Mirabile Dictu! SEC Probes Relationship Among Toxic CDO Sponsor Magnetar, Merrill, and CDO Manager

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.

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  1. Conscience of a Conservative

    I’m shocked, shocked to find that gambling is going on in here! In other words, the relationships between CDO managers and the dealers has been back-room talk for years.

    1. jerry 101

      I don’t think you can call it gambling once the fix is in.

      One party to the “bet” is virtually guaranteed to win, and the other party is virtually guaranteed to lose, though it may be presented as a fair bet.

      I’d call that fraud.

  2. Thorstein

    What if Goldman, Merrill et. al. did NOT use compliant and/or “dumb” collateral managers.

    Wouldn’t the end result have been the same?

    1. ambrit

      Any other entities trying for a little clawback? Why only a Dutch bank? Shouldn’t the Feds also be striving manfully to reclaim ‘our’ heritage? (Sorry, obviously rhetorical question.)

    2. ambrit

      Sorry Thorstein;
      The above posted in wrong place. As for your question, no, I don’t think the result would have been the same. If I understand rightly, truly independant collateral managers can demand changes in the make up of the ‘assets’ within the fund, and make it stick. Thus, most of the obvious ‘dogs’ in the tranches would have ended up in ‘funds Purgatory.’ Then, whomever traded the ‘dogs’ would have known they were gambling. As it was, the dice were loaded and, as usual, the ‘suckers’ were in the dark.

      1. NotExactly

        To be fair, the mandate of the deal(i.e. invest in high-yield structured notes) predetermined the outcome for the investor (i.e. they were gonna lose money). The collateral manager could have been as independent as possible, but if your mission is “select the best from this pool of garbage” then even if you select the very very best, it is still a portfolio of garbage. The collateral managers didn’t have a clue about the short, they wouldn’t even understand it.

  3. jake chase

    I get your point that the sponsors were determined to create CDOs that would blow up. I continue to wonder why buy side investors were so easily gulled. These were supposed to be professionals capable of protecting their own interests, but nothing you have written suggests they were anything but fast asleep and desperately reaching for yield. Of course their built in excuse is the rating agencies, but it is difficult to make a fraud case out of this, particularly when complete information on the underlying mortgages was available to anyone who bothered to examine it.

    As for the SEC confining itself to low hanging fruit, it has done that consistently since at least 1968. The consistent excuse is lack of resources, the consistent reason is bureaucrating time serving apathy and incompetent leadership.

    1. Lyle

      Its clear that there are a few very clever folks in the financial industry and a lot of dim bulbs as well. I guess part of it is an unwillingness to say you don’t understand something, its an admission of defeat that you are not among the clever, and so you don’t say it. As the book F.I.A.S.C.O. points out the goal of a person making CDOs (and all derivatives) is to rip the face off the other guy, and it appears that the clever folks succeeded big time.
      Now the question is how well are the dim bulbs compensated compared to the clever folk? Sometimes when the financial folks say I have to pay the big bucks to keep the top people I wonder if the best and brightest managed to screw it up as thoroughly as they did do we need to bring in the mediocre bankers, because they probably could do no worse.

      On the point of who gets investigated, the point is that since prohibition the US government has not had enough resources to prosecute all the crime that happens, so the goal is to make an example. The example is used to get people to be afraid and behave because they might get caught, since someone got investigated. We see this with the IRS offshore bank accounts scheme, catch a few and then offer amnesty for a fee. (Of course I have become a total cynic as I get older)

      1. jake chase

        It was game over as soon as the government stepped in to protect the banks against loss and the bankers against the consequences of going balls up. Whatever “enforcement” does now will be selective, inconsequential, so much lipstick on the pig. If capitalism really existed, all of these “major banks” would have failed. A good deal of “wealth”, most of it in rentier hands would have evaporated. So what? Did anything serious result from the “bankruptcy” of GM? Stockholders’ equity evaporated and burdensome obligations to retired workers disappeared.

        The investment game is rigged from start to finish. If you don’t understand the game don’t play. The sooner people realize there is no such thing as an “investment” which places wealth under the control of someone other than themselves, the sooner some chance will exist for meaningful change. All this whining about the need for more and better regulation is ridiculous, and it plays into the hands of the monopolists who coopt the regulation and employ it as a barrier to competition from new players who might use honesty as a competitive strategy.

        Wall Street is and always has been about putting a shine on shit and stuffing it into the portfolios of pigeons. To suggest any firm is engaged in anything else is complete nonsense. To trust anybody employed by any firm ever is completely absurd. They write those prospectuses for a reason. They know the buyers don’t understand a single paragraph.

        1. Anonymous Jones

          “To suggest any firm is engaged in anything else is complete nonsense.”

          Huh? What? Where did that come from?

