"Extreme leverage, broker fraud edition
Blithe investment in CDOs, it has come to be known, was generally a very bad idea.
Among their many failings, the instruments had huge built-in leverage: from the leverage inherent in the underlying mortgages themselves, up through the tranched leverage of a mortgage backed-security and again through the CDO tranches themselves.
Which is why the only thing that could be more completely disastrous than buying a CDO (apart, admittedly, from buying a CDO^2 or a LSS) would be buying a CDO on margin.
The people that facilitated such madness - ten of them at least - are crooks, says the SEC:
According to the SEC’s complaint, the defendants portrayed particularly risky types of CMOs as secure investments to defraud more than 750 customers, ultimately costing them more than $36 million in losses. Meanwhile, the 10 brokers received $18 million in commissions and salaries related to their customers’ investments in CMOs.
The complaint against the ten CDO brokers in full is available here, and is an interesting read. CDO brokers beware.
To be honest, we here at FT Alphaville were astounded that CDOs were being offered to retail punters at all, let alone CDOs on margin. The SEC is clearly astounded too:
Between 2004 and 2007, Defendants, formerly registered representatives at ‘Brookstreet Securities Corp. (”Brookstreet”), made false and misleading statements in connection with the offer, sale, or purchase ofcertain types of Collateralized Mortgage Obligations (”CMOs'’). Defendants told their customers that the CMOs in which they would invest were safe, secure, liquid investments that were suitable for retirees, retirement accounts, and investors with conservative investment goals. Contrary to what they told customers, between 2004 and 2007 Defendants invested in risky types of CMOs that: (l) were not all, guaranteed by the United States government; (2) jeopardized customers’ yield and principal; (3) were largely illiquid; and (4) were only suitable for sophisticated investors with a high-risk investment profile.
In addition, Defendants heavily margined customers’ accounts (up to a ten to one margin to equity ratio), making the CMOs in which they invested even more sensitive to changes in interest rates and downturns in the CMO market.
Defendants’ fraudulent misrepresentations and omissions attracted more than 750 investor accounts with CMO investments of more than $175 million.
Were it not for the particulars of this case (material misrepresentations) it might though, seem slightly invidious to single out individual brokers. The whole of Wall Street convinced itself CDOs were risk less miracle instruments. There was, in the words of Alan Greenspan a vast “intellectual edifice” that justified it all.
May 29 17:02
Sorry Sam, that's wishful thinking. All financial crises begin with the Elmer Fudd Defense, Stupidity Defense, Following The Herd Defense, Ostrich Defense, The Devil Made Me Do It Defense, etc., stage. It takes litigation and good investigative reporting to suss out the Fraud, Collusion, Negligence, and Fiduciary Mismanagement, underlying a financial crisis, such as this one.
Mark my word. I'll still be reading in the future if you're still writing.