Sub Prime Securities Investment Law Blog

So how bad is it? Take a look at the “Money and Investing” section of the February 8, 2008 Wall Street Journal. The story “Prosecutors Widen Probes into Subprimes” reveals that criminal or regulatory investigations concerning fraud in the subprime market are underway by:

(1) U.S. Attorneys Office for the Eastern District of New York (Brooklyn) – investigating Bear Stearns and UBS;

(2) U.S. Attorneys Office for the Southern District of New York (Manhattan) – newly initiated investigation concerning activities of Merrill Lynch & Co.;

(3) Securities & Exchange Commission – thirty-six investigations involving such biggies as Merrill, UBS, Bear Stearns, Morgan Stanley, and Citigroup;

(4) FBI – investigating 14 companies for accounting fraud and insider trading;

(5) New York Attorney General – has issued subpoenas to Bear Stearns, Deutsch Bank, Morgan Stanley, Merrill Lynch and Lehman;

(6) Massachusetts Secretary of State - has sued Merrill Lynch over mortgage- backed securities sold to a municipality and is now probing Bear Stearns.

And that was just on Page C1! On Page C2, we learn that New York’s Attorney General, Andrew Cuomo, has blasted as mere “window dressing” the proposals of Moody’s and Standard & Poore’s to “improve” the manner in which they rate mortgage related bonds. These rating firms are squirming under heavy scrutiny for having given their highest ratings of creditworthiness to bonds backed largely by loans to uncreditworthy borrowers. And why would they do that? Cynics might suspect it has something to do with the fact that S&P and Moody’s get paid to rate the bonds by the people who issue them. Can you say “conflict of interest”?

Judging by the WSJ, I’d say we are about to enter an era of full employment for white-collar criminal defense lawyers. Times may be tougher for the poor investors who got stuck holding the bag when Wall Street’s tainted investments got sold to Main Street.

Brian N. Smiley

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“They” are the giants of Wall Street. “They” are the folks who pumped billions of dollars of bonds backed by subprime mortgage obligations into the hands of unsuspecting investors like you. These loans are called subprime because they were made to people who were likely to be unable to repay them. Subprime loans were made to borrowers who had low credit scores, a history of late payments, or even recent bankruptcies. These subprime loans were then bundled and “repackaged” by financial institutions into securities with impressive names such as collateralized debt obligations (CDOs) that were snapped up by banks, traders, and hedge funds in the United States and throughout the world. “They” meaning brokerage firms, might have even foisted CDOs on you in bond mutual funds your broker told you were a safe place to stash money you weren’t willing to risk in the stock market.

Continue reading "THE SUBPRIME MESS: WHY WHAT “THEY” SOLD YOU WASN’T AND STILL ISN’T WHAT YOU NEED" »

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Merrill Lynch reported recently its 2007 statistics. The new boss announced $15 billion in subprime mortgage write-downs and a fourth quarter 2007 loss of $9.91 billion. Citigroup recently made similarly stunning write offs and other major brokerage firms are in the same boat.

The Associated Press notes that, by posting significant fourth quarter losses, “Merrill Lynch joins rival Wall Street investment houses Morgan Stanley and Bear Stearns Cos. in posting losses in the last three months of fiscal 2007. Citigroup Inc., the nation’s largest bank, reported on Tuesday a quarterly loss of almost $10 billion, the largest in its 196-year history.” The article also noted that Merrill’s stock fell around 50% in 2007.

All of these companies are toying with layoffs, bailouts from foreign investors, and other uplifting alternatives. All of the companies point to the CDO and subprime debt debacle as the cause of their woes.

http://www.nytimes.com/aponline/business/AP-Earns-Merrill-Lynch.html?scp=5&sq=subprime

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Two New Jersey residents have filed an arbitration claim against Lehman Brothers holdings for $1.14 billion. The claim alleges that the firm placed the investors savings into “investments that have become hard to sell.” The securities held were auction-rate securities, yet another form of security that has been racked by the subprime mortgage market and ensuing credit crunch.

The Lehman Brother’s contingent “disputed the [claimant’s] accusation. ‘These clients had a professional investment consultant with whom we dealt… we believe we have meritorious defenses to this claim.’” In other words, the claimants sought securities over exposed in the subprime market.

