A Window Into the Wall Street Frauds

A Window Into the Wall Street FraudsFoxBusiness.com – February 4, 2009
By Elizabeth MacDonald

Second in the Crackdown on Wall Street Series

“What’s taking so long?”

That’s the common refrain you hear among even the rank and file on Wall Street, home to the subprime bond factories.
Even lower level workers want to know when miscreant Wall Street executives will get arrested, the officials who went berserk cranking out fraudulent, dangerous securities and who, in the process have flattened the world’s largest investment metropolis and sent the U.S. banking system still lurching around in a hospital gown, despite a year of being in detox.

In due time, law enforcement officials say, as these predatory securitizations and other complex securities frauds take time to unspool and investigate.

Law enforcement officials must prove criminal intent to make their securities and loan fraud cases, as well as accounting fraud cases, a higher bar than the civil cases brought by the Securities and Exchange Commission.

FBI Director Robert Mueller, in congressional testimony, has already pledged to “pursue these cases as far up the corporate chain as necessary to ensure those responsible receive the justice they deserve.”

But what exactly are the Justice Dept., the FBI and the SEC looking at?

Wall Street Speaks

Back in September 2007, I asked James Cayne, former head of Bear Stearns, what was on his mind, knowing that this was the firm that would securitize the issuance from a fire hydrant. “What happened, what exactly went wrong?” I asked.
“Everybody lost their minds,” was his short answer. Indeed. (Bear Stearns collapsed six months later and was bought by JPMorgan Chase for a tiny $10 a share).

The US government, notably the Federal Reserve, has now become the world’s biggest junk investor, as it has taken on the rotting paper crafted by habitually self-deceiving, hubristic hustlers on Wall Street, who, unburdened by conscience, felt entitled to follow their own codes of conduct as they went berserk enriching themselves by crafting fake securities now draped like a drunken paper daisy chain around the earth.
“The credit rating agencies were complicit, too,” another Wall Street executive says, salivating after fees with their drive-by appraisals of nonsensical real estate securities, where they happily gilded the silly by rubberstamping this rubbish as Triple A.
And as bank lending has locked up and the economy is in a deep freeze, the government’s bailout plan has slipped free of its sponsoring facts, its once resounding authority has dwindled into so many solemn doodles on a government yellow pad. The Obama Administration is now discussing a brand new bailout.
This time, a mega-dumpster to buy the Street’s Kryptonite paper, a taxpayer-funded trash compactor whose size has never before been seen in the history of finance.

That means taxpayers will be staring morosely at this mountain of rotting paper for some time to come. And paying for it, too.

Behind the Predatory Securitizations

Wall Street’s derivatives managers are in the FBI’s bulls’ eye, as they were supposed to be selling securities backed by actual assets–not imaginary assets.

But that’s what happened, says derivatives expert Janet Tavakoli, author of ”Dear Mr. Buffett: What An Investor Learns 1,269 Miles From Wall Street” (John Wiley & Sons, 2009).
During the bubble years, which has its roots in the mid-90s, as home prices and mortgage lending exploded, Wall Street and bankers nationwide concocted ever more ingenious ways to repackage trillions of dollars in mortgages, selling them off in pieces to investors around the globe in what are called collateralized debt obligations, or CDOs.

Ironically, Wall Street’s compulsive financial engineering was supposed to limit the risk of financial contagion, but it didn’t work as the subprime crisis went viral and sickened all asset classes around the world. And the CDOs exploded in Wall Street’s face.

CDO Primer

A CDO, generally speaking, is a bond that is backed by income from a pool of bonds, derivatives and other securities. So a CDO based on mortgages could be backed by slivers of a hundred or even more bonds. And those bonds could be comprised of thousands of individual loans.

The CDO then issues a new set of bonds with their own levels of risk. The higher the risk, the bigger return the CDO pays investors–but those investors are first to take losses. This hocus pocus then got Triple-A rated by the credit rating agencies, hungry for fees, a rating that denoted that they were safe.
When they weren’t.

