Ratings Arbitrage a/k/a Fraud

Investment banks bundled mortgage loans into securities and then often rebundled those securities one or two more times. Those securities were given high ratings and sold to investors, who have since lost billions of dollars on them.

Editor’s Note: The significance of this report cannot be overstated. Not only did the investment bankers LOOK for and CREATE loans guaranteed to fail, which they did, they sold them in increasingly complex packages more than once. So for example if the yield spread profit or premium was $100,000 on a given loan, that wasn’t enough for the investment bankers. Without loaning or investing any additional money they sold the same loans, or at least parts of those loans, to additional investors one, two three times or more. In the additional sales, there was no cost so whatever they received was entirely profit. I would call that a yield spread profit or premium, and certainly undisclosed. If the principal of the loan was $300,000 and they resold it three times, then the investment bank received $900,000 from those additional sales, in addition to the initial $100,000 yield spread profit on sale of the loan to the “trust” or special purpose vehicle.

So the investment bank kept $1 million dollars in fees, profits or compensation on a $300,000 loan. Anyone who has seen “The Producers” knows that if this “show” succeeds, i.e., if most of the loans perform as scheduled and borrowers are making their payments, then the investment bank has a problem — receiving a total of $1.3 million on a $300,000 loan. But if the loans fails, then nobody asks for an accounting. As long as it is in foreclosure, no accounting is required except for when the property is sold (see other blog posts on bid rigging at the courthouse steps documented by Charles Koppa).

If they modify the loan or approve the short sale then an accounting is required. That is a bad thing for the investment bank. But if they don’t modify any loans and don’t approve any short-sales, then questions are going to be asked which will be difficult to answer.

You make plans and then life happens, my wife says. All these brilliant schemes were fraudulent and probably criminal. All such schemes eventually get the spotlight on them. Now, with criminal investigations ongoing in a dozen states and the federal government, the accounting and the questions are coming anyway—despite the efforts of the titans of the universe to avoid that result.

All those Judges that sarcastically threw homeowners out of court questioning the veracity of accusations against pretender lenders, can get out the salt and pepper as they eat their words.

“Why are they not in jail if they did these things” asked practically everyone on both sides of the issue. The answer is simply that criminal investigations do not take place overnight, they move slowly and if the prosecutor has any intention of winning a conviction he must have sufficient evidence to prove criminal acts beyond a reasonable doubt.

But remember the threshold for most civil litigation is merely a preponderance of the evidence, which means if you think there is more than a 50-50  probability the party did something, the prima facie case is satisfied and damages or injunction are stated in a final judgment. Some causes of action, like fraud, frequently require clear and convincing evidence, which is more than 50-50 and less than beyond a reaonsable doubt.

From the NY Times: ————————

The New York attorney general has started an investigation of eight banks to determine whether they provided misleading information to rating agencies in order to inflate the grades of certain mortgage securities, according to two people with knowledge of the investigation.

by LOUISE STORY

Andrew Cuomo, the attorney general of New York, sent subpoenas to eight Wall Street banks late Wednesday.

The investigation parallels federal inquiries into the business practices of a broad range of financial companies in the years before the collapse of the housing market.

Where those investigations have focused on interactions between the banks and their clients who bought mortgage securities, this one expands the scope of scrutiny to the interplay between banks and the agencies that rate their securities.

The agencies themselves have been widely criticized for overstating the quality of many mortgage securities that ended up losing money once the housing market collapsed. The inquiry by the attorney general of New York, Andrew M. Cuomo, suggests that he thinks the agencies may have been duped by one or more of the targets of his investigation.

Those targets are Goldman Sachs, Morgan Stanley, UBS, Citigroup, Credit Suisse, Deutsche Bank, Crédit Agricole and Merrill Lynch, which is now owned by Bank of America.

The companies that rated the mortgage deals are Standard & Poor’s, Fitch Ratings and Moody’s Investors Service. Investors used their ratings to decide whether to buy mortgage securities.

Mr. Cuomo’s investigation follows an article in The New York Times that described some of the techniques bankers used to get more positive evaluations from the rating agencies.

Mr. Cuomo is also interested in the revolving door of employees of the rating agencies who were hired by bank mortgage desks to help create mortgage deals that got better ratings than they deserved, said the people with knowledge of the investigation, who were not authorized to discuss it publicly.

Contacted after subpoenas were issued by Mr. Cuomo’s office late Wednesday night notifying the banks of his investigation, spokespeople for Morgan Stanley, Credit Suisse and Deutsche Bank declined to comment. Other banks did not immediately respond to requests for comment.

