CDO regulation

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IOSCO report on post-trade transparency of structured products

II.B. Benefits of enhanced post-trade transparency (Section 4.1 of the Consultation Report)

Improved price discovery and reduction of information asymmetries

Some respondents focused on the information asymmetry between the buy-side and sell-side. One respondent noted that sell-side sees a much larger volume of trading, and can use this information to the detriment of the buy-side. Another respondent argued that the lack of post-trade transparency helps to extend the market dislocation that recently occurred, as participants were fearful of being gamed by other market participants and had no way of determining market prices.

One respondent stressed that an analysis should be done to ensure that regulatory objectives/benefits are appropriately balanced with market quality objectives. This respondent stated that some potential benefits include:

  1. the ability to monitor quality and consistency of executions as well as valuations;
  2. the ability to monitor for risk build-ups at specific firms;
  3. the possibility to identify and study apparent correlations and/or market impacts between trading of a particular SFP and another product; and
  4. the ability to develop an audit trail of transactions to detect instances of market abuse. This respondent also stressed the value in conducting studies during times of market stress as well as during more normal periods.

One respondent supported the publication of trade information on a periodic basis and further supported the use of time frames similar to those contained in the FINRA TRACE feed and Xtracter TRAX feed (intervals of less than one hour).

Valuation of products and portfolios

One respondent stated that the report should more directly address the accounting issues that could arise if post-trade transparency regimes are mandated, such as the use of prices available through reporting systems when such prices may not be an accurate reflection of current market values.

On the other hand, one respondent noted the current difficulties faced in making mark-to-market valuations of SFPs, and argued that increased post-trade transparency would encourage improvements in valuation methodologies, while another mentioned the importance of prices for risk management processes.

One respondent noted that the difficulty in valuing SFPs is making it more difficult for asset managers to comply with their fiduciary duties. Another respondent stated its belief that post-trade transparency would facilitate the price discovery process and would assist those who prepare financial statements in meeting reporting and disclosure requirements.

Involvement of retail investors

Most respondents did not comment on steps to introduce retail investors into the market for SFPs. Most argued that greater transparency of SFPs would encourage wider participation generally by improving confidence in the market and attracting new investors.

Nevertheless, one respondent expressed the concern that volatility in valuing SFPs could result from the increased participation of retail investors, who may not fully understand the nature of these securities.

SEC sues asset managers for CDO fraud

ICP Asset Management LLC and its founder were sued by U.S. regulators for their role in selling mortgage-backed securities to vehicles insured by American International Group Inc. as the housing market declined.

Thomas Priore, 41, and New York-based ICP directed more than $1 billion of trades starting in 2007 by multibillion- dollar collateralized-debt obligations known as Triaxx at artificially high prices to protect other clients from losses or generate profits for ICP, the Securities and Exchange Commission said in a lawsuit filed today at federal court in New York.

The lawsuit, which said victims also included bond insurer FGIC Corp., may open a new front for the SEC in examining firms that managed mortgage-backed assets before the credit crisis that followed the 2007 collapse of the U.S. housing market. ICP violated its fiduciary duty by entering into prohibited investments, failing to obtain approvals for trades, misrepresenting the value of holdings and deceiving clients, the SEC said.

“The CDOs were complex but the lesson is simple: collateral managers bear the same responsibilities to their clients as every other investment adviser,” George Canellos, director of the SEC’s New York regional office, said in a statement. “When they violate their clients’ trust, we will hold them accountable.”

ICP, which managed the four Triaxx CDOs, structured trades in a way that disadvantaged the securities and let the firm reap “massive, risk-free and undisclosed profits,” said the SEC, which is seeking fines and disgorgement of ill-gotten gains.

Priore, the majority owner of ICP, declined to comment. He founded the firm as an affiliate of Bank of New York in 2004. It became an independent company in 2006.

SEC subpoenas big banks over CDOs

Several leading international banks have received subpoenas from US regulators investigating one of the complex securities markets at the heart of the financial crisis, people familiar with the probe say.

The Securities and Exchange Commission sent subpoenas last month to banks including Goldman Sachs, Credit Suisse, Citigroup, Bank of America/Merrill Lynch, Deutsche Bank, UBS, Morgan Stanley and Barclays Capital, these people said. Requests for information were also made by the Financial Industry Regulatory Authority, which oversees broker-dealers.

The regulators are seeking information about the sale and marketing of so-called synthetic collateralised debt obligations during the financial crisis.

The SEC and Finra declined to comment on the investigation, which is at an early stage. The banks declined to comment. None has been accused of wrongdoing. CDOs are pools of bonds or mortgages and other loans that are sold to investors. Synthetic CDOs are backed by derivatives known as credit default swaps – a form of credit insurance – rather than actual loans or bonds themselves.

Securities regulators, who are under pressure to investigate possible wrongdoing related to the crisis, have been focused on whether investors in the market were provided accurate and relevant information or misled in some manner.

