In the wake of suing Goldman Sachs for fraud in the creation and sale of mortgage-backed derivatives, the Securities and Exchange Commission said it will look closely at other similar transactions by other big Wall Street banks, according to a recent Wall Street Journal article by Carrick Mollencamp, Serena Ng, Gregory Zuckerman and Scott Patterson (Note: the WSJ appears to have double the usual number of reporters on this story).
The SEC’s case against Goldman has shined a light on a “morally bankrupt” practice that was well-known on Wall Street: As the housing bubble began to burst, Wall Street banks allowed key clients to bet against mortgage-backed derivatives that those banks designed and sold to less favored clients.
The firms that designed and sold failed mortgage-backed derivatives include Deutsche Bank AG, UBS AG and Merrill Lynch & Co., now owned by Bank of America Corp., according to the article.
As with the case against Goldman Sachs, the SEC is expected to focus on the materiality of the misrepresentation and omission of facts and risks associated with the toxic derivatives, and not simply whether a deal favored one client over another. As the Wall Journal article points out, a critical part of the SEC’s case against Goldman is that Goldman allegedly failed to disclose to investors the fact that the selection of the underlying securities was directly influenced by a hedge-fund manager who was bearish on the deal and intended to (and did) purchase swaps that would increase in value as the mortgage-backed derivatives decreased in value.
It is widely believed that such deals, which generated billion dollar revenues for the Wall Street banks that sold them, were instrumental in precipitating the near-failure of American International Group Inc. AIG was “on the risk” for billions in credit default swaps of the kind that Paulson’s hedge fund was on the other side of in the Goldman Sachs deal. AIG was rescued by TARP money because it was “too big to fail” and would likely drag large pieces of the economy into the vortex as it went down the drain, unable to pay off on the credit default insurance it sold.
By January 2008, credit-rating firms had downgraded 99% of the mortgage securities in the collateralized debt obligation at the center of the SEC’s fraud case against Goldman Sachs. Some CDOs created by Deutsche Bank, Merrill and UBS also suffered downgrades to most of their assets by early 2008, according to the article.
In his recent article titled “Bank: Merrill Committed Same Fraud as SEC Claims Goldman Did,” Chad Bray of the Wall Street Journal quoted attorneys for a Dutch bank known as Rabobank as saying that Merrill Lynch committed the “same type of fraudulent conduct” in connection with a deal called Norma CDO Ltd.
Deutsche Bank is said to have packaged similar securities, and its investors were reportedly “devastated” by news of the Goldman case, according to a New York Times article by Floyd Norris, “Is Deutsche Bank in, or Out of, Trouble?”
Deutsche Bank’s traders and bankers were alerted to problems in the housing industry as early as September 2005, well before the bubble burst, by its own mortgage-securities analyst, who warned of pending losses in subprime loans, according to the article. That analyst’s report recommended buying credit default swaps as insurance against mortgage-bond defaults.
Nevertheless, during 2005 and 2006, Deutsche Bank created several CDOs that sold credit default insurance on mortgage bonds that the firm’s hedge-fund clients bet against, according to the article. Deutsche Bank itself bought swaps that would pay off if mortgages backing the CDOs weakened.
Among the hedge-fund clients was one run by the hedge fund manager (Paulson) who selected at least some of the mortgage securities for the Goldman CDO (Abacus). Paulson reportedly also helped choose about 100 mortgage assets for some of Deutsche Bank’s CDOs. Paulson’s hedge fund made billions on the mortgage meltdown, according to the article.
These bearish conflicting interests were not adequately disclosed to investors who purchased tranches of the CDOs, which took bullish positions on mortgage bonds, according to some observers.
Page Perry is an Atlanta-based law firm with over 125 years collective experience representing institutional and individual investors in CDO litigation and arbitration all over the country. 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.