Toxic Assets

Starting on the left, debt obligations are originated. For the purpose of this illustration, we will assume mortgages, though CDO’s have also been created from credit card obligations, student loans, business loans and other debt. Problems with CDO securities based on debts other than mortgages are in the early stage of development.

The next step moving to the right is to pool these mortgages (or other debt obligations). Obviously, the nature and quality of the debt that is pooled has everything to do with the nature and quality of the ultimate securities. Unfortunately the identity of that original debt has been substantially obscured in the securitization process. Even more unfortunately, millions of investors, including supposedly sophisticated hedge funds, endowments and foundations, in seeking marginally higher yields, have forgotten the first fundamental rule of investing — that you never invest in something you do not understand — and purchased trillions of dollars of these structured securities.

The next step moving to the right is to divide the pool into tranches. This diagram greatly oversimplifies the wide variability in structuring the priorities of the various tranches with respect to each other. The most draconian structure, and a very common one, was the “Cash Flow Waterfall”. Under this structure, the top tranche has all of its financial rights fulfilled before the second tranch receives anything. The second tranch gets completely fulfilled next and that process continues to cascade down the tranches. Additionally special tranches were sometimes created such as Interest Only (IO) and Principal Only (PO) tranches. These special tranches could be anywhere on the Cash Flow Waterfall, from top to bottom.

One has to question the extent to which any investor in (or seller of) these securities could really evaluate (or satisfactorily represent) the risks of investing in securities from any particular tranch. To resolve this problem, the creators and underwriters of these structured securities enlisted and apparently corrupted the credit rating agencies. More about that later.

Auction Rate Securities

Auction rate securities (ARS), investments once sold as safe as cash, are another victim in the fallout of the subprime mortgage collapse.

Auction-rate securities are long-term corporate bonds, municipal bonds and preferred stock on which the interest rates are reset periodically — typically every seven, 14, 28 or 35 days — based on bids submitted through securities firms.

In the past, auction-rate securities were popular with issuers like state and local governments, colleges, universities, hospitals, charitable organizations, cultural institutions and other not-for-profit entities because of their low financing costs and the fact there are usually fewer parties involved in the financing process and no requirements for third-party bank support.

Holders of auction-rate securities were allowed to sell them on the days in which the interest rates reset. The problem is that there are no longer any buyers at these auctions.

Until early 2008, auction failures were rare. But increasing concern regarding the credit strength of insurers backing the underlying debt obligations led to a rapid decline in demand for the securities. Adding more fuel to the fire is the withdrawal of the major investment banks, who had been bidding when auctions threatened to fail, to continue to submit bids in fear they could be at risk of holding too many bonds. As reported in a Feb. 13, 2008, article by Martin Braun on Bloomberg.com, nearly half of the $20 billion in securities that went up for auction on Feb. 12 failed to generate interest among bidders. As result, no securities were sold.

When an auction fails, issuers are forced to abandon their offerings. Or, they have to pay exorbitant interest rates, which is exactly what the Port Authority of New York and New Jersey recently had to do. Although the interest rate on the $100 million of bonds that the Port Authority of New York and New Jersey sold during the week of Feb. 4, 2008 was only 4.3%, the rate more than quadrupled, ultimately soaring to 20% on Feb. 12, 2008.

A similar dilemma confronted the state of Wisconsin at its 28-day auction of taxable bonds on Feb. 12, 2008, Bonds that the state sold at 4.75% on Feb. 7 jumped to 10% five days later. Shortly after Ambac Financial Group, the insurer of student loan debt issued by Vermont’s Student Assistance Corp., lost its AAA credit rating, the interest rate on this student loan debt was reset from 5% to 18%.

Other bond auctions failed outright, including bonds issued by Presbyterian Healthcare in Albuquerque, Georgetown University, Nevada Power and New York State’s Metropolitan Transportation Authority and Dormitory Authority. According to New York Times reporters Julie Creswell and Vikas Bajaj, nearly 1,000 auctions failed during the three-day period between Feb. 12 and Feb. 14.

In addition to the impact these auction failures have on investors, auction failures can have a devastating effect on the issuers, whose only alternative is to pay the higher interest rates or cut back on their programs. For not-for-profit entities that depended on these instruments to raise funds for their institutions and programs, and municipalities that are forced to raise taxes to meet higher costs of borrowing, the consequences are even more severe.

WHAT WENT WRONG/LESSONS LEARNED

The Law of Conservation of Structured Securities Risk

Today’s CMO losses resulted from the relatively recent introduction of CMOs with substantial credit risk and the inadequate or misleading way in which that credit risk was disclosed.

