While the New York Times’ DealBook section generally hews to a financial-services-industry-friendly line, presumably as a Faustian bargain for being a preferred leakee, there’s not even a weak defense for the article by the New York Times’ so called “Deal Professor” Steven Davidoff, “If Little Else, Banker’s Trial May Show Wall St. Foolishness.” It’s yet another brazen effort to diminish the seriousness of rampant fraud by arguing it was just carelessness. But to make his case, Davidoff misrepresents both the facts of the situation as well as the law. Since Davidoff’s lawyer union card is an explicit part of his brand at the Times, this story amounts to another credentialed effort to run the “nothing to see here, it’s too hard to get these guys” line that has become the Administration’s pet excuse for not going after one of its biggest sources of campaign funds.
But in this whitewashing by Davidoff plays so fast and loose with the underlying material, one is forced to one of two conclusions: either he didn’t even remotely do his homework or he decided (or was encouraged) to engage in baldfaced misrepresentation.
The case in question is the SEC’s suit against Brian Stoker, a Citigroup staffer who was responsible for structuring and marketing a CDO squared, Class V III, which closed at the end of February 2007 and was toast by November, when it declared an event of default. This case has gotten considerable attention because Judge Jed Rakoff flagged it when he rejected a proposed settlement between Citi and the SEC on the very same CDO. As we wrote:
What has Rakoff’s dander up is that the allegations made by the SEC in its lawsuit were that Citigroup stuffed the fund full of crappy CDO tranches and went short against them, and got investors to buy it by telling them the assets were selected by an independent party. Citi was a typically inefficient looter, earning about $160 million while investors lost $700 million (note that Rakoff had to pry that information out of the parties). Citi is admitting only to negligence when the violations the SEC described its filing and in a related case amount to fraud, or in securities speak, scienter.
Rakoff’s ruling calls the entire process a sham:
Here, the S.E.C.’s long-standing policy – hallowed by history, but not by reason – of allowing defendants to enter into Consent Judgments without admitting or denying the underlying allegations, deprives the Court of even the most minimal assurance that the substantial injunctive relief it is being asked to impose has any basis in fact.
Rakoff appears to have been particularly incensed at the fact that the SEC included allegations only in its filing against Brian Stoker that were germane in its case against Citi, specifically, that the bank knowingly engaged in fraud because it was necessary to get the deal placed:
Citigroup knew it would be difficult to place the liabilities of a CDO squared ifit disclosed to investors its intention to use the vehicle to short a hand-picked set of CDOs and to buy Citigroup’s hard-to-sell cash CDOs. By contrast, Citigroup knew that representing to investors that an experienced, third-party investment adviser had selected the investment portfolio would facilitate the placement ofthe CDO squared’s liabilities
If I’m reading between the lines correctly, Davidoff’s piece looks like an effort to discredit Judge Rakoff’s attack on the settlement. He had ordered the case to trial, and the outcome is still in play (his ruling was appealed by the Citi and the SEC, and the decision is pending).
Before we get to the substance, such as it is, of Davidoff’s piece, let’s first look at how it tries to dismiss the significance of the case:
A midlevel former banker at Citigroup, Brian Stoker, is in court this week in connection with his role in creating exotic mortgage securities. While the civil trial is being hyped as a great exposé of Wall Street’s role in the financial crisis, it may be something more banal, merely showing how clueless financiers can be.
Even in this bit, there is lot to unpack. First, “midlevel” is meant to suggest that Stoker was a mere foot soldier. In fact. one of salient characteristics of investment banking businesses, as Davidoff surely knows well, is the way they delegate authority and give large numbers of people autonomy and decision making authority. While it is fair to question whether Stoker should be singled out for punishment, Davidoff is saying that all that happened here was that the banks were dopey, and he does not mean dopey in the sense that they neglected to cover their tracks. Since not all that many media outlets are in fact taking note of the Stoker case, it isn’t clear whether his “hyped” is a dig at, say, The Litigation Daily’s even-handed observation that the trial might provide some useful insights into Wall Street’s inner workings, or a cheap shot at Rakoff.
So how does Davidoff accomplish his whitewash? He makes four fundamental misrepresentations. First, he resorts to the Lloyd Blankfein market maker argument (without using those words), arguing that Citi was just finding a way to profit for demand for CDOs. This omits the fact that Citi from the start conceived of this deal as “prop” or proprietary trade, meaning one undertaken with the intent that it would take a position, as opposed to matching up buyer and seller interest in the marketplace. Par for this dissimulation, he characterizes the hedge fund Magnetar, which “sponsored” as in created, a toxic CDO program which our analysis suggests drove at least 60% of subprime demand in the toxic phase, as having “invested in” these CDOs, as opposed to having designed them to fail. For instance, Davidoff claims that “Citigroup created its own C.D.O. to meet this demand” when half the short demand in the CDO was always intended to be from Citi itself!
Second, he tries arguing that “everyone knew that the other side of the CDO was shorts”. That’s simply not true. First, the banks misrepresented this actively in their marketing, claiming that synthetic and hybrid CDOs (ones that had credit default swaps as all or part of their assets) were the same as cash CDOs (ones made entirely of actual bonds) but faster to tee up. Cash CDOs were not created to serve the needs of shorts; they were created to offload unloved tranches of mortgage bond deals. More important, at that point, most players though subprime shorts were a noisy fringe activity. Magnetar’s huge role and influence were not recognized (the first coverage of any sort was in a January 2008 Wall Street Journal article, nearly a year after this toxic trade closed). John Paulson was press hungry but seen as a small player (and he was not a major force in CDO creation; of his $25 billion in short bets, only $5 billion came via CDOs where he took the entire short side).
