SEC/CDO Litigation: Why Aren’t the Collateral Managers Being Sued Too?

By Tom Adams, an attorney and former monoline executive, and Yves Smith

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 one hand, that emphasis had a certain logic, since the investment banks profited from these deals in numerous ways (fees for underwriting the CDO itself, the profits that could be attributed to the CDO by virtue of keeping the subprime machines that the various banks were operating going, the opportunity the CDOs gave for at least some of the dealers to set up short positions). That, plus their size, makes them the logical deep pocket to target in litigation.

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. Its role was to serve all the investors, not just the equity investor/sponsor. 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.

The Abacus 2007 AC1 transaction is atypical as far as the role of the collateral manager is concerned.
While Goldman appears to have chosen the collateral manager, ACA, based on its willingness not to ask tough questions, ACA was acting both as the collateral manager and an investor (through a separate unit). Thus Goldman had every reason to treat ACA like another long investor, and therefore omit or artfully present any information that might lead ACA to get cold feet.

By contrast, as we discuss in ECONNED and Michael Lewis covers in The Big Short, collateral managers were widely seen as being closely tied to investment banks. Some even had former employees of the same investment bank on staff and housed in the same building as the trading operations.

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?

Magnetar Deal List by Manager

Click here to view at ScribD.

It may prove that private litigants will blaze the trail as far as CDO managers are concerned, and the SEC may or may not follow.

Richard Smith contributed to this article

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  1. john bougearel


    The same thing happened with trustees back in the 1920s. Trustees had a fiduciary responsibility to investors but were hired by the banks. They were trustees with fiduciary responsibilities in name only.

    The role of CDO manager seems to be a close parallel to trustees of yesteryear.

  2. Wanderer

    Somewhat unrelated, but what investor/fiduciary would take part in any structured transaction by any investment bank?

    While we can argue about the legality of ABACUS etc, there can be no doubt that GS viewed with their customers with utter contempt.

    For that matter, why are investors entering into transactions in products such as the Markit Indexes where pricing is done based on a poll of dealers?

    1. NS

      The entire financial sector views everyone other than themselves with contempt. This is the nature of pathological narcissism. It will; however, be their ultimate undoing as arrogance, contempt is their Achilles heel. The capture of government(s), regulatory authorities with revolving doors in and out of government positions, powerful lobbyists and deep pockets to fund campaigns and favors will make that process slow. They were successful in extortion at the highest levels on fear and haste. Classic con game. This laid bare for all to see those who serve one master rather than their constituents, irrespective of political party.

      The gig is up basically. Only those who still think they can swim with the sharks and profit will continue. No market sector is untouched. Wall Street/the markets effectively separated themselves from Main Street economies and honest business endeavors. They are deaf, dumb and blind to the real suffering, the real fallout of their misdeeds and misallocation of capital towards unproductive endeavors. This nastly little game ramped up to provide shelters for profits and obscene concentration of wealth, socialization of losses and the ability to hide debt/malfeasance to include sovereign nations.

      Like all organization who become so large and powerful they lose sight of their purpose, they will fail from within. The only people they fool now are themselves and those they own. I’m skeptical and cynical that justice will be served in my lifetime. If it is, then I along with huge populations of people will count themselves fortunate to witness it.

    2. Doug

      The GS customers who bought the CDO had the opportunity (or should have) to know what they were putting their money into. Right?

  3. fresno dan

    I am probably all wet, but I can’t help when looking at this problem that the complexity of these “investments” makes it very, very difficult for anyone on the buy side. And I think that is obvious.
    Now, my first inclination would be, “no one makes you buy anything.” But on the other hand, I am essentially getting 0% on my saving. I could live with that IF banks were leading at 3% – but they lend at rates far, far higher.
    And pensions need returns. But who can invest in Treasuries and get any income? We may be in a low inflation environment, but I find it hard to believe that treasuries are giving a real return.
    I am contemptuous of conspiricy theories – I don’t think the FED is conspiring with banks, its just that the FED believes the be-all and end-all of the economy is big banks, and the FED is simply incapable of seeing that there is a point of diminishing returns in allowing big banks to be essentially in control of money creation, and thereby capture all return on money lending.

    1. Ignim Brites

      Strikes me, Fresno Dan, that you are on the mark. The ultra low interest rate policies of the FED, now, earlier in the decade, and back in the nineties provide the incentive and the liquidity (whatever that is) to drive down interest rates across the board. This leads to a general mis-pricing of risk. The search for yield leads to ever increasing interest in what would have been before considered dodgy deals. The role of miscreants in all this should not obscure the essential problem. But it does.