Introduction

Prior to the 1980s, homeowners applied to their local savings and loan, bank or mortgage company for a loan to purchase or refinance a home. The lending institution would assess the terms of the loan, the borrower’s creditworthiness and the value of collateral. If the institution extended a loan, the homeowner would make monthly principal and interest payments through a “servicer” which could be a department of the lender or an independent company that specialized in bookkeeping for mortgages. If the homeowner was late, the servicer would pester him and if the borrower ultimately defaulted the lender would foreclose.

There was accountability in this framework. If a borrower defaulted, the lending institution’s shareholders suffered. Shareholders could hold bank managers and lending officers accountable for mismanagement and had good incentives to do so. As a result of so-called innovations in mortgage financing and securitization, accountability has been diffused and dramatically reduced. Potential liability for the sale of these products to investors has not lessened, however.

Agency Mortgage Pass-Through Securities

In the 1980s, Fannie Mae and Freddie Mac – private companies sponsored by the Federal government – bought qualified mortgage loans from lenders and used the mortgages as collateral to issue pro-rata interests in pools of mortgages. An investor in these newly issued “agency” mortgage pass-through securities or mortgage backed securities (“MBS”) received a pro-rata share of the periodic interest and principal payments made by borrowers on an underlying pool of mortgages, after the payment of a servicing charge.

Agency pass-through securities made investing in mortgages much more attractive to investors by eliminating credit risk. Investors received timely interest and principal payments whether or not borrowers made their monthly payments in a timely fashion. Fannie Mae and Freddie Mac guaranteed timely payment of principal and interest on their pass-through securities. Ginnie Mae – a Federal government agency – guarantees timely principal and interest payments on privately issued pass-through securities backed by FHA and VA loans. Agency pass-though securities thus expanded the available mortgage funding, lowered mortgage interest rates and increased home ownership.

Prepayment Risk

Despite being free of credit risk, agency pass-through securities had significant interest rate risk. Pass-through securities’ interest risk is similar to the interest risk in ordinary bonds but is amplified by borrowers’ ability to prepay their mortgages. ¹ On average, mortgages are paid off well before their stated maturity. For example, 30-year mortgages are paid off on average after only 16 or 18 years at typical prepayment rates. When interest rates fall, homeowners refinance, paying off their mortgages either: (a) to take advantage of the lower interest rates available compared to when the mortgages were first taken out or (b) to move up since monthly payments on the next size/quality home up is now more affordable. These accelerated prepayments harm investors because the investor must reinvest principal, received earlier than expected, at lower currently available re-investment rates. On the other hand, when interest rates rise, mortgage prepayments come in slower than initially expected. These reduced prepayments harm investors because the investor is not able to reinvest as much principal at the new, higher, current interest rates as had been anticipated before interest rates rose.

The impact of changes in interest rates and resulting changes in prepayment speeds on the value of a mortgage pass-through security can be readily estimated. The cash flows from a pool of mortgages can be forecasted for a given prepayment speed assumption and then discounted at a credit spread above the Treasury yield curve that equates the present value of the cash flows to the market price of the security. Changes in prepayment speed and yield curve assumptions generate alternative discounted cash flow values, allowing the analyst to evaluate the sensitivity of the mortgage pass-through security to interest rates and prepayment speeds.

Collateralized Mortgage Obligations Circa 1994

Pass-through securities were not attractive to some investors because they had more risk – especially prepayment risk – than non-callable coupon bonds. Financial engineers knew that the cash flows coming out of a pool of mortgages didn’t have to be paid out in the strictly pro rata fashion of pass-through securities. As long as every dollar of principal and interest paid on the mortgages after servicing costs – but not a dollar more – was allocated to a security holder, each pool of mortgages, however homogenous, could support a wide variety of complex structured securities. The customized classes of CMOs have been referred to as tranches after the French word for “slice”. Tranches in early CMO deals were typically sequential-pay securities. That is, principal payments would be applied to tranches sequentially with lower priority tranches to receive principal payments only after higher priority tranches’ principal balances are paid off.

Redistributing Risk

Planned amortization classes (“PACs”) were designed to have stable maturities and cash flows over a broad range of prepayment speeds. Principal and interest payments on the underlying mortgages were allocated to meeting the principal amortization schedules and interest obligations of the PACs. Any principal payments in excess of what was required for the PACs would be allocated to the “support” tranches. PACs could therefore be designed to look exactly like a Treasury security with fixed cash flows and no credit risk. Since all classes in a deal collectively had the prepayment risk of the underlying pool of mortgages and the PACs had little or no prepayment risk, the remaining securities bore a concentrated amount of prepayment risk. The more protected the PACs in a CMO deal were from prepayment risk and the bigger these PAC classes were, the more concentrated the prepayment risk borne by the support classes. CMO classes were also created to redistribute interest rate risk. ²

