10 Prospectus for Adams Square Funding I, Ltd. CreditSuisse offering memorandum, January 22, 2007, 34, 35.
11 Carrick Mollenkamp and Serena Ng, “Wall Street Wizardry Amplified the Credit Crisis,” Wall Street Journal, 27 December 2007.
12 Ibid.
13 Janet Tavakoli, “Dead Calm: No One Trusts You: A Letter to Certain Banks and CDO Managers,”Tavakoli Structured Finance, Inc. 30 July 2008.The following is an excerpt:
Some market pundits say that ‘disclosure’ is the answer to the “dead calm” of a securitization market adrift in the doldrums.That is not it guys. It is one thing to have documents that disclose risks—many of the documents of death spiral collateralized debt obligations (CDOs backed by private-label residential mortgage backed securities) in 2007 disclosed eye-popping risks—it is quite another to bring deals to market that you knew or should have known were overrated and deeply troubled the day the deal closed.
The real issue is timely, complete and continuing disclosure. If you knew or should have known your “triple-A” tranches deserved a junk rating on the day the deal closed, that should have been specifically disclosed, no matter what the rating agencies, or your attorneys, said. As the investment bank securitizing the deal and selling the securities, it was down to you. You thought the disclaimers in the documents protected you—well how is that working out? You are now suffering some of the consequences.The SEC may say you were within the “rules” (let’s see what happens), but the market is holding you responsible. Investors shun you.
The reason no one trusts securitizations is not “disclosure” of loan data.The reason is that you, the securitization departments of several investment banks and the “friendly” CDO “managers,” that “managed” their death spiral CDOs, have no credibility. If securitization professionals failed to perform appropriate due diligence, they have a problem. If they performed due diligence, but suppressed the reports, they also have a problem. Going forward, investors may not even trust “disclosures” of due diligence, because loan data can be manipulated. Your current lack of credibility means your former customers will be reluctant to believe your data and your documents in future.
So, how did the CDOs that Merrill Lynch brought to market in 2007 perform? All of the deals I captured are in serious trouble at the “triple-A” level. [The deal names are: Lexington Cap Fundg III; Port Jackson CDO 2007-1; Highridge ABS CDO I; Maxim High Grade CDO I; Broderick CDO 3; Kleros Real Estate CDO IV; Norma CDO I; Maxim High Grade CDO II; Newbury Street CDO Ltd.; South Coast Funding IX; Euler ABS CDO I; Glacier V; Lexington Capital Funding V; Libertas Preferred Funding IV; Silver Marlin; Kleros Preferred Funding VII; NEO CDO 2007-1; Forge ABS High Grade CDO I; IMAC CDO 2007-2; Mars CDO I; Brookville CDO I; Fourth Street Funding Ltd.;Wester Springs CDO; Jupiter High Grade CDO VI; Tazlina Funding II; West Trade Funding CDO III; Robeco HG CDO I; Durant CDO 2007-1; Biltmore CDO 2007-1; Bernoulli High Grade CDO II].All have one or more originally “triple-A” rated tranches downgraded below investment grade (junk) by one or more rating agencies. Of the 30 CDOs, 27 have even the topmost original “triple-A” tranche now ranked as junk by one or more rating agencies.
As of June 10, 2008, of 30 CDOs totaling more than $32 billion in notional amount, 19 have declared an event of default, are in acceleration, or have been liquidated. Ten others are “toast,” as evidenced by downgrades of their “triple A” tranches to junk status, yet I could find no record of a declared event of default (EOD).The remaining CDO has “triple-A” tranches downgraded to junk, but the two topmost tranches are still rated investment grade (the topmost is Aa1 neg/ AAA neg and the formerly “triple-A” tranche below that is Baa2 neg/ BBB+ neg). The EOD may be undeclared due to documents that avoid that declaration so that investors cannot trigger acceleration or liquidation (or the declaration may be pending).
Merrill had pieces of other investment banks’ deals embedded in many of the CDOs, and likewise other investment banks had pieces of Merrill’s CDOs in their deals. And, of course, their credit derivatives desks bought and sold protection on each others CDOs.
As far as I can tell, disclosing loan data is not the problem. The problem is that investment banks knew or should have known they packaged damaged product to sell to unwary investors.
Granted, some of these investors were sophisticated and should have known better; investment banks and “sophisticated” investors, like the bond insurers can slug it out with each other. But there is a difference between an account with a lot of money and a “sophisticated” investor. Many smaller municipalities and other retail-like accounts may have been saddled with dodgy products.
