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So Maybe Citi Created A Mortgage-Backed Security Filled With Loans They Knew Were Going To Fail So That They Could Sell It To A Client Who Wasn’t Aware That They Sabotaged It By Intentionally Picking The Misleadingly Rated Loans Most Likely To Be Defaulted Upon, So What?By Matt Levine
Citi today paid out some of its DVA gains to settle SEC charges that it sold investors a CDO-squared that facilitated its own naked CDS purchases on the underlying CDOs, while misleading investors into thinking that an independent collateral manager selected the underlying portfolio. If my grandmother reads Dealbreaker she’s now stopped.
Anyway. I’m proud of my time at Goldman, which I thought was a great place filled with smart and ethical people (really) and which also was a market leader in many areas, including paying fines for fraudulent CDO structuring fraud. In that line of business we were first both in time and in market share, settling Abacus for $550mm in July; JPMorgan’s $153.6mm Magnetar settlement came a week later and Citi didn’t get around to their $285mm entry (and Credit Suisse’s $2.5mm addition) until today.
Now, maybe it’s just my Goldman bias talking but I never really got the outrage at these things, which always seemed to come from importing an already incorrect understanding of how nonfinancial transactions work into a market-making, two-sided, financial markets context. But reading the Citi CDO documents, which are fascinating, I think makes it a little more comprehensible.
There are five points to which your free-floating rage could maybe attach:
1. You were shorting a thing that you were selling to your customers! This is what drove Congress bonkers. But that’s what selling is. If you have 20 apples and sell me 15, you now have fewer apples, and I have more. If apple prices decline, I am worse off, and you are relatively protected. Banks, which are always long some risks and short some others, don’t see zero as a particularly interesting point on this continuum – if you have 20 apples and sell me 30, and apple prices decline, you make money, but that’s different only in degree, not in kind, from selling me 15 and reducing your risk to 5.
2. You didn’t tell buyers you were short. Well, see above – someone had to be short, that’s what a synthetic CDO is. So buyers knew. But also, you did. From the SEC complaint:
43. Both the pitch book and the offering circular contained disclosure concerning Citigroup’s role as “Initial CDS Asset Counterparty,” including explanation of potential conflicts of interest resulting from Citigroup assuming that role. Page 88 of the 192-page offering circular included a statement that “[t]he Initial CDS Asset Counterparty may provide CDS Assets as an intermediary with matching off-setting positions requested by the Manager or may provide CDS Assets alone without any off-setting positions.” These disclosures did not provide any information about the extent of Citigroup’s interest in the negative performance of the collateral in Class V III, or that Citigroup already had short positions in $500 million of the collateral.
44. Notwithstanding that Class V III was structured as a “prop trade,” i.e. a vehicle into which Citigroup would short assets for its own account, Citigroup did nothing to ensure that the marketing documents accurately disclosed Citigroup’s actual interests in the collateral.
In other words, the SEC has a sad because Citi didn’t specifically tell clients that the other side of the market was Citi prop, rather than customer facilitation, although it did say “it might be.” Fortunately, that will no longer be a problem. Similarly (oppositely?), with Abacus the SEC was pissed that Goldman didn’t tell clients that the other side of the market was John Paulson, who had a stellar reputation for market clairvoyance for about 45 minutes (though those 45 minutes, to be fair, occurred after Abacus was already dead). But of course you’re not supposed to tell people who the other side of the market is. Banks have rules against telling buyers who the sellers were, and vice versa. That’s why you trade through a market maker: to preserve anonymity and avoid being front-run by competitors. Citi disclosed that it might have a conflict by being short; it just didn’t want to give away its whole book by explaining exactly how short it was and whether the risk was laid off elsewhere.
3. You picked the worst securities. This feels more compelling, but it isn’t. That’s what makes a market. If you want to buy an exposure for $100, all you can get is an exposure that someone else thinks is worth less than $100. If they thought it was worth more than $100, they wouldn’t sell it to you. In every securities transaction, each side thinks that it’s ripping off the other side. And the logic of “OH NOES DESIGNED TO FAIL” can take you too far: if Goldman had structured the bestest CDO ever known to man, would Paulson have a case against GS for selling him protection “designed not to pay off”?
4. You didn’t tell buyers that you picked the worst securities. That is no different from #3. They know you picked securities that you, or someone, was willing to sell. That is enough.
5. You told buyers that a third party was picking the securities and that that third party had both a brain and a heart. In some sense this is no different from #3 and #4. But I find it a bit more compelling, for reasons that are sort of depressing.