Wall Street’s Sleight of Hand

The notion that tranches backed by completely rotten subprime mortgages could be rated Triple-A, notably in the CDO squared products, is jawdropping, given that these loans defaulted right and left, loans given by reckless lenders to reckless people without even a credit check or income verification.

However, the name of the game for Wall Street was, “if I had a large bonus in my sights and mischief on my mind, how would I unload toxic CDO tranches” from the worst of the subprime loans, the junkiest of junk, how would I hide them?, asks Tavakoli.

A Popular Gimmick

“If you work at an investment bank and you stuff the toxic tranches of only your own CDOs into another CDO, it will be too obvious. You need help from your friends who work for other investment banks, hedge funds, and CDO managers,” Tavakoli says.

But “since you all have toxic CDOs and still want to earn high fees, you can all play investment banking hawala, similar to the complex, but highly effective, money brokering system use in the Middle East,” she says.

(Which is why the FBI has enlisted 15 al Qaeda and terrorist financing agents to work these frauds, overseen by special agent Rachel Rojas, to track the money trail, see first installment, “The Perp Walks are Coming”).

“Hawala makes it virtually impossible to trace cross-border money flows. It will be hard for anyone, except the SEC or someone with subpoena power to examine your trade tickets, to figure out what you are doing. Since the SEC seems to have lost its will to exist, you are good to go,” Tavakoli says.

So, you might mix the really bad subprime junk in with some higher quality loans, “mix it in with some Alt-A or even some prime collateral,” Tavakoli suggests. “That way, if you use this collateral for a CDO, it won’t look so bad, and it will be devilishly difficult to analyze.”

And presto change-o, you’ve magically transformed your subprime bond into a Triple A, goldplated bond.

In the process, you have hot potatoed the risk to the next deal, all within a hermetically sealed system, with all of Wall Street holding each others’ risky junk, a daisy chain of mortgage-linked investments that took stakes in one another.

And then Wall Street got to pricetag these assets through mark to market accounting (which sets values based on what they could get in the market at that time), based on their own phantasmagorical computer models, generating billions of dollars in fees-all concocted on artificial value.

A massive CDO deli machine that sliced and diced bad loans into bonds, pumping out a ton of baloney that eventually destroyed investors around the world.

Has Your Head Exploded Yet?

The madness did not stop with mortgage loans, Tavakoli says.
“Collateralized debt obligations can be backed by any combination of debt: credit derivatives, asset-backed securities, mortgage-backed securities, other collateralized debt obligations, hedge fund loans, credit card loans, auto loans, bonds, leveraged corporate loans, sovereign debt, or any kind of combination of actual or notional debt man can imagine and create.”

Ethical Problems that Can Lead to Fraud Charges

“There is one small problem with this: If you know or should know that you are not correctly pricing your balance sheet or if you knowingly sell overrated securities, you must disclose that, and you must be specific about it,” Tavakoli says.

“If you know something is rated super-safe AAA, but it deserves a near-default rating of CCC, you cannot kept silent about it when you sell it,” she adds.

Tavakoli says that “when I pointed out to an investment banker that this is a classic situation for fraud, he told me: ‘Our internal OGC [Office of General Counsel] disclaims virtually all liability for [our investment bank] and its bankers in small print fully disclosing the risks in the prospectuses.’ I knew what he meant, but he sounded like a smart 10-year-old parroting an adult.”
In other words, the atomic-sized, pharmaceutical-font sized disclosures provide tissue thin cover for this fakery and absolutely no excuse, much less a defense.

“Just because you disclose serious conflicts of interest, it does not protect you if you fail in your duty of care to investors. You lawyers can’t give you a license to kill,” Tavakoli says she admonished him.

But there’s an even bigger problem law enforcement has to deal with.–with reporting by Cristine Ambrose

http://emac.blogs.foxbusiness.com/2009/02/04/a-window-into-the-wall-street-frauds/

Previous Article: http://emac.blogs.foxbusiness.com/2009/02/02/crackdown-on-wall-street-the-perp-walks-are-coming/

DEAR MR. BUFFETT: http://www.amazon.com/Dear-Mr-Buffett-Investor-Learns/dp/047040678X