Wall Street Probes: Collateralized Debt Obligations
Rob Silverblatt

 

Some were named after constellations. Others, in a morbid turn of events, derived their monikers from dead U.S. presidents. The most high-profile ones are linked to the implosion of the housing market and -- as new reports increasingly highlight -- to just about every major investment bank on Wall Street.

Collateralized debt obligations, once hailed as the ingenious brainchildren of a Wall Street that knew no bounds, are now at the center of a widening government probe into the nation's most prominent banks. And as the focus gradually shifts from Goldman Sachs, which last month was the target of a lawsuit filed by the Securities and Exchange Commission, to all of Wall Street, CDOs have become the rallying cry for those who see the need for regulators to erect walls between banks' varying -- and often conflicting -- divisions.

[See Your Guide to the Goldman Sachs Lawsuit.]

"Whether we like it or not, we're committed to a course of action where investment banks are going to be riddled with conflicting operations: people who sell things and say that they're good, and traders who make money by determining that they're bad," says James Cox, a professor at Duke University's law school. The question, according to advocates for reform, then becomes: What can Congress do about it?

But first, a step back.

On the heels of the Goldman Sachs suit, there are reports that government regulators have opened criminal probes into JPMorgan Chase, Deutsche Bank, Citigroup, Morgan Stanley, and UBS.

So far, the award for the catchiest nickname goes to Morgan Stanley's Buchanan and Jackson CDOs, which have been dubbed the "dead presidents" deals. The SEC has yet to confirm these investigations, which all reportedly pertain to CDOs.

According to Thomson Reuters, Wall Street banks issued upwards of $1 trillion in CDOs between 2005 and 2007. In essence, these CDOs gave investors exposure to baskets of mortgage bonds. When the housing bubble burst, investors on the long end of these deals lost out, while those who took short positions saw hefty gains. In many instances, the very banks that created the CDOs went on to bet against them. Over the past few weeks, the key question has been: In structuring these deals, did banks mislead any of their clients?

Separately, there are reports that New York Attorney General Andrew Cuomo is looking into whether a number of firms -- Goldman Sachs, Morgan Stanley, Citigroup, UBS, Deutsche Bank, Merrill Lynch, Credit Suisse, and Crédit Agricole -- had undue influence over the ratings given to securities tied to the housing market.

Specifically, Cuomo is said to be looking into the firms' dealings with the "big three" credit ratings agencies: Standard & Poor's, Fitch, and Moody's.

All told, these alleged investigations would shine a light on a veritable "who's who" of Wall Street powerhouses. That's hardly surprising, according to James Hackney, a professor at Northeastern University's law school. "If there's some way to exploit a market, smart players are going to gravitate there," he says. "There's no reason to think that the Goldman situation was unique."

In fact, some are arguing that the sheer expanse of the alleged probes can only serve to benefit Goldman, since the firm can now share the unwelcome spotlight with its peers. "That's the best thing that Goldman Sachs can have going for itself," says Cox. The broad nature of the supposed investigations also increases the chances of a so-called "global settlement," in which a number of firms would contribute money to a big pot in exchange for the government dropping its civil and criminal probes, according to Cox. "You get some peace with government regulators, put some money on the table, and you all go away and say that this was an industry problem, not a Goldman Sachs or a Morgan Stanley problem," he says.

Still, even though many experts consider it unlikely, it's possible that the firms may prefer to try their luck in court. After all, in the time since the SEC announced its civil suit against Goldman, the firm managed to cobble together some support -- at least in the court of public opinion -- most notably from Warren Buffett, who has publicly argued that the charges are unfounded.

The stickier question, though, is what will happen on the regulatory front. In Congress, for instance, the debate over CDOs and other forms of derivatives has proven to be quite contentious. Perhaps the most far-reaching proposal still under consideration comes from Sen. Blanche Lincoln. The Arkansas Democrat wants to force banks to spin off their derivative desks and establish them as separate entities. The proposal, though, has failed to garner support even within her party, and many speculate that Democrats are merely biding their time (Lincoln faces a primary challenge next week, and having her proposal rejected before could harm her chances of winning) before killing it. Still, both parties have expressed support for at least some regulation, although partisan bickering has prevented onlookers from getting a clear picture of what kind of reforms will eventually emerge from Congress.

Even as the derivatives issue remains unresolved, credit rating agencies are getting fresh scrutiny amid news that Cuomo is looking into whether investment banks manipulated them. Currently, the banks are the parties that are supposedly under investigation, but Sean Egan, a co-founder of the ratings agency Egan-Jones, says that S&P, Fitch, and Moody's also deserve some of them blame for the highly rated securities that fell apart when the housing market cratered.

Egan says that even if the three firms were misled by investment banks, they should have made a more concerted effort to vet the securities in question. "The rating firms are supposed to assess the true credit quality of the securities that they're reviewing," he says.

 

 

Wall Street Probes: Collateralized Debt Obligations

 

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