People familiar with the investigation said regulators are particularly interested in whether banks that created such instruments also bet against the clients who purchased them – thereby profiting while investors lost money.

Synthetic CDOs have been blamed by many analysts for exacerbating the financial crisis. Because synthetic CDOs are not backed by actual loans or bonds, but by derivatives, the market grew rapidly during the credit boom that ended with the collapse of the US subprime mortgage market.

However, because so many synthetic CDOs were ultimately linked to subprime mortgages, defaults by home buyers with poor credit histories reverberated around the global financial system. Investors came to discover than tranches of synthetic CDOs that had been rated triple A were, in fact, worthless.

Mary Schapiro, SEC chairman, told a commission investigating the financial crisis on Thursday that the SEC was probing complex debt securities that were sold by big banks in late 2006 and 2007.

Banks created CDOs, bet against then and won

"In late October 2007, as the financial markets were starting to come unglued, a Goldman Sachs trader, Jonathan M. Egol, received very good news. At 37, he was named a managing director at the firm.

Mr. Egol, a Princeton graduate, had risen to prominence inside the bank by creating mortgage-related securities, named Abacus, that were at first intended to protect Goldman from investment losses if the housing market collapsed. As the market soured, Goldman created even more of these securities, enabling it to pocket huge profits.

Goldman’s own clients who bought them, however, were less fortunate.

Pension funds and insurance companies lost billions of dollars on securities that they believed were solid investments, according to former Goldman employees with direct knowledge of the deals who asked not to be identified because they have confidentiality agreements with the firm.

Goldman was not the only firm that peddled these complex securities — known as synthetic collateralized debt obligations, or C.D.O.’s — and then made financial bets against them, called selling short in Wall Street parlance. Others that created similar securities and then bet they would fail, according to Wall Street traders, include Deutsche Bank and Morgan Stanley, as well as smaller firms like Tricadia Inc., an investment company whose parent firm was overseen by Lewis A. Sachs, who this year became a special counselor to Treasury Secretary Timothy F. Geithner.

How these disastrously performing securities were devised is now the subject of scrutiny by investigators in Congress, at the Securities and Exchange Commission and at the Financial Industry Regulatory Authority, Wall Street’s self-regulatory organization, according to people briefed on the investigations. Those involved with the inquiries declined to comment.

While the investigations are in the early phases, authorities appear to be looking at whether securities laws or rules of fair dealing were violated by firms that created and sold these mortgage-linked debt instruments and then bet against the clients who purchased them, people briefed on the matter say.

One focus of the inquiry is whether the firms creating the securities purposely helped to select especially risky mortgage-linked assets that would be most likely to crater, setting their clients up to lose billions of dollars if the housing market imploded.

Some securities packaged by Goldman and Tricadia ended up being so vulnerable that they soured within months of being created.

Goldman and other Wall Street firms maintain there is nothing improper about synthetic C.D.O.’s, saying that they typically employ many trading techniques to hedge investments and protect against losses. They add that many prudent investors often do the same. Goldman used these securities initially to offset any potential losses stemming from its positive bets on mortgage securities.

But Goldman and other firms eventually used the C.D.O.’s to place unusually large negative bets that were not mainly for hedging purposes, and investors and industry experts say that put the firms at odds with their own clients’ interests.

“The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen,” said Sylvain R. Raynes, an expert in structured finance at R & R Consulting in New York. “When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson.”

Investment banks were not alone in reaping rich rewards by placing trades against synthetic C.D.O.’s. Some hedge funds also benefited, including Paulson & Company, according to former Goldman workers and people at other banks familiar with that firm’s trading.

Michael DuVally, a Goldman Sachs spokesman, declined to make Mr. Egol available for comment. But Mr. DuVally said many of the C.D.O.’s created by Wall Street were made to satisfy client demand for such products, which the clients thought would produce profits because they had an optimistic view of the housing market. In addition, he said that clients knew Goldman might be betting against mortgages linked to the securities, and that the buyers of synthetic mortgage C.D.O.’s were large, sophisticated investors, he said.

The creation and sale of synthetic C.D.O.’s helped make the financial crisis worse than it might otherwise have been, effectively multiplying losses by providing more securities to bet against. Some $8 billion in these securities remain on the books at American International Group, the giant insurer rescued by the government in September 2008.

From 2005 through 2007, at least $108 billion in these securities was issued, according to Dealogic, a financial data firm. And the actual volume was much higher because synthetic C.D.O.’s and other customized trades are unregulated and often not reported to any financial exchange or market.

Goldman Saw It Coming

Before the financial crisis, many investors — large American and European banks, pension funds, insurance companies and even some hedge funds — failed to recognize that overextended borrowers would default on their mortgages, and they kept increasing their investments in mortgage-related securities. As the mortgage market collapsed, they suffered steep losses..."