As the true extent of the subprime debt crisis plays out, it is safe to expect many more situations where damages have been incurred.

Read the full story:
http://www.bloomberg.com/apps/news?pid=20601087&sid=aMvCcBjj9w9M&refer=home#

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Fed Chairman Ben S. Bernake appeared before Congress this week to discuss his thoughts on the dwindling US economy, which is still sliding from the subprime debt crisis. The chairman indicated support for a stimulus package, indicating that further Fed action (another rate cut seems inevitable) is not enough to put the economy back on its feet.

The New York Times quotes Bernake in saying that “In the financial markets, the subprime shock ‘has contributed to a considerable increase in investor uncertainty,’ he reported, adding that the Fed is seeing ‘considerable evidence that the banks have become more restrictive in their lending to firms and households.” The extent of the subprime mortgage damage goes beyond investor uncertainty as many investors unknowingly purchased risky securities and suffered as a result.

http://www.nytimes.com/2008/01/11/business/11fed.html

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The recent purchasing patterns in Florida’s pension funds serve to identify a sleazy side of the subprime debacle. In the February 2008 Bloomberg Markets David Evans has discussed some horrid behavior in a pension fund that was once an example for the rest of the nation. “On Sept. 30, 2005, 25 percent of the pool was invested in U.S. Treasuries and debt issued by U.S. agencies, the safest and most liquid debt sold… Florida was more aggressive than most states. In October, the Florida pool had the highest return of any public fund in the U.S., earning 5.63 percent.” However, in 2007, something changed and Florida’s fund managers began buying risky, subprime holdings.

Coleman Stipanovich supervised an investment fund for Florida’s school district until he resigned on December 4, 2007 and after school districts in Florida began panicking and pulling money out of his fund. Apparently, in July and August 2007, Stipanovich bought $842 million of mortgage-backed debt with taxpayer money. The securities defaulted within four months.

David Evans uncovered a consistent scheme of purchasing subprime laden debts. “As the subprime crisis unfolded around the world, Stipanovich and [pool manager] Lombardi increased their holdings of high-risk debt. They steadily reduced holdings of government securities in favor of higher-yielding—and riskier—commercial paper. In February 2007, London-based HSBC Holdings Plc, Europe’s largest bank by market value, reported it had losses of $1.8 billion more than expected on its U.S. subprime lending. In the same month, Lombardi bought the $400 million in Countrywide CDs.”

Florida’s funds suffered not only due to a consistent plan of purchasing high risk subprime securities but also from the predatory self-dealing of its managers.

http://www.bloomberg.com/news/marketsmag/mm_0208_story2.html

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Once again the subprime mortgage crisis is taking its toll on the average working American. Bloomberg Markets has recently described investments in Structured Investment Vehicles (SIVs) and Collateralized Debt Obligations (CDOs) by public funds across the United States. Both SIVs and CDOs invest heavily and opaquely in subprime mortgages, and fund managers are enticed by the potential returns and undisclosed risks.

SIVs are perhaps the most sinister investment vehicles. “SIVs finance themselves by selling asset-backed commercial paper, or short-term loans backed by collateral such as mortgages. When the subprime debt market blew up in August, investors stopped buying SIV commercial paper. As a result, in September and October, SIVs didn’t have the cash to pay debt holders of more than $8 billion of their paper.” These programs do not file with the SEC and do not publicly disclose financial statements. As a result, they can hide any and all risk associated with their investments.

State pension plans bought up SIVs and CDOs riddled with subprime debt and are now facing tremendous losses not only from market declines but from major default rates. As Bloomberg Markets David Evans says: “Until municipal fund managers learn to steer clear of traps like CDOs and SIVs, taxpayers’ money will be at risk—and it’s not likely anyone will tell them.” Taxpayers certainly aren’t the winners in the subprime mess.

http://www.bloomberg.com/news/marketsmag/mm_0108_story3.html

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Collateralized Debt Obligations, or CDOs, have blown up in terms of sales in the past few years. According to Richard Tomlinson and David Evans of Bloomberg, “Sales of CDOs worldwide have soured since 2004, reaching $503 billion last year, a fivefold increase in three years.” For the first few years, CDOs were an investors dream, offering high yields, sometimes around 9% annually, while being backed by high ratings by Moody’s or S&P. As the Bloomberg authors asked: “Why buy a corporate bond yielding 5 percent when you can invest in a CDO with the same credit rating and the promise of a return twice as high?” Good question.