Investment banks and the rings of highly paid managers, securitization professionals, and lax CDO managers have an enormous amount of responsibility for the collateral damage done to the U.S. housing market and “insured” bond markets.
One can argue that the bond insurers were willing victims, but municipalities paying higher funding costs were not. One can argue that some homeowners knowingly overextended themselves, but many others were victims of predatory lending practices. U.S. taxpayers are unwilling victims, paying either directly or indirectly for housing market assistance, turmoil in municipal bond markets, frozen auction rate securities, and bailouts of errant mortgage lenders and investment banks.
The Federal Reserve Bank is now providing liquidity for many investment banks either directly or indirectly. Investment banks may not be “borrowing,” but the Fed’s willingness to accept “AAA” assets in exchange for treasuries is a back-door bailout.
14 Elinor Comlay, “Merrill Lynch 2007 CDOs under water-consultant,” Reuters, 31 July 2008.
15 Greg Newton,“Thos 2007 Merrill CDOs in Foole,” Seeking Alpha, 31 July 2008.
16 Yalman Onaran, “Banks Hide $35 Billion in Writedowns From Income, Filings Show,” Bloomberg News, 19 May 2008.
17 Yalman Onaran, “Subprime Losses Top $396 Billion on Brokers’Writedowns: Table,” Bloomberg News, 18 June 2008.
18 Yalman Onaran and Dave Pierson, “Banks’ Subprime Market-Related Losses, Capital Raised,” Bloomberg News, 16 October 2008.
19 Huw Jones,“IMF sticks by $1 trillion U.S. subprime fallout,” Reuters, 16 July 2008.
20 Warren Buffett to Janet Tavakoli, private conversation, 10 January 2008.
21 Benjamin Graham, The Intelligent Investor (New York: Harper & Row, 1973), 300.
Chapter 7: Financial Astrology: AAA Falling Stars
1 Based on data from Berkshire Hathaway annual reports for 2002 to 2007.
2 Aline van Duyn and Francesco Guerrera, “Wall St. Banks Face $10bn Cost,” Financial Times, 11 June 2008.
3 Jo Johnson,“Questions Raised over Fitch’s Credibility,” FinancialTimes, 20 July 2003.
4 Ibid.
5 Warren Buffett, memo dated September 27, 2006, Financial Times 9 October 2008.
6 Ibid.
7 Arturo Cifuentes, “CDOs and Their Ratings: Chronicle of a Foretold Disaster,” Total Securitization, 4 June 2007.
8 Charles Bachelor,“Agencies Under Fresh Pressure on Rating Worth” Financial Times, 23 December 2003.
9 Ibid.
10 Janet Tavakoli, “Investors Are the Gullible Ones if They Rely on Ratings as Indicators of Financial Robustness,” Financial Times, 29 December 2003; and Janet Tavakoli, Collateralized Debt Obligations & Structured Finance (Hoboken, N.J.: John Wiley & Sons, 2008), 386-388.
11 Paul J Davies, “Questions Lie Behind CPDO Hype,” Financial Times, 14 November 2006.
12 Sam Jones, Gillian Tett and Paul J. Davies, “Moody’s Error Gave Top Ratings to Debt Products,” Financial Times, 20 May 2008.
13 Ibid.
14 Karen Richardson, Kara Scannell, and Aaron Lucchetti, “The Hits Keep on Coming at Moody’s,” Wall Street Journal (Deal Journal), 23 May 2008.
15 Neil Unmack, “CPDO Investors May Lose 90% as ABN Funds Unwind,” Bloomberg News, 25 January 2008.
16 Aline van Duyn and Joanna Chung, “S&P Discloses Errors in
Rating Models,” Financial Times, 13 June 2008.
17 Gyan Sinha and Karan Chabba, “Sell on the Rumor, Buy on the News,” Bear Stearns, 12 February 2007.
18 Janet Tavakoli, “Comments on SEC Proposed Rules on Rating Agencies,” 13 February 2007.
19 “Fed & Sub-Prime Loans,” CNBC, 20 February, 2007. Segement with Susan Bies, Steve Liesman, and Gyan Sinha.
