The CDO-prosecution bandwagon gathers more steam

By Felix Salmon
May 13, 2010
Louise Story says that Andrew Cuomo, NY attorney general and would-be governor, is piling onto the CDO bandwagon, sending subpoenas to eight (count 'em) banks, asking if they misled the ratings agencies when they were putting together their structured products. It's a long article, and notably the substance of Cuomo's investigation is left until the very last paragraph:

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Louise Story says that Andrew Cuomo, NY attorney general and would-be governor, is piling onto the CDO bandwagon, sending subpoenas to eight (count ‘em) banks, asking if they misled the ratings agencies when they were putting together their structured products. It’s a long article, and notably the substance of Cuomo’s investigation is left until the very last paragraph:

A central concern of investors in these securities was the diversification of the deals’ loans. If a C.D.O. was based on mostly similar bonds — like those holding mortgages from one region — investors would view it as riskier than an instrument made up of more diversified assets. Mr. Cuomo’s office plans to investigate whether the bankers accurately portrayed the diversification of the mortgage loans to the rating agencies.

I’d love more detail on this because it seems a little weird to me. The ratings agencies knew exactly which bonds were being put into in the CDOs and it really should have been up to them to check on things like geographical diversification. In the case of a CDO-squared, I can imagine that tracking down the true underlying assets might have been difficult and that the ratings agencies might have relied on the investment banks to help them with that. But there’s no mention in the story of CDO-squareds, or synthetic CDOs, or anything else which might have increased complexity and therefore the opportunity for deliberate befuddlement. Instead, there’s lots of talk about banks hiring former ratings-agency employees, which might be distasteful but which is hardly illegal.

That said, I think we’ve probably moved beyond the point at which it’s important how strong these cases are. All that Cuomo needs to do is tell Story about his investigation and most of the damage is already done: he never needs to bring an actual case, and in fact, given the amount of time it takes to put such cases together, he’ll probably have moved on to grander elected office by then anyway.

The theater of all this, then, is what really matters. The banks in question are going to be on the back foot; I’d advise them simply to say that they’re cooperating fully etc, etc and leave it at that. At least unless and until some substantive accusations start emanating from Cuomo’s office. But as Cuomo’s predecessor Eliot Spitzer knows, the attorney general of New York has a lot of power when it comes to bullying banks, and right now the harder Cuomo bullies the banks, the more popular he’ll be. The bankers, in turn, have little choice but to take their lumps and remind themselves how much money they’re making while doing so.

Ultimately, it’s entirely possible that the banks are going to wind up having to make some kind of settlement with the AG. Everybody knew that the job of the CDO origination desks at the investment banks was to put together the riskiest and highest-yielding instruments possible while still retaining a triple-A rating. Similarly, everybody knew that investment bankers during the dot-com boom would carefully put together “friends and family” lists of people getting access to hot IPOs, so as to butter up potential clients. And then, when the party was over, suddenly prosecutors declared themselves shocked — shocked! — that such activity had been going on.

The fact is that the investment banks exacerbated and profited from the incompetence of the ratings agencies by hiring away anybody smart, by gaming the models (which the agencies made public) and by funneling so much cash to the agencies in the form of fees that the agencies had no incentive to crack down on them. That’s shameful, and I for one would love to see the banks get their comeuppance for that behavior. Even if the forensic justification for it is dubious at best.

Meanwhile, the WSJ has a bit more information on the case against Morgan Stanley, adding that it’s not only Dead Presidents but also deals named ABSpoke and Baldwin being looked at:

Some CDO offering documents indicated that mortgage assets selected for the deals may have factored in the interests of market players whose interests were “adverse” to other investors. But none went as far as to state that hedge funds or banks’ trading desks were making bets against the deals for their own accounts, according to documents reviewed by the Journal.

This is essentially a slightly weaker version of the case against Goldman in the Abacus deal. In that case, the SEC is saying that Goldman implied to investors that the person structuring the deal was long when in fact he was massively short. In these cases, the banks did make a disclosure about adverse interests, but didn’t go as far as they should have done in terms of revealing that they themselves intended to hold on to the short position.

Again, the same political calculus applies: it’s incredibly dangerous to take the Goldman route of fighting the accusations aggressively. Better, I think, to just cooperate fully with the SEC and see what happens. And, of course, if and when the relevant Wells notice arrives, to disclose that fact to investors immediately.

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