Floating rate CMOs (“floaters”) are CMOs whose coupon rates fluctuate up and down with a specific indicative interest rate – typically LIBOR. Floating rate notes were attractive to buyers because they had virtually no interest rate risk. The coupon rates paid on the underlying mortgages were almost always fixed, so if there was a floating rate class, there invariably had to be a roughly equivalent size class whose coupon rates moved up and down in the opposite direction as interest rates. Since floating rate bonds have no interest rate risk, the offsetting “inverse floaters” had roughly twice the risk of a fixed rate bond. Issuers could issue much larger floating rate classes if they added leverage to the inverse floaters, making their coupons change by a multiple as high as six or eight times the change in the reference interest rate. For example, $20 million in inverse floating notes could offset $100 million in floating rate notes if the inverse floater had a coupon that adjusted five times the change in the reference interest rate. These leveraged inverse floaters had as much as ten times the interest rate risk as an ordinary bond with the same stated maturity and duration and were the source of much of the CMO losses in 1994.

¹ The price of a fixed coupon bond increases when interest rates fall because bondholders continue to receive the fixed coupon rate which is now above market. Unless the bond is callable, a corporate issuer would have to pay investors more than par to redeem bonds and stop paying the above market coupon rate.

² Financial marketers knew that if they could structure securities so that unsophisticated investors would buy the securities with high concentrations of interest rate and prepayment risk, the low risk securities would sell themselves.

Issuers also created classes of securities that only received payments of interest (“IO strips”) or received only payments of principal (“PO strips”) on the underlying mortgages. These IO and PO strips had highly unstable market values and were therefore extremely risky. If interest rates fell after an investor purchased an IO strip, the underlying mortgage loans would pay off more rapidly than expected and the IO strip would stop making payments earlier than had been anticipated. While IO investors lost when interest rates fell, PO investors gained since they would receive their cash flows from principal payments earlier than expected. If interest rates increased, IO investors gained and PO investors lost as the mortgages returned principal to PO investors more slowly and continued to make interest payments longer than expected.

The Law of Conservation of Mass (or Energy) Applies to Structured Securities. Mortgages have interest rate risk, prepayment risk and credit risk because of the behavior of borrowers and the features of the mortgages. A pool of mortgages has the average interest rate risk, prepayment risk and credit risk of the individual mortgages in the pool just as surely as it has their average coupon rate and average maturity. If investors purchase 1/100th interests in a pool of mortgages, the owner of each interest bears the same interest rate risk, prepayment risk and credit risk as the owners of the other interests and collectively they own all the risks of the entire portfolio. This principle is so fundamental to understanding mortgage-backed securities that it warrants being called The Law of Conservation of Structured Securities Risk. When issuers created CMO classes that had less than a pro rata amount of interest rate or prepayment risk, they had to include in the same deals classes with more interest rate risk or prepayment risk than average in the underlying mortgages.

Private Label CMOs

The CMOs discussed so far were all U.S. Government Agency CMOs. That is, they had interest rate and prepayment rate risk from the underlying pool of mortgages but no credit risk. Recent CMO losses have occurred because of the development of “private label” CMOs that have significant credit risk.

Pass-through securities have many of the same features as agency securities but don’t benefit from the agency securities’ expressed or implied US Treasury guarantees. This credit risk has not been adequately disclosed by the metrics used in CMO prospectuses.

CMOs are in the news today largely because of the spectacular failure of the subprime lending industry. Underwriters such as CSFB and subprime lenders such as Oakwood Mortgage Investors significantly expanded the borrowing of poor credit quality borrowers by bundling subprime mortgages into pools, carving the pools up into many smaller securities, obtaining investment grade ratings from Moody’s and S&P, and then selling the securities as low risk. This was followed by a fall in housing prices and mortgage defaults. As a typical eample, I offer the following analysis of one CMO By Dr. Craig McCann and his Securities Litigation & Consulting Group (“SLCG”).

OMI Trust 2001-E B-1

The $171,660,148 OMI Trust 2001-E 13 deal sold by Oakwood Mortgage Investors in November 2001 is a great illustration of the complex structure and targeted abuse in the private label CMO market. These securities were not worth $172 million when issued and the losses suffered by the lowest priority tranches were completely predictable. Figure 4 lists the securities offered to the public in the deal.

Figure 4
OMI 2001-E
Senior/Subordinated Pass-Through Certificates
Oakwood Mortgage Investors, Inc.