To read the rest of the article... Banks Bundled Bad Debt, Bet Against It and Won

Goldman Sachs created SPV to obscure Greek sovereign obligations

The media world is aflutter with recent revelations that Goldman may have facilitated Greece in creating an SPV that "rebalanced" budget payments via an interest rate swap arrangement, which the NYT describes as "a currency trade rather than a loan, [which] helped Athens meet Europe’s deficit rules while continuing to spend beyond its means." For those curious to get a much more detailed perspective on the mechanics of not just this, but a comparable Goldman-facilitated transaction, we suggest the following article in Risk Magazine, which focuses on a similar prior deal completed over six years ago. Yet we are fairly confident that all this barrage of information is merely a Houdini distraction act: the prospectus of the February 2009 securitization deal clearly delineates the mechanics of the deal; it was full public knowledge. Of course, a Europe gripped by sudden chaos due to their aggressive and quick "bail out" response with no regard for public backlash, is now taking full advantage of this recent "discovery" to make it seem that Greece and Goldman were hiding even more information: Bloomberg reports that "Greece was ordered by European Union regulators to disclose details of currency swaps it may have used to deal with the debts that threaten to swamp its economy." Germany's CDU has gone one step further and claims that the "Goldman deal broke the spirit of Euro rules." Alas, this is nothing but more scapegoating while Europe tries to find its bearings and, if possible, back out of the bail out while finding more pretexts to throw Greece out of the euro zone entirely. If it takes a Goldman smear campaign, so be it.

However, where the rub truly lies, and where things for Greece may get very hairy fairly quick, is in the interplay between the rating agencies and the rating of the Goldman underwritten swap agreement securitization SPV known better as Titlos PLC. As one recalls, it was precisely the rating agencies that were the proximal catalyst that started the collateral call cascade that ultimately resulted in AIG's failure and subsequent bailout (ignoring for a moment the pent up toxicity on AIG's books: both AIG then, and Greece now, are in deplorable shape: the question is what will bring it all to the surface). So here are some recent facts: On December 23, 2009, Moody's downgraded Titlos, following the prior day's downgrade of Greece itself from A1 to A2 with a negative outlook. Fact: last week Moody's said it could further downgrade Greece to Baa1. Fact: the Titlos PLC rating mirrors that of Greece itself. Fact: according to Moody's "Framework for De-Linking Hedge Counterparty Risks from Global Structured Finance Cashflow Transactions Moody's Methodology" a counterparty can enter into a hedge transaction with an SPV and continue to participate in that transaction without collateralizing its obligations so long as it maintains a long-term senior unsecured rating of at least A2. When (not if) Titlos is downgraded again, and its rating drops below the A2 collateralization threshold, look for AIG's margin call driven liquidity crisis escalation from the fall of 2008 to spread to Greece. And that's not all. The Titlos SPV itself may be null and void should the rating of the National Bank of Greece, as the Hedge Provider, drop below a "relevant rating" as defined in the hedge agreement. Should Greece then be forced, at Titlos' option, to unwind the swap agreement, and be forced to cash out to the tune of €5.4 billion (net of the 107.54 issuance price), look for all hell to break loose.

AIG legal team studying CDOs

American International Group Inc.'s legal staff is scrutinizing complex mortgage deals the company insured before its government rescue, and will take action if it concludes the transactions wrongly harmed AIG, Chief Executive Robert Benmosche said at the company's annual meeting.

"We are looking at all activities from that period," Mr. Benmosche said. "To the extent we find something wrong that harmed AIG inappropriately, our legal staff will take appropriate action."

Mr. Benmosche made his remarks in response to a question from an investor about Goldman Sachs Group Inc., which is facing a civil suit by the Securities and Exchange Commission over a mortgage deal known as a collateralized debt obligation. That deal, dubbed Abacus 2007-AC1, wasn't insured by AIG, though the bailed-out insurer previously worked with Goldman on other "Abacus" transactions. Goldman has denied wrongdoing in the case.

AIG's chairman, Harvey Golub, said the company continues to do business with Goldman, which he called a "fine firm that does a lot of things extraordinarily well."

Still, the insurer recently picked Citigroup Inc. and Bank of America Corp. instead of Goldman to advise the company on a plan that would help it pay back the bailout it got from the federal government, according to people familiar with matter.

The giant insurer had considered Goldman for the job, but picked the other banks after the firm was sued by the SEC, the people said. Goldman advised AIG on its recent deals to sell two overseas life-insurance businesses for $51 billion.

Where Goldman "can serve the purposes of AIG we will continue to use them," Mr. Golub said. "Where we can get better service from other firms we will do that."

A Goldman spokesman declined to comment.

Lehman ruling creates new doubts for CDOs

"Collateralised debt obligations, the complex debt securities linked to pools of risky mortgages and derivatives, have caused astronomical losses across the global financial system.

Many of the macroeconomic assumptions about house prices - and the likely default rates on mortgages - have turned out to be so wrong that the resulting losses for banks and insurance companies turned a financial crisis into a global economic disaster which continues to be felt to this day.

