It’s worth reading the full SEC complaint in the case which was settled by Citigroup yesterday for $285 million. For anybody familiar with Goldman’s Abacus deal, it all rings very familiar; in fact, the wording on the Abacus sign can be applied perfectly accurately to Class V Funding III. It’s worth rehearsing in full:
It’s wrong to create a mortgage-backed security filled with loans you know are going to fail so that you can sell it to a client who isn’t aware that you sabotaged it by intentionally picking the misleadingly rated loans most likely to be defaulted upon.
The loans in this case — just like in the Abacus case — were “synthetic”, or made up of credit default swaps rather than actual loans. Wall Street, at the time this deal was done, had run out of actual loans to securitize, and so was forced to create such things by inventing ever more complex transactions. This one, for instance, is a hybrid CDO-squared: it’s a CDO made up mostly of CDSs written on the mezzanine tranches of other CDOs.
Citigroup had two aims when it structured this transaction; one was fully disclosed to its client-investors, and the other was not. The first was to make millions of dollars — $34 million, to be precise — in fees. The second was to put on a $500 million short position in the CDO market. Citi was a big trader in CDSs on CDOs, and therefore could simply have acquired that short position directly, in the open market. But when Class V Funding III was put together, such protection was already very expensive. And the CDOs that Citi wanted to buy protection on were known in the market to be particularly horrible. Probably, it couldn’t buy protection on those particular names at all. And if it could, the price would be prohibitive.
So Citi created Class V Funding III instead. It gave Credit Suisse Alternative Capital a list of the CDOs it wanted to buy protection on, and CSAC did what it was expected to do — it persuaded itself that it could live with having a large number of them in its deal. After all, CSAC wasn’t investing its own money in this dog — it was just managing it for others. And hey, it was AAA-rated! What could possibly go wrong?
Citi, with CSAC on board, then went out to investors and told them that the portfolio had been selected by CSAC — professional! experienced! expert! — and that they could have confidence in CSAC’s selection of securities. Citi did not tell investors, of course, that Citi itself had actually picked most of the CDOs in Class V Funding III, and they certainly didn’t mention that Citi would be holding a $500 million short position in those securities on its own books indefinitely, as a naked-short prop trade. Here’s how the complaint puts it:
The pitch book and offering circular were materially misleading because they failed to disclose that:
a. Citigroup had played a substantial role in selecting assets for Class V III;
b. Citigroup had taken a $500 million short position on the Class V III collateral for its own account, including a $490 million naked short position; and
c. Citigroup’s short position was comprised of names it had been allowed to select, while Citigroup did not short names that it had no role in selecting.
The fine, in this case, is richly deserved, and the money’s going to the right place — the investors who bought into this dreadful deal. I do wonder how many more of these late-vintage CDOs there are, sitting out there and as yet unprosecuted. (I have to admit that I didn’t think of Citi as being particularly evil in this regard; I thought they were more at the incompetent end of the spectrum.) And I certainly hope that if and when there’s some big mortgage settlement with the banks, that the banks don’t receive in return immunity from prosecution on this kind of deal.