erage. All of the CDO’s investors were wiped
out, except for the investor in the senior-most
AAA tranche. Since the prospectus shows
that the senior most-tranche made up 29%
of the deal, those investors appear to have
lost some principal, too. It is reminiscent of
the opening scenes of the movie Cliffhanger,
in which a climber’s supports snap one-by-one, ending in a spectacular steep fall. That
last plastic buckle was “AAA” rated. Adams
Square Funding I is not an isolated example,
just a handy one, because it unwound. It is
not even close to being the funkiest deal I
have seen.
The Adams Square Funding I prospectus
disclosed the conflicts of interest between the
investors, Credit Suisse Alternative Capital
(CSAC) and other Credit Suisse affiliated
entities, including the Leveraged Investment Group (LIG) of
Credit Suisse Securities (CSS). I always recommend that investors eliminate this kind of moral hazard by insisting on
changes to the deal.
Conflicts of interest do not mean that there is anyone is doing anything wrong, but when the moral hazard is enormous,
things never seem to end well for investors. Rating agency
models do not capture these huge risks, yet, the rating agencies never seem to refuse to rate these deals.
Among many classes of bad deals, the problems of CDOs
named after constellations were well publicized. Approximately $35 billion of these CDOs had been underwritten by
Citigroup, UBS, Merrill Lynch, Calyon, Lehman and others.
They are mostly fallen stars.
For example, Norma, a Merrill underwritten CDO comprised mostly of credit derivatives linked to BBB-rated
tranches of other securitizations, had a ridiculously difficult to
interpret prospectus, and the risks were legion. It had come to
market in March 2007, and by December 2007, it was worth
a fraction of its original value. The rating agencies slashed the
ratings of even its most senior tranches to junk. Any savvy
investor would have thrown the deal documents in the trash
bin, before the deal closed.
Risky loans were only part of the problem. Predatory securitizations amplified losses. As a result, the entire landscape of
global investment banking changed. Toxic assets fell in value
due to permanent value destruction, not due to temporary
price fluctuations. The losses are permanent impairments
caused by surging defaults. There is no coming back from permanent value destruction,
and much of the rhetoric surrounding resistance to mark-to-market accounting seems
designed to cover-up the facts.
Credit derivatives
added leverage
and opacity that
We Have the Solutions
The global financial meltdown was due to
control fraud. Credit derivatives added leverage and opacity that enabled the current financial crisis, but they were not the
root cause. The increased transparency of
exchange-traded credit derivatives is a worthy goal, but it is an incomplete answer to a
side issue. Accounting and risk management
were undermined. Financial institutions and
their shareholders collapsed. Investors in
toxic deals lost money. Only the agents —
fee-bloated mortgage lenders, CDO managers and rating
agencies, or bonus beneficiaries such as securitization professionals, CFOs and CEOs — prospered.
The recent web of fraud is much more widespread and
costly than that of the Savings and Loan crisis of the late
1980s. The full scope will only be revealed if Congress provides funds to resource starved investigators. The enforcement of regulation catches fraud and allows honest people
to prosper.
Troubled financial entities should be put into receivership
and restructured, just as they were after the S&L crisis. Old
shareholders will be wiped out, and debtholders will take a
haircut along with a debt for equity swap. Recapitalizing financial institutions in this way forces a fair valuation of assets
and avoids using public funds.
Traditional commercial banking must be done by entities
independent of investment banks engaging in proprietary
trading and other high-risk activities. In other words, we
need a return to a Glass-Steagall-like structure. U.S. banks
that stuck to traditional banking and prudent lending preserved shareholder value.
We already have the solution, but we need the political
will.
enabled the
current financial
crisis, but they
were not the
root cause.
Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based consulting firm. She is also the author of Credit Derivatives & Synthetic Structures (Wiley, 1998, 2001) and Structured Finance & Collateralized Debt
Obligations (Wiley, September 2008).