The B-1 tranche in this deal and other similar lowly ranked tranches from other deals were sold to elderly investors in southern California as safe substitutes for bank CDs. These investors were falsely told that the CMOs would provide high yields and that their principal was safe. ⁴

The assets in the OMI 2001-E Trust were predominantly subprime mortgages on manufactured homes. Many of the mortgages were on homes that had been previously repossessed; most were on the homes, but not on the land beneath them. Many of the loans were already delinquent or likely to become delinquent. They had an average remaining stated maturity of 26 or 27 years and carried an average mortgage interest rate around 10.5%. The home borrowers whose mortgage notes backed these CMOs were among the worst credit risks in the market place.

³ The A-IO strip had a $57.4 million notional principal amount which is not included in the total at the bottom of the column. The notional principal is the amount against which the inerest rate is applied to yield the interest payment due on the IO strip.

⁴ “Mortgage Bets Trip Up Main Street Investors – And a Group of Nuns” The Wall Street Journal, July 14, 2007.

The prospectus describes the collateral as:

• manufactured housing installment sales contracts secured by interests in
• manufactured homes and, in some cases, by liens on the real estate on which the manufactured homes are located,
• mortgage loans secured by first liens on the real estate on which manufactured homes are permanently affixed, and
• cash in the pre-funding account. ⁵

And among the risk factors listed in the prospectus were:

• You May Experience A Loss On Your Investment If Losses And
• Delinquencies On Assets In The Trust Are High

Manufactured housing usually depreciates in value. Over time, the market values of the manufactured homes could be less than the amount of the loans they secure. This may cause delinquencies and may increase the amount of loss following default. In this event, your trust may not be able to recover the full amount owed, which may result in a loss on your certificates. …

• Losses Will Affect Subordinated Certificates Before Affecting More Senior Certificates

The class M-1, M-2 and class B-1 certificates are subordinated to the class A certificates. Losses in excess of the credit support provided by the class B-2, class X, and class R certificates will be experienced first by the class B-1 certificates, second by the class M-2 certificates, and next by the class M-1 certificates. … ⁶

As discussed above, the average credit quality of the securities backed by a pool of mortgages will have the same or lower than the average credit quality of the underlying mortgages unless the issuer has purchased meaningful credit insurance or has over-collateralized the securities. There was no credit insurance or over-collateralization in OMI 2001-E, despite the prospectus’s claimed over-collateralization. The trust’s assets totaled $172,159,171 or about 8% more than the eight securities’ $159,215,000 principal listed in Figure 4. These eight securities were sold to the public at or shortly after the offering for $171,660,148. In addition to these eight securities, the collateral supported payments to the B-2, R and X classes not offered to the public and the servicer, Oakwood Acceptance, expected to take approximately 5% of the present value of any cash flows as a result of its 1% annual servicing charge. Thus there was no overcollateralization in this deal.

Without credit insurance or over-collateralization, the average credit quality of the tranches had to equal the subprime borrowers’ credit quality. Yet, 76% of the tranches by market value were rated Aaa/AAA, 10% were rated Aa3/AA, 8% A3/A and the remaining 6% were rated Baa3/BBB by Moody’s and S&P. Thus, Oakwood took $172 million worth of subprime paper backed by installment sales contracts on mobile homes, subtracted value and sold $172 million of “investment grade” securities.

The B-1 tranche was the riskiest of the securities offered to the public in this deal. The classes received principal sequentially with each class receiving principal payments only after all the higher ranked classes were paid off. The B-1 class would therefore not receive any principal payments until A-1, A-2, A-3, A-4, M-1, and M-2 were completely paid off. In addition to concentrating the interest rate risk on the B-1 class, this sequencing meant that B-1 provided credit support for all the higher ranked classes. Thus, the B-1 securities had much more credit risk than the subprime mortgages, which already had a high probability of default.

Not All Investors Are Equal

Not all investors who are sold CMO tranches – even in a deal like OMI 2001-E – are being taken advantage of. In fact, these deals were structured so that sophisticated investors received significantly higher risk-adjusted expected returns than they could find elsewhere. Unfortunately, these higher risk-adjusted returns to sophisticated investors were a wealth transfer from unsophisticated investors who bought the lower tranches like the B-1 tranche in our example.

Figure 5 lists the average yields to maturity on corporate bonds of different credit qualities and maturities when OMI 2001-E was issued on November 30, 2001. At 100% MHP ⁷, investors who bought the A-2 tranche would have their principal substantially paid off after four or five years. They received a 5.05% coupon, roughly 50 basis points more than they would have received on a four year or five year AAA corporate bond. Investors who bought the A-3 tranche likewise got approximately 50 basis points more than a AAA corporate bond with comparable cash flow timing.