A look at defaults on CDOs backed by asset-backed securities (see chart) highlights how wrong the beliefs underpinning deals struck at the height of the US housing bubble were: nearly 90 per cent of $186bn of such CDOs issued in 2007 have been defaulted on, compared with a 3 per cent default rate on deals backed by mortgages from 2001.

Much of that is due to the poor mortgage underwriting which prevailed at that time. In other words, these CDOs proved to be among the most toxic of toxic assets.

So much for the past. Now a new uncertainty looms, and it is linked to the assets and money that might be available to investors as these distressed securities are unwound.

This follows a US court ruling last month in the Lehman Brothers bankruptcy which may turn the conventional wisdom which has driven many of these deals on its head.

Structured deals such as CDOs are composed of many different tranches of securities, each representing different levels of risk. When these deals are liquidated, the legal structure of the deals determines which investors are repaid first.

It had long been assumed that investors in structured deals - the ones owning the notes - will get paid before swap counterparties do.

Often swap counterparties have only a small stake in a CDO, providing a hedge on interest rates, for example. But in some of the Lehman deals being contested, swap counterparties had a huge stake. This is particularly true for so-called synthetic CDOs, a shadowy market the scale of which is still hard to pin down, and which surged once banks ran out of mortgages to repackage into CDOs. Instead, credit derivatives linked to these mortgages were repackaged - creating the synthetic CDOs - and at the centre were credit default swaps written by dealers like Lehman's.

Now, Lehman's lawyers are seeking to get paid before other investors do. This position has now been backed by US courts but not by English ones.

"If not overturned, this decision could result in [Lehman Brothers] receiving billions of dollars from various CDOs that would otherwise be distributed to noteholders," said lawyers at Cleary Gottlieb in a note to clients.

Lawyers say they have received requests for advice from investors who have been paid on synthetic CDOs deals after Lehman's default triggered the unwinding of deals. They fear they may be forced to repay money already received, which could add up to $8bn, according to Cleary Gottlieb.

"The problems around CDOs, particularly synthetic CDOs, are really highlighting just how deficient and insufficient many of the assumptions underlying this huge market were," said a lawyer working for a hedge fund which has been paid money on a CDO.

The next step in the Lehman case will come at a hearing in New York on February 10.

Regardless of the outcome, another question mark has been added to the future of structured finance. Even though new deals are not expected to be structured in the same way or linked to mortgage-backed securities, the basic building blocks of structured finance could be affected by the turmoil around CDOs.

The Lehman rulings, for example, could affect whether or not structured finance deals can be rated higher than the ratings of the swap counterparties backing parts of the deal.

If there are divergent decisions in England and the US, one answer may be to just use non-US swap counterparties. However, it highlights the risks that courts may rule in a way which is different to the way lawyers thought they would.

Other issues which have come to the fore are uncertainty about how holders of different slices of the CDOs stand when there are defaults, as well as numerous uncertainties relating to the valuation of these securities when investors are seeking to settle or sell.

Such valuation issues have been particularly in the spotlight since the collapse of AIG, brought down by the weight of CDS insurance sold on hundreds of billions of dollars of CDOs. The pay-outs made by the Federal Reserve Bank of New York when it took over the insurer in 2008 to AIG counterparties like Goldman Sachs and Société Générale - the terms of which appear to have allowed the banks to determine the value of the CDOs when asking for collateral payments - continue to be a source of political scrutiny.

"The provisions in these CDS contracts, with hindsight, do not work well when you have hard-to-value, illiquid financial instruments," said Paul Forrester, partner at Mayer Brown.

"This is just one of the assumptions underpinning structured finance markets that is being re-examined. The status of swap counterparties is another one. All of these outcomes will need to be taken into account when future financial innovations are developed and designed.," Mr Forrester went on.

Inherent risks in CDOs

  • Key qualitative considerations affecting the value of a CDO:
    • Liquidity (or illiquidity)
    • Legal documentation
    • Collateral manager quality;
    • Leveraged, direct, counterparty, and monoline exposures
    • Elements of a FAS 157-compliant evaluation for hard-to-value securities
  • Fair Value Compliance, Avoidance, and Disclosures
    • A review of current accounting frameworks,
    • Their approach to fair value;
    • Side pockets and adjustments in regulatory classification (AFS to HTM)
    • Varying levels of disclosure

New Basel rules could hit synthetic CDOs

"New bank capital rules could deal the final blow to any resurgence of deals in synthetic collateralised debt obligations as well as hurt the value of $330 billion of existing triple-A tranches, Goldman Sachs said.

Proposed changes to Basel II rules, effective end-2010, would increase bank capital requirements by an estimated 11.5 percent overall and 223.7 percent in the trading book, according to a study by the Bank for International Settlements.

At the height of the financial crisis, fears of a market meltdown and defaults of investment-grade credits such as Lehman Brothers drove spreads of synthetic CDOs, also known as collateralised synthetic obligations (CSOs), sharply wider.

Spreads have since largely recovered, and a smattering of new deals have been done, but credit strategists at Goldman Sachs see the potential for new pain.

