cdos

The SEC settled a little crisis-era CDO fraud case with UBS today and the fraud is pretty entertainingly shitty. Basically UBS provided the warehouse for a synthetic CDO where the notorious ACA was the collateral manager, and the disclosed deal was that, when the CDO closed, it would enter into (as protection seller) any CDS contracts that UBS had entered as part of the warehouse at (1) the market price of those CDS or (2) the price UBS had received for them as initial counterparty, whichever was more favorable to UBS.1 Now right there you’ve got some optionality and room for fuzziness, and you could imagine various unpleasant schemes where, for instance, UBS cherry-picks some contracts to transfer at market and some at historic price, or where UBS mis-marks some contracts to get a better deal when it transfers them.

But the actual scheme was simpler and dumber: Read more »

To help inject humor into what was an otherwise intense process, Ms. Rhett said she and other jurors compared the lawyers’ likenesses to actors. “I’m only going to say that there was someone who looked like Dan Aykroyd, someone who looked like Kevin Spacey and someone who looked like a cross between Patrick Stewart and Stanley Tucci,” she said. But when it came time to consider the seven claims against Mr. Tourre, they moved methodically and efficiently. The group chose 52-year-old Steven Zucker, a former retail broker on Wall Street who is now co-dean for art and history at the Khan Academy, a nonprofit educational organization, to be foreman. The jurors devised rules, and Mr. Zucker would call on people to speak. The jurors strove to begin on time every morning and worked through lunch, which consisted of sandwiches of grilled chicken and ham and cheese, in addition to soda and leftover muffins from the morning. [WSJ, earlier]

Poor Fab! I, for one, was utterly persuaded that he didn’t commit securities fraud by sending an email that he admitted was “not accurate” but not “false,” but the significance of that distinction seems to have eluded the jury:

A federal jury found former Goldman Sachs Group Inc. trader Fabrice Tourre liable for misleading investors in a mortgage-linked deal that collapsed during the financial crisis, delivering a historic win for a U.S. regulator eager to prove its mettle inside the courtroom.

The panel of nine jurors reached their verdict during the second day of deliberations, finding Mr. Tourre liable on six of seven claims that he violated federal securities law. … Mr. Tourre, who left Wall Street to pursue a doctorate in economics, may face a fine and a ban from the securities industry.

I think it’d be a shame to deprive the securities industry of Fab’s financial-structuring creativity and proclivity for sending embarrassing emails, but as we’ve established I’m in the minority here. Read more »

  • 24 Jul 2013 at 10:53 AM

Fab Tourre’s CDO Deal Wasn’t Complicated Enough

If you wanted to short the housing market in 2007 you could just buy protection on mortgage-backed securities via a synthetic CDO, and that’s what John Paulson did in the Abacus deal, for which Goldman Sachs and Fab Tourre got in trouble. But the problem with that is that buying protection costs money; just for instance the super-senior protection in Abacus would run you about 50bps, or around $4.5 million a year on the $909mm notional that ACA Capital wrapped.1 And who wants to throw away millions of dollars a year waiting for the housing market to crash?

So another way to short the market is to buy a lot of protection on senior tranches of CDOs (cheap because: what are the odds that the housing market will crash?) while also selling a little protection on junior tranches (expensive because the odds that there’ll be some defaults are higher). If you do this, you can have a positive carry (you get paid as more each year on the protection you sold than you pay on the protection you bought), but you can make just about as much money if the housing market craters and there are massive defaults. (The tradeoff is that if performance is mediocre, with some defaults, then you lose money on the junior protection you sold and don’t make it back on the senior protection you bought.)

This second trade is a very stylized description of what Magnetar did,2 in another CDO deal for which JPMorgan got in a bit of trouble. Less than Goldman, though! Read more »

I haven’t been following Fabrice Tourre’s trial all that closely but I gather that the main evidence against him is that a Goldman saleswoman, Gail Kreitman, told her client ACA Capital Management that Paulson & Co. was going to be a long investor in a CDO called Abacus. That turned out to be false, and arguably in a material and fraudy way. So: why isn’t the SEC suing Gail Kreitman? Well, because someone told her that that it was true, and there’s at least, like, a 60/40 chance that that someone was Fab. Because he was pretty competent: Read more »

The judge hearing the Justice Department’s CDO-rating lawsuit against S&P refused to dismiss it yesterday, rejecting S&P’s much-mocked theory that its pre-crisis claims of independence and objectivity and, like, plausible ratings were just “puffery” that no one should have taken seriously. Here is the story, and here is his opinion, and here is a rhetorical question:1

At the hearing on this matter, Defendants repeatedly asserted that no reasonable investor would have relied on S&P’s claims of independence and objectivity. Regarding the question of materiality, S&P argued that, since the issuer banks had access to the same information and models that S&P analysts did, they could not have been fooled by faulty credit ratings. This begs the question: if no investor believed in S&P’s objectivity, and every bank had access to the same information and models as S&P, is S&P asserting that, as a matter of law, the company’s credit ratings service added absolutely zero material value as a predictor of creditworthiness?

Well so I mean do you want an answer? How much value do you think they added?

The S&P case is a pretty weird beast because it’s brought under the FIRREA, a law designed to protect federally insured banks, and so the government has to assert that: Read more »

“I think the jury was lost,” John “Sean” Coffey, a lawyer for Tourre, 34, said during a break this morning in the testimony of Professor Dwight M. Jaffee, called to the stand to describe the collateralized debt obligations at the heart of the case. “It is critical that they understand how a synthetic CDO works.” Before Jaffee’s cross-examination, an SEC lawyer used a PowerPoint presentation to help him explain a CDO as a sinking cargo ship, with the equity and mezzanine investors the first to take on water. Not long after the super-senior deck flooded, the animated ship was shown sinking to the bottom. Later, Forrest tried to rephrase one of Coffey’s questions to Jaffee about a failing CDO, apparently using the wrong aquatic metaphor. “You’re talking waterfalls, I’m talking flood,” Coffey said…After Jaffee left the stand, the SEC called Sihan Shu, a Paulson managing director who testified that the firm in 2006 and 2007 was in search of investment vehicles that would allow it to make short investments on U.S. mortgages. “We wanted to express a bearish view on the U.S. housing market via subprime mortgage-backed securities,” Shu said. The jury wasn’t alone in grappling with the subject matter of today’s testimony. Paolo Pellegrini, a former top Paulson executive, testified after Shu. “What does ‘CDO’ stand for?” SEC lawyer Matthew Martens asked Pellegrini, who wasn’t in the courtroom for Jaffee’s testimony. “I’m not sure,” Pellegrini said. “It may stand for collateralized debt obligation, but I’m not sure.” [Bloomberg]