Wednesday, December 19, 2007

Barclays sues Bear Stearns over CDO hedge funds

Barclays Bank Plc (BARC.L) on Wednesday accused Bear Stearns Co Inc (BSC.N) of using two hedge funds that collapsed last summer as places to unload troubled assets.

Clickhere for full article.

The London-based bank's allegations appear in a lawsuit filed in U.S. Court for the Southern District of New York in Manhattan.

Barclays described the collapse of two Bear Stearns-run hedge funds as one of the most shocking in the last decade.

"Bear Stearns ... used the enhanced fund as a place to unload excessively risky or troubled assets that could not be sold to other investors at the prices paid by the enhanced fund," Barclays said in its complaint.

At the end of May, for example, Bear Stearns Asset Management had the enhanced fund buy about $500 million of the riskiest classes of securities in a deal that it managed, Barclays' complaint says.

"BSAM did so despite the fact that investment restrictions it had promised Barclays did not permit those securities to be held in the fund," the complaint said.

(Reporting by Tim McLaughlin; Editing by Jeffrey Benkoe, Leslie Gevirtz)

Wednesday, November 14, 2007

The Subprime Meltdown: For CDO Investors There is a Remedy

Click here for full article.

While each CDO is unique, certain tendencies in the formation of both the rated and unrated tranches have emerged. By 2006, data was available showing a dramatic increase in the risk of subprime mortgages comprising many pools of CDO collateral. The quality of loans, the rate of default, the loan-to-value ratios, and the level of documentation were known to be in decline.

CDO issuers could have taken defensive steps, including rejecting risky loans, adding more loans to cushion against loss, and fully and timely disclosing declining creditworthiness of their CDOs. Rating agencies also could have demanded changes. But, as the market for CDOs expanded and financial institutions discovered that they could pass off mortgage risk to investors, underwriting standards collapsed to irresponsible levels--with the full knowledge of the rating agencies. Both groups reaped enormous profits.

Historically, Wall Street has responded to criticism of product sales with two powerful arguments, neither of which applies to mortgage-backed CDOs.

The first defense is that independent ratings agencies such as S&P, Moody's, and Fitch evaluated and blessed each CDO before it was sold. But in the past few years, rating agencies were paid only on condition that the CDO went to market, received large continuing fees for periodically re-evaluating the products, and also collaborated with managers in structuring many CDO investments. In short, the rating agencies were not independent, and now many 2006 and 2007 CDOs are facing defaults and downgrades, effectively an acknowledgment that the original ratings issued only months earlier were deficient.

The second defense typically offered is that CDOs were purchased by institutions and sophisticated individuals with access to their own financial professionals, who were fully capable of evaluating the risks. This isn't rocket science. Caveat emptor.

But structured investment vehicles are rocket science, and not just any institutional investor or high net worth individual has the capacity to engage the army of math Ph.D.s and MBAs that Wall Street employs to create and value these products.

In 2006, the Law Offices of Alan W. Sparer won an award of $5.8 million against Deutsche Bank for its role in connection with the sale of CLOs and CDOs.

Florida Agency Holds $2.2 Billion of Debt Cut to Junk Status

November 14, 2007 - Bloomberg reports that the Florida agency that manages about $50 billion of short-term investments for the state, school districts and local governments holds $2.2 billion of debt that was cut below investment grade. Florida rules require the state's short-term investments to only be top-rated, liquid securities, so taxpayer funds aren't placed at risk.

Former SEC Chairman weigh in...

``Investment of public money needs to be carefully conducted and thoroughly researched,'' said Harvey Pitt, former chairman of the U.S. Securities and Exchange Commission. ``This is not the place for seat-of-the-pants judgments. It requires a lot more than jumping on the latest investment du jour to improve your results.''

Florida isn't the only government whose short-term investments have been affected by rising mortgage defaults in the U.S. and investors' diminished appetite for the securities tied to them.

``I think there are other communities that are going to follow, probably a lot of them,'' former U.S. Securities and Exchange Commission Chairman Arthur Levitt said today in an interview.

``I think we've got to pay more attention,'' Levitt said. ``They're playing with pensioners' money. That's serious. That's more serious than a brokerage firm or a bank losing money on a bad bet. We're talking about pension losses, and I think the fact that this is spreading is something that we've got to watch very, very carefully.''

According to the report, nearly 1,000 school districts, cities and counties invested in the fund, and have now been informed of its downgraded debt. Click here for full article.

"Breaking the buck?" Money Market Funds are Spending Millions to Ensure a Dollar is Still Worth a Dollar

Bank of America announced Tuesday, November 13, 2007 that it planned to set aside $600 million to cover potential losses in tis money market funds and an institutional cash management fund. This is the largest step by a financial institution to ensure that its money funds aren't forced to reduce the value of their shares. Click here for the full article.

"Money funds have long appealed to people as super-safe investments. And they've kept their share prices fixed at $1 a share. But unlike banks' money market deposit accounts, money funds are not federally insured. The crisis in subprime mortgages has jolted the market for the short-term securities that money funds invest in. Even so, assets in money funds recently hit a record $3 trillion.