The answer, as most of us now know, is that the credit ratings were not the same, and many funds were overexposed to subprime mortgages with no warnings to their investors. For example, Evans and Tomlinson noted that “Corporate bonds rated Baa, the lowest Moody’s investment rating, had an average 2.2 percent default rate over five-year periods from 1983 to 2005… From 1993 to 2005, CDOs with the same Baa grade suffered five-year default rates of 24 percent.” Were these CDO ratings a mistake? Did the rating services really not know of the subprime risk? Or was something else at stake?

Evans and Tomlinson looked into the rating companies themselves and found that “[i]n the past three years, S&P, Moody’s and Fitch have made more money from evaluating structured finance—which includes CDOs and asset-backed securities—than from rating anything else, including corporate and municipal bonds, according to their financial reports. The companies charge as much as three times more to rate CDOs than to analyze bonds.” Also, the ratings companies are typically paid by the issuers of debt.

The ratings companies are quick to point to their disclaimers, noting that investors should not rely on said ratings. In the end, many investors and brokers did. However, many fund managers who gathered up subprime securities should have known better.

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ajD1HS5Dj_Ro
http://www.bloomberg.com/news/marketsmag/ratings.html

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Arguably the safest, non-FDIC insured investments are money market funds, which were introduced to offer investors slightly higher returns than savings accounts. Unfortunately, according to Bloomberg Markets, “Unbeknownst to most investors, some of the largest money market funds today are putting part of their cash into one of the riskiest debt investments in the world: collateralized debt obligations backed by subprime mortgage loans.” The scope of the subprime infection is daunting: “U.S. money market funds run by Bank of America Corp., Credit Suisse Group, Fidelity Investments and Morgan Stanley held more than $6 billion of CDOs with subprime debt in June.”

To illustrate how extremely out of place subprime debt is in money market funds, David Evans rounded up Bruce Bent, who is said to have created the first money market fund. Bent said, “ ‘[subprime debt] doesn’t have a place in money market funds. When I created the first money market fund, I said you have to have immediate liquidity, safety, and a reasonable rate of return.”’ CDOs backed with subprime mortgages are illiquid, risky, and defaulting.

Most major brokerages contend that they will not allow their money markets to default, and will infuse cash to ensure shares trade at $1 per share. Unfortunately, the appeal of an FDIC insured account is growing compared to any investment with CDOs and subprime debt.

http://www.bloomberg.com/news/marketsmag/mm_1007_story2.html

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The financial industries have come up with a colorful, appropriate name for the equity tranches of CDOs - the toxic tranch. Also sometimes called, ‘first loss’ portions, these tranches promise the highest return and are the first to default. The subprime crisis hit the equity tranches first and hardest, and, incongruously, pension funds across the nations lost millions of dollars.

David Evans of Bloomberg wrote in July 2007 about the increase in equity tranch purchases by pension funds. “Seven percent of all the equity tranches sold in the U.S. in the past decade were purchased by pension funds, endowments and religious organizations…. Public pension funds have bought more than $500 million in CDO equity tranches in the past five years.” These equity tranches are riddled the very subprime debt that plummeted throughout the second half of 2007.

Evans spoke with Chriss Street, the treasurer of Orange County, California, who “says the big risks taken by public pension fund managers to juice up their investment performance with CDO equity tranches could result in big losses. Those tranches are filled with risky debt, which is sometimes in the form of subprime mortgages… ‘Very few pension plans could meet their fiduciary duty by buying portfolios of subprime loans,’ [Street] says.”

All of the players involved in peddling toxic securities are responsible for the losses due to pension participants and individual investors. Financial Institutions have advertised the high returns, and pension fund managers have accepted the bait, sometimes unwittingly exposing their clients to risky subprime debt.

Read the story:
http://www.bloomberg.com/news/marketsmag/pension.html

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Posted In: Effect on Securities Markets , Institutional Investors

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