In response to questions for the Times article in April, a Goldman Sachs spokesman, Samuel Robinson, said: “Any suggestion that Goldman Sachs improperly influenced rating agencies is without foundation. We relied on the independence of the ratings agencies’ processes and the ratings they assigned.”

Goldman, which is already under investigation by federal prosecutors, has been defending itself against civil fraud accusations made in a complaint last month by the Securities and Exchange Commission. The deal at the heart of that complaint — called Abacus 2007-AC1 — was devised in part by a former Fitch Ratings employee named Shin Yukawa, whom Goldman recruited in 2005.

At the height of the mortgage boom, companies like Goldman offered million-dollar pay packages to workers like Mr. Yukawa who had been working at much lower pay at the rating agencies, according to several former workers at the agencies.

Around the same time that Mr. Yukawa left Fitch, three other analysts in his unit also joined financial companies like Deutsche Bank.

In some cases, once these workers were at the banks, they had dealings with their former colleagues at the agencies. In the fall of 2007, when banks were hard-pressed to get mortgage deals done, the Fitch analyst on a Goldman deal was a friend of Mr. Yukawa, according to two people with knowledge of the situation.

Mr. Yukawa did not respond to requests for comment.

Wall Street played a crucial role in the mortgage market’s path to collapse. Investment banks bundled mortgage loans into securities and then often rebundled those securities one or two more times. Those securities were given high ratings and sold to investors, who have since lost billions of dollars on them.

Banks were put on notice last summer that investigators of all sorts were looking into their mortgage operations, when requests for information were sent out to all of the big Wall Street firms. The topics of interest included the way mortgage securities were created, marketed and rated and some banks’ own trading against the mortgage market.

The S.E.C.’s civil case against Goldman is the most prominent action so far. But other actions could be taken by the Justice Department, the F.B.I. or the Financial Crisis Inquiry Commission — all of which are looking into the financial crisis. Criminal cases carry a higher burden of proof than civil cases. Under a New York state law, Mr. Cuomo can bring a criminal or civil case.

His office scrutinized the rating agencies back in 2008, just as the financial crisis was beginning. In a settlement, the agencies agreed to demand more information on mortgage bonds from banks.

Mr. Cuomo was also concerned about the agencies’ fee arrangements, which allowed banks to shop their deals among the agencies for the best rating. To end that inquiry, the agencies agreed to change their models so they would be paid for any work they did for banks, even if those banks did not select them to rate a given deal.

Mr. Cuomo’s current focus is on information the investment banks provided to the rating agencies and whether the bankers knew the ratings were overly positive, the people who know of the investigation said.

A Senate subcommittee found last month that Wall Street workers had been intimately involved in the rating process. In one series of e-mail messages the committee released, for instance, a Goldman worker tried to persuade Standard & Poor’s to allow Goldman to handle a deal in a way that the analyst found questionable.

The S.& P. employee, Chris Meyer, expressed his frustration in an e-mail message to a colleague in which he wrote, “I can’t tell you how upset I have been in reviewing these trades.”

“They’ve done something like 15 of these trades, all without a hitch. You can understand why they’d be upset,” Mr. Meyer added, “to have me come along and say they will need to make fundamental adjustments to the program.”

At Goldman, there was even a phrase for the way bankers put together mortgage securities. The practice was known as “ratings arbitrage,” according to former workers. The idea was to find ways to put the very worst bonds into a deal for a given rating. The cheaper the bonds, the greater the profit to the bank.

The rating agencies may have facilitated the banks’ actions by publishing their rating models on their corporate Web sites. The agencies argued that being open about their models offered transparency to investors.

But several former agency workers said the practice put too much power in the bankers’ hands. “The models were posted for bankers who develop C.D.O.’s to be able to reverse engineer C.D.O.’s to a certain rating,” one former rating agency employee said in an interview, referring to collateralized debt obligations.

A central concern of investors in these securities was the diversification of the deals’ loans. If a C.D.O. was based on mostly similar bonds — like those holding mortgages from one region — investors would view it as riskier than an instrument made up of more diversified assets. Mr. Cuomo’s office plans to investigate whether the bankers accurately portrayed the diversification of the mortgage loans to the rating agencies.

Gretchen Morgenson contributed reporting

Moody’s Investors Service and Fitch Ratings enriched themselves by assigning high ratings to bonds backed by mortgages “that were designed to fail”

NATION’S HOUSING

Civil rights complaint targets Wall Street rating firms
Moody’s and Fitch’s high ratings of subprime mortgage bonds disproportionately harmed black and Latino home buyers, the National Community Reinvestment Coalition alleges.
By Kenneth R. Harney
November 30, 2008
In what is apparently the first legal action of its kind, an association of community-based organizations has filed a federal civil rights complaint against two of the three largest Wall Street rating firms, charging that their inflated ratings on subprime mortgage bonds disproportionately caused financial harm to African American and Latino home buyers across the country.