Figure 5
Corporate Bond Yields
November 30, 2001

Investors who bought the top-tier tranches received higher returns than they could earn on AAA corporate bonds and were shielded from the interest rate risk, prepayment risk and credit risk by investors who bought the B-1 tranches. The B-1 tranche was not expected to be substantially paid off until after about ten years. B-rated, ten-year corporate bonds were paying 11% on November 30, 2001. B-1 tranche investors on the other hand were exposed to far greater risks than investors in B-rated corporate bonds and were given a coupon of 7.5%. OMI 2001-E and many other CMO deals transferred wealth from unsophisticated investors to investment banks, mortgage lenders, ratings agencies and sophisticated investors.

Conclusion

Current CMO losses have been attributed almost exclusively to the credit losses in subprime mortgages as a result of the simultaneous increase in interest rates and slowing of home price appreciation. This attribution is too superficial and too convenient.

CMO losses in 1994 illustrated how CMOs with substantial interest rate risk can be misrepresented to have little interest rate risk and sold to unsophisticated investors. The ability of investment banks and mortgage lenders with the help of ratings agencies to sell high risk securities to unsophisticated investors allowed them to put together deals that were attractive to sophisticated investors. OMI 2001-E and many other CMO deals transferred wealth from unsophisticated investors to sophisticated investors, investment banks, mortgage lenders and ratings agencies.

⁵ Page S-2.

⁶ Page S-5.

⁷ MHP is the base prepayment speed assumption for manufactured housing. It equals 3.7% per annum of the outstanding principal in the first month, increasing 0.1% per month for 24 months and then constant at 6.0% per annum until the mortgages are paid off. Base MHP therefore assumes more rapid pay down of principal than base PSA.

WHAT WAS THE ROLE OF THE RATING AGENCIES;
WHY DID THEY MISS THE MARK? ⁸

No analysis of the subprime debacle can be complete without addressing the culpability of the ratings agencies that routinely gave “investment grade” ratings to securities that were backed primarily by rights in pools of subprime mortgages. Some of these securities have since been significantly downgraded by these same ratings agencies while many other such securities are likely facing such downgrades. How can securities that were granted “investment grade” ratings suddenly become rated as below investment grade or even junk? How can groups of below prime, exotic, junk mortgages that were originated in an overvalued housing market be pooled together and carved up into different securities most of which are given “investment grade” ratings? These questions and others like them demand an answer.

There is little doubt that most investors purchasing MBS/ABS/CDO securities placed significant emphasis on the ratings issued by the ratings agencies. In many cases, investors were required by law, by their operative documents or by reasonable prudence to limit most, if not all, of their investments to “investment grade” securities. Even more fundamentally, the prices that investors paid for these securities and the benefits that they were willing to accept from their investments was dictated by the purported quality of the securities they were buying. (It is well accepted that highly rated debt instruments pay lower interest rates than speculative securities and sell for higher prices.)

Furthermore, it is apparent that the ratings agencies understood the importance of their ratings to investors and encouraged investors to rely on these ratings. This is perhaps, best evidenced by a DerivativeFitch advertisement in which it purports to be “Quantifying All Sides of Risk.” In its advertisement Fitch states:

“At DerivativeFitch we are committed to analyzing risk from all angles. Our mission is to develop and deliver ratings, productive and timely analysis of the distinct characteristics of CDOs and the credit derivatives market globally. Through our deep understanding of the market and our unmatched commitment to service, we provide the focus, analysis and insight to help you identify and measure risk in a multi-dimensional market place.”

Other ratings agencies held themselves out in a similar manner.

Again, it must be asked — how and why did the ratings agencies miss the mark so badly? What caused this to happen?

Among other things, the facts indicate the following:

1. the ratings agencies were actively participating with and advising the Wall Street underwriting firms in the structuring and construction of the MBS/ABS/CDO securities
2. the ratings agencies generated a significant portion of their revenues from consulting on and rating these MBS/ABS/CDO securities.
3. the ratings agencies routinely charged two to three times more in fees to rate MBS/ABS/CDO securities.⁹
4. the ratings agencies failed to reasonably investigate, analyze and consider various well known risks that impacted the mortgage securities market including:
   • the low credit quality of the loans.
   • the impact of exotic mortgage loans such as option mortgage loans, negative amortization mortgage loans, “piggyback” mortgage loans, and “teaser” adjustable rate mortgage loans.
   • the impact of new and untested mortgage origination techniques, including no-doc loans.
   • the existence and implication of a housing bubble in the US real estate market.
   • the law of conservation of structured securities risk.

