Wall Street may find itself on the hook

September 10, 2009

Sometimes legal fishing expeditions pay off.

A year ago, a Connecticut hedge fund sued UBS, contending that it knowingly sold toxic mortgage-backed securities to institutional investors but never disclosed that information.

At the time, the accusation by the fund, Pursuit Partners, seemed intriguing. But because the complaint lacked any sign that it had the beef to back up its potentially explosive claim, the litigation all but fell off the radar screen.

Now, it appears the hedge fund managers were onto something, thanks to a Connecticut state judge’s decision to allow Pursuit’s lawyers to get limited access to some of UBS’ internal emails.

In some of the emails, the investment firm’s employees describe the $35 million in collateralized debt obligations sold to Pursuit in summer 2007 as “crap” and “vomit.”

At first glance, it might be easy to chalk this up as simply another case of Wall Street bankers peddling securities they privately thought were junk.

But the big revelation unearthed by Pursuit’s lawyers is the extent to which credit rating agency Moody’s Investors Service shared information with UBS about its impending decision to lower its ratings on some of the CDOs the firm was selling.

In short, what struck a chord with Connecticut Superior Court Judge John Blawie is the evidence that Moody’s gave UBS a sneak peak into its decision-making process and that UBS used the information to its advantage. In ordering UBS to post a $35 million bond in advance of a trial, the judge said the firm’s bankers “were in possession of material nonpublic information regarding imminent ratings downgrades.”

The judge didn’t call what UBS was doing insider trading. But that’s one way to think of the critical allegation in this case.

And that’s why the Pursuit case could be bad news not only for UBS, but for other investment banks that packaged and sold exotic securities that were dependent on getting a stamp of approval from one of the major credit rating agencies.

It’s doubtful that this sharing of information between a rating agency and a Wall Street bank was an isolated event.

In one of the emails turned over by UBS and cited by Blawie, a banker is quoted as saying, “It sounds like Moody’s is trying to figure out when to start downgrading, and how much damage they’re going to cause — they’re meeting with various investment banks.”

That email should prompt some enterprising securities regulator or prosecutor to begin asking bankers at UBS and other firms who were packaging CDOs in the spring of 2007: What did you know and when did you know it?

In response to the bond order, a UBS spokeswoman said that “the decision by the Connecticut Superior Court is a preliminary procedure to require defendants to post security while a case is pending, nothing more,” adding that the bank expects to prevail in the case.

It’s less clear whether Moody’s, which also is a defendant in the Pursuit lawsuit, has any liability. There’s nothing to indicate that Moody’s had any knowledge of UBS’ plan to sell the CDOs to Pursuit.

A spokesman for the rating agency said Moody’s believes the claims against it are baseless.

The litigation sheds light on the all-too-chummy relationship that exists between the big rating firms and the investment banks.

And it’s just one more reason why the Obama administration needs to push harder for reforms that would make it easier for smaller credit rating firms to compete for work with the two big gorillas of the debt-rating world.

That’s a lot of heat coming from a lawsuit that most on Wall Street weren’t even aware of until this week.


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This rating agency/ bank relationship is largely at fault for the credit crisis. The collapse of the CDO market happened not because there is anything fundamentally wrong with these products. Instead there was a problem of information transfer that led to institutions taking on more risk than they thought they were getting as these products were being advertised with very high ratings.

There is no doubt that certain key salespeople within these product areas and their colleagues at rating agencies knew the ratings were bogus but maintained the illusion while the banks tried to offload the assets. By summer of 2007, the CDO market was beginning its collapse and, as one of the biggest structurers, UBS must have been well aware they were holding toxic assets.

Very naughty.

Posted by alejandro | Report as abusive

The whole Credit Agency/Score scene needs revamping in the US. Basic financial planning 101 requires that you look at ASSETS as well as liabilities before making judgments on how ‘creditworthy’ a person is. Its one thing for this not to be recognized on an individual level, but at the corporate level… the mind boggles.

Posted by Arthur Vann | Report as abusive

The wheel of justice turns slowly, but it grinds fine.