The complaint, filed by the National Community Reinvestment Coalition, alleges that Moody’s Investors Service and Fitch Ratings enriched themselves by assigning high ratings to bonds backed by mortgages “that were designed to fail” because of “unfair payment terms and insufficient borrower income levels.”

The firms “knew or should have known” that subprime loans disproportionately were marketed to minority consumers — a process known as “reverse redlining” — and that those borrowers would ultimately default and go into foreclosure at high rates, according to the coalition’s complaint.

Fitch Managing Director David Weinfurter said the NCRC’s filing “is fully without merit, and Fitch intends to defend itself vigorously.” Moody’s had no immediate comment.

The filing cites multiple studies that found that African Americans and Latinos received a disproportionate share of subprime loans during the housing boom years. A Federal Reserve study in 2006 estimated that 45% of mortgages extended to Latinos and 55% of loans to African Americans were subprime — a utilization rate “three to four times that of non-Hispanic whites.”

Because the loans themselves often came with terms that increased borrowers’ probability of default — upfront teaser rates followed by unaffordable reset payment adjustments, no required documentation of applicants’ incomes or assets, plus hefty prepayment penalties — African Americans with subprime mortgages are projected to lose $71 billion to $92 billion through foreclosures, while Latinos are projected to lose $75 billion to $98 billion, according to one study cited in the complaint.

“Had subprime loans been distributed equitably,” the complaint estimates, “losses for whites would be 44.5% higher and losses for people of color would be about 24% lower.”

A third rating firm with heavy involvement in the subprime boom, Standard & Poor’s Corp., was not named in the complaint but has been “in discussions” with the NCRC, said David Berenbaum, the group’s executive vice president. If the discussions with S&P prove “unsatisfactory,” he said, the company could be the subject of a separate action.

The NCRC filed its complaint with the Department of Housing and Urban Development’s fair housing and equal opportunity unit. After a review, HUD could either dismiss the allegations or refer the case to the Justice Department of the incoming Obama administration for litigation next year. If HUD fails to respond adequately, the NCRC says it may file a federal civil lawsuit.

The civil rights complaint is the latest in a series of lawsuits, regulatory investigations and congressional criticism of the rating firms’ roles and conduct during the mortgage bond heyday years of 2003-05. In dollar terms, subprime and so-called Alt-A no-documentation loans accounted for 32% of all mortgage originations in 2005. Their share had been 10% two years before. Virtually all of those high-risk loans were sold to Wall Street firms for inclusion in complex bond structures that were resold, often in bits and pieces, to pension funds and financial institutions.

The traditional function of the rating firms has been that of Wall Street’s “gatekeepers,” evaluating the risks involved in the collateral backing bonds. Their assignment of investment-grade ratings to securities based on high-risk mortgages — and their subsequent mass lowering of those ratings as default losses piled up — has earned them scorching criticism from investors, regulators and Congress.

Much of the criticism focused on the fact that the firms are paid lucrative fees for their ratings by bond issuers themselves — not investors — thereby creating potential conflicts of interest. The firms also competed with one another to rate subprime loan securitizations, creating additional pressure to provide the most favorable possible ratings.

The Securities and Exchange Commission investigated the rating firms this year and found “serious shortcomings” at Moody’s, Fitch and S&P, including lack of oversight of conflicts of interest. Investigators also turned up evidence that employees apparently knew that some of the mortgage pools they were rating were potentially toxic.

In one instant-message exchange, an analyst reportedly called a deal “ridiculous. . . . We should not be rating it.” A colleague responded: “We rate every deal. It could be structured by cows and we would rate it.”

Critics such as Berenbaum contend that without mass securitizations of high-risk mortgages — with stamps of approval from the rating firms — far fewer subprime loans would have been made, and far fewer minority home buyers would have ended up in foreclosure.

Foreclosure Defense and Offense: Rating Agencies and Appraisals

Taking the entire Mortgage Meltdown process as a single transaction starting with the origination of the loan to the borrower and ending with the sale of an asset backed security to an investor, a pattern of deception and confusion emerges — providing the borrower with an arsenal of offensive and defensive strategies to avoid foreclosure, recover damages and even free their property from the mortgage altogether. In foreclosure defense and particularly offense for “lender” liability, keep in mind that there was a chain of entities who all knowingly conspired (under a cloak of what they deemed “plausible deniability”).

This chain was never disclosed to the borrower — thus the disclosure obligations set forth in TILA, state law, RICO, common law and other resources were never met and the right to rescission was blocked by lack of information, to wit: the borrower in most cases does not know who to send the rescission letter to because in all likelihood there are now multiple parties who have an interest in the security instrument, the note and the risk of loss, none of whom were disclosed to the borrower at or after closing. 