WHAT NOW

For Previously Sold CDO/MBO/MBS, There Are More Shoes to Drop

Exception Loan Securities

Prosecutors in New York and Connecticut, along with the SEC, are examining evidence that Wall Street investment banks actively withheld material information about the risks inherent in investments tied to high-risk “exception” and other subprime loans. Among the riskiest of subprime loans, exception loans are those that failed to meet even the questionable credit standards of subprime mortgage lenders and Wall Street firms. More than any other, you’d expect these investments to come under due diligence.

Yet according to some outside due diligence consultants hired to examine the loans being considered for purchase, pooling and resale, what the investment banks called “due diligence” was a sham. The banks routinely ignored the red flags the experts raised, and even told the consultants to drastically scale back the number of loans they examined. “We stopped checking,” said one loan examiner. “Common sense was sacrificed on the altar of materialism.”

The credit rating firms who were next in line say that underwriters generally did not provide due diligence reports, even when they were requested. But the ratings firms waved along the exception loans anyway, often bestowing them with investment grade ratings.

According to officials, these exception loans took up 25% to 50% of some portfolios and in other cases as much as 80%. Yet in the prospectuses for these subprime portfolios, the investment banks gave only standard, “boilerplate” disclosures. These kinds of disclosures are really just “overbroad, useless reminders of risks,” said Connecticut’s attorney general, Richard Blumenthal indicating that they may not be enough to shield the banks from legal liability. “…[A] company that knows in effect that the disclosure is deceptive or misleading can’t be shielded from accountability under many circumstances,” Blumenthal said.

On January 12, 2008, Vikas Bajaj and Jenny Anderson reported in the New York Times that New York attorney general Andrew M. Cuomo had opened an investigation last summer into how the investment banks bundled billions of dollars of exception loans and other subprime debt into complex mortgage investments. Mr. Cuomo has subpoenaed Merrill Lynch, Bear Stearns and Deutsche Bank AG, seeking information about their conduct in the creation of subprime mortgage investment instruments. The State of New York gives Mr. Cuomo broad powers to bring criminal as well as civil charges, while in Connecticut the attorney general can only bring civil charges.

⁸ Rating agencies, Moody’s in particular, may yet be the big loser in the current CMO crisis. “Moody’s Faces the Storm” The Wall Street Journal, July 10, 2007.

⁹ 44% of Moody’s 2006 revenues came from providing credit ratings to CMOs and CDOs – significantly more revenue than it received from rating the credit of companies. “The Ratings Charade” Bloomberg Markets July 2007.

Variable Interest Entities

A new thorn is in the side of an already beleaguered Wall Street: Variable Interest Entities, or VIEs.

VIEs – like another obscure financial structure, the SIV (Structured Investment Vehicle) – allow banks to move certain risky assets, such as subprime-mortgage securities, off their balance sheets. VIEs finance themselves by selling short-term debt backed by securities, some of which are insured against default.

As Mark Pittman of Bloomberg.com reported on February 26, 2008, VIEs may add another $88 billion in losses for Wall Street, which already has been hit hard by the subprime meltdown in the housing market. Not surprisingly, Citigroup and Merrill Lynch have sizable exposure in VIEs.

Interestingly, two firms that have largely avoided the subprime debacle, Goldman Sachs and Lehman Brothers, may now be affected. Goldman recently said that it could incur losses of up to $11.1 billion from its VIEs. Lehman Brothers, having already marked down the net value of subprime mortgages by $1.5 billion, has guaranteed $6.1 billion of investors’ money in VIEs and $1.4 billion of clients’ secured financing.

Right now all eyes are on the bond insurer firms, Ambac and MBIA. If these firms continue to see their ratings downgraded by Standard & Poor’s, Moody’s, or Fitch, then the assets in the VIEs are certain to be downgraded. This will then cause the financial firms to have to put back onto their balance sheets the assets making up the VIEs.

Therein lies the real problem. As David Hendler, an analyst at the bond research firm of CreditSights, warns, “The securities in the VIEs may be worth as little as 27 cents on the dollar.”

The Future of Litigation/Arbitration

In evaluating potential liability to investors by Wall Street Underwriters and/or Rating Agencies, most good claimants lawyers are focusing on: (a) the adequacy of the disclosures that were provided to investors; (b) the adequacy of the ratings, by the Rating Agencies, on the investment created by subprime, exotic and high risk loans; (c) the valuations and appraisals, and systems therefor, of the underlying mortgages by the investment banks and/or the rating agencies during the “due diligence” and structuring phases of the investment; (d) the conflicted position of the Rating Agencies and the evaluation models that were utilized for both the initial formulation of their ratings and the subsequent monitoring of the same; (e) the business practices and procedures implemented by the Wall Street Underwriters, and reviewed by the Rating Agencies, in creating the pipeline for the subprime and high risk collateral utilized in creating Structured investment vehicles.