Posted by Casper | Report as abusive

Something similar occurred with Merrill Lynch back in the seventies.
Can’t recall the name of the firm, but again Merrill has inside track and used it to dump the stock on unsuspecting investors. As long a people are involved their will be fraud. Caveat emptor.

Posted by David | Report as abusive

To my way of thinking this highlights the conundrum facing the world… banks that are too big to fail, corporations who have domination over the market, and a massively wealthy elite with their tame political poodles who are daily becoming more and more disconnected from the “regular” citizen, spiced with an underlying waft of righteousness and intolerance.
Is it possible to “level the playing field” while maintaining a competitive business environment? or does it need to get to “Game Over” first?

Posted by Peter H | Report as abusive

These people are all a part of the same alphabet soup, with four letters being especially prominent within the murk: G, R, E, D, with the letter E being doubled in number.

Posted by jr | Report as abusive

I have the utmost faith Goldman had no hand in this. But then again, I may be naive.

Posted by Matt | Report as abusive

hoooraaaaay for the free market model.
participants with equal information.

Matt, Paulson bailed out AIG so he wouldn’t have to bail out Goldman.

Posted by C C Reider | Report as abusive

Posted by alejandro
“By summer of 2007, the CDO market was beginning its collapse and, as one of the biggest structurers, UBS must have been well aware they were holding toxic assets”.

Actually the start of the downturn was around February of 2006, that is when the price of the bulk loan sales started to decline to somewhere around Par (sub-prime).
The investment bankers started to tighten up on the quality of the loans they were buying and the bids where coming in much lower due to their losses on first thru third month defaults.
The writing was on the wall starting in 2006, it is just that the news media did not start to take notice until 2007.

Posted by Jim | Report as abusive

The first most important thing to prevent these crises happening again in future is to ban the practice of administrations and governments appointing top executives from Wall Street and financial institutions in the top government, finance, treasury, and regulatory positions.

For example, ppointing H Paulson as Treasury Secretary was the most serious mistake.

Posted by progress | Report as abusive

The first most important thing to prevent these crises happening again in future is to ban the practice of administrations and governments appointing top executives from Wall Street and financial institutions in the top government, finance, treasury, and regulatory positions.

For example, appointing H Paulson as Treasury Secretary was the most serious mistake.

Posted by progress | Report as abusive

Racquel Welch (alias NR), The Subprime Mess & A New Order – A Tongue-in-Cheek View of the Subprime Mess

Fantastic Ratings!, a re-make of the 1966 movie, Fantastic Voyage was shot in the summer of 2007 and won an “Oscar” for its surprising effects – an Oscar which I believe was well deserved. Although the effects have dated in the sense that they appear to be in a very 1960s psychedelic style, they are still impressive.

The storyline has a medical ratings team reduced to the size of microbes, who are given the task of being injected into a CDO’s body to cure him of an incurable blood clot on the brain – the subprime region. They have to navigate their way around the CDO structure and layers of artificial tranches, previously rated as healthy, in a green-powered submarine which has also been miniaturized. There are lots of action in the film – witness the volatility and liquidity crunch in the voyage – and the presence of Racquel Welch alias NR in any film makes it more than watchable! Other cast members include the “nursing” members of the CityBears’ team, the ML (“mortgage lenders”, etc.) team and other luminaries on WS.

The premise of the re-make was based on the fact that prior to miniaturization, the health of the CDO was mistakenly rated and diagnosed based on its bodily krebsz@web.de (portfolio) measures like BP, BMI, etc., which tended to be very static in the “corporate body” framework, rather than on the dynamically unhealthy delinquency rates of the underlying “retail loan organs”. Investors depended heavily on these ratings/measures as the underlying parts of most CDOs, especially those that were retail-based and asset-backed, were very opaque.