One might have a model of CDO investing that goes as follows: investors (hedge funds, German banks, monolines, whatever) want exposure to certain credits. They are professionals with paid credit analysis staffs. They go buy things that give them exposure to the credits they want exposure to at the price they are willing to pay. They are one side of an informed and efficient market in credit.
The CDO settlements suggest that this model turned out to be mostly false. The offering circular for Citi’s monstrosity doesn’t name the initial reference assets of the CDO-squared; it just says “A list of the portfolio of Eligible Collateral Debt Securities expected to be acquired by the Issuer on the Closing Date may be obtained upon request from the Initial Purchaser and the Placement Agent.” Clearly at least some investors did this (see below), but the offering document isn’t exactly putting reference security quality front-and-center, or making credit analysis transparent.
The correct model is more like CDO investors as retail mutual fund investors. They buy into funds/CDOs based on some complex of factors that may include their independent analysis of the general sort of stuff that the CDO is investing in, but also includes things like past results of the CDO manager, the quality of graphics in the pitchbook, and, um, the educational background of its employees. So the prospectus includes zero pages on what’s in the portfolio, and seven pages (101-107) on the Credit Suisse employees who will manage the CDO. (This includes analysts! I, for one, would be comforted to know that the team’s most junior member “joined [Leveraged Investment Group] as a credit analyst in 2006″ and “recently earned his Bachelor of Arts in Economics from Harvard University.”)
Here, Citi proposed the collateral for the CDO-squared, but investors were told that Credit Suisse Alternative Capital (CSAC) selected the collateral independently and with a rigorous selection process. Now, again, CSAC just can’t select collateral on its own – it needs to buy stuff (sell protection) that someone is willing to sell (buy protection). But still, CSAC’s judgment seems to have mattered to people. From the complaint again:
54. Citigroup also offered and sold notes with a par value of $343 million to the Subordinate Investors, a group of approximately fourteen (14) institutional investors including hedge funds, investment managers and other CDO vehicles. Citigroup provided the Subordinate Investors with marketing materials for Class V III, including the pitch book and offering circular.
55. At the time of their investments in Class V III, the Subordinate Investors were unaware of Citigroup’s role in selecting the investment portfolio, and many considered experience as a collateral manager and rigorous asset selection process to be important to their investment decision. One wrote in an internal investment memorandum, “We do think CSAC has a strong record in selecting good portfolios, but we are not 100% comfortable with their asset selection in this case, but since their franchise and structured credit platform is generally strong . . . we felt comfortable with this transaction.”
So this investor got the list of assets, did the credit analysis, didn’t like what they saw – and bought anyway, presumably concluding that nothing touched by a recent Harvard econ grad could possibly go wrong.
If you believed the “just do the credit analysis” model, then those investors were not fulfilling their market function and deserved what they got. But if you believe that they’re just supposed to be trusting rubes who have put their faith and their money in the hands of a collateral manager, then the fact that the collateral manager was a Citi captive is … troubling.
We probably do need to have a financial system where not every buyer of a financial product is expected to do their own detailed investment analysis, but is allowed to trust the manager. It’s probably (maybe?) a good thing for retail investors to be able to buy mutual funds without those funds just being mechanisms for managers to screw them. It’s less clear that the same logic applies to, say, hedge funds charging 2-and-20, but I’m willing to believe it applies to say small regional banks and pensions that might buy a CDO for the yield. But the fact that the trust-the-gatekeeper, we-couldn’t-possibly-be-expected-to-know-what-we-bought types seem to be the marginal buyer of products like CDO-squareds is troubling – for the financial system broadly, and for quirky areas like getting rid of the too-powerful role of ratings agencies.
Read that last quote one more time, by the way:
Citigroup also offered and sold notes with a par value of $343 million to the Subordinate Investors, a group of approximately fourteen (14) institutional investors including hedge funds, investment managers and other CDO vehicles.
Somebody was building a CDO-cubed out of this! So good! Maybe the next CDO settlement will come from a bank that was shorting that?
SEC complaint [pdf]
Class V Funding III Offering Circular [pdf from ProPublica]
As for the sign/title [The Atlantic]
Disclosure: it is maybe worth pointing out that I didn’t work in, talk to, sit near, etc. etc. Goldman’s (or for that matter Citi’s) CDO business so no inside information. Also, as always, GS stock accounts for an ever-dwindling percentage of my net worth.