As an example, Mortgage Servicing News reported in its March 2009 edition as follows.

Merrill Pays $450 Million in OH Settlement

Washington-Merrill Lynch & Co. – now the property of Bank of America – has agreed to pay $450 million to settle a subprime collateralized debt obligation lawsuit brought by lead plaintiff, the Ohio State Teachers Retirement System.

According to the complaint, Merrill Lynch artificially inflated the value of CDOs and other assets backed by subprime mortgages by issuing false and misleading statements about the bonds.

In a public filing, Merrill says it settled the case but did not admit any wrongdoing.

During the height of the subprime crisis, Merrill financed several non-bank subprime funders, bought their loans and packaged them into ABS and CDO investments, selling them worldwide.

Merrill also settled a similar, $75 million case brought against it by employees.

In a new SEC filing, the Wall Street firm says that even though a settlement has been reached there is no assurance that a “final” deal will be concluded and gain court approval.

Our analysis of this from a Plantiff’s lawyer perspective is that this development confirms that even larger, more sophisticated investors can recoup damages when they are misled into purchasing complex investments such as CDOs that are virtually incomprehensible for normal people.

The Future of Auction Rate Securities

SEC Release

Washington, D.C., Dec. 11, 2008 — The Securities and Exchange Commission today finalized settlements with Citigroup Global Markets, Inc. (Citi) and UBS Securities LLC and UBS Financial Services, Inc. (UBS) that will provide nearly $30 billion to tens of thousands of customers who invested in auction rate securities before the market for those securities froze in February.

The settlements resolve the SEC’s charges that both firms misled investors regarding the liquidity risks associated with auction rate securities (ARS) that they underwrote, marketed and sold. Previously, on August 7 and 8, 2008, the SEC’s Division of Enforcement announced preliminary settlements with Citi and UBS, respectively.

According to the SEC’s complaints, filed in federal court in New York City, Citi and UBS misrepresented to customers that ARS were safe, highly liquid investments that were comparable to money markets. According to the complaints, in late 2007 and early 2008, the firms knew that the ARS market was deteriorating, causing the firms to have to purchase additional inventory to prevent failed auctions. At the same time, however, the firms knew that their ability to support auctions by purchasing more ARS had been reduced, as the credit crisis stressed the firms’ balance sheets. The complaints allege that Citi and UBS failed to make their customers aware of these risks. In mid-February 2008, according to the complaints, Citi and UBS decided to stop supporting the ARS market, leaving tens of thousands of Citi and UBS customers holding tens of billions of dollars in illiquid ARS.

“Today’s settlements are the largest in SEC history, and represent the largest return of customer money in the agency’s 75 years,” said SEC Chairman Christopher Cox. “The Commission’s prompt action after the auction rate securities market froze in February of this year, which led to last summer’s settlements in principle, helped restore liquidity to tens of thousands of investors. Every one of the investors covered by these settlements will be able to receive 100 cents on the dollar on their ARS investments.”

Linda Chatman Thomsen, Director of the SEC’s Division of Enforcement, said, “The SEC will continue to aggressively investigate whether other broker-dealers and individuals have failed to disclose to investors material risks about ARS that they marketed and sold. We also look forward to finalizing the four other settlements-in-principle that the Division has entered into with Bank of America, RBC Capital Markets, Merrill Lynch and Wachovia.”

The settlements, which are subject to court approval, will restore approximately $7 billion in liquidity to Citi customers who invested in ARS, and $22.7 billion to UBS customers who invested in ARS.

Without admitting or denying the SEC’s allegations, Citi and UBS agreed to be permanently enjoined from violations of the broker-dealer fraud provisions and to comply with a number of undertakings, some of which are set forth below. Investors should review the full text of the consents executed by Citi and UBS.

The Citi settlement provides, among other things, that:

Citi will offer to purchase ARS at par from individuals, charities, and small businesses that purchased those ARS from Citi, even if those customers moved their accounts.

Citi will use its best efforts to provide liquidity solutions for institutional and other customers, including, but not limited to, facilitating issuer redemptions, restructurings, and other reasonable means, and will not take advantage of liquidity solutions for its own inventory before making those solutions available to these customers.

Citi will pay eligible customers who sold their ARS below par the difference between par and the sale price of the ARS.

Citi will reimburse eligible customers for any excess interest costs associated with loans taken out from Citi due to ARS illiquidity.

The UBS settlement provides, among other things, that:

UBS will offer to purchase at par from all current or former UBS customers who held their ARS at UBS as of Feb. 13, 2008, or purchased their ARS at UBS between Oct. 1, 2007 and Feb. 12, 2008, even if they moved their accounts. Different categories of customers will receive offers from UBS at different times.