20 Bethany McLean, “The Dangers of Investing in Subprime Debt,” Fortune, 19 March 2008.
21 Ibid.
22 Mark Pittman, “Moody’s, S&P Defer Cuts on AAA Subprime, Hiding Loss,” Bloomberg News, 11 March 2008.
23 Eric Gelman, “Fear of a Black Swan,” Fortune, 14 April 2008.
24 Benjamin Graham, The Intelligent Investor (New York: Harper & Row, 1973), 110.
25 Ibid. 98.
26 Craig Karmin, “Springfield, Mass., Takes Aim at Merrill over Subprime Losses,” Wall Street Journal, 19 January 2008.
27 Vickie Tillman, “The Truth about Triple-A Ratings,” Financial Times, 20 March 2008.
28 Aaron Lucchetti, “S&P Email: ‘We Should Not Be Rating It’,” Wall Street Journal, 2 August 2008.
29 David Scheer and Karen Freifeld, “Citigroup to Unfreeze $29.5 Billion of Auction Debt,” Bloomberg News, 7 August 2008.
30 Karen Freifeld and Michael McDonald, “Morgan, JPMorgan Settle Auction-Rate Probe, Pay Fines,” Bloomberg News 14 August, 2008.
31 Robert Frank and Liz Rappaport, “Big Boys Face ‘Auction’ Monster Alone: Settlement Excludes 4Kids, Other firms; Battle with Lehman” 29 August 2008.
32 Karen Richardson, Kara Scannell, and Aaron Lucchetti, “The Hits Keep on Coming at Moody’s.”
Chapter 8: Bear Market (I’d Like a Review of the Bidding)
1 “U.S. Housing and the Gamble of Subprime Loans,” CNBC 30 January 2007. Segment with Diana Olick, Jim Melcher, and Janet Tavakoli.
2 David Evans, “Florida Got Lehman Help Before Run on School’s Funds,” Bloomberg News, 18 December 2007. This article gives a subprime chronicle of events in 2007 including information on New Century and HSBC.
3 Gyan Sinha and Karan Chabba, “Sell on the Rumor, Buy on the News,” Bear Stearns, 12 February 2007.
4 Steven Church and Bradley Keoun, “ResMae Collapse May Signal More Subprime Bankruptcies,” Bloomberg News, 23 February 2007.
5 Gretchen Morgenson, “Crisis Looms in Mortgages,” New York Times, 11 March 2007.
6 Randall Smith and Susan Pulliam, “As Funds Leverage Up, Fears of Reckoning Rise,” Wall Street Journal, 30 April 2007.
7 Ibid.
8 Richard Beales, “NY Fed Warns on Hedge Fund Risk,” Financial Times, 3 May 2007.
9 James Mackintosh, “Hedge Funds Survey Reveals Lower Gearing,” Financial Times, 1 May 2007.
10 Janet Tavakoli, “Letter: Greater Global Risk Now than at Time of LTCM,” Financial Times, 7 May 2007.
11 Serena Ng and Emily Barrett, “Fed Turns Focus to Derivatives Market,Wants Improved Infrastructure Soon,” Wall Street Journal, 10 June 2008.
12 Everquest Financial Ltd., Form S-1 Registration Statement under the Securities Act of 1933, 9 May 2007.
13 Offering Circular for Octonion I CDO, Ltc. Octonion I CDO Corp., March 16, 2007. Most of Everquest’s assets were priced as of December 31, 2006, but there were some 2007 additions to the portfolio. For example, it owned some of the “first loss” equity risk of a CDO named Octonion I CDO (Octonion), a deal underwritten by Citigroup in March 2007. If the IPO came to market, some of the proceeds from Everquest would pay down Citigroup’s $200 million credit line. Octonion’s prospectus disclosed an inexperienced CDO manager with conflicts of interest with the CDO investors. It used 95 percent credit default swaps referencing BBB rated asset-backed securities including subprime assets.This CDO appeared to be a very risky investment for investors in the AAA or AA rated tranches. The equity, 48 percent of which was owned by Everquest, may have been entitled to the residual cash flow of the deal. Even if they did not, the tranches looked high risk, undeserving of an investment grade rating.Time proved my concerns warranted since Octonion triggered an event of default in February 2008, at which time even the original seniormost AAA tranche was downgraded to CCC by S&P (it was still AAA by Moody’s). By the summer of 2008, the seniormost AAA had been downgraded to Caa3 by Moody’s and CCC- by S&P.
14 The information about the underwriters (UBS, Citigroup, Merrill and others) is not listed in the registration statement, but can be found by cross referencing the listed CDO with the information in each of the prospectuses. Everquest also invested in mezzanine tranches that were problematic as well since the amount of protection underneath them can be too slender for assets backed by risky mortgage loans. These tranches were already trading at wide spreads—lower prices—in the secondary market.
