It has taken forever for the SEC to probe the workings the biggest sponsor of toxic CDOs and of course the agency is going after only one highly publicized doggy deal. Nevertheless, the SEC has finally decided to look at the less than arm’s length relationship between the hedge fund Magnetar, whose Constellation program played a central role in blowing up the subprime bubble, and its collateral manager, which in this case a Merrill affiliated firm called NIR. As we will discuss, collateral managers were critical because they effectively served as liability shields for the other participants.
Note that Magnetar does not appear to be the target; the Financial Times reports that the SEC is examining how the deal’s underwriter Merrill sold the deal and how it worked with NIR.
The very same CDO that is the focus of the SEC probe, Norma, was also the first to be noticed outside the comparatively small community involved in creating and buying these deals, in a Wall Street Journal story by Serena Ng and Carrick Mollencamp in late 2007. By the standards of CDOs, Magnetar’s were somewhat exotic, in that they were heavily synthetic. Most (but not all) of the assets were credit default swaps; about 20% of the deal’s asset were bonds, primarily BBB tranches of subprime bonds or the lower rated tranches (AA to BBB) of other “mezz” (for mezzanine, meaning made largely of lower rated bond tranches) CDOs.
Ng and Mollencamp did a second story about Magnetar, which discussed how it had launched a series of CDOs (by their tally, $30 billion) and had set the deals up to fail. We did a fuller treatment of Magnetar in our book ECONNED and broke the story of how the fund played a central role in pumping up demand for the very worst subprime mortgages in the toxic phase of the bubble
Magnetar constructed a strategy that was a trader’s wet dream, enabling it to show a thin profit even as it amassed ever larger short bets (the cost of maintaining the position was a vexing problem for all the other shorts, from John Paulson on down) and profit impressively when the market finally imploded. Both market participant estimates and repeated, conservative analyses indicate that Magnetar’s CDO program drove the demand for between 35% and 60% of toxic subprime bond demand. And this trade was lauded and copied by proprietary trading desks in 2006.
As a source who worked in the structured credit area of a firm that did Magnetar trades explained in ECONNED:
At their peak, Magnetar was *THE* driver of RMBS [residential mortgage backed security] CDO issuance. The size of their “Constellation” program was the most amazing thing I’ve seen in my entire career. . . .
Magnetar’s idea was that CDOs were destined for long term failure—that the leverage on leverage based on cr*p assets made the BBB tranches long-term zeros. And, they realized that while most other hedge funds were content shorting the BBB tranches from subprime RMBS, shorting BBB tranches from RMBS CDOs was a much more slam dunk of a trade. The commentary is right . . . without someone willing to fund the equity of a CDO there was no way to get one done. So, Magnetar made the logical leap . . . they’d fund the equity necessary to create the structures and then short a multiple of the bonds their equity money had allowed to be created.
The gravy was that the equity was typically good for one or two VERY HEFTY cashflow distributions—i.e., these structures went terrifically bad, but it usually took a little while from a timing perspective for that to happen. So, their carry cost of the shorts was offset by the one or two equity payments. After that, their upfront costs were covered and they would own the 100 point options for free.
Magnetar made A TON of money . . . I’d expect every bit as much as Paulson
The important part of this arrangement was that the equity funder put up 4-5% of the deal in a cash or hybrid CDO. Because this was the scarce part of the equation, and the riskiest exposure, this investor was the sponsor of the deal and gained control over its parameters. At a minimum, the equity investor had veto rights over the bond exposures chosen, and reports from various Magnetar deals indicate that in some cases it presented lists of bonds to go into the deal and/or set criteria (as in the bonds be particularly “spready” which also meant drecky). Since Magnetar was using its equity stake to make sure it would be able to establish a short position that was a multiple of its equity position, making it net short, its interest lay in using its influence to make sure the CDO had particularly bad exposures.
One of the keys to this arrangement was the role of collateral managers (also called “CDO managers”), which were often not independent even if billed as such (for instance, the Levin report includes Goldman pitch books for its really doggy CDOs have pitchbooks that stress the quality of the CDO manager, when internal e-mails show the firm favoring CDO managers who were expected to be compliant). Many were small free standing firms (the industry joke was “a couple of guys with a Bloomberg terminal”) who depended on investment bank warehouse lines (lines of credit) to stay in business. We’ve written often about the questionable role of the CDO manager, first in ECONNED, and repeatedly on the site. From ECONNED:
If credit defaults swaps were regulated, this would be insurance fraud on a massive scale….
Anyone involved in these transactions probably understood the implicit logic, even if no one acknowledged it. But there is a remarkable absence of anyone who could be pinned with liability. Magnetar officially had no legal relationship to these deals. The investment bank packager/structurer was off the hook as long as he made reasonable disclosure (and remember, the standards are much lower here than for instruments that fall in the SEC’s purview). The only party on whom liability could be pinned is the CDO manager, who does have a fiduciary responsibility to all investors, not just the sponsor. But the fact that the party who in theory had the most to lose, Magnetar, approved their investments, would seem to exculpate the CDO manager.
