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.

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.

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

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