After Sure-Bet Investment Fails, a Bank Contends It Was Duped

Nearly two years ago, on a Tuesday in February 2007, a Wall Street salesman pitched an investment that sounded almost magical. It was called Gemstone VII. A shiny amalgam of financial instruments, it promised attractive returns — with virtually no risk.

If that sounds too good to be true, that is because it was. Like so many investments that Wall Street concocted in recent years, Gemstone was fashioned from subprime dross. The M&T Bank Corporation, which got the sales talk and subsequently bought into the investment, lost $80 million.

M & T Bank logo

At issue now is who should bear responsibility for those losses. Should it be Gemstone’s creator, Deutsche Bank , which had sold mortgage investments to customers like M&T Bank while encouraging others to bet against them? Or should it be M&T, which had invested in Gemstone, an instrument known as a collateralized debt obligation, and taken the risks? The two banks are arguing over these questions in a lawsuit in upstate New York.

M&T Bank says it was duped. Deutsche Bank representatives portrayed Gemstone as safe — “fully rock solid,” and “a layup,” M&T contends in its complaint. The German bank counters that M&T executives entered into the investment as consenting adults, and that they knew, or should have known, the risks they were taking.

Gemstone may seem like footnote to the financial crisis, but in many ways it encapsulates the story of homeowners, bankers, businesses and an entire economy undone by the lure of easy money. Gemstone also lays bare many of the conflicts inherent in the financial engineering that spread the risks in the American housing market to every corner of the world.

Opaque markets in instruments like Gemstone were allowed to balloon with little oversight from regulators. Gemstone, for instance, was not required to be registered with the Securities and Exchange Commission. That is because Gemstone, like many C.D.O.’s, was set up offshore, in this case in the Cayman Islands. It was listed on the Irish Stock Exchange, although it was neither regulated nor traded in Ireland.

The consequences of the binge years — a collapse in the stock and housing markets; a multitrillion-dollar government rescue of the financial industry; and a recession or worse — has deeply shaken the confidence of professional investors and ordinary Americans. Analysts say investors’ trust is unlikely to return fully until Washington and Wall Street address fundamental failings in the financial system that put it in jeopardy.

Gemstone, and trillions of dollars of investments like it, have not gone away. Loans that cannot be paid, bad mortgage investments and other worrisome financial instruments are clogging up companies and, increasingly, courts. More than 100 securities cases involving losses of $400 billion were filed against financial firms last year, according to Cornerstone Research. The legal wrangling has only just begun.

Among the most toxic investments that Wall Street devised as housing boomed were C.D.O.’s, which bundled together all kinds of debt, including subprime mortgages. But Gemstone was a popular variant: a hybrid C.D.O., composed not only of mortgage bonds but also of credit-default swaps, which have played a critical role in the running crisis.

The swaps enabled some investors to multiply their mortgage bets, while letting others wager that the housing bubble would pop. Worldwide, there are about $55 trillion of these contracts, which enable people to make side bets on whether borrowers will default on their debts. The market is so big that problems with even a fraction of these instruments could further destabilize the financial markets.

How did so many investments like Gemstone go so wrong? Janet Tavakoli, a leading expert on so-called structured investments like Gemstone, says there is plenty of blame to go around. Some financiers who created these investments obscured their risks, she says. And some investors, lured by promises of risk-free riches, became “willing victims,” she says.

“It was so outrageous the way these deals were being put together,” said Ms. Tavakoli, a consultant and author of several books on derivatives and structured finance. The securities, she said, were “so overrated, and the prices weren’t worth it.”

The dangers were clear even to some inside Deutsche Bank. Several months before the bank sold Gemstone to M&T Bank, Greg Lippmann, who headed trading in C.D.O.’s and asset-backed securities at the bank, was encouraging hedge funds to bet against mortgage investments.

In the summer of 2006, Mr. Lippmann began giving presentations to select clients and traders at rival banks about the fragile state of the housing market, according to people who attended the meetings. He handed out T-shirts to some clients with a logo that proclaimed his bearish view: “I’m Short Your House.” His presentations contrasted with the more bullish opinions expressed by other Deutsche Bank officials.

“He would bluntly share his opinion, and he would tell people that were buying that they were idiots,” said a hedge fund manager who was familiar with Mr. Lippmann’s presentations and who asked that he not be named in order to preserve professional relationships.

Deutsche Bank declined to make Mr. Lippmann or other executives available for comment.

But filings in the lawsuit paint a vivid picture of the case, and of how both the buyers and sellers of investments like Gemstone often overreached, with disastrous results.

“You can’t turn manure into filet mignon."

The story begins in early 2007, at One M&T Plaza, the Buffalo headquarters of M&T Bank, a regional lender with more than $65 billion in assets.

At that time, M&T’s executives had much to crow about. M&T had largely avoided subprime mortgages and other risky loans, and its reputation was bolstered by the fact that its second biggest shareholder was Warren E. Buffett, one of the most successful investors of all time.

But because loan rates were relatively low at that time, M&T began hunting for more profitable assets. It turned to a longtime adviser, Deutsche Bank, which had expanded into the American market with its acquisition of Bankers Trust in 1999.