  4. Tiger Woods

    Both the the collateral managers AND the investment banks should indeed be sued. Every private placement offering memorandum that a CDO is issued from has a disclosure section where parties to the transaction (in this case, both the CDO collateral manager and the arranging investment bank) are required to disclose ALL risks to the transaction as well as ALL conflicts of interest. If the equity sponsor of the CDO (Paulsen/Magnetar) was responsible in effect hired/selected/employed the collateral manager, and the equity sponsor at the same time was taking short positions in securities issued from the transaction, and either the CDO manager and/or the investment bank knew that the equity sponsor was taking short positions in the securities issued, that should be considered failure to disclose a material conflict of interest. Both Paulsen and Magnetar were indeed driving these deals and responsible for hiring their collateral managers, and based on my CDO industry sources at the time (which were involved with these transactions), everyone involved knew about the long equity/short CDO tranche trades being put on by Paulsen/Magnetar. Upon hearing about these trades, I remember thinking about the inappropriate lack of disclosure and now these problems are correctly coming home to roost. The disclosures should have read: “The CDO collateral manager has been hired by the equity sponsor of this deal, who is also taking short positions in the same securities that are being offered to you as an investor in this transaction, and furthermore the CDO collateral manager has been advised by the equity sponsor to buy the lousiest collateral they can find so that this deal craters as quickly as it can.” The SEC will not have to go far in its depositions to find many industry participants who will corroborate this story. Sorry Magnetar, Paulsen, and all you sleazy CDO collateral managers…

  5. Andreas

    Someone may have asked this already, but why doesn’t a NY district attorney prosecute Goldman, Paulsen, and all the others involved for conspiracy to defraud under the RICCO statutes?

  6. been there done that

    Tiger – as you know, the disclosure opinion(s) and the reps therein must be rather interesting for these deals. Would love to know who gave the reps about the collateral and what did the reps say.

  7. Slasher

    I think this article is right on target. All the CDO Managers must be sued for fraud. They are the true scum of the earth in this whole scandal. The fact that they are all enjoying their ill gotten gains tells you how far away from true justice we are in this economy. If one of steals a piece of bread from ShopRite, we’d be in jail for months if not years. However, these “sophisticated” thiefs stole from pension funds and mutual fund managers for years while disclosing nothing of substance. These guys have gone scot-free. We need more prosecutions of white collar crime and stiffer sentences.

  8. Haigh

    Axis of Logic reports rating agencies Moody’s and S&P gave this CDO Triple A grades. Are they likely to be charged with fraud? Could there be a civil action claiming incompetence?

  9. steelhead23

    Tom, I too believe that collateral managers should be on the hook to investors who were bilked by the enterprise. Please note my use of the word enterprise. That is because these “deals” were not simply constructed by independent actors, seeking fraudulent returns. Rather they were and are criminal enterprises in which multiple entities played a part in enhancing fraudulent returns. I am not a lawyer, but …, well, I’ve heard a few words about RICCO and frankly, I believe that Yves, et al. have described a large and pervasive criminal enterprise encompassing investment banks and their officers, hedge funds and their officers, ratings agencies and their officers, and possibly even monolines and their officers. That is, much of Wall Street. Perhaps my thinking is way too grandiose, but shouldn’t some aggressive prosecutor be thinking this very same thing? Aren’t you?

  10. a

    “Its role was to serve all the investors, not just the equity investor/sponsor.”

    Please excuse my ignorance on the subject but will someone clarify the nature of a collateral manager’s duties? Do they owe a duty to the investors? To the IB that selected them? To others? If so, what type of duty (e.g., fiduciary duty, general prudence/diligence/good faith, treat all classes fairly/equally, disclosure), to whom do they owe it, and what is its scope and duration (e.g., full disclosure of any conflict or potential conflict of interest to all investors during the initial offering and ongoing, general prudence wrt to all acts involved in managing the CDO to the IB that hired them throughout their tenure as manager)?

    The ProPublica story on Magnetar says “The managers had a fiduciary duty to represent the CDO fairly to all investors, ensuring investors got accurate and equal information.” I don’t understand that. They say that the managers had a fiduciary duty to the investors but then describe that duty as solely one of disclosure, not a normal fiduciary duty to the investors. It’s not even clear what the duty of disclosure (“accurate and equal”?) they describe is (e.g, full and complete disclosure, material disclosure, disclosure only during the initial offering or ongoing disclosure, how prompt if ongoing, etc.) I’m only quoting the ProPublica story because it’s one of the few I’ve found that discusses the duties of the collateral managers.

    If the managers don’t have duties to investors, this area of the law needs to be changed.

    (Yves, if this is in your book, I apologize. I’m reading it but my eyesight has been poor lately so it’s taking much longer than I’d hoped.)

  11. Vangel

    “How plausible is it that they had no idea of the sponsor’s true aims?”

    How plausible was it that the sophisticated funds and institutions that bought the paper did not understand that the other side of the transaction did not expect to gain? There was a bubble and many people were looking to make a lot of money by betting on that bubble. The other side was taken by people who bet against the bubble. Some of them were early and were wiped out even though they were right about the bubble, which was kept expanding by a great deal of fraud and meddling by governments that were interested in keeping housing prices higher. Eventually the bubble burst and those that bet on its continuance are now crying and pretending that they did not know that they were betting on garbage in order to make a fraction of a percent greater yield.

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