New York, New York
November 24, 2009
FOR IMMEDIATE RELEASE:
New York, New York
November 24, 2009
FOR IMMEDIATE RELEASE:
CDOs and Treasury Bonds - Risk, Return, and Credit Ratings? We aren't economists, but something sure seems wrong.
PLEASE - set us straight if we are off base here...
OK, if two fixed income investments have the same risk profile, they should offer the same return (or something very close to it). Right?
If so, then are we right to assume that two classes of fixed income investments stamped with the same credit rating should have very similar risk characteristics? If one investment offers higher returns with no added risk, common sense (and, we presume, the science of economics) dictates that rational investors will choose the higher yielding investment product.
So far, so good? If so, then what in the world were the Credit Rating Agencies doing during the housing bubble?
A huge volume of mortgage-backed securities (MBS) and related investments like collateralized debt obligations (CDO's) received AAA credit-ratings and offered investors yields that, for several years, were superior to AAA U.S. bonds. To managers of massive pension funds, sovereign wealth funds, and other investors, a AAA credit-rating means there is virtually zero risk of default (we looked that one up). Therefore, the only logical conclusion is that Moody's, S&P, and Fitch told investors that certain mortgage securities were pretty much impregnable, just like obligations of the United States government.
It seems kind of clear to us that no fund manager would purchase super safe U.S. government bonds when investments in high-rated tranches of MBS and CDO's carried higher yields with no added risk? Predictably, demand for mortgage-related securities skyrocketed.
In nearly every case, investors relied on credit ratings. Institutions believed the CDOs were safe. AAA means AAA, and because financial engineers at places like Bear Stearns and Lehman brothers were able to slice and dice the cash flow from all kinds of mortgages in ways that were too complex for practically anyone to truly understand, even sophisticated investors were unable to do any independent risk assessment.
Again, it is our understanding that the basic risk-reward principle dictates that two or more AAA-rated fixed income investments issued in the same interest rate environment should produce virtually identical returns. Is there some basic fact or principle that Wall Street Law blog is missing? And yet...
Vast quantities of AAA-rated mortgage-backed securities and CDOs consistently promised and, until the credit bubble started to leak, actually delivered significantly higher yields than AAA-rated U.S. Treasury bonds (which are, of course, guaranteed by the full faith and credit of the United States Government).
All of this leads us to one of two conclusions -
The science of economics and/or the business of credit ratings are farsical-
Wall Streeters like Merrill Lynch, Lehman Brothers and Bear Stearns colluded with the major credit rating agencies to obtain bogus investment grade ratings (at least for AAA tranches) in order to maximize the universe of potential investors for CDOs.
If we have this stuff way wrong (and maybe we do), we'd sure like to hear what really happened and where our amateur analysis went awry.
Posted at 02:35 PM in 10b-5 Securities Fraud, CDO Credit Ratings, Collateralized Debt Obligations, Credit Crisis, Credit Ratings, Greatest Hits, Investment Grade Mortgage Backed Securities, Investment risk, Ratings Agencies, Risk, risk-return principle, Risk-return tradeoff, S&P, subprime crisis, Treasury Bonds | Permalink | Comments (2) | TrackBack (0)
Tags: credit ratings, financial crisis, risk reward principle
Absolutely. Remember, the definition of NOT GUILTY is not innocent. Not guilty means the Government failed to prove its case beyond a reasonable doubt. The American criminal justice system works best when the system protects individual rights. Proving criminal defendants guilty beyond a reasonable doubt is a very high hurdle, and rightfully so. No defendant should face the possibility of imprisonment unless a jury is convinced beyond all reasonable doubt that the defendant is guilty as charged.
In the case of former Bear Stearns hedge fund managers Ralph Cioffi and Matthew Tannin, the jury did NOT find anyone innocent. But the jury clearly did not believe the government met its very high burden of proof. Not guilty was the only proper verdict.
That said, extensive misconduct, including fraud, occurred at Bear Stearns. Of that we have no doubt (reasonable or otherwise).
UPDATE: William Cohan's November 12 Op-Ed Piece in The New York Times (reprinted here from nyt.com) really hits the nail on the head
November 12, 2009
How the Scapegoats Escaped
By WILLIAM D. COHAN
THE quick “not guilty” verdict reached Tuesday afternoon by a Brooklyn jury in the federal criminal trial of two former Bear Stearns hedge fund managers was at once surprising — for its failure to comport with the zeitgeist — but also entirely understandable, based on a close reading of the prosecution’s arguments and the evidence the judge allowed to be introduced. “There was a reasonable doubt on every charge,” one juror told The Times afterward. “We just didn’t feel that the case had been proven.”