          It’s possible for something to be 90% rotten without being entirely rotten. It’s not “nonsense” to suggest this. In fact, your task in proving that it is always and everywhere rotten is in fact *impossible*. It’s like saying there are only white swans because you’ve seen a million swans and they’ve all been white. Don’t get me wrong, knowing that all the ones you’ve seen are white is *very useful*, but it not “nonsense” to suggest that, who knows, the next swan might be black.

          1. A Good Bankster

            From experience I’ve learned it’s always possible for an honest person to end up on Wall Street, that is, if you’re not careful. This happened to me once, and it’s happened to at least one of my friends. In my case I hired some hedge fund analyst over the phone without bothering to check references. He showed up the next day in one of those cheap suits with an American-flag pin on his lapel. Turns out he was from Kansas, or one of those flyover states.

            I immediately got suspicious so the first thing I did was instruct him to sell some toxic CDOs to a local orphanage for crippled children. “So’s we can rip their face off” I said, testing him.

            The little pr*ck refused and so I fired him on the spot. End of problem.

            An honest person on Wall Street is about as useful as a condom dispenser at the Vatican.

    2. Yves Smith Post author

      You are missing how these deal work. Many were “managed” which meant they were basically blind pools. The managed deals just had general parameters. The CDO manager would assemble the assets after closing. So you were hiring the manager, that’s why the independence of the manager was key and the banks promoted that so aggressively.

      You may say that’s nuts, but hedge funds and PE funds are blind pools too, with far fewer constraints than a CDO.

      The static pools would be marketed on general parameters 2-3 months in advance, the deal would get indications of interest, but the actual exposures would be disclosed only 24 hours prior to closing, which was too short a time frame to evaluate the deals.

      Moreover, there was a remarkable absence of real buyers. More than half of the AAA CDOs in the toxic phase wound up at banks for bonus gaming purposes (we described this in ECONNED). AIG and the monolines were the other big buyers of the AAA tranches, along with IKB and other Landesbanker (real dumbnicks) and the two famed Bear Sterns hedge funds. These buyers were the overwhelming majority of the AAA trache buyers, and that was ~75% of the value of the deal. The lower rated tranches also had few real buyers. Probably at least half was rolled into other CDOs. Correlation traders, who were arbing one tranche v. another, took some, and the rest went to real stuffees, like Australian town councils.

      1. jake chase

        Well, you’ve nailed it: that’s nuts. I wonder how many people whose “savings” were being managed understood that the managers were blind pigs chasing yield in the dark. If you are saying that the fraud was claiming a CDO manager was “independent” when in fact he was hired to create a package certain to explode, I wish you the best of luck attempting to prove this. Knowing that even govt attorneys dislike losing and generally stick to slam dunks, it is hardly unexpected that herds of them are not lining up to prosecute this kind of case.

        1. Yves Smith Post author

          It’s already been proven in the exhibits to the Levin report, on Timberwolf and I am pretty sure Hudson too. And remember Goldman was considered to be more upstanding than other Wall Street firms….I still get the occasional message from a Goldman customer “how can you say such bad things about Goldman, they are nicer and more professional than all the other firms I deal with.”

        2. MicahelC


          It’s a shame Yves dignified your comment with a response you don’t deserve. You say:

          “If you are saying that the fraud was claiming a CDO manager was “independent” when in fact he was hired to create a package certain to explode, I wish you the best of luck attempting to prove this.”

          then you haven’t been following this story at all. Ng and Mollencamp laid out the patterm pretty clearly in their Dec 07 piece about Norma.

          Spend an hour googling other Norma like deals and it’ll soon become clear even to you that Merrill was in bed with former Merrill alumni (oops, independent collatoratl managers) like these pikers,who set up shop to feed Merrills CDO machine.

          Based on that hour’s work, you’ll soon discover a pattern that should be useful to any semi competant prosecuter to build a case that, Yes, there likely was a lot of fraud, and its not a stretch to think your “good luck with that” posturing is an encouragement rather than bloviating disdain.

          Spend another hour googleing Cohen/Merrill/ Philadelpia. Follow that path ,then come back and argue your position re: good luck with that.

          1. MicahelC

            if anyone at the SEC is reading this :

            Follow the Google search I recommended to Jake.

          2. jake chase

            At the risk of dignifying your comment let me say that you miss the essential point: an investment industry staffed by people who simply appear respectable and shlep off to work leaving intellect behind are easily and inevitably whipped and driven by the psychopaths who gravitate to Wall Street investment banks. If you really think the answer to this problem is incarcerating selected bankers on charges of “fraud”, you have no idea how difficult fraud is to prove, particularly when confronted by nearly inconceivable negligence on the part of the putative victims.