If you had asked the parties that took down the CDO tranches who was on the other side in 2006 and 2007, it’s a safe bet most would have said the CDS buyers were hedgers. It was only after the market failed that the way the short players crafted deals to fail became known. Hedgers would have included commercial banks who wanted to hedge some of the risk of mortgage lending and warehouse line lenders. And they were not an inconsiderable force. The CDO structurers we have spoken to say that 25% of the CDS in subprime CDOs were taken down by hedgers. But the CDO investors at the time would have been shocked to find out the percentage was that low; they would have assumed well over 50%, probably over 75%, went to hedgers. So this statement by Davidoff is abjectly misleading:
After all, to even have this C.D.O., there had to be someone willing to bet against it. That it was Citigroup really didn’t matter.
Davidoff’s third dishonest defense is that Citi disclosed that it might short the deal. Sorry, “might” is not the same as “conceived this entire deal as a way to go short”. Citi might well have had reason to take up a short position if it really had been a mere neutral broker. For instance, if it thought the CDS were going out at too low a price, it might take a short term trading position and offload them later.
The professor’s final misrepresentation concerns the importance of the collateral manager. Citigroup pretended that the assets were being selected by a party that was working on behalf of the investors. And if that had really been the case, the question of whether the other side of the deal was shorts or hedgers would be less important. You as investor would be betting on the competence of the collateral manager. If you had reason to think the collateral manager was good at his job (and all the marketing materials stressed that they were), it would make sense to take the plunge.
In addition, Davidoff says that the investors were sophisticated and should have done their own due diligence. But investors can’t do proper diligence if material information is being withheld from them. It doesn’t matter how sophisticated they are.
He also points out that the exposures in the deal were presented to investors. True, but that’s less useful than you might think. The actual positions for this type of CDO were typically disclosed to investors less than 48 hours before closing. The Alternative Banking Group of Occupy Wall Street’s amicus brief in support of Judge Rakoff’s position in the pending appeal makes clear what would be involved in assessing them (boldface original):
The Citigroup CDO at issue in this case was a “hybrid” – this meant that the CDO included cash bonds, and simultaneously made it possible (through CDS) to bet against the housing market. The fact that the security was also a “CDO squared” meant that it was a repackaging of approximately sixty bonds issued by other CDOs, which in turn were backed by fifty to one hundred tranches of MBS bonds, making the leverage on the mortgage market even greater. It appears that this single CDO transaction was backed by approximately three thousand MBS bonds which, by a conservative estimate, were backed by approximately fifteen hundred MBS transactions. Each MBS transaction contained, on average, over two thousand mortgage loans, with an average balance of approximately $160,000. Therefore, in aggregate, the Class V Funding III transaction referenced approximately three million subprime mortgage loans with an aggregate balance of around five hundred billion dollars.
Davidoff also mentions that the monoline Ambac insured the deal. Ambac’s executive team came from Citigroup; it was very proud of its “relationship” with Citi and would thus have been loath to see a deal be done away from them. Ambac made the fatal mistake of thinking that having a “relationship” meant you were close enough to be treated well, as opposed to close enough to be easy to abuse.
Finally, Davidoff disingenuously contends that the standard at issue is mere negligence, when the famed ruling by Rakoff against the Cit and SEC’s settlement that the argument made by the SEC was “would appear to be tantamount to an allegation of knowing and fraudulent intent.” And where does this “negligence” nonsense come from? The SEC filing is a securities law claim, and our soi disant deal professor surely knows better:
As set forth above, Stoker, in the offer or sale of securities or securities-based swap agreements, by the use of the means or instruments of interstate commerce or by the mails, directly or indirectly, obtained money or property by means of untrue statements of material facts or omissions ofmaterial facts necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, and engaged in transactions, practices or courses of business which operated or would operate as a fraud or deceit upon purchasers o f securities in violation of Sections 17(a)(2) and (3) of the Securities Act [15 U.S.C. § 77q(a)(2) & (3)].
But you need to do quite the snow job to set up a penultimate paragraph like this:
Although we’re going to get an inside view into an arcane world, the case more than likely won’t show that anybody acted out of malice. Rather, it will highlight that no one thought hard about the risks — not the buyers, the sellers or the investment banks packaging these complex derivatives. Only a few smart hedge funds realized what was going on, and profited from it.
Davidoff craftily uses “malice” which is a criminal law concept, when this is only a civil case, but now that he mentions it, the shoe sure seems to fit. From Black’s Law Dictionary:
In its legal sense, this word does not simply mean ill will against a person, but signifies a wrongful act done intentionally, without just cause or excuse
If the SEC has its facts remotely right, it’s bloomin’ obvious Citi knew damned well what it was doing. If the only way you could offload dreck ($92.5 million of the $1 billion was Citi assets it dumped into the CDO) and set up a prop trade was by falsely telling investors a collateral manager was independent, that is deceptive and predatory.
This piece would be less troubling if Davidoff could be dismissed as a useful idiot. But for a well known lawyer with a public platform to write such an embarrassing article in defense of deliberate, destructive behavior, is yet another sign of how diseased our elites have become.