In short, the prosecution blew it — on two counts. First, in devising the original indictment for conspiracy and securities fraud against the two defendants, Ralph Cioffi and Matthew Tannin, it relied on damning snippets of lengthy e-mail messages that when viewed in their entirety proved to be highly ambiguous. Second, the prosecution made a reductionist opening argument claiming the men were nothing more than out-and-out liars, needlessly raising the bar in terms of what it had to prove to jurors.
In that opening speech, Patrick Sinclair, the assistant United States attorney for the Eastern District of New York, tried to head off all the confusing Wall Street jargon soon to be unleashed by claiming the defendants had simply been deceitful. He accused them of lying about the size of their personal investments in the funds and in their dealings with nervous investors who were considering getting out when subprime mortgages — in which the funds had invested heavily — began to rapidly lose value in March 2007.
“They did the best thing that they could think of to keep those investors in the fund and with any luck keep their bonuses coming: they lied,” Mr. Sinclair told the jury. “They lied over and over again to lull those investors into a false sense of confidence and make them think that these failing funds continued to be a good investment when the exact opposite was true.”
Unfortunately for the government, the evidence was not nearly as clear-cut as Mr. Sinclair portrayed it to be, and his strategy to make it seem so backfired. Consider the e-mail messages the prosecution placed at the center of its case.
In the indictment, the prosecution quoted from a note Mr. Tannin sent in April 2007 from his personal Gmail account to Mr. Cioffi’s wife. The government made much of the fact that Mr. Tannin chose not to send it to Mr. Cioffi himself or from his Bear Stearns’ e-mail account, suggesting he was trying to hide something. “The subprime market looks pretty damn ugly,” Mr. Tannin wrote, adding that if a recent financial report was correct, “I think we should close the funds now .... The entire subprime market is toast.”
But the jury eventually saw the entire message, in which Mr. Tannin ruminated at length about various courses of action and seemed to be striving to make the soundest financial choice. In other words, it was just what you would hope your fund manager would be worrying about in a precarious time. In the end, he concluded he was feeling “pretty damn good” about what was happening at the funds and that “I’ve done the best possible job that I could have done.” Any wonder the jurors came away with reasonable doubt?
The prosecution’s misjudgments are doubly vexing because there was other evidence around which it might have built a stronger case. The prime example was a “talking points” memo in June 2007, sent by Bear Stearns’s senior management to its brokers for use in discussions with hedge fund investors worried about a meltdown. The episode raised pretty clear doubts about whether Mr. Cioffi and Mr. Tannin had told investors the truth.
According to the memo, one of the questions deemed likely to be asked was: “I thought the fund was diversified, and now it turns out it seems to have had a fair amount of exposure to the subprime mortgage market. What exactly was the exposure?” The answer: “60 percent.” The problem was that in all previous communications to the investors, the two fund managers had suggested that only about six percent of the funds were invested in subprime mortgages.
During the trial, a prominent former Bear Stearns broker, Shelly Bergman, testified about the damning nature of this talking points memo, which was as close to a smoking gun as prosecutors could have hoped for. Yet the prosecution never made much use of his testimony, and it did a poor job of rebutting the defense’s claims that Mr. Bergman had a conflict of interest in testifying against the two fund managers.
So where does the verdict leave us? Word is that three federal grand juries are still investigating what went wrong at Lehman Brothers in 2007, but those prosecutors may be forced to tread lightly in the wake of what happened this week. Even though the facts and circumstances of the Lehman matter are very different from the Cioffi/Tannin episode, Tuesday’s verdict may be the best news in more than a year for Richard Fuld, the former Lehman chief executive.
For now, Mr. Cioffi and Mr. Tannin remain the only bankers indicted for their professional behavior in what became one of the worst financial crises in our history. They became a symbol of greedy carelessness for a public intent on blaming someone — anyone — for Wall Street’s folly. There must be some accountability for the Bear Stearns calamity, to say nothing of the $12 trillion of taxpayer money used to prop up capitalism, right? Not so fast, this Brooklyn jury declared. “The entire market crashed,” one juror explained. “You can’t blame that on two people.”
