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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Regardless of the content of a portfolio, ratings agencies, like investors, can evaluate investments only within a wide confidence interval, and understand that other market actors have information they do not and that would be material to the rating process. Like investors, raters reasonably take into account the economic interest of issuers.

With respect to CDOs in particular, I understand that ratings agencies typically subjected “balance sheet” motivated CDOs — CDOs issued by banks in order to insure their own loan portfolios — to heightened scrutiny (relative to CDOs initiated by third parties to satisfy investor interest), because obviously banks would have an incentive to try get insurance at cheap “AAA” rates for their shoddiest loans if they could. Third party issuers were indeed understood to seek yield, but when acting to attract and serve long investors, they would have sought the highest quality portfolio possible for a given yield, while balance-sheet or short-aligned issuers would prefer that “lemons” be included, even (especially) if the impairment of the assets was not known to the market and not reflected in yield.

Rating agencies did want and need to know the interest of the arranger of the CDOs, and to the degree that was obfuscated, the ratings process was compromised. Like “yield hog” institutional investors, ratings agencies performed so poorly that it is tempting to declare a pox on all houses and sloppily absolve the investment banks for subverting the ratings process by concealing the circumstances under which the CDOs were arranged. But that is foolish. We have a series of institutional checks that are supposed to prevent corrupt agents from being able to take heads-I-win/tails-you-lose risks. Plain disclosures to institutional investors would have attached career and legal risk to taking foolish bets with other peoples’ money, even if managers wished to do so. Plain disclosures to ratings agencies would have compelled raters to employ the higher-standard of scrutiny they applied to balance-sheet motivated deals, or at least would have attached greater risk to corrupt laxity on the part of ratings agency employees.

Nondisclosure of the economic interest of CDO arrangers to ratings agencies is a significant and underemphasized aspect of the short-initiated CDO scandals.

Posted by stevewaldman | Report as abusive

So, when do investors en masse start having their own ratings agencies rate CDO’s etc?

If a fund manager pays ratings agency X a fee to rate the bonds, he is much more likely to get an accurate rating. And ,no, rating agency X is NOT going to be S&P and Moody’s. Why in the world would anybody buy a bond based on those guys’ ratings?

Posted by randymiller | Report as abusive

Good article! It’s really time for the US Government to act responsibly & get the better of the financial behemoths. You might like this more article: ontext=va&aid=14637

Posted by chnswam | Report as abusive

Intervention and “bullying” are not the same.

If and when it actually comes to bullying banks, send me a tweet. A pinch of salt large enough to make present circumstances taste anything like bankster victimhood has yet to be invented. There’s been too little, too late by way of tangible outcome after months of relatively gentle persuasion for the banks themselves to appear interested in retaining more than a ghostly illusion of Trustiness Past.

Likewise with the ratings agencies acting as an anaesthetic subset of banks whose combustible investments they accessorily rated as fire-proof.

Fact is, the case against them is no less solid than the moral relativity by which they justify daily doing more of the same old dark deeds. I’d prefer to invest less time scrounging around for excuses for them, and more locking away the steroids of usury to which they’ve become addicted.

If this were baseball, they’d be banned for life. Would you call that “bullying” too?

Posted by HBC | Report as abusive

So Felix let’s get this straight.

You said, “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”. How can one AAA be materially better than another, that is fraud and you knew it.

If everyone knew this, and seeing how stupid the concept is from the perspective of an investor, then the people on Wall Street are even more corrupt than it appears. And that is pretty corrupt.

Another statement you make is that the banks hire all the smart people at the ratings agencies to get the ratings they want from the remaining morons?

Did you say this out loud and hear how illegal that sounds, that is conspiracy to manipulate an industry and deceive the public, and you knew that too.

This isn’t settling time if I’m a DA, I think we pull that thread through and get a few of those Madoff length sentences for a few thousand Wall Streeters that “All knew that”, complicit weasels one and all.

Just like they told us with the crack dealers, put them away for at least 20 and the financial district will be safe for decades to come just like the five boros were after Rudy.

Posted by jstaf | Report as abusive

We need to raise the tax rate on Wall Street payouts to 60%

This is so good on so many levels

Posted by STORYBURNcom2 | Report as abusive

To: storyburn
Raising the tax rate is not the solution. It’s our money, not their money.

Posted by doctorjay317 | Report as abusive


Maybe I misunderstand your definition of our money. As a taxpayer, I say Wall Street used taxpayer (our) money to avoid huge losses, cheap fed money to leverage back up, etc.

Does anyone seriously believe that the big financials would have made the money they are making without the TBTF discounts they are getting when they go to the credit markets? How many times do we have to walk people through the scenario of a TBTF company getting cheaper rates because of the implicit federal guarantees, and making a lot more money than a small regional bank would make on the same transaction?

If TBTF firms are getting subsidized, their profits need to be taxed accordingly.

Posted by randymiller | Report as abusive