Questions for Banks That Put Together Deals

They were the black boxes of the subprime era, byzantine creations of the brightest minds on Wall Street that made — and then lost — vast fortunes.

Goldman Sachs
Getty Images
Goldman Sachs

But now, after so much financial pain, Wall Street is nervously tallying the potential legal costs from its misadventures in collateralized debt obligations, known as C.D.O.’s, among the most toxic financial instruments ever devised.

C.D.O.’s, which produced much of the financing for the mortgage explosion, are at the heart of the Securities and Exchange Commission’s civil fraud case against Goldman Sachs — as well as a broader S.E.C. investigation of sales and disclosure practices at many Wall Street firms.

Until the bottom fell out, these instruments also powered an age of riches on Wall Street. Initially, bundling mortgage bonds into C.D.O.’s helped open the spigot of easy money that allowed Americans to buy more house than they could afford.

But Wall Street, as it is wont to do, took the concept to another level, creating securities that allowed investors to make side bets on the housing market. Known as synthetic C.D.O.’s, they did not raise money for home loans or serve any other broad economic purpose.

Instead, like a casino offering blackjack along with slot machines and Texas hold ’em, they were just one more way to bet against the housing market.

Now, the question in Washington is whether other banks, in addition to Goldman, might face legal action stemming from their role in this market. Bank analysts on Wall Street, too, are trying to figure out who might have done deals similar to Goldman’s, exposing them to potential liabilities.

C.D.O. transactions are not publicly traded, so it is difficult to get a full picture of the market’s size. But research suggests it is huge. Thomson Reuters estimates that sales of C.D.O.’s peaked at $534.2 billion in 2006, from $68.6 billion in 2000. Even in 2007, when the housing market was starting to crumble, Wall Street created an estimated $486.8 billion in new C.D.O.’s.

Synthetic C.D.O.’s accounted for just over 10 percent of total C.D.O. issuance in 2007, according to an analysis by the Securities Industry and Financial Markets Association. Traditional cash bond C.D.O.’s made up most of the rest.

Many banks on Wall Street and in Europe were even bigger players in the types of complex investment deals that Goldman is now defending. Merrill Lynch was at the top of the heap, assembling $16.8 billion worth between 2005 and 2008, according to a new report by Credit Suisse.

UBS put together $15.8 billion worth of similar products, according to the Credit Suisse estimates, while JPMorgan Chase and Citigroup each created more than $9 billion worth. Goldman Sachs was a comparatively small issuer, at $2.2 billion.

While Wall Street tallies who issued what, and how much money might be on the line at each firm in the event of lawsuits, the S.E.C. has been conducting an industrywide investigation of how banks sliced and diced mortgages, raising fears that more federal suits may be coming.

The S.E.C. has a team of about 40 investigators focusing on C.D.O. market practices, and regulators are examining a broad array of subprime mortgage-related issues at Wall Street banks. Those include the timely disclosure of losses, accounting irregularities and possible conflicts of interest. A spokesman for the S.E.C. declined to comment on its investigations.

Crucial to the case against Goldman is the question of whether the firm should have disclosed that an investor who was betting against the securities in the portfolio also helped select them. In legal filings, Goldman argues that it was not standard industry practice to make such a disclosure.

Magnetar, a Chicago hedge fund, also invested in C.D.O.’s that it then bet against, without disclosing its role, according to an investigation by ProPublica, a nonprofit journalism organization. Magnetar has denied that it picked individual securities, however, adding that its investment strategy was market-neutral.

The threat of more litigation represents the abrupt end to what was a golden era on Wall Street. The C.D.O. business has been a vital engine in the money machine at many firms for much of the last decade.

Big investors became addicted to the extra yield. Rating agencies earned windfall profits from evaluating the securities. Investment banks enjoyed hefty fees from ready buyers of the assets. And C.D.O. dealmakers racked up huge bonuses, regardless of whether their products later imploded.

If the limitless appetite for these so-called structured products provided much of the easy money that fueled the housing boom, it also contributed to its bust. What began as a financial innovation lauding the benefits of diversified portfolios of corporate investments morphed into one giant bet on the American housing market.

To lure investors who wanted higher returns, bankers increasingly stuffed C.D.O.’s with riskier assets like subprime mortgage securities, rather than traditional corporate bonds.

They bought their own mortgage companies to feed their loan packaging machines and relaxed the standards on the types of assets they would accept.

Once the air started coming out of the housing market and there were no more mortgage bonds to sell, they created synthetic C.D.O.’s, whose supply was unlimited because they did not rely on hard assets.

C.D.O.’s are, in some ways, like mutual funds that hold bonds rather than stocks. But instead of selling shares, the creators of a C.D.O. sell slices, or tranches as they are known, that are linked to different securities in the underlying portfolio.

A C.D.O. manager, working for either the bank or an outside investment management firm, typically picks those assets for a fee. Each C.D.O. slice is then rated by credit agencies for its potential risk, with more risky slices offering higher yields.

At the height of the housing boom, as interest rates dropped on competing investments like corporate bonds, big institutional investors like pension funds were tempted by these C.D.O.’s, which offered yields two or three times comparable investments but were marketed as “ultrasafe.”

But there was a catch. Top-rated tranches could hold mortgages and other shaky loans that were at risk of defaulting if the overall housing market weakened.

An ostensibly top-rated triple-A tranche might contain bottom-of-the-barrel subprime mortgage junk. That was supposed to make the tranche safer through diversification. In practice, however, it compounded the effect of a sharp, nationwide decline in home prices.

As homeowners began to default in ever greater numbers in 2007, the value of these C.D.O.’s collapsed.

Many investors and analysts now say that a lack of transparency made the fall of C.D.O.’s that much swifter and heavier. Unlike bonds or stocks, which are bought and sold on open markets, C.D.O.’s are traded privately, with dealers quoting prices to prospective buyers.

“The dealer knows everything and you don’t know anything,” said Geoffrey Gwin, a principal at Group G Capital Partners, an investment fund that researched C.D.O.s but decided against buying any.

“You have to take the word of Goldman or Morgan Stanley,” he said, “and the trading desk always had the advantage. The more exotic the security, the more advantage they had.”