November 14, 2013

When a Deal Goes Bad, Blame the Ratings

By FLOYD NORRIS

Did 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 Stearns hedge funds that went broke in 2007 said it was absolutely not the managers fault. They bought 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 MORE IN BUSINES & Poors, Moodys and Fitch. They gave ratings of AAA and AA to securities that turned out to Reaching f be junk, and the managers rightly relied on those ratings. Market participants, such as the More Read

funds, did not and could not know the loan level detail of the mortgages underlying the structured finance products at issue, the suit states. 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 a securitization, 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

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, meaning that 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 quoted as 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 tumbled after it was reported that mortgage foreclosures had risen to a record high.

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.