Beware of Geeks
Bearing Grifts
Investors missed important warning signs in collateralized debt obligation
deals. But they also received no help from rating agencies and the SEC.
BY JANET TAVAKOLI
n the summer of 2005, Eliot Spitzer, at the time
the New York Attorney General, sent Bear Stearns
Co. (“Bear Stearns”) a subpoena. Hudson United, a
New Jersey bank, had tried to sell mortgage-backed
collateralized debt obligations (CDOs) it bought in
2002 back to Bear Stearns, the underwriter and seller. Hudson discovered its investments were worth only a small
fraction of the “market prices” Hudson had been supplied by
Bear Stearns up until it tried to sell them back.
Sophisticated investors were baffled by the complexity.
Even multi-strategy hedge funds such as Chicago-based Citadel had contacted me about CDOs. Investors seemed to rely
on ratings, and rarely asked how the underlying assets were
priced or whether they would get full price if they need to sell
the investment.
The Securities and Exchange Commission launched a
separate investigation into Bear Stearns’ CDO activities. Like
the New York Attorney General’s office, it wanted to know
if Bear Stearns had mispriced mortgage-backed CDOs and
harmed investors. Bear Stearns subsequently disclosed in a
regulatory filing that the SEC intended to recommend action.
Many financial professionals believed Bear Stearns would be
charged for alleged improper pricing of CDOs it had sold to
both a bank and an institutional investor.
Yet, despite increasing attention in the financial press,
the New York Attorney General’s office dropped its case.
The SEC’s rumored civil enforcement action involving Bear
Stearns’ CDO pricing practices fizzled, and the investigation
I
was closed. The Slumbering Esquires Club rolled over and went
back to sleep.
Christopher Cox, then chairman of the SEC, struck me as
the anti-Christ of investor advocacy. At his July 2005 confirmation hearing, Cox, a senior Republican Congressman and
key fund raiser for his party, did not mention that his former
law firm, Latham & Watkins, paid to settle a civil suit filed
by the receiver for defrauded funds run by its client, an investment firm. (The client’s mutual fund manager, William
Edward Cooper, pleaded guilty and got a 10-year sentence.)
Instead, Cox said he was he was dismissed as a defendant.
Worse — if possible — for advocates of a strong SEC,
Cox’s actions as a lawyer showed he was the antithesis of an
investor advocate. Cox had worked on a separate public offering that was not implicated in the case, but involved the
same structure. Among other things, Cox wrote a letter for
his client saying it “would unfairly and unreasonably harm
the investors’ rate of return” to appraise pools of mortgages.
In other words, due diligence would be too expensive, so one
should take Cox’s client’s word for it rather than verify value.
Cox also asserted suitability — a standard meant to ensure
that naïve investors did not get saddled with risky products —
need not be applied, because the investments are “relatively
low risk.”
This kind of advice is backward for a future head of the
SEC, given that the market is steeped in risky products masked
as “low risk.” On July 29, 2005, Floyd Norris of The New York
Times disclosed the facts surrounding Cox’s economical dis-
