Risk Professional - December 2009

the risk boomeranged back onto bank balance sheets.

The madness, unfortunately, did not stop with mortgage loans. Collateralized debt obligations were backed by various asset classes: credit derivatives, asset-backed securities, mortgage-backed securities, other collateralized debt obligations, hedge fund loans, credit card loans, auto loans, bonds, leveraged corporate loans, commercial real estate loans, sovereign debt and more.

CDO Hawala: Systemic Fraud

If I had a large bonus in my sights and mischief on my mind, how would I unload toxic CDO tranches? This is all hypothetical, mind you, but here’s how it might work.

If you work at an investment bank and you stuff the toxic tranches of only your own CDOs into another CDO, it will be too obvious. You need help from your friends who work for other investment banks, hedge funds and CDO managers.

Since you all have toxic CDOs and still want to earn high fees, you can all play investment banking hawala similar to the complex, but highly effective, money-brokering system used in the Middle East. Hawala makes it virtually impossible to trace cross-border money flows. It will be hard for anyone —– except someone with the authority or subpoena power — to examine your trade tickets and to figure out what you are doing. Fortunately for you, the SEC is a captured regulator.

Mix your toxic junk with your friends’ toxic junk into a CDO-squared. Now you can prop up the prices of these toxic assets and have deniability. After all, why would you buy someone else’s CDOs at full price if they were toxic? Now get the compliant rating agencies to rate a huge chunk of this risky hairball AAA.

If you are lucky, you may find an investor to buy it. Failing that, you may find a bond insurer to insure it. Failing that, you may find an investment vehicle or hedge fund willing to do a credit derivative or other leveraged transaction. These diversions should get you through bonus season. If all else fails, your investment bank can beg the Federal Reserve to take overrated AAA paper in exchange for treasuries.

There is, however, one small problem with this. If you know or should know that you are not correctly pricing assets on your balance sheet, or if you knowingly sell overrated

securities, you must disclose that, and you must be specific about it. If you know something is rated super-safe AAA but it deserves a near-default rating of CCC, you cannot keep silent about it when you sell it.

When I pointed out to an investment banker that this is a classic situation for fraud, he told me: “Our internal [Office of General Counsel] disclaims virtually all liability for [our investment bank] and its bankers in small print, fully disclosing the risks in the prospectuses.” I knew what he meant, but he sounded like a smart 10-year- old parroting an adult.

“I did not attend law school,” I responded, “but I am pretty damn sure that just because you disclosed serious conflicts of interest, it does not protect you if you fail in your duty of care to investors. Your lawyers can’t give you a license to kill.”

The moral hazard swamped any risk the rating agencies’ models could capture. One synthetic CDO deal with a notional amount of more than $2 billion went into liquidation, and less than three percent of investors’ money was recovered. Even the investor in the top-most AAA, the super senior tranche, lost principal.

Imaginary CDO Management

CDO managers are supposed to be managing securities backed by actual assets — not imaginary assets. CDO managers are unregulated. Most do not have the expertise or resources to perform CDO management or surveillance. Many cannot build a CDO model. Moreover, many managers rely on the bank arranger both for structuring expertise and to take a lead role with the rating agencies to secure the initial ratings. Rating agencies, meanwhile, rarely ask for background checks on CDO managers.

In December 2007, I wrote Warren Buffett about Adams Square Funding I, which had closed December 15, 2006. It was an “asset backed” deal, a collateralized deal. It was rated by Moody’s and S&P. Yet, before 2008 ended, the CDO unwound, meaning all of the underlying assets were sold in an attempt to pay investors back. Unfortunately, there was not enough cash after selling the loans to go around.