Several other financial institutions have also bolstered their money funds:

- SEI, an insitutional money manager in Oaks, Pa., has set aside $129 million to support two of its money funds.

- Legg Mason, a Baltimore money management firm, has set up a $238 million line of credit for two money funds. It also invested $100 million to buoy an offshore money fund.

- SunTrust (STI) has received SEC permission to set up credit lines for two money funds.

Sunday, November 11, 2007


A report in the week-end edition of the Wall Street Journal dated Saturday/Sunday, October 27 - 28, 2007--that Moody’s, Standard & Poor and Fitch are being investigated in connection with potential antitrust violations--sheds light on potential abuses that may account for the recent precipitous round of rating downgrades by these same agencies. According to the REPORT, the Connecticut Attorney General’s office has issued subpoenas to the three rating agencies in connection with the alleged practice of “unsolicited ratings, “notching,” and “exclusive contracts.” CLICK HERE FOR FULL ARTICLE.

"There are allegatuions that some raters conduct an unsolicited rating and then demand the issuer pay for it or face a possible poor rating," the attorney general said. Notching is when raters allegedly threaten to downgrade an issuer's debt unless they get a contract to rate the issuer's entire debt pool, even if parts already have been assessed by another agency.
Exclusive contracts give issuers discounts for having all their debt rated by a single agency. "Such agreements may hinder competition by locking out other debt raters," the attorney general said.

These practices, if they did occur, are designed to do anything but ensure accurate classification of residential mortgage backed securities, such as collateralized debt obligations (CDOs). Whether the alleged practices violate antitrust laws or not, they could and would have resulted in inaccurate and misleading ratings upon which investors relied in purchasing CDOs, which have been sold in the billions. Such practices would also explain why many such products have been substantially downgraded only a few months after receiving a favorable rating.

In fact, the same Wall Street Journal edition carries a report with the headline “CDO Ratings Are Whacked By Moody’s: AAA to Junk in a Day Raises More Questions About Credit Arbiters.” The Journal announces $8.3 billion of DOWNGRADES by Moody’s primarily in connection with mortgage back securities. In one instance a $843 million CDO slice, known as a tranche, and having a AAA rating (which means first call on the income stream of a mortgage loan pool) was downgraded “10 notches to a junk rating of Ba1.” Another $229 million AAA tranche was cut “14 notches to a junk rating of B2.”

These kinds of changes can lead to a distress sale by purchasers, such as insurance companies, pension funds, and hospital or educational non-profits, who are required to hold rated investments by regulatory mandate or by the terms of their established investment policy.

Monday, October 29, 2007

MetroPCS files $134 million suit against Merrill for CDO losses

Merrill Lynch & Co. is being sued by Metro PCS in Dallas County, Texas, over a $134 million investment made this spring in CDOs that Merrill underwrote between 2003 and 2006. This according to a WSJ artcile written last week in the wake of Merrill's giant write-down of $8.4 Billion of CDOs. Click here for the full artcile. The article profiles Christopher Ricciardi, a former Merrill hand who pioneered the firm’s entrance into the CDO market. It describes how Merrill's sales people "scoured the globe for buyers of CDOs" and
distributed some of its riskiest CDO slices through its global network of wealthy clients. One former Merrill executive recalled attending an event at New York's Harvard Club in 2004 at which salesmen described the merits of CDO investing to doctors, hedge fund managers and businessmen. The WSJ writes that "Mr. Ricardi coached salespeple he worked with to stress that mortgage CDOs offered better interest rates than corporate bonds with similar ratings."

MetroPCS is suing over particluar investments known as auction-rate securities. They were marketed as short-term investments that buyers could resell, if they wanted to, in auctions run by Merrill. But this summer, as nervous investors began to shun almost anything connected to subprime mortgages, MetroPCS found it couldn't sell the CDOs it had bought, and it now expects to incur losses.

For its part Merrill says it believes it acted appropriately with MetroPCS and made all of "the appropriate disclosures..."

Wednesday, October 24, 2007

Subprime Meltdown: The Reckoning

Here's the latest tally from the New York Times:
  1. Sales of existing homes are falling twice as fast as expected;
  2. Merrill Lynch is taking a $3 billion charge on the mortgage backed securities on its books over and above the $5 billion charge that it announed just two weeks ago;
  3. Total losses to investors and financial firms is now estimated at $400 billion;
  4. Total loss in real estate wealth expected to be between $2 and $4 trillion;
  5. The Joint Economic Committee of Congress predicts about two million foreclosures by the end of next year on homes purchased with subprime mortgages;
  6. Housing prices are predicted to decline between 10-20% over the next year and a half;
  7. A 5% drop in prices is expected to result in a $60 billion decline in consumer spending, because of reduced wealth;
  8. Over the next year and a half, interest rates are due to reset higher on two million homes;
  9. Inventories on unsold existing homes has reached the highest level in 20 years;
  10. From 2003 to March 2006, housing-related businesses added 1.3 million jobs, or about 23 percent of all new jobs created in that period. Since March 2006, the housing industry has lost 383,000 jobs and more layoffs are ahead; and
  11. Layoffs in the financial industry are expected to be just as bad.
On the positive side, you can buy one square inch of a Miami condo for only $35.50. So, if you're a mouse with a taste for South Beach, you're in luck.

