Merrill Investigated by Massachusetts for CDO Sales

Merrill Lynch is under investigation in Massachusetts for having sold some CDOs that fell 91% in value in less than a year to Springfield, a municipality that was just getting out from under its own fiscal woes.

The amount at issue isn’t large by Wall Street standards; the CDOs in question fell by $13 million. While Merrill may try to characterize the transaction as the action of a rogue broker, the state is also examining a questionable $20 million dollar sale by another Massachusetts-based broker to a public retirement entity in Maine.

It’s going to be tough for Merrill to escape liability on this one. Brokers are subject to a “know your customer” requirement; Municipalities are risk and loss averse. There is no way a risky CDO can be characterized as an appropriate investment. And the fact that the CDOs that Merrill is holding on its books have fallen far less in value isn’t helpful to the giant brokerage company either.

Ah, but they do make for tempting stuffees, as the fact that Manly (a suburb of Sydney, Australia), Orange County, California, King County, Washington, and investment pools in Florida, Montana, and Connecticut have all taken hits on complex mortgage-related investments. And I am willing to be that the broker got a bonus credit (extra commission) on the sale of the toxic CDO to Springfield.

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  1. doc holiday

    In related very interesting news:

    Brady Bonds may be collateralized or uncollateralized, are issued in various currencies (primarily the U.S. dollar) and are actively traded in the over-the-counter secondary market. Brady Bonds are not considered to be U.S. Government securities. U.S. dollar-denominated, collateralized Brady Bonds, which may be fixed rate par bonds or floating rate discount bonds, are generally collateralized in full as to principal by U.S. Treasury zero coupon bonds having the same maturity as the Brady Bonds. Interest payments on these Brady Bonds generally are collateralized on a one-year or longer rolling-forward basis by cash or securities in an amount that, in the case of fixed rate bonds, is equal to at least one year of interest payments or, in the case of floating rate bonds, initially is equal to at least one year’s interest payments based on the applicable interest rate at that time and is adjusted at regular intervals thereafter. Certain Brady Bonds are entitled to “value recovery payments” in certain circumstances, which in effect constitute supplemental interest payments but generally are not collateralized. Brady Bonds are often viewed as having three or four valuation components: (i) the collateralized repayment of principal at final maturity; (ii) the collateralized interest payments; (iii) the uncollateralized interest payments; and (iv) any uncollateralized repayment of principal at maturity (these uncollateralized amounts constitute the “residual risk”).

  2. Dave F

    Why would a municipality invest in a risky CDO? Are we really to believe that its financial managers are so incompetent as to not do due diligence on a product sold to them by their broker?

    Point conceded regarding the “know your customer” requirement, but, still, it is awfully hard to have sympathy for those who invest in that which they do not understand.

  3. Anonymous

    Yes, Dave F, we are really to believe that such incompetence is the case. The complexity of these securities was beyond the competence of 99% of those who came in contact with them, including municipal financial managers, brokers, Federal Reserve officials, private investors, rating agency employees…. indeed, even the wizard innovators who created them.

    It was and is a massive cluster fuck generated by that always enticing combination of greed, trust and an absence of any umpires.

    Indeed, convincing evidence of this lies in the following: who, dave f, is out there today who demonstrably understands these securities?

  4. "Cassandra"

    Anon…Part of me (the part that poked fun here) is scathing and unsympathetic, but in times more generous in spirit, I can empathize more. For even as a skeptic, if I am not mistaking, one could be forgiven for confusing a CDO c2004 with a what I recall were CMOs of old. And please correct me if I am wrong (which I may be) but until housing prices really vaulted, lending standards subsided dramatically, and the quality of debt became came to include anything and everything with a coupon whether with or without a prospectus, and CDO managers/originators/marketers placed more emphasis on shoving the product out the door (current Merrill allegations?), than any concern for what was inside, and rating agencies went syphilitic in regards credit quality distinction, there, was little discernible difference. But these “innovations” were incremental, and it’s not easy to see the point precisely where the line was crossed.

    OK, so I personally rarely trust Wall St. because I am a skeptic by nature, view them as hucksters, and mostly because I spent sufficient time on the sell-side. BUT, Investors delegate agency responsibilities all the time, and my (small) sympathies extended to non-pro’s (like city, county treasurers etc) who were ultimately snookered by agency-failures at multiple points: the portfolio managers, the selling agents, and of course the rating agencies, who in the land of the non-pro are (or were) a most logical and useful division of labour. Yes, there should have been a smoking-like warning on the front of the documents: WARNING: The rating agency, and its personnel, have received substantial compensation from the issuer in regards to the rating issued for this product. Additionally, it maintains a significant historical revenue relationship with the issuer, contributing significant revenue and profit to the agency. Such conflict of interest may compromise the opinion issued and so attached ratings should not be relied upon for investment purposes, and are for entertainment-purposes only. And yes, one perhaps shouldn’t buy something with such limited transparency, particularly when credit excess is rife – be it sub-prime, cov-lite, or what have you.

    But while most know that the best credit analysts on the street are NOT, with the agencies, few non-pro’s would have contemplated that their “ratings” were so utterly meaningless. So, while they are an easy target, I am not certain that if I (even as a skeptic) were in the same job, squeezed say by demagogic officials who want to spend freely, and voters who demands services but are unwilling to pay for them in the form of appropriate tax levels, that I too, might not “reach for a bit of yield” in the money markets, particularly where its managed by trusted agents and vetted by trusted intermediaries, and blessed by supposedly smarter experts in credit than I could ever hope to be.

    But then, I am not so clever, or else I suppose I would have been somewhere at the top of the compromised and fraudulent food chain.

  5. doc holiday

    Related to CDOs & Bonds, this from a very recent Pimco SEC doc:

    Securities issued by U.S. Government agencies or government-sponsored enterprises may not be guaranteed by the U.S. Treasury. GNMA, a wholly owned U.S. Government corporation, is authorized to guarantee, with the full faith and credit of the U.S. Government, the timely payment of principal and interest on securities issued by institutions approved by GNMA and backed by pools of mortgages insured by the Federal Housing Administration or guaranteed by the Department of Veterans Affairs. Government-related guarantors ( i.e. , not backed by the full faith and credit of the U.S. Government) include the Federal National Mortgage Association (“FNMA”) and the Federal Home Loan Mortgage Corporation (“FHLMC”). Pass-through securities issued by FNMA are guaranteed as to timely payment of principal and interest by FNMA but are not backed by the full faith and credit of the U. S. Government. FHLMC guarantees the timely payment of interest and ultimate collection of principal, but its participation certificates are not backed by the full faith and credit of the U.S. Government.


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