17 December 2011
By Brett Sherman Wall Street Law Blog
Is it reasonable to believe that Wall Street used complexity as a tool to dupe even sophisticated investors as to the quality of bonds backed by non-conforming mortgages during the United States housing bubble?
In a word – ABSOLUTELY.
Indeed, there was so much complexity in the various methods that Wall Street used to package and repackage mortgage bonds in the 2000s that it was nearly impossible for anyone outside the big banks that engineered and sold these products to know the truth about how risky these really were. And the truth was that these products were extremely risky.
Indeed the vast majority of mortgage bonds that were sold to investors during the 2000s were junk – toxic waste. The problem is that these investments were packaged and sold by issuer banks, with the help of rubber-stamps from the credit rating agencies, as though they were high-quality (safe) securities (see also ‘The securitization food chain‘).
Were the risks disclosed in prospectuses, as some have argued? In a word, NO. Sure, there were boiler-plate risk disclosures. Tons of them in fact. But there was no loan-level data. No specifics about the actual mortgages. And the actual mortgages were the root of the problem.
The issuing banks concealed real, known problems from investors by cloaking the problems as risk factors. Risk factors in a prospectus are warnings about potential hazards. A hazard that has already come to fruition at or before the bond is issued is, in fact, already a problem; because there is no longer anything “potential” about such risks, it is fraud to label them as risk factors. Still confused? That’s okay. The whole idea was to confuse investors. Here’s an example of what we mean:
One risk factor in every mortgage bond prospectus that we’ve read is about potential liquidity problems with CDO investments. In other words, the prospectuses would warn investors that there was no assurance that there would be a ‘secondary market’ for the bonds, meaning that a buyer might struggle to re-sell the investment. Unlike stocks, mortgage-based derivatives are not freely traded on stock exchanges. Market demand could dry up, and if it did, investors who wanted to sell their bonds might be out of luck.
But by late spring 2007, there was virtually no secondary market for CDOs. Technically, it might have been possible to sell them, but only to ‘bottom feeders’ at distressed prices (i.e. at nowhere near face value). And yet, there were tons of new CDO offerings during 2007. The issuing banks concealed the absence of a real secondary market because they wanted to offload as much of their inventories of bad mortgages and mortgage bonds as they could before the jig was up.
The issuers – investment banks including Bear Stearns, Merrill Lynch and Lehman Brothers (to name but a few) – knew that there were serious problems in the secondary market. But instead of disclosing that the after-market was becoming frozen, they kept on including the same old generic risk factor about the ‘possible absence of a secondary market’.
Also, there is ample evidence that the big banks:
(a) Created the false appearance of market demand for CDOs by selling the investments to each other;
(b) That when the mortgage-bond market was imploding, these same big banks colluded to hold bad mortgage investments on their balance sheets so that they could report artificially high market prices and avoid/delay taking true mark-to-market writedowns (Ian’s note – this is exactly what Jay Levine did at RBS Greenwich Capital Inc).
Just how confusing were CDOs to investors? Consider the following excerpts from the interview that CNBC’s David Faber conducted with the former Federal Reserve chairman Alan Greenspan in 2008 (interview excerpts below, via New York Times Dealbook and CNBC’s House of Cards documentary).
David Faber: I would think you’re one of the few people who might understand what a CDO really is…
Alan Greenspan: But some of the complexities of some of the instruments that were going into CDOs bewilders me. I didn’t understand what [the banks that produced CDOs] were doing or how they actually got the types of returns out of the mezzanines and the various tranches of the CDOs that they did. And I figured if I didn’t understand it – and I had access to a couple hundred PhDs – how the rest of the world is going to understand; it sort of bewildered me. But here I am observing all of these very sophisticated investors trying to buy more of this stuff than existed.
David Faber: Yes, but this goes to my original point in my question to you: If Alan Greenspan can’t understand how they are getting to where they are getting on these particular structured products, then how are any of these investors supposed to understand?
Alan Greenspan: Well, we learned the answer to that. THEY DIDN’T.