U.S. News

A Wipeout That Didn’t Have to Happen

Gretchen Morgenson|The New York Times

Bobby L. Hayes, an engineering entrepreneur in Incline Village, Nev., used to trust financial institutions. This is the story of why he no longer does.

Picturegarden | The Image Bank | Getty Images

Mr. Hayes won a securities arbitration last week and was awarded $1.38 million from the panel that heard the case. Banc of America Securities, now Merrill Lynch, must pay the award, which represents all the money Mr. Hayes lost on a complex security, plus accrued interest, lawyers’ costs, and hearing fees.

The Hayes case highlights this question: Exactly how did Wall Street price the loans that it bundled into securities and sold to investors?

For anyone hoping to hold firms and individuals accountable for misconduct in the credit crisis, valuation practices are a rich vein to mine. Last week, for example, prosecutors in New York City wrung guilty pleas from two former mortgage traders at Credit Suisse who admitted inflating the values of mortgage bonds that the bank held on its books. As the subprime disaster spread in 2007 and 2008, one trader said he mismarked the bonds to please his superiors; another said the fraud was intended to keep him in line for a rich bonus. The bank itself was not charged.

The outcome of Mr. Hayes’s case seemed to confirm his argument that prices on some of the loans in the pool were artificially inflated at the time of purchase. We can’t know for sure, though, because the arbitrators did not say why they ruled as they did.

Mr. Hayes said he told his broker that he didn’t want to take risks with the money that went into the investment, a collateralized loan obligation known as Lyon Capital Management VII that was issued in July 2007.

“I was a trusting client, and it was like a bad dream,” Mr. Hayes said. “I had a lot more assets in the bank, and it was unfathomable to me that they would deliberately do this to even a small depositor.”

When Banc of America Securities was concocting the Lyon Capital deal, a $400 million collection of commercial loans that it planned to sell to investors, Wall Street’s labyrinthine and lucrative loan-pooling machine was starting to break down.

An expert witness who testified at the arbitration said that as the security was being cobbled together, the loans purchased over previous months were losing value. Instead of owning up to that fact, this witness said, Banc of America Securities sold the investment as if the loans still carried prices from months earlier.

By selling the Lyon Capital deal with inflated asset values, Banc of America Securities was able to make sure that it did not incur losses on the loans purchased for the security.

Thomas C. Bradley, a lawyer based in Reno, Nev., who represented Mr. Hayes, said that while the security was being created, the loans lost 5 percent of their value.

“Our whole case rode on the premise that the investment was intrinsically worthless as of the day the investments closed,” Mr. Bradley said. “The panel agreed.”

Mr. Hayes had been sold the riskiest piece of the loan pool, known as the equity or E tranche. Because of the way losses are distributed in these instruments, the loans in the pool had to decline only by one-half of 1 percent before Mr. Hayes’s investment would be wiped out. The entire security was liquidated at a loss of around $75 million about 16 months after it was sold.

Bill Haldin, a spokesman for Bank of America, the parent company, said it disagreed with the arbitrators’ decision.

“Following the purchase of this investment, the market experienced extreme volatility,” he said. The bank denied that the investment was worthless when it was sold to Mr. Hayes.

Craig J. McCann, founder of the Securities Litigation and Consulting Group in Fairfax, Va., testified on behalf of Mr. Hayes at the arbitration. His firm has done research on the problems posed to investors by firms that collect loans during a period of steep asset price declines. He has identified several cases where securities contained loans that had been bought at prices substantially higher than their market value when the pools were issued.

“If the loans drop in value during the warehousing period, as they did in this case precipitously, then the trust is agreeing to pay something significantly more than the market value of the securities,” Mr. McCann said. “The right thing for Banc of America to do would have been to only charge the trust the current market value of the loans or at least disclose to investors the trust is paying $400 million when the loans are worth $380 million.”

The loans were gathered for the LCM security from November 2006 to June 2007, as the credit markets were coming unglued. The prospectus for the deal did point out that the loan purchases made during the period would be reflected on account summaries at acquisition costs. What was not made clear, though, was that those costs were considerably above current values; investors, therefore, would incur immediate losses when they bought the security, Mr. McCann said.

Banc of America Securities later changed its disclosures about the potential for losses embedded in loan pools like the Lyon Capital deal. In a similar offering dated August 2007, the prospectus noted that because of declining market values of loans, it was likely that the value of the portfolio “on the closing date will be substantially less than the principal amount” of the loans in the pool.

Another problem with the Lyon Capital deal, Mr. McCann said, was a conflict of interest in its structure, which was disclosed in the prospectus. Affiliates of Banc of America Securities, it noted, were among those selling loans to the firm for inclusion in the pool. Collecting loans for lengthy periods also allows for opportunistic trade allocation, Mr. McCann said. If, for example, the loans had risen in value while the security was being created, one might well wonder if those loans would have ever made it into the final product.

Even though he won his case, Mr. Hayes said he was still livid. “I no longer trust any financial institution,” he added.

Something tells me he’s not alone in that.