“For banks, this would mean a much higher cost for running the CSO issuance business,” said strategists Charles Himmelberg, Albert Gallo, Lotfi Karoui and Annie Chu in a note to investors.

A failure of the CSO issuance market to recover, furthermore, will have a long-term impact on the CDS market by comparison with the boom years of 2006 and 2007, when CSO deals boosted demand for CDS and drove spreads to razor-thin levels.

“That means a cap on the size of the CDS market and a higher floor on the level of CDS spreads compared to 2006 and 2007,” Gallo said in a interview.

AAAs HIT BUT NO SUDDEN COLLAPSE

The Goldman strategists said AAA tranches of synthetic CDOs would be hit the hardest, because lower-level tranches are not generally held by the banks.

But they did not predict a sudden market drop.

“Whatever new policies are ultimately introduced would be implemented gradually, limiting the risk of sudden unwinds. Nevertheless, we believe senior tranches would face lower demand going forward and would underperform,” the note said.

They recommended investors buy protection on top AAA tranches of the investment-grade Markit iTraxx Europe index.

Synthetic CDOs are portfolios of mostly investment-grade credit default swaps (CDS) that have been divided into tranches, or slices. The bottom tranche takes the first default losses from any credit in the portfolio, and the senior AAA tranche is hit only after defaults have wiped out all other tranches.

As markets have recovered over the past year, spreads on top tranches of the iTraxx Europe index, have tightened in to 15 to 25 basis points from more than 80 basis points in the crisis.

The strategists now expect the estimated $330 billion of top tranches that remain to underperform the market as demand diminishes.

Spreads on the single-name CDS that were the most popular constituents of CSOs are also likely to underperform, they said.

An analysis of the Standard & Poor’s list of top 100 names in synthetic CDOs shows that they underperformed when the market slumped and outperformed during the subsequent rally, the strategists said.

“We think any further unwind risk would likely result in increased pressure on these single names.”

Reuters published an S&P report at the time on the top 50 CSO names. At the top remain Volkswagen, GE Capital Corp, France Telecom, Deutsche Telekom, Hutchison Whampoa, Telecom Italia, Merrill Lynch & Co., Morgan Stanley, Goldman Sachs and Daimler AG.

IOSCO on investment manager due diligence

The International Organization of Securities Commissions' (IOSCO) Technical Committee has published a final report - "IOSCO Good Practices in relation to Investment Managers' Due Diligence When Investing in Structured Finance Instruments (Investment Manager Due Diligence Practices)" – which contains guidelines aimed at assisting both investment management industry participants and regulatory bodies, in assessing the quality of their due diligence procedures regarding investments in structured finance instruments (SFI) by collective investment schemes (CIS) offered to retail investors.

Transparency of structured finance products

In light of the crisis in financial markets, the Technical Committee (TC) of the International Organization of Securities Commissions (IOSCO) mandated its Standing Committee on the Regulation of Secondary Markets (TCSC2) to examine the viability of a secondary market reporting system for structured finance products (SFPs), with a particular focus on the nature of the market and its participants as well as on the potential benefits and drawbacks of such a regime. In undertaking this task, TCSC2 solicited information from a variety of sources from the financial services industry across several jurisdictions.

Views from market participants varied considerably.

In general, buy-side participants are supportive of increased post-trade transparency for SFPs. They expressed the view that increased transparency would assist them in valuing these products, and in general lead to an improvement in price discovery and liquidity.

In contrast, sell-side participants raised concerns. One of their primary concerns is that the non-standardised, complex and illiquid nature of structured finance products would make meaningful price comparability difficult or impossible. In their view, publishing details of distressed sales might even result in an increase in volatility, a loss of confidentiality and a further downturn of the market. They also raised concerns about the perceived high cost of implementing such a post-trade transparency regime.

The TC recognises that there are divergent views about the merits of requiring enhanced post-trade transparency for SFPs, but nevertheless believes that greater information on traded prices could be a valuable source of information for market participants. The TC therefore recommends that member jurisdictions consider enhancing post-trade transparency in their respective jurisdictions.

In the TC's view, it is appropriate for post-trade transparency regimes to be tailored to take into account the unique nature of the market and participants in each jurisdiction, and that each member jurisdiction is best placed to judge the appropriate time, scope and manner for enhancing post-trade transparency. In general, however, the TC believes that enhanced post-trade transparency should be provided in the most cost-effective way reasonably possible, but should at the same time seek to avoid a negative impact on efficiency and liquidity of markets. Moreover, it may be appropriate in some jurisdictions to introduce post-trade transparency via a step-by-step or phased-in approach.