    3. anon48

      Jake Cheese:

      “I continue to wonder why buy side investors were so easily gulled”

      I’ll take a shot at answering that question

      I knew the senior financial/ accounting person who worked for a small union/ defined benefit pension trust. He was a solid admin accounting guy/ ok on financial reporting issues. He didn’t have a clue about the investment strategies utilized for the trust assets. Main reason was his boss, the CEO and the board had no interest in his opinion. According to my guy, they understood less than he did. They relied totally upon the expertise of an outside investment management advisors.

      Further, I distinctly recall a discussion that I had with him about the markets in general during late spring 2008(almost a year after the subprime meltdown). I asked if there was any concern on his part about the quality and stability of the financial institutions that housed their investments. He gave me a stern lecture that I was crazy even asking the question. He was certain by that time the credit crisis was completely over. (Of course this was only three months before Lehman collapsed, Merrill almost blew up, Freddie & Fannie were taken over, etc). (Turns he too, like most everyone else up to that time, still wouldn’t have known what a CDS was even if it bit him.)

      Haven’t spoken to him in a few years and can’t say for sure whether they had any blow-ups. But my guess is that the organizational dynamics of his firm were probably not so different from many of the other institutional entities that were eventually stuck with some of the subprime drek.

  4. Lloyd C. Bankster

    The SEC is looking into complicated CDOs involving Merrill and Magnetar? ha ha ha

    Best laugh I’ve had all week.

    Those idiots couldn’t tell the difference between a complex CDO and a porn site. Speaking of which, I’ll have my boys look into this. Supply the SEC with a list of *real* porn sites to surf this time, maybe they’re getting bored with all those men in bathing suit “porn sites” we gave them two years ago as a joke. (Who knows, after two years, maybe they got that it was a joke?)

    And I’ll see about getting them some condoms to wear while they surf the Internet.

    That should keep those SEC retards from snooping around.

    1. Doug Terpstra

      Speaking of condoms, it could be that the SEC finally realizes, a bit late, that it neglected prophylaxis for so long that the economy contracted a terminal STD. Then again, it might be agency funding time, and it’s simply boning up in anticipation of next year’s erection … sorry, election.

  5. Jimbo

    With an election on the horizon the SEC gets a jab in the ribs to create some appearances. What’s next? Just-in-time-indictments of so far protected criminal bankers? Better hurry, the statutes of limitations will be running out soon.

  6. Jmd

    Hello…Chris R. the well-known CDO snake-oil manufacturer and salesman also worked at Credit Suisse…anyone, anyone?

  7. Paul Tioxon

    Unlike the just in the nick of time Jack Bauer “24” bullshit, the indictments will be timed for the elections, to embarrass enemies, to stop a rolling momentum of enemies, to distract from something that is not making the administration look good, etc. Of course it is not timed for your bourgeoisie sense of justice, propriety and my favorite, the all you can eat buffet “rule of law”. They will enforce the law against these crooks when it benefits them and at the timing which is to their benefit as well, as they define it. Run for office, take over the White House and prosecute your own damn personal stable of bad guys.

  8. Un giustiziere o vigilante

    lowest-hanging fruit, and in a product area as complex as CDOs,

    ~~Yves Smith~

    Was MadCow lowest-hanging? Did he go for 11 years avoiding harvest? Who knows? One thing for sure == SEC has garnered a spot within The Historic World Book Of Guinness Recreational Ale. SEC is now on the map for being most successful gang of feather-bedder-s sipping ale. Should we turn Madcow loose but mount up a posse to hunt down the slim customers who allow the mob to infiltrate some of the World’s Largest Corporations for the purpose of setting up these complex systems that defraud the unsuspecting? Or should we take the advice of Ross Perot? Did Ross once say, “Poisonous predators should be shot on sight.”? Imprecisely, but he did give us a hint.

    Naaahhh! Mobsters are good guys.

    Enjoy your local mobster

  9. MicahelC

    I think you’re being too glum and cautious. This IS low hanging fruit, a nice juicy peach actually.

    Not sure how to put this, but since you broke the story and Ng and Meolencamp got a critical chunk of it out earlier (and caused quite a shock as I recall), and Pro Publica wrote a ditty on it ( and a story too) it seems like there’s a competent bunch still watching (and itching, perhaps allying?, plus a fearful few working to make this story go away) to remind who ever listens to them that this fruit has been ripening for at least a year (3 for the WSJ guys), since it was first brought up.

    A year ago the story landed with a thud in the MSM. This was odd given the ProP investment (and snub, and Pulitzer won on your behalf) in your story. They expected this to go viral, with good reason. And yet it didn’t.

    Perhaps something has changed at the SEC if their intital lack of interest was based on fear rather than disinterest.

    The JPM suit may be playing a role in the SEC overcoming their anxieties about confronting the connected folks on the wrong side of this trade. They’re not known for sprouting a set spontaneously.

    You, on the other hand…

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