By Tom Adams, an attorney and former monoline executive
When the financial crisis hit, I was in the direct line of fire. My company blew up very early in the crisis, giving me the dubious opportunity to see how bad things were going to get long before most of the rest of the world, including other banks, insurers, investors, administration officials or Federal Reserve members, were able to perceive the trajectory of the crisis.
After Lehman and AIG blew up, however, suddenly, everyone was talking about my industry and how horrible it was. I had already concluded that I had failed at the business I had worked at for over twenty years. I blamed myself for rationalizing taking credit risks that, with each passing month, were becoming more obvious and acute.
I was not alone in the many mistakes I had made. My competitors, including the largest and savviest banks and investors had made the same errors on an even grander scale. If you were to take them at the word, the highest ranking regulators, officials and economists had failed to anticipate the decline in home prices and its impact on mortgage bonds and, even worse, the impact of such declines on the US and global economy.
As this realization began to sink in, I began to wonder how I had made such mistakes. I began to look into the parties and transactions and the connections between them and what they knew, should have known or had no way of knowing. I pulled the loose threads of some questions I had about how the problems were so widespread and how so many people could have made such large mistakes.
The more I pulled on these threads, the more I discovered that much of what I thought I knew was based on things that weren’t really true. And by that I don’t mean assumptions about housing prices, I mean information people like me had been provided about specific deals by other parties to those transactions. While many of the failings of the structured credit market were due to unsound reliance on historical data, some were not mistakes in judgment but were the result of bad actors, misinformation and wrongdoing.
Over the past year, journalists, investigators and law enforcement officials conducted their own investigations into what went wrong in the financial markets. The veil was pulled back on actions of people like Magnetar, John Paulson and various banks such as Goldman Sachs. While some of these parties have managed to stay within the boundaries of the law, it’s become clear that the CDO market itself was filled with dubious participants, misaligned incentives and damaging activities.
Back in April of this year, Yves Smith and I suggested that some of the responsibility for the widespread failure of CDOs might lie with CDO managers. CDO managers were tasked with assembling the assets that went into CDOs and overseeing the transactions. While they failed miserably at creating successful deals, they have somehow managed to escape the wrath of the broader world. Large investment companies, such as TCW, Putnam, BlackRock and even Pimco, had assembled and managed CDOs backed by toxic mortgage bonds as had well-regarded banks such as Goldman, Merrill, UBS and Citibank.
Thanks in large part to the CDO managers own assertions of expertise, investors trusted in their ability to wisely select safe mortgage bonds while avoiding the increasing risks that were appearing in the mortgage market. By 2008 it was obvious that the faith that investors had in these highly skilled and highly paid managers was misguided.
After several months of analyzing the deals and participants in the market, I began to suspect that the CDO managers, had ample opportunity and motivation to knowingly or negligently contribute the collapse of the deals under their charge.
As jaded as I have now become, I must confess that I am still surprised at just how blatant and casual some of the thievery in the CDO market appears to have been. As an example, I look to the SEC’s complaint against a company called ICP. I met with the folks from this company many times and my former company insured a large transaction that they assembled. This week the SEC accused the company and its founder of defrauding my former company and AIG in the way they managed the transaction after it closed. The SEC accuses ICP of inflating the prices of bonds it sold to the CDOs and defrauding the investors in the transactions by manipulating the bond price data, violating the terms of the agreements and effectively stealing from the investors and insurers in order to line their own pockets. The actions of ICP helped offset their own losses and bad investment decisions (they purchased a $1.3 billion pool of mortgage bonds from the blown up Bear Stearns hedge funds at what they thought was a great bargain but what turned out to be overly optimistic prices).
ICP’s alleged manipulation of bond prices also, conveniently, helped them keep the deals in compliance with their triggers, which helped them wrongfully earn millions of dollars in fees at the direct expense of the bondholders. The bondholders and insurers on the deals suffered many millions of dollars in losses as a direct result of these alleged activities. Because AIG insured two very large deals from ICP, US taxpayers were ultimately on the hook for some these losses because the Federal Reserve bought the CDO bonds at par and placed them into the Maiden Lane transaction.
Over the course of diligence visits, meetings and dinners, I had formed the impression that the people at ICP were knowledgeable, smart and reputable. Mr. Priore, ICP’s founder, was held in high regard in the industry and occasionally spoke about his views on the market to reputable news organizations such as Bloomberg Television, the New York Times and Reuters. He was listed by Investment Dealers Digest magazine as one of the 40 under 40 worth watching. So not only was I completely taken in by his knowledge and interpersonal skills, so were many others. In fact, given his sterling reputation, voicing suspicion of him would have been seen as paranoia rather than well founded skepticism.
The CDO transactions at issue in the SEC complaint were not structured as speculative, risky bets on the housing market. The deals were backed by a pool of AAA-rated mortgage bonds (by contrast, the overwhelming majority of CDOs contained much lower-rated assets). The CDO bonds to which the insurers took exposure had an additional cushion of protection in the amount of approximately 10% to create “super senior” AAA bonds. Nonetheless, within about a year, the super senior bonds were valued at about 60 cents on the dollar and required cash payments of about $2 billion by AIG and the Federal Reserve to make bondholders whole (see previous discussion of AIG and Maiden Lane amounts here: http://www.nakedcapitalism.com/2010/01/more-of-that-secret-maiden-lane-iii-transaction-level-detail.html).
As described in the SEC’s complaint, ICP stole from my old company and from AIG and caused millions of dollars of losses, the loss of many jobs, the misapplication of taxpayer funds and contributed to the destruction of the economy. They did so while smiling and shaking our hands, vowing to protect our interests and then asking about our children and our families. They did so while taking that money and paying themselves millions of dollars of misappropriated fees and bonuses, even as our companies ran out of money and struggled to understand why.
What is most interesting about the ICP case to me is not that the people involved were unusual or evil, but rather how common and normal they seemed. They seemed to be knowledgeable and reasonable people; above average, by my assessment of the industry. As the CDO manager was allegedly committing its fraudulent activities they probably believed that their actions were justifiable and, indeed, were a normal way to conduct CDO business. I would agree: their behavior was likely commonplace, not extraordinary, and part of the acceptable course of business.
Investors purchased CDO bonds based in large part on the expertise, experience and reliability of the CDO managers to create and manage safe bonds. As it turns out, investors were foolish to hold such beliefs. The CDO market was far more opaque than it appeared and the structures permitted far too much latitude and created far to many opportunities for the managers to line their own pockets at the expense of their investors. Following its complaint against ICP, the SEC may finally be uncovering the widespread, ordinary frauds that lurked behind the failed CDO market.