In light of the above, the TC believes that, amongst other things, it would be appropriate for member jurisdictions to consider the following factors when seeking to develop a post-trade transparency regime for SFPs:

  • The degree of liquidity or secondary market trading for a particular SFP;
  • The initial and outstanding amount of the issue;
  • Whether the SFP was publicly offered or offered via private placement;
  • Whether there is a broad investor base for the particular instrument;
  • The degree of standardisation of a particular SFP;
  • Costs of implementation of a post-trade transparency regime or costs of extending any existing post-trade transparency system to SFPs;
  • Any appropriate time delays in publishing trade information;
  • Whether to require the dissemination of trade-by-trade or aggregate trade information; and
  • Thresholds with respect to the disclosure of trade volumes and further measures to help ensure anonymity of the market participants.

S&P puts $578B of CDO tranches on watch

"Standard & Poor's Ratings Services recalibrated its ratings criteria for collateralized debt obligations, resulting in the ratings firm putting about 4,790 CDO tranches totaling $578 billion on watch for downgrade.

The changes will make the CDO ratings more comparable to ratings in other sectors, S&P said.

The ratings firm will introduce tests -- both quantitative and qualitative -- to supplement its default-simulation model. S&P will also adjust its models to target AAA default rates it believes are commensurate with conditions of extreme macroeconomic stress, such as the Great Depression, as well as BBB default rates consistent with the highest actual coproate defaults over the past 28 years.

S&P said downgrades are likely to be multiple notches after reviewing the tranches over the coming months, with Chief Credit Officer Thomas Gillis estimating that outstanding synthetic CDOs will likely experience an average downgrade of four notches. Super senior AAA tranches will probably be affected less, with expected downgrades of two to three notches, while tranches rated AAA will likely be affected more, with an estimated downgrade of four to five notches.

"We believe that adding quantitative and qualitative elements to our analysis --entirely apart from the Monte Carlo default simulations we run -- will provide a more robust analysis than using only simulation models," Mr. Gillis said.

Ratings agencies have been criticized about being overly optimistic with their ratings earlier this decaded when structured-finance securities were created by packaging loans into newly created investments. CDOs, which use sliced-and-diced assets such as subprime-mortgage bonds to create customized products offering various levels of risk, have been at the heart of steep write-downs at big banks and brokerage firms."

Liquidation of CDOs aids banks

Billions of dollars’ worth of the complex securities at the heart of the financial crisis are being liquidated, enabling banks, insurance companies and other investors to clear toxic assets from their books.

Market participants say the unwinding is occurring in the market for collateralised debt obligations (CDOs), complex securities backed by the payments on mortgages, corporate loans and other debt.

Hundreds of billions of dollars of CDOs have defaulted, but the structures can only be liquidated if the underlying collateral can be sold. In recent weeks, more investors have been buying the underlying assets at deep discounts, leading to increased trade and boosting prices for some existing CDOs.

“There has been a significant increase in the amount of CDO liquidations,” said Vishwanath Tirupattur, analyst at Morgan Stanley. “The rally across asset classes has given investors an incentive to liquidate.”

CDOs were one of the main vehicles through which risky US mortgages were repackaged and sold to investors around the world. Much of their value was wiped out amid a wave of defaults on subprime mortgages. The inability to sell or unwind complex securities such as CDOs was one of the prime problems of the financial crisis. Now, the option to sell these so-called toxic assets is re-emerging. “For a long time it may have made sense for investors to liquidate CDOs, but this was not possible when there was no market for the underlying collateral,” said Ed O’Connell, partner at Jones Day.

The recent rally has been particularly marked for CDOs backed by corporate bonds and loans. Of the more than $500bn of CDOs backed by asset-backed securities sold in the boom years, $350bn have already experienced an “event of default”.

Once that happens, the holders of the top tranches, those once rated triple A, can opt to liquidate the CDO. This involves selling off the collateral. CDOs backed by corporate loans are now trading at levels last seen neary a year ago, shortly after the bankruptcy of Lehman Brothers. Morgan Stanley estimates about $123bn of these defaulted CDOs have been liquidated.

SEC is examining securitizers

U.S. securities regulators are probing the collateralized debt obligations market and are focused on products that were structured as the housing market began to show signs of distress, a top regulator said on Thursday.

At a hearing to examine the origins of the 2008 financial crisis, the Securities and Exchange Commission said it was also looking at investment banks that securitized subprime mortgages.

"We are seeking to determine whether investors were provided accurate, relevant and necessary information, or misled in some manner," SEC Chairman Mary Schapiro told the Financial Crisis Inquiry Commission. The commission was created by Congress and charged with issuing a report by Dec. 15.

The SEC has brought a few enforcement actions against individuals and companies that played a role in the financial crisis. Those include securities fraud charges against Angelo Mozilo, who built the largest U.S. mortgage lender, Countrywide Financial Corp. Countrywide came to symbolize the excesses of the heated housing market and later was bought by Bank of America (BAC.N).

The SEC also continues to pursue its case against two Bear Stearns managers whose hedge funds collapsed in the early stages of the financial crisis. The two men were acquitted of criminal charges in what was a setback for the Justice Department.

Schapiro told the panel that her agency is conducting investigations involving mortgage lenders, investment banks, broker-dealers, credit rating agencies and others that relate to the financial crisis.

