The National Credit Union Administration (“NACUA”) should be considering litigation against Wall Street firms that sold collateralized debt obligations (“CDOs”) to its member firm Eastern Financial Florida Credit Union (“Eastern Financial “), which resulted in losses of nearly $150 million and Eastern Financial’s placement in conservatorship in April 2009, according to a recent New York Times article by Gretchen Morgenson.
Eastern Financial was created in 1937 to serve the Miami employees of what later became Eastern Airlines. It later added other Florida employee groups and was serving 208,000 members when it failed last year. Eastern Financial had $1.6 billion in assets at the end of 2008.
The CDOs sold to Eastern Financial fell in value almost immediately. By September 2007, the losses were $63.4, almost two-thirds of the original investment. By the time of its failure, all of the CDOs had been written down to zero.
The National Credit Union Share Insurance Fund, a federal agency that guarantees credit union deposits, will have to pay an estimated $40 million in connection with the failure of Eastern Financial.
As the article points out, the brokerage firms that marketed and sold the CDOs to Eastern Financial typically try to pin the blame on institutional customers for being “sophisticated investors” who should have known better. As the article further points out, however, that argument is flawed for a number of reasons.
The report from the inspector general of NACUA found that the major cause of Eastern Financial’s collapse was the toxic CDOs that were sold to it just as the mortgage mania was faltering. Between March 2007 and June 22, 2007, some firm or firms (apparently not identified in the IG’s report) sold Eastern Financial nearly $100 million of CDOs that mostly contained “dicey home equity loans.”
The IG’s report also noted that the CDOs sold to Eastern Financial were private placements, “which provided less readily available market data to perform analysis and provide better understanding of underlying assets and grading system, tranches, etc.”
“This situation illustrates yet again why over-the-counter securities and derivatives are not suitable for federally insured banks and other ‘soft’ institutional clients,” the article quoted Christopher Whalen, editor of The Institutional Risk Analyst, as saying. “Wall Street securities dealers who knowingly cause losses to federally insured depositories should go to jail,” he added.
The IG also found that Eastern Financial’s management and board “relied too heavily on rating agencies’ grading of C.D.O. investments,” and failed to evaluate and understand their complexity.
According to Richard Field, managing director of TYI, which develops transparency, trading and risk management information systems, there is a lack of loan-level data on what is in these pools, making due diligence impossible. “A sizable percentage of the problems in the credit markets and bank solvency are directly related to this lack of information,” Mr. Field said.
The brokerage firms that sold the CDOs to Eastern Financial are required to pre-sale conduct due diligence on all securities and investment products they sell. They cannot lawfully sell an investment to anyone without having first used due diligence to determine that the investment is suitable both generally and for the particular customer. This requirement is specified in Notices of Members published by the Financial Industry Regulatory Authority (“FINRA”), which is responsible for policing broker sales practices. It is a virtual certainty that this requirement was not met.
According to Mr. Whalen (quoted above), the Eastern Financial insolvency illustrates why regulators should make Wall Street adhere to concepts of suitability for institutions as well as individuals. “The dealers who sold the C.D.O.’s to this credit union should be sanctioned,” he was quoted as saying. “It might even be possible to pursue the dealer who sold the C.D.O.’s under current law. At a minimum, the Securities and Exchange Commission should impose retail investor suitability standards onto banks and public sector agencies to end the predation by large Wall Street derivatives dealers.”
The good news for institutional investors like Eastern Financial is that the suitability rules apply to brokers whether the customer is retail or institutional, a novice or financial sophisticated.
In addition to the legal prohibition against recommending unsuitable investments, brokers are required to disclose and not misrepresent all material facts and risks concerning any investment they sell.
In short, there is no license to mislead or sell unsuitable investments to institutional investors, and many institutions have filed arbitrations and lawsuits against brokerage firms that misled them, because they owe it to their stakeholders to do so.
In addition, the timing of the sales seems suspect. The sales to Eastern Financial occurred between March and June 2007, which was “when Wall Street’s mortgage machinery was sputtering” and “it became a matter of some urgency for these firms to jettison mortgage-related securities in their pipelines.” Were brokerage firms unloading their inventories on unsuspecting clients? It would not be the first time that happened.
Will NACUA seek legal remedies? “We always consider potential claims of third-party liability in cases of this magnitude,” said John J. McKechnie III, director of public and congressional affairs at the administration.
NACUA should focus on the real culprits ? the brokerage firm(s) – that misled Eastern Financial’s executives into purchasing unsuitable securities.
Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 30 occasions. Page Perry’s attorneys are actively involved in representing institutional and corporate investors that lost money in CDOs and other structured finance instruments. For further information, please contact us.