From a 2010 post by Tom Adams, “SEC/CDO Litigation: Why Aren’t the Collateral Managers Being Sued Too?“:
One issue that continues to puzzle us, in looking at the sudden furor about seemingly duplicitous dealings by investment banks in the real estate related CDO business, is that the focus thus far has been primarily on the investment banks that packaged and sold these toxic investments….
On the other hand, in the great majority of CDOs, the collateral manager was presented as an independent party whose role was to make sure that the CDO performed well…..Thus the CDO manager can also be argued to have defrauded investors to the extent it acted as a rubber stamp for the wishes of the sponsor, and/or simply served as a marketing device for the investment bank packaging and arranging the deal…
It is also hard to imagine that the collateral managers didn’t understand the intentions of CDO sponsors like Magnetar and Paulson who were using CDOs as a way to establish a short position more cheaply than they might have otherwise. If you look at our list of Magnetar deals, sorted by collateral manager, four firms, Harding Advisory, GBC Partners, Putnam Advisory, and NIBC Credit Management, worked on multiple transactions. How plausible is it that they had no idea of the sponsor’s true aims?
The Ng/Mollencamp story (in 2007, mind you) suggests that the CDO manager for Norma was simply a shield for Magnetar’s true intent:
In 2006, [former penny stock operator Corey] Ribotsky [who headed the Merrill affiliated CDO manager NIR] says Merrill came to NIR with a new proposition: One of the investment bank’s clients, a hedge fund, wanted to invest in the riskiest piece of a certain type of CDO. Merrill worked out a general structure for the vehicle. It asked NIR to manage it.
“It was already set up when it was presented to us,” Ribotsky says. “They interviewed a bunch of managers and selected our team.”
So with the outlines of a case set forth in the Wall Street Journal over three years ago and the role of CDO managers getting considerable attention here and in other venues, most notably Michael Lewis’ The Big Short, the Financial Times tells us the SEC has finally roused itself:
The Securities and Exchange Commission is investigating Merrill Lynch’s sale of a complex mortgage-related security it created for Magnetar, an Illinois hedge fund, and the collateral manager involved in the deal, according to people familiar with the matter.
The investigation is one of several SEC probes into banks that helped underwrite billions of dollars of collateralised debt obligations, securities comprised of mortgages or derivatives linked to them.
It also marks a broadening of the SEC’s investigation into the role of collateral managers, institutions that help select the assets included in CDOs.
NIR Capital Management, a Roslyn, New York firm run by Corey Ribotsky, served as manager for the security under scrutiny, a $1.5bn CDO known as Norma. Neither Mr Ribotsky nor his attorney returned calls seeking comment.
Regulators are looking at whether collateral managers, which are supposed to serve CDO investors’ interests, fulfilled their obligations…
Regulators are also looking into whether Merrill mispriced assets in the CDO, these people say. Bank of America, which acquired Merrill Lynch, declined to comment. The bank previously said it lost $900m on the Norma CDO.
Merrill got stuck with a lot of CDO inventory when the music stopped. Louise Story in the New York Times described how Merrill engaged in dubious accounting to hide how large its holdings were.
And even better….the SEC case piggybacks on a private action:
In 2009 Dutch bank Rabobank, which invested in Norma through a loan, sued Merrill in a New York state court, alleging the bank overvalued some assets by marking them at face value even though their market value had already deteriorated by 15 per cent…
According to Rabobank’s lawsuit, Merrill allegedly created Norma as a “tailor-made way to bet against the mortgage-backed securities market”. The suit said: “Merrill Lynch hand-picked a beholden collateral manager that was willing to ignore its fiduciary duties to Norma’s investors by selecting Norma’s collateral pool at Merrill Lynch’s behest rather than on the basis of the rigorous independent analysis.”
This is an indication of how asleep at the wheel the SEC has been. Normally, you expect regulators to launch investigations and develop cases and then have private claimants build on the groundwork they have laid, not the reverse.
Tom Adams and I have tried multiple times to get the attention of the SEC, with no success. Tom is an attorney and an industry expert, and there are virtually none who are willing to jeopardize their union card by helping develop litigation strategies and/or serve as an expert witness. We finally did get to someone in the SEC Compliance division but we were told Compliance and Enforcement don’t play well together, and the Compliance officer got nowhere with Enforcement.
It is one thing if the SEC had met with us and decided we would not add much to their team, but the lack of interest when there were very few people who had a seat at the table in the CDO business to begin with seems very short sighted. But as this post suggests, the SEC’s approach here seems to be to go after only the lowest-hanging fruit, and in a product area as complex as CDOs, that will yield very few targets.