"We will continue to look hard at those that may have caused or profited from the financial crisis and bring cases as appropriate," Schapiro said.

Separately, Schapiro said large interconnected institutions should be supervised on a consolidated basis, but warned that this type of oversight has limits.

The SEC did supervise the country's then-largest investment banks Bear Stearns, Lehman Brothers, Goldman Sachs (GS.N) Morgan Stanley (MS.N) and Merrill Lynch.

Those banks have either collapsed, been acquired or reorganized as bank holding companies.

But the agency lacked the statutory authority to supervise the banks' capital and liquidity levels. The program, which ran from 2004 through 2008, was voluntary and deemed fundamentally flawed by former SEC Chairman Christopher Cox.

SEC seeking internal CDO documents

Almost three years since banks started taking losses that led to the worst financial crisis since the Great Depression, the Securities and Exchange Commission is still asking basic questions about what happened.

The SEC is conducting an information-gathering sweep of the key players in the market for collateralized debt obligations, the bundles of mortgage securities whose sudden collapse in price was at the center of the meltdown of the global banking system.

In a letter dated Oct. 22, the SEC sent what amounts to a questionnaire to a number of collateral managers — the middlemen between the investment banks that created the complex financial products and the investors who bought them.

Collateralized debt obligations are made up of dozens, if not hundreds, of securities, which in turn are backed by underlying loans, such as mortgages. Investment banks underwrite the structures and recruit their investors. Collateral managers, brought in by the investment banks but paid by fees from the assets, select the securities and manage the structures on behalf of the investors. CDO managers have a fiduciary duty to manage the investments fairly for investors.

Since 2005, $1.3 trillion worth of CDOs have been issued, with a record $521 billion in 2006, according to the securities industry lobbying group SIFMA (Securities Industry and Financial Markets Association). The collapse in value of mortgage CDOs triggered the 2008 financial collapse.

ProPublica and NPR have confirmed that the SEC letter was sent to several managers, although the distribution list was likely industrywide. At the height of the boom in 2006, only 28 managers controlled about half of all CDOs, according to Standard and Poor's.

Banks began disclosing the first big losses on CDOs in early 2007. The infamous Bear Stearns hedge funds ran into problems beginning that summer. By that August, the credit markets began seizing up. Merrill Lynch and Citigroup were among the hardest hit by losses on bad investments in mortgage-based securities and CDOs.

The SEC's letter focuses on information regarding "trading, allocation and valuations and advisers' disclosure," though it also asks for other details on how the managers ran their businesses. The letter requests information on CDOs issued since Jan. 1, 2006.

The letter asks collateral managers for information about what investments they made on their own behalf and how they valued these investments. Securities experts say the letter indicates that the agency is still gathering basic information about the CDO market, despite its centrality to the banking crisis.

"One wonders why this letter, especially given the general nature of it, is just now being sent. And why wasn't it sent several years ago, as the CDO market was exploding?" says Lynn Turner, who was the SEC's chief accountant in the late 1990s. "It makes it look like the SEC is several years behind the markets."

Even Wall Street executives and securities lawyers who were involved in the CDO business at its height have privately expressed surprise that the SEC was only now contacting them for such rudimentary information.

The SEC declined to comment on the letter. As a policy, a spokesman said, the agency doesn't comment on its regulatory actions. The SEC has jurisdiction over CDO managers and enforces rules against securities manipulation, among other violations. The letter does not use the words "inquiry" or "investigation."

Interviews with market participants and former regulators point to several areas that the SEC might be investigating. Some managers had their own in-house investment funds and may have taken positions that were in conflict with those of the investors in the structures that they managed. In some cases, their hedge funds may have bet against the very slices of the securities they were managing on behalf of the investors in the structure.

Underwriting investment banks often had influence over the investment choices some CDO managers made, giving rise to another possible conflict of interest. The agency may be looking at whether that influence was proper or not.

"The possibility for conflicts and self-dealing is huge," says Turner, the former SEC chief accountant.

To date, the agency has little to show for its probes into the causes of the crisis that engulfed global financial markets just over a year ago. In June 2007, Christopher Cox, then the SEC chairman, testified before Congress that the agency had "about 12 investigations" under way concerning CDOs and collateralized loan obligations and similar products. A little more than a year later, Cox told Congress that the number of investigations into the financial industry, including the subprime mortgage origination business, had ballooned to more than 50 separate inquiries.

There could be multiple reasons why investigations are proceeding slowly. Such cases are complex and require enormous resources and expertise. Regulators also face the hurdle of proving intent to defraud.

Under Cox's stewardship, the SEC fell into disarray, and it was harshly criticized by Congress and its own inspector general, particularly for its failure to catch the Ponzi scheme of Bernie Madoff. The turnover of the new administration, which ushered in new leadership at the much-criticized agency, has also likely slowed efforts. In recent months, under new Chairman Mary Schapiro, the SEC has made insider-trading inquiries a high priority.

