprime bonds, says UBS Investment Research, a unit of Swiss bank UBS AG.
Why pump out an infinite number of derivatives?
You got it–to grab even more lucrative underwriting fees.
The Journal reports that Ribotsky said at the time that “the selling required little effort, as Merrill drummed up interest from its network of contacts.”
“That’s what they get their fees for,” he reportedly said.
Disclosures Don’t Cut It
Keep in mind Tavakoli’s comic book crack here.
Norma’s marketing documents, where investors get their risk disclosures, “noted plenty of risks” for investors but also said that” Norma “had a high degree of stability,” the Journal says.
But that stability was based on Merrill’s and Ribotsky’s assumptions that house prices would defy the laws of physics and grow to the moon, and defaults would not occur en masse.
Wall Street’s Dirty Rosy Glasses
In fact, the Inspector General of the Securities and Exchange Commission would later find in 2008 that these reckless assumptions were in vogue on Wall Street.
For example, he found that Bear Stearns’ “stress scenarios included the 1987 stock market crash, the 1998 collapse of Long Term Capital Management and the 9/11 terrorist attacks.”
However, the SEC Inspector General found “no discussion of the most serious forward looking risk” Bear Stearns faced, “a complete meltdown of mortgage market liquidity accompanied by fundamental deterioration in the mortgages themselves, resulting from falling house prices.”
Bear Stearns collapsed in March 2008, and was bought by JPMorgan Chase in a shotgun wedding orchestrated by the US government.
Credit Bubble Explodes, So Does Norma
As house prices plunged and mortgages defaulted, by September 2007, Merrill’s Norma and all subprime-backed bonds went into a free fall, the Journal says.
Credit ratings agencies began to downgrade $153.5 bn worth of mortgage-backed securities, including those which Norma had insured.
By November, Moody’s slashed the ratings on seven of Norma’s nine rated slices, three plummeting all the way from investment-grade to junk. Fitch downgraded all nine of Norma’s slices to junk.
That was just eight months after the ratings agencies gave Norma a Triple-A rating.
The Collapse of Wall Street Was Just Beginning
After reporting record losses in the fall of 2007, Merrill Lynch ousted its chief executive E. Stanley O’Neal and other top executives.
Norma’s CDO creator Margolis by that time was already gone, the Journal says.
Merrill Lynch, near collapse after more than $45 bn in writedowns and losses in a year’s time, was taken over in a shotgun wedding with Bank of America in September 2008.
A deal made under pressure from the US government–with the help of $20 bn in taxpayer money to get BofA’s CEO Kenneth Lewis to pay for the $20 bn deal price for Merrill.
BofA also got $118 bn in government guarantees on its bad assets, after Lewis threatened to walk away in December of 2008. — with reporting by Cristine Ambrose
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