UBS will not liquidate its own inventory of a particular ARS without making that liquidity opportunity available, as soon as practicable, to customers.

UBS will pay eligible customers who sold their ARS below par the difference between par and the sale price of the ARS.

UBS will reimburse customers for any excess interest costs incurred by using UBS’s ARS loan programs.

The Commission wishes to alert investors that, in most instances, they will receive correspondence from Citi and UBS, and that they must advise the respective firm that they elect to participate in these settlements, or they could lose their rights to sell their ARS. Further, if eligible customers incurred consequential damages because of the illiquidity of their ARS, they may participate in special FINRA arbitrations.

Both Citi and UBS will also be permanently enjoined from violating the provisions of Section 15(c) of the Exchange Act of 1934, which prohibit the use of manipulative or deceptive devices by broker-dealers. Both firms also face the prospect of financial penalties to the Commission. After the buy back periods are substantially complete, the Commission may consider imposing a financial penalty against Citi and/or UBS based on the traditional factors the Commission considers for penalties and based on whether the individual firm has fulfilled its obligations under its settlement agreement.

The SEC notes the substantial assistance and cooperation from the New York Attorney General, the Financial Industry Regulatory Authority (FINRA), the Texas State Securities Board, and the North American Securities Administrators Association (NASAA).

The Commission’s investigation of the auction rate securities market is continuing.

Other ARS Settlements in Principle

Bank of America Agrees in Principle to ARS Settlement (Oct. 8, 2008)

SEC Division of Enforcement Announces ARS Settlement in Principle With RBC Capital Markets Corp. (Oct. 8, 2008)

SEC Enforcement Division Announces Preliminary Settlement With Merrill Lynch to Help Auction Rate Securities Investors (Aug. 22, 2008)

Wachovia Agrees to Preliminary Auction Rate Securities Settlement That Would Offer Approximately $9 Billion to Investors (Aug. 15, 2008)

As a follow-up to the SEC Settlements and Proposed Settlements, FINRA has adopted special arbitration procedures for cases involving auction rate securities.

Special Arbitration Procedure (SAP) for Investors of Firms that Entered into an Auction Rate Securities (ARS) Settlement with FINRA

Adjudication of Auction Rate Securities-Related Consequential Damage Claims

Arbitrations under the SAP will be administered in accordance with the FINRA Code of Arbitration Procedure for Customer Disputes (Code), except that:

1. 1. Claim Filing: Rule 12302 is revised to provide that the FINRA Claim Form must be completed and constitutes the Initial Statement of Claim and Submission Agreement for purposes of the Code of Arbitration Procedure. Investors who elect to proceed under the SAP may not also file a regular arbitration for claims related to Eligible ARS.
   • Only a Firm that has entered into an ARS settlement with FINRA may be named as a respondent in the SAP (hereinafter referred to as “Firm”);
   • Investors with Eligible ARS-related claims have a choice to proceed with a regular arbitration at FINRA under the Code OR to participate in the SAP, which will then be the Investors’ exclusive remedy for resolving claims against the Firm related to Eligible ARS;
   • The SAP is for the recovery of consequential damages only and no other claim related to ARS securities may be brought and/or continued in any forum against the Firm by any Investors who elect to submit a claim in the SAP;
   • Any Investors who choose to pursue such claims shall bear the burden of proving that they suffered consequential damages and that such damages were caused by Investors’ inability to access funds consisting of Investors’ ARS purchases through Firm;
   • Investors proceeding under the SAP may not recover as consequential damages any attorneys’ fees incurred in connection with this ARS SAP arbitration or any related mediation proceeding;
   • Claims relating to securities other than the Eligible ARS may not be asserted in the SAP;
   • Investors who previously arbitrated or previously settled and released claims relating to their Eligible ARS securities are not eligible to participate in the SAP;
   • Investors who participated in the ARS settlement and who choose to participate in the SAP must file the attached SAP Claim Form to initiate an SAP case. The Claim Form is also available on FINRA’s web site; and
   • Any claim filed requesting the SAP that does not include a Claim Form will be considered deficient under the Code; a Claim Form must be submitted before the claim moves forward under the SAP procedures.

THE OUTLOOK FOR FUTURE SALES
OF STRUCTURED SECURITIES.

This is a topic for which other presenters on this program who are in the business of advising investment bankers are better qualified than I to prognosticate. From the perspective of this claimant’s lawyer, however, trust is a lot like a vase. Once it is broken, you can glue it back together, but it will never again be the same. I propose that the only way this market will be restored in the foreseeable future is to greatly simplify the products so they can be understood and greatly improve the disclosure so risk can be accurately assessed.

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