So far, there have been few indictments or civil complaints. In a sign of how long these cases can take, the mortgage company New Century Financial Corp. disclosed in March 2007 that it was the subject of an SEC investigation into possible insider stock sales and accounting irregularities. It wasn't until last week — Dec. 7 — that the SEC filed a formal complaint against former executives of the company. The government's highest-profile prosecution involving the financial collapse — the case against two managers of the Bear Stearns hedge fund for alleged securities and wire fraud — failed to gain a conviction when a jury decided that the men were simply bad businessmen rather than criminals.

Have US regulators been soft on banks

ABSTRACT

This article was originally written as a comment on the proposed Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities, 71 Fed. Reg. 28329 (May 16, 2006). The statement is Interagency Statement is a joint effort of all the federal agencies having a role in the regulation of financial institutions, including the SEC, FDIC, Federal Reserve, OTS, and the Comptroller of the Currency.

The comment argues that the proposed Interagency Statement is a mistake and should be withdrawn because in its current form, it can be (and we think will be) read to encourage and condone illegal conduct. The proposed Interagency Statement gives financial institutions too much discretion to determine which “complex structured finance transactions” (CSFT) pose the problem of “elevated risk.”

More troubling, the Statement provides a list of transaction characteristics that “may . . . warrant additional scrutiny” without recognizing or emphasizing that all of the characteristics are strongly indicative of potential fraud which in our view invites reckless participation in illegal conduct, either as a primary wrongdoer or as an aider and abetter.

UBS employee called CDO ‘Vomit’ in e-mail

" A UBS AG employee referred to asset-backed securities sold by the Swiss bank as “vomit” in an internal e-mail in 2007, according to a fraud lawsuit brought by hedge fund Pursuit Partners LLC.

A Connecticut judge cited the e-mail in ruling that UBS must post a $35.6 million bond because Pursuit has enough evidence to pursue a claim that the bank failed to disclose that its collateralized debt obligations faced rating downgrades.

“OK still have this vomit?” a UBS employee wrote in September 2007 to a director, referring to a CDO with an investment-grade rating, according to the ruling. Another UBS e- mail referred to selling “crap” to Pursuit.

“Pursuit has established probable cause to sustain the validity of a claim that the UBS defendants were in possession of material nonpublic information regarding imminent ratings downgrades on the notes it sold to the plaintiffs, information UBS withheld from the plaintiffs,” Superior Court Judge John Blawie wrote in a Sept. 8 opinion in Stamford, Connecticut.

The judge allowed the lawsuit to proceed without ruling on the merits of the case by Stamford-based Pursuit. Zurich-based UBS, the largest Swiss bank, sold Pursuit $40.5 million worth of CDOs between July and October 2007, just as the market for such securities was declining, according to court papers.

A worldwide credit crisis, sparked by defaults on debt tied to subprime mortgages, resulted in more than $1.6 trillion in writedowns and losses since the start of 2007.

Moody’s Review

UBS employees pitched the securities to Pursuit while they were in contact with the credit-rating company Moody’s Investors Services Inc., which was reviewing its “investment grade” ratings on the CDOs, according to court papers.

After meetings with Moody’s, UBS employees became aware that the CDOs would “soon turn into financial toxic waste,” Blawie wrote.

Pursuit, which claims it lost $35.6 million, can pursue claims that UBS hid material non-public information that the debt instruments would lose their investment-grade rating, and that the loss of the rating would render their investments “worthless,” the judge wrote.

UBS spokeswoman Karina Byrne said the bank expected to prevail in the litigation and that no UBS employee had information that Moody’s was considering downgrading the securities before Pursuit bought them.

‘Sophisticated Investor’

“Pursuit Partners is a sophisticated investor whose own evidence demonstrated that Pursuit was fully aware that it was purchasing troubled securities at deep discounts in the summer of 2007,” Byrne said in a statement. “Pursuit insisted on discounts that averaged 70 percent; one investment was purchased as a 96 percent discount.”

Pursuit itself referred to the investments in unflattering terms, according to Byrne.

“In e-mail correspondence with their UBS client relationship manager, a Pursuit principal described the collateral underlying some of these securities as ‘sh--,’” Byrne wrote. “Any suggestion that Pursuit was unaware of the risks it was assuming in purchasing these investments is unsupported by Pursuit’s own e-mails and evidence.”

Moody’s, which also is a defendant, wasn’t required to post a bond. Moody’s is a unit of New York-based Moody’s Corp. Moody’s spokesman Michael Adler didn’t immediately return calls before business hours seeking comment.

On Sept. 2 a federal judge in New York allowed a class action, or group, case against Moody’s, Standard & Poor’s and Morgan Stanley to proceed. The lawsuit claims the credit rating companies hid the risks of securities linked to subprime mortgages.

The case is Pursuit Partners, LLC v. UBS AG, 08-cv-4013452, Connecticut Superior Court (Stamford).

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