Representatives of the two banks began discussing possible investments. Sean Whalen, the Deutsche Bank salesman who called M&T Bank that February day in 2007, urged M&T to opt for Gemstone. M&T officials traveled to the Park Avenue offices of HBK Investments, a firm that would manage Gemstone, for a sales presentation.

Within two weeks, M&T invested $82 million in Gemstone VII, the last in a series of seven deals totaling more than $4.3 billion. For the final Gemstone, Deutsche Bank shared $10 million in fees with ratings firms, lawyers and others involved in the transaction.

The $1.1 billion Gemstone VII was typical of the C.D.O.’s that were being offered at that time. It consisted of $500 million of bonds, mostly backed by home loans, and $600 million of credit-default swaps. Deutsche Bank used the swaps to insure bonds on behalf of hedge funds and other clients, paying Gemstone VII premiums that would be passed on to investors like M&T.

But thousands of the loans that backed Gemstone turned out to be deeply troubled. For instance, 3,949 home loans backing one of the mortgage bonds in Gemstone had been made by New Century Financial , which that February disclosed that it had discovered problems in its accounting for delinquent loans.

Many of those mortgages were made without fully verifying the borrowers’ income and assets, and they were made to homeowners in California and Florida, where inflated home prices were already falling. By January 2007, nearly 14 percent of the New Century loans were delinquent or in foreclosure, up from 11 percent in December.

Gemstone insured $30 million of the bonds backed by this pool. In other words, if the bonds lost value — which they subsequently did as more homeowners defaulted — someone stood to make a profit. The bonds were wiped out in 2008. Under the terms of the deal, Gemstone owed Deutsche Bank $30 million. Many other bonds insured through Gemstone also deteriorated rapidly.

Wall Street officials say investment banks served as intermediaries in such swap trades for other clients like hedge funds, but deal documents do not list those players.

Some investors say the collapse of deals like Gemstone is a wakeup call for money managers. “It’s finally dawning on market players and investors that Wall Street’s interest and those of investors have never been aligned,” said Thomas C. Priore, chief executive of ICP Capital, an investment firm that specializes in credit markets. “Investors are beginning to say to themselves: ‘Hey, there is someone who will benefit if this doesn’t go well.’ ”

Others on Wall Street say that investment banks’ potential conflicts should have been apparent. “As an institutional investor, your first duty is to do your own work,” said Ron D’Vari, who is chief executive of NewOak Capital and previously managed the C.D.O. business at BlackRock. “You have to do your own due diligence.”

In its complaint, M&T claims that Deutsche Bank and HBK never disclosed fully what Gemstone was made of or that subprime mortgages were souring fast. The bank “was told that it was receiving high-quality collateral that was triple-A rated and that had been screened for safety, when in fact it received impaired loan collateral,” said Robert J. Lane, a lawyer overseeing the case for M&T.

But Deutsche Bank has asserted that it gave M&T all the information it needed to evaluate Gemstone, including a 390-page offering document with detailed descriptions of the kinds of bonds that would go into Gemstone.

Furthermore, Mr. Whalen e-mailed a list of bonds that would be part of Gemstone to M&T two months before the deal closed. A copy of the message was provided to The New York Times by Deutsche Bank, which declined to comment further. (M&T countered that the list it received was preliminary and carried the disclaimer that the bonds it listed “may or may not be included.”)In its filings, HBK, which declined to comment, added that it could not have deceived M&T because it has lost millions as an investor in Gemstone, too.

The justice hearing the case, John M. Curran of State Supreme Court in Buffalo, is expected to rule soon on a motion to dismiss the case.

While M&T’s losses on Gemstone and similar securities were relatively small, amounting to less than 2 percent of the bank’s investment portfolio, M&T’s chief executive, Robert G. Wilmers, wrote about them at length in his bank’s 2007 annual report.

He lamented the decision to trust others, and said that the fact that some C.D.O.’s paid just 0.25 of a point more than traditional mortgage securities “makes one rue the choice all the more.”

Deutsche Bank, however, emerged relatively unscathed from Wall Street’s misadventures in C.D.O.’s. While other banks, like Citigroup and Merrill Lynch, were staggered by bad C.D.O.’s because they retained tens of billions of dollars of the investments, Deutsche Bank has reported only modest losses from its significant involvement in the American housing market.

Analysts say that Deutsche Bank, which is the world’s second largest bank by assets after Royal Bank of Scotland, held on to fewer of the investments it originated, selling more of them to investors like M&T. It also, presciently, bought protection against mortgage bonds at the urging of traders like Mr. Lippmann.

Still, Deutsche Bank has not been immune from the crisis. Last week the bank said it would lose $6.3 billion in the fourth quarter in part because of losses in bond and swaps trading.

The vast majority of investments like Gemstone have deteriorated rapidly. Moody’s Investors Service found that from the start of 2007 until last September, it had downgraded more than $449 billion in securities similar to Gemstone VII, or 82 percent of all those outstanding. Moody’s had downgraded more than three-quarters of C.D.O. securities that it once rated triple-A — which has enraged many investors, who claim that ratings firms like Moody’s failed them.

Curtis D. Ishii, senior investment officer for Calpers, the big California pension fund, says many banks and investors have learned the hard way that no amount of financial engineering can transform bad financial ingredients into good investments.

“You can’t turn manure into filet mignon,” he said. “You just can’t.”