15 Everquest Financial Ltd., Form S-1, p. 48. It is impossible to calculate a precise number without more information, but it can be ball-parked from the S-1. It showed 16.2 percent of non-Parapet (a CDO-squared) assets were ABS/CDOs. There was more subprime exposure in a CDO-squared called Parapet, the initial deal backed by assets coming from the two hedge funds managed by BSAM. Parapet accounted for 53 percent of the CDO assets. Included in Parapet were mezzanine tranches that were 38.6 percent of the CDO assets, of which it appeared that a high percentage were subprime. Furthermore, 42.8 percent of the Parapet equity was backed by ABS/CDOs, most of which according to the S-1 was subprime. As a rough estimation subprime exposure was 40 percent to 50 percent of the collateral. That seemed substantial to me. As for the hedges, the document said that on May 8, 2007, the two hedge funds had transferred their interest on credit default swaps that referenced 48 tranches of ABS securities held by the CDOs with a notional amount of $201 million and stated: “The hedges will not cover all our exposure to RMBS held by our CDOs that are backed primarily by subprime residential mortgage loans. Our CDOs may experience negative credit events relating to RMBS tranches that are not hedged.” The hedges may or may not have done the trick. There was no indication of when the hedges were actually put on, only that they were transferred on May 8, 2007. Single name ABS/CDO credit derivatives had become very expensive and were no longer very good hedges, so the timing was important.
16 Peter Eavis, “Freddie Mac Report Soft-Pedals Thorny Case,” The Street. com, Real Money, 24 July 2003. According to a report by Freddie Mac’s then regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), Freddie Mac’s officers decided that volatility calculated based on the then current market prices did not reflect fair value. Instead, Freddie Mac used historic prices as the basis on which to calculate volatility when it revalued its options. This one assumption change alone eliminated $731 million from Freddie’s 2001 accounting transition adjustment gain (through adoption of a new accounting rule, SFAS133).
17 Office of Federal Housing Enterprise Oversight, Report of the Special Examination of Freddie Mac, December 2003, 134-135.
18 Everquest IPO. Everquest’s managers would get an annualized base fee of 1.75 percent of the company’s net assets up to $2 billion decreasing on a sliding scale until they reached only 1 percent on net assets over $4 billion. If Everquest returned more than 8 percent, as computed by the managers that stood to benefit, the managers would get 25 percent of the upside, and that seemed high by industry standards for a fund that managed assets originally transferred by funds already managed by BSAM. Cioffi later said Everquest’s employees had an asset management agreement with BSAM and Stone Tower and that asset management fees that BSAM received for managing Everquest were rebated back to the hedge funds.
19 Everquest IPO,”Table of Contents.” ii.
20 Matthew Goldstein: “The Everquest IPO: Buyer Beware,” revised title “Bear Stearns’ Subprime IPO,” BusinessWeek, 11 May 2007. The article quoted me as saying there was moral hazard with BSAM providing the valuations and surveillance on the CDO equity, and why would a customer want to buy “if it is trying to get CDO equity off of its balanc
e sheet, incur the costs of securitization, and sell the risk without arm’s length valuation.” I had been clear that the assets were coming from the hedge funds, not Bear Stearns’s balance sheet, but the quote seemed to imply otherwise, and elsewhere in the article, it implied the assets were coming from Bear Stearns, instead of the hedge funds managed by BSAM, an affiliate of Bear Stearns, although the conflicts with the assets coming from the BSAM managed hedge funds seemed worse.
21 Jody Shenn, “Bear Stearns Funds to Transfer Subprime-Mortgage Risk with IPO,” Bloomberg News, 11 May 2007.
22 Cioffi had said he was “short sub prime thru the ABS CDS market . . . the 2006 vintage exposure the market value totals only about $70M, against which I have shorted $340M Baa2 and Baa3 sub prime names thru the single name ABS CDS market. We determined these to be the weakest of the 2006 deals.”The Everquest IPO states: “The hedges will not cover all our exposure to RMBS held by our CDOs that are backed primarily by sub-prime residential mortgage loans” (p. 55).
23 Kurdas, Chidem, Levered Bear Funds: A Peek into the Black Box,” HedgeWorld, 26 June 2007.
24 Matthew Goldstein, “Bear’s Big Loss Arouses SEC Interest,” BusinessWeek, 25 June, 2007.
25 Kate Kelly and Serena Ng, “Bear Stearns Bails out Fund with Capital Injection,” Wall Street Journal, 23 June 2007.
26 Kate Kelly, and Serena Ng, “The Sure Bet Turns Bad,” Wall Street Journal, 7 June 2007.
Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street Page 28