Intermediaries, financial health structurers and insurers like CityBears and the other WS firms, typically also received the health information at the portfolio body level, rather than at the granular “loan” organ level. As the affliction grew from the subprime region and spread to the rest of the body (housing market), encompassing even the so-called healthier HB (home buyers) organs, the deteriorating prices rapidly impacted on those “ARM1 and HEL2 drug treatments” re-setting to higher thresholds, further exacerbating the crisis!

While part of the blame lie at the doors of the aggressive sales brokers, who reaped huge commissions by selling these exotic ARM treatments, one fundamental flaw as depicted in the re-make, Fantastic Ratings!, is the whole process of structuring and treating the CDO bodies, where the medical ratings team used an approach more suitable to a fairly static environment of a corporate body framework, rather than a more dynamic rating on the granular retail organs, where health delinquency rates may change more quickly. While the health ratings of bodies like CityBears tend to remain pristine, in spite of the widening spreads, at the microbial “consumer” organ level, if the individual cells lose their functions (jobs), their credit-worthiness would simply deteriorate.

In the real world, a company like Merrill or Citi, etc., would hardly have its ratings downgraded, even in a crisis. Typically, the manifestation would appear as a credit spread widening rather than an actual downgrade – this is because the corporate ratings of such companies are benchmarked to default rates over a span of 5 to 20 years as default incidences are actually scarce in the corporate world. Hence, the ratings of highly rated companies (those with AAA or AA ratings) tend to remain pristine or static (more TTC).

In comparison, asset-backed securities like the CDOs based on the subprime and other residential mortgage payments were also assigned AAA ratings, partly because of the equivalent ratings of the bond insurers like MBIA and partly because they were rated based on the “portfolio” loss rate (default) information. Here, the payments to the investors have their origins in the consumer credit mortgage payments.

If one of these borrowers works for Merrill or Citi and loses his job as a result of the crisis, e.g., in a cost-cutting exercise, his FICO (or credit score) or individual credit rating would be downgraded as his credit-worthiness would simply deteriorate. Hence, consumer credit risk rating is a different animal from corporate credit risk rating as it tends to be more dynamic and susceptible (more PIT) to the “boom and bust” economic cycles. Moreover, the ratings agencies would not be able to capture this information on credit deterioration at the account or granular level as their model is usually based on information obtained at the portfolio level.

As a start, one possible solution is to revamp the whole process of structuring financial products. Firstly, there is a need for some form of entity, with a fiduciary duty to protect the interests of certain groups of investors, esp. the pension funds and as a counter-check to the ratings agencies, to demand some form of accountability in terms of having access to the information on or tracking the underlying behavioral scores/ratings of the underlying pools of consumer credit loan payments that constitute the tranches in the CDOs, that were rated by the ratings agencies. Secondly, the current modeling process of rating these structured financial products would need to be modified in a holistic manner to take into account the nature of the underlying ratings (consumer vs. corporate), the asset-liability or liquidity risk environment (witness the drying up of the liquidity in the ABCP3 space), the dimensions or impact of the other players like the bond insurers and their own ratings. Thirdly, like what Yul Bryner said in the movie, “The King & I” – quote, “et cetera, et cetera, et cetera, ……”!

Here then, lies the nub of the subprime mess! Thank you.

Posted by gskhoo | Report as abusive

All you need to know why the banksters are quaking in their loafers. God only knows how many lawsuits in waiting there are. There was fraud in practically every case. Read with delight as the perpetrators squirm and wiggle.

http://www.sfgate.com/cgi-bin/article.cg i?f=/c/a/2007/12/09/IN5BTNJ2V.DTL&feed=r ss.business

Posted by Dave | Report as abusive

I see a problem with the statutes of limitation in resolving these vast numbers of potential cases. The legal system was not designed for this sort of volume of well heeled & represented perpetrators. Don’t hold your breath. I should imagine the regular seven year limit would apply, perhaps even less.

Posted by Sterling | Report as abusive

It appears that the “cat is out of the bag”!!
The media needs to hammer this info right now! The common man needs to understand how this happened as he will most certainly be on the jury that hears the case!
It would be my suggestion that UBS settle out of court ASAP!!

Posted by Al Davis | Report as abusive