when a deal goes bad, blame the ratings - nytimes

8/13/2019 When a Deal Goes Bad, Blame the Ratings - NYTimes

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November 14, 2013

When a Deal Goes Bad, Blame the

RatingsBy FLOYD NORRISDid you make an incredibly bad decision during the great credit bubble?

Dont worry. Join the crowd denying responsibility. Explain that nobody should have expected

you to do any homework before investing.

Until now, my favorite denial of responsibility had come from MBIA, the bond insurance

company. It had insured some very risky mortgage-backed securities without doing much to

inspect what it was insuring.

It would be enormously expensive, even if it were logistically feasible, for a credit insurer to

investigate the health of these ground-level loans, MBIA argued in a suit against Merrill

Lynch, contending that Merrill Lynch lied about the quality of loans backing the securities that

MBIA insured.

MBIA explained that if it did such research, it would have to charge much higher premiums.

MBIA said its premiums were as low as $77,500 for each $100 million of insurance.

My new favorite denial came this week, when the trustee for two Bear Stearnshedge funds that

went broke in 2007 said it was absolutely not the managers fault.

Theybought some of the more dubious securities around securities whose payment

depended on securities that in turn depended on securities that depended on subprime

mortgages while knowing little about what they were buying.

Those securities paid a low return, but the managers got around that by borrowing as much as

10 times the actual capital invested in the initial fund. Their second fund the enhanced

leverage fund promised even better returns by borrowing more money. It was started in

August 2006, with timing that could not have been much worse, and was destroyed within a

year.

The way the funds trustees see it, all of the blame should go to the ratings agencies Standard

& Poors, Moodys and Fitch. They gave ratings of AAA and AA to securities that turned out to

be junk, and the managers rightly relied on those ratings. Market participants, such as the

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funds, did not and could not know the loan level detail of the mortgages underlying the

structured finance products at issue, the suitstates.

Could not? MBIA could claim it could not afford to do due diligence, given the low premiums it

took in, but hedge fund management fees are anything but low. Could the fund managers not do

the research?

I have gone over several of the investments cited in the suit and can confirm that there is little

public information available. Presumably money managers could have gained more information

about deals they purchased. But even then, it would have been difficult.

Before going further into that, what follows is a short primer on the private-label R.M.B.S.

(residential mortgage-backed securities) market and the related C.D.O. (collateralized debt

obligation) market.

The R.M.B.S. market is relatively straightforward. A bunch of mortgages are put together into asecuritization, with several tranches of securities. The senior tranches of securities pay

relatively low interest rates but are first in line to collect mortgage payments. Lower tranches

get higher rates but will become worthless sooner if enough homeowners default.

What made this market possible was the conclusion eagerly endorsed by the rating agencies

that tranches secured by risky assets, like subprime mortgages, could nonetheless receive

AAA ratings, signifying virtually no risk. That was because there were extra mortgages in the

pool and because more junior tranches would lose money first.

It was not that difficult to obtain some decent information about the mortgages in any

particular R.M.B.S. deal, although it later turned out that those making the loans had often

failed to live up to their promises about the creditworthiness of borrowers. But that information

generally became available only weeks after the deal was sold to investors. The rating agencies

rated, and the funds bought, based on what the sponsors said would be included. By the time

the real information was available, fund managers presumably had moved on to other

investments.

C.D.O.s took that one step further. What backed a C.D.O. was not mortgages; it was tranches

from previous mortgage securitizations. The rating agencies concluded you could take a bunch

of R.M.B.S. tranches with relatively low ratings, like A, put them together, and create more

AAA-rated paper.

Some of what the Bear Stearns funds bought was what we will call normal C.D.O.s. I managed

to obtain offering documents for some of those cited in the lawsuit but learned little about the
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actual investments. The offering documents described the tranches they would acquire in

broad, general terms but gave no specifics. Presumably those specifics later became available,

but researching them would have taken a great amount of effort.

But some of what those funds bought added another layer of complexity. They were called

C.D.O.s squared. The sponsor put together tranches of C.D.O.s and sold new securities backed

by them. Sometimes the C.D.O.s were not actually owned. They were synthetic, meaningthat someone promises to pay whatever the actual C.D.O. pays. The rating agencies obligingly

came up with models that concluded C.D.O.-squared tranches could be rated AAA.

Now we are into real complexity, and there is little doubt that the managers of the Bear Stearns

funds had no chance of really knowing what they owned. Warren Buffett has been quotedas

saying such an analysis was beyond him: If you take one of the lower tranches of the C.D.O.

and take 50 of those and create a C.D.O. squared, youre now up to 750,000 pages to read to

understand one security. I mean, it cant be done.

One of the C.D.O.s squared cited in the Bear Stearns suit, called Timberwolf, was sponsored by

Goldman Sachs and was later investigated by the Senate Permanent Subcommittee on

Investigations, which found emails indicating Goldman officials had trouble finding buyers and

thought the deal was a bad one.

The Timberwolf offering memorandum, released by the subcommittee, lists the 58 C.D.O.

tranches that backed it. Some of those C.D.O.s seem to have themselves contained other

C.D.O.s, but I could not identify those deals. So perhaps this was a C.D.O. cubed.

One thing that stands out is that the C.D.O.s backing Timberwolf were relatively low-ranked

tranches of deals that themselves seem to have been backed by risky assets. And yet the

security that Bear Stearns bought received AAA ratings from Moodys and S.&P. It paid buyers

a tiny interest rate of one-half percent over Libor, the London interbank offered rate. It was

sold to Bear Stearns on March 13, 2007.

Note that date. Due to their unique knowledge and capabilities, the Bear Stearns suit argues,

the rating agencies knew, and were solely able to know that the securities were far riskier

than the ratings indicated.

In hindsight, that rating does seem especially egregious. The Timberwolf security the fund

bought was worthless by late 2008. But you did not need unique knowledge in March 2007 to

know that the subprime market was in trouble. On the very day Bear Stearns bought the

security, stock prices tumbledafter it was reported that mortgage foreclosureshad risen to a

record high.
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Im fearful of these markets, Ralph R. Cioffi, one of the managers of the Bear Stearns funds,

wrote in an email two days later. It may not be a meltdown for the general economy, but in our

world it will be.

Later in the month, he pulled $2 million of his own money out of the fund.

Mr. Cioffi and Matthew M. Tannin, the other manager, settled a suit filed by the Securities and

Exchange Commission, which contended they had deceived investors, by paying a little more

than $1 million between them and agreeing to be barred temporarily from working in the

securities industry. But they were acquitted of related criminal charges after the jury concluded

that a seemingly incriminating email statement had been taken out of context.

The new suit is filled with email quotations from people at the rating agencies that the funds

trustees say indicate the agencies issued ratings they knew, or at least suspected, were too high

If that can be proved and the Justice Department has made a similar allegation in a civil suit

against S.&P. then the traditional defense of the rating agencies could be in trouble. That

defense is that their ratings are opinions, and in that way protected by the First Amendment

even if they turn out to be wrong.

Maybe the suit will work. MBIA ended up collecting a lot of money from banks that were

accused of deceiving the insurer. But even if the rating agencies are found to have acted

wrongly, that in no way should absolve money managers from blame for investing billions of

dollars in securities they knew little about.

At a minimum, funds that bought this trash should volunteer to return their management fees

to the investors they served so badly.

Floyd Norris comments on finance and the economy at nytimes.com/economix.
http://www.sec.gov/litigation/litreleases/2012/lr22398.htm

when a deal goes bad, blame the ratings - nytimes

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