Despite the best efforts of Lanny Breuer to hide it, the complaint filed against Standard and Poor’s by Los Angeles US Attorney André Birotte, Jr. proves that the Department of Justice is fully aware of the corruption on Wall Street in the run-up to the Great Crash. The alleged facts point directly at the issuers of real estate mortgage-backed securities and collateralized debt obligations as the leading cause of the losses of the victims of S&P’s alleged frauds.
In a nutshell, the issuers, a term which deal underwriters, played a major role in creating the software and techniques used to rate RMBSs and CDOs. They used that role to delay and water down changes to the ratings systems. They played the ratings agencies against each other, and they got much higher ratings than were justified by the mortgage loans that underlay the securities. The issuers had mountains of these bad loans, and were desperate to get them off their baoks to protect their balance sheets. Those issuers include Too Big To Fail Banks, and some others as well.
The complaint explains the role played by issuers in developing the RMBS ratings systems at S&P, beginning at ¶ 123. In April 2004 S&P executives met to discuss changes to the process for creating and implementing changes to its ratings criteria. The new policy
… required consideration of “market insight” and “rating implications” and the polling of both “3 to 5 investors in the product” and “and appropriate number of issuers and investment bankers for a full 360-market perspective.”
¶ 125. That policy was implemented on July 1, 2004. The complaint says that issuer feedback led S&P to limit, adjust and delay updates to ratings criteria in order to preserve profits and market share. I described this in more detail here. The impact was dramatic. One internal S&P document says that “Competition among ratings agencies has helped drive down support levels in deals”, meaning that RMBS securities became more risky. ¶ 131.
S&P also invited input from issuers into its CDO ratings process. The discussion begins at ¶ 158. In response to one group of changes, Bear Stearns allegedly said Bear Stearns would quit using S&P. The changes were not implemented. Issuer input resulted in weakened ratings criteria and delays in implementation in this and other cases^.
Issuers were trying to get that garbage off their books. In 2006, it was becoming clear to S&P that RMBSs and CDOs were not performing as predicted by their ratings. Line-level personnel at S&P wanted to change a policy that permitted analysts to rate CDOs based in part on the initial ratings of RMBS tranches included in the CDO, even when S&P knew downgrades were likely. ¶ 207. S&P executives discussed the actions of issuers:
Issuers were shtting down and liquidating their warehouses i.e., stores of RMBS temporarily held by issuers as they assembled assets for future CDOs), in part to enable the issuers to avoid being required to mark their positions to market — and being stuck with collateral that had suffered losses.
¶ 233(b). What this means is that issuers were taking advantage of the lag time they actively created in adjusting ratings criteria to shovel more of their garbage off their books and onto actively misled investors.
Who were these issuers? The complaint doesn’t name any specific issuers, but it names a large number of securities. Here are some names:
Gemstone CDO VII: $1.1 billion, sold by Deutsche Bank, relationship of managers unclear; litigation pending; March 2007.
Sorin CDO VI: $550 million, Bear Stearns (now owned by JPMorgan), March 2007
Stack 2007-1: $1.5 billion, Citigroup, April 2007
Octonion I CDO: $1 billion, Citigroup, April 2007
Corona Borealis CDO Ltd.: $1.5 billion, underwritten by Lehman Brothers, other relationships unclear, April 2007.
Vertical Capital LLC, distributed by UBS: Vertical ABS-CDO 2007-1, $1.5 billion April 2007.
And these are just some of the issues rated or for which final ratings were issued. The complaint says S&P rated more than $135 billion in securities from March to June 2007, long after it was obvious that the housing market had collapsed.
The Department of Justice knows this, but it refuses to indict anyone. This complaint makes it clear that it wasn’t just an accident or a matter of greed, as the President and his henchmen claim. With the departure of Tim Geithner and Lanny Breuer, the most offensive proponents of the get out of jail free card, there is an opening for change.
We have this Progressive Caucus in the legislature. Why haven’t some of them taken on the task of learning about this stuff and asking out loud why there are no indictments? Once you know the Obama Administration is making crap up, it’s easy to get past their false explanations. This is one area of bipartisan agreement: every single American hates these cheats.
* The complaint doesn’t say why, so it may or may not have been requested by issuers; but one change S&P made was to change to zero the correlation assumption “…between ‘a CDO of ABS asset” and ‘an RMBS asset in a CDO/ABS transaction.” Correlation in this sense refers to the statistical relation between the failure of two assets: if one fails, what is the probability that the other will. Readers may recall that one of the tools that made RMBSs seem plausible was the Gaussian Copula, which theoretically is a way to measuring the likelihood of correlation of defaults in a large group of mortgage loans. Intuitively, if the portfolio of loans is spread geographically and by other criteria of separation, there should be low likelihood that if a loan in Boston fails, so will a loan in Las Vegas. The model had a number of weaknesses.
There is a close relationship between two tranches of the same RMBS. If one fails, it raises the likelihood that another will fail. Calling it zero removes that relationship, and gives the CDO a higher rating than it should have.
Image screenshot from The Investigators