William D. Cohan, a contributing editor at Fortune and a former Wall Street banker, is the author of “House of Cards: A Tale of Hubris and Wretched Excess on Wall Street.” In January, he will begin a regular column on business at nytimes.com/opinion.
Reprinted by Wall Street Law Blog
CIOFFI TRIAL SET TO GO TO JURY...Latest Update on Criminal Trial of Former Bear Subprime Hedge Fund Managers Ralph Cioffi and Matthew Tannin
Associated Press News Wire
November 9, 2009
NEW YORK (AP) — The case of two former Bear Stearns hedge fund managers charged with lying to investors is moving into the final stages.
Deliberations were expected to begin Monday at the Brooklyn trial of Ralph Cioffi and Matthew Tannin. They've pleaded not guilty to conspiracy and fraud charges.
It was the first criminal case to hit Wall Street amid the housing market meltdown.
The eventual implosion of the defendants' hedge funds cost 300 investors about $1.6 billion.
The domino effect nearly led to the demise of Bear Stearns itself. The firm barely avoided bankruptcy in a rescue buyout by JPMorgan Chase & Co.
By Brett Sherman
As a general rule, we tend to ignore the lessons of our financial past whenever markets are humming and money is flowing. Economists have long believed that market bubbles come along every 15 - 20 years, the approximate length of the financial memory. After 15 years or so, unpleasant consequences of the previous bubble are forgotten and a whole new generation of con artists and suckers come along, full of hot air and ready to blow. Presto, a new bubble is inflated.
Something about bubbles clearly has changed in the first decade of the new millennium. 15 years between huge bubbles? Hah. This decade saw the implosion of two massive bubbles. First tech stocks went ka-boom. Then, almost immediately, the housing bubble began to inflate. And, well, you probably know how that ended.
Consider the last market bubble, the tech-wreck. Remember proclamations of a a new age of prosperity, a "new economy" in which the old rules of Wall Street no longer applied? Remember all the "paper millionaires"? Remember Dow 36,000? Remember irrational exuberance?
Remember how the tech stock driven new economy ended? Of course you do. The bubble popped, the market deflated, billions were lost.
Wall Street executives (not to mention financial risk managers) may have short memories, but we're talking about recent history, the immediate past. The tech bubble received quite a bit of media attention too. It was a textbook market bubble. And it was fresh in Wall Street's collective memory. So don't believe the nonsense about the housing bubble being a surprise or catching anyone off guard. By 2005 at the latest, the housing market bore the classic hallmarks of a market bubble. By definition, all bubbles are unsustainable.
Even if Wall Street execs didn't foresee the extent of the current disastrous financial crisis, they sure knew the unprecedented inflation of home prices and home ownership was a mammoth bubble. They knew it would end badly.
How could Wall Street be so naive as to allow a huge asset bubble to inflate on the heels of the tech-wreck? Naivety had nothing to do with it. What happened to the 15 year financial memory? Not a thing. Wall Street forced the housing bubble on the American people. Investment banks needed lots of mortgages to stuff into mortgage-backed securities.
But how, you ask, could Wall Street knowingly play a leading role in the inflation of the housing bubble if it was certain to end badly? Hints - Look up the antonym for altruism and think about multi-million dollar paydays.
Wall Street Law Blog occasionally takes a deep breath and reflects on the evolution of the financial crisis. Looking through our huge archive of bookmarks, we sometimes find a bit of analysis that, in real time, was right on the money.
The following excerpt is from a March 18, 2008 post on the Stanton Champion website called Bear Stearns Meltdown:
"Bear's real problem was a lack of faith in their assets: mortgage securities. Over the past several weeks, the markets for these assets have simply stopped moving, meaning that in many cases buying and selling them is very difficult."
"For Bear Stearns, the problem was simply that some of their creditors wanted repayment on their repos (they wanted their money they had lent to Bear back), but Bear was unable to find enough liquidity in the market using its large portfolio of mortgage securities. In other words, Bear couldn't find enough money through additional repos and nobody would buy their mortgage securities outright. Other creditors, sensing trouble, began piling on and trying to get their money back as well. Since Bear Stearns had $75 billion more borrowed than lent, they were ultimately screwed without extra financing."
Pretty good stuff considering the quoted material was posted just a few days after Bear Stearns collapsed...
Wall Street Law Blog; published by The Sherman Law Firm 2009