Housing Bubble or Credit Bubble

The Big Picture notes that what we're seeing here is not the result of a bubble in housing prices, but of a bubble in credit:

We can define a bubble as a “trade in high volumes at prices that are considerably at variance from intrinsic values." By that definition, I'm not so sure Housing was a true bubble -- the run up in prices, a doubling over the course of about 7 years, was actually a rational market response to interest rates being dropped to generational (46 year) lows. Trading volumes moved up, but proportionately so. Compare that with the Nasdaq, which doubled from October 1999 to March 2000 on a dynamic of a new paradigm. Trading volumes skyrocketed. When it was over, the Nazz had plummeted 78%.

House prices normally fluctuate in response to interest rate changes due to how they are financed. An example I used a few years ago: The first house I owned had a $300,000 mortgage. Back when interest rates were over 9%, the monthly payment would equal $2,632.71 (30 year fixed 10% mortgage). When mortgage rates plummeted, a buyer could finance a $500,000 purchase with a 6% fixed mortgage for a monthly payment of $2,997.75.

That easy credit resulted in part because lenders no longer worried about whether the loans would be repayed. Instead, they repackaged and sold off their loans through mortgage backed securities:

This drop in lending standards and absurdly easy credit is where things truly went awry: Despite the incredibly accommodative interest rates, lenders simply stopped being concerned about the borrowers' ability to repay loans. My favorite example: California strawberry picker Alberto Ramirez, who despite earning just $14,000 a year, was able to obtain a mortgage to buy a home for $720,000.

The assumption appeared to be that lenders could simply sell the mortgages to Wall Street to be securitized, without worries about delinquencies, defaults and foreclosures.

At the end of the day, it's the investors who purchased CDOs consisting of mortgages owed by strawberry pickers who are going to feel the bubble pop.

Tuesday, October 23, 2007

If your money market fund didn't give you your money back

. . . because the fund manager invested in a bunch of SIVs that in turn invested in subprime debt through a series of opaque transactions that would be bad, right?

It's like subprime redux: Some money market fund investors are again wondering if their investments are at risk because another complex investment product has fallen out of favor and become difficult to unload.

* * * *

The uncertainty among money market fund investors centers on what would happen if the SIVs couldn't repay their debts because their assets lost value. Some money market fund investors are, in turn, worried about losing money.

But, don't worry, because that's almost totally not going to happen:

But that's unlikely, says Bruce Bent, who invented the money market fund in 1970. His firm, The Reserve, has about $83 billion in assets and doesn't hold investments in SIVs.

"In the history of the money funds, you've had a number of situations where the management companies have bailed out the funds," he said.

He thinks it's unlikely the companies running money market funds would allow them to "break the buck," as it's known in Wall Street parlance even if the funds lost money on SIV-related investments. The draw of money market funds, of course, is that an investor putting in $1 get $1 back plus interest. If a fund were to, say, give back only 90 cents for every dollar, investors would be outraged.

Still, it's important to remember that money market funds, though considered safe investments, aren't FDIC insured.

Gee, ya think? [h/t Atrios]

Proposed Legislation Povides No Relief For CDO Investors. “The Mortgage Reform and Anti-Predatory Lending Act of 2007” H.R. Bill 3915

Yesterday, House Democrats introduced legislation to combat abuses in the mortgage lending market, and to provide basic protections to mortgage consumers and investors. Click here for Press Release. The bill, H.R. 3915, the “The Mortgage Reform and Anti-Predatory Lending Act of 2007” reportedly aims to reform mortgage practices in three areas. First, the bill would establish a federal duty of care, prohibit steering, and call for licensing and registration of mortgage originators, including brokers and bank loan officers. Second, the legislation would set a minimum standard for all mortgages which states that borrowers must have a reasonable ability to repay. Third, the legislation attaches limited liability to secondary market securitizers who package and sell interest in home mortgage loans outside of these standards.

Section 204 of the Bill, “Securitizer Liability” is a lot less than advertised in press releases and news reports. Click here for HR 3915 Summary. The idea is to open another pocket to the injured borrower which could be important as mortgage brokers are increasingly insolvent and unavailable to provide a remedy. However, the securitzer can avoid liability by offering the borrower a loan that meets minimum standards or by maintaining various policies and procedures designed to avoid purchasing unqualified mortgages. It is not enough to deter conduct in a billion dollar business where carefully looking the other way means large profits.

More important, there is no protection for unsuspecting customers who purchase bonds or CDOs made up of loans that violate the proposed Bill’s lending rules. The subprime lending debacle was fueled with innocent investor money, as purchasers of mortgage-backed securities bought billions in bonds and CDO tranches they thought were designed to produce an uninspired but steady and safe return. HR 3915 does nothing to hold the securitizers liable to customers for the mortgage backed securities they sell. As long as that lucrative market is unchanged the lifeboat for mortgage borrowers is going to leak big time.


HR 3915 Summary.

House Finance Committee Press Release:

New Stories:

New York Times, October 23, 2007, p C1.