These participants are subject to liability for monetary damages and many are insured as well as having deep pockets of their own. They also de-linked several aspects of what had been a single event — the purchase of a home with a first mortgage on residential property using money in part loaned by a lender who took the risk of non-payment, followed underwriting guidelines set by the banking industry and regulators, and therefore had a direct stake in the outcome of the loan and a specific desire to avoid default on the loan. 

The de-linking of teht ransaction and overlapping with other parts of the entire single “mortgage meltdown” chain resulted in separation of the security interest from the the obligation to pay, adding obligors who had liability for payment, and adding receivers of income. Thus the classic and relatively simple foreclosure that involved non-payment by the borrower to the lender, was converted in a complex series of transactions leaving the investor who bought the asset backed security with the right to the income and some rights to the security interests, and others with the the right to the security interest but no right to payment, and still others who made payments to the investor or who were liable for non-payment to the investor who acquired the right to payment from the underlying mortgage and note from which his asset backed security derived its value.

The significance of this in foreclosure defense is that the party alleging non-payment by the borrower is NOT and CANNOT allege non-payment to the entity or person (investor) who is entitled to that payment. The usual person entering the foreclosure process is the trustee posting notice of sale or the originating lender filing foreclosure. But they do not know if the investment bank, an insurer or some other third party, including another borrower was contributing to the flow of payments that the investor received, nor do they know the allocation of those funds which the investor received.

Thus the party entitled to income from the borrower’s note may or may not have been paid by the borrower (through overcharges and other TILA violations in addition to regular monthly payments, or by third parties whose obligation derived in part from the note signed by the borrower and in part by hundreds or thousands of other notes in cross collateralization agreements or cross guarnatees, indemnifications, indentures and covneants between the lender, mortgage agregator, investment banker, seller of teh security and the investor who bought the security. 

You can therefore take the position that if the default alleged is non-payment, the entity or person making the allegation must prove the non-payment and that proving that the borrower did not make one or more payments does not prove that the party (investor) entitled to payment did not get paid in whole or in part. Thus no default has been alleged without alleging that no payment was received by the holder of the original note and mortgage and the party to whom payment was to be received as a result of the income stream from this mortgage combined with thousands of other mortgages.

Production of the original note and mortgage becomes critical and a condition precedent to any action, sale, motion for summary judgment, judgement of foreclosure, sale or rights of redemption. Equally important and perhaps more so is the production of the documents that assigned, sold or otherwise transferred the security interest, the income from the note or the risk of non-payment to one or more parties. You will find that in many cases, those are all different third parties with different interests and agendas.

Perhaps the most important, we are finding in Ohio and other states, that NOBODY can come up with documents that directly link a particular borrower with any of these third parties holding primary or secondary rights to the security instrument, the note, or the risk of loss. In those cases, we are seeing borrowers walk away with their home free and clear of any encumbrances and lawyers getting paid fat bonuses or contingency fees for eliminating the risk of foreclosure, and feeing the borrower from the entanglement in a complex transaction that was never disclosed to him/her/them.

The appraisers, who are usually insured by errors and omissions policies, state the fair market value of real property through supposedly independent analysis of comparable statistics and other factors. The standards are governed by the regulatory board in each state that licenses them, although there might still be some states who do not license appraisers. In states without licensing, they are governed by common law and other applicable law concerning deceptive business practices.

The rating agencies state the quality of a security that is used to determine the fair market value of the security. They too are supposedly using objective means, analysis and due diligence to issue their rating. In the world of the mortgage meltdown, rating agency objectivity broke down y virtue of two main factors: (a) the rating agencies were competing for customers and revenue and (b) in a related factor, the rating agency analysts were receiving gifts, pressure from clients (issuers) and pressure from management to “accommodate” the client (issuer). A Nationally Recognized Statistical Rating Organization (or “NRSRO”) is a credit rating agency which issues credit ratings that the U.S. Securities and Exchange Commission (SEC) permits other financial firms to use for certain regulatory purposes.

The nine organizations currently designated as NRSROs are:

Ratings by NRSRO are used for a variety of regulatory purposes in the United States. In addition to net capital requirements (described in more detail below), the SEC permits certain bond issuers to use a shorter prospectus form when issuing bonds if the issuer is older, has issued bonds before, and has a credit rating above a certain level. SEC regulations also require that money market funds (mutual funds that mimick the safety and liquidity of a bank savings deposit, but without FDIC insurance) comprise only securities with a very high rating from an NRSRO. Likewise, insurance regulators use credit ratings from NRSROs to ascertain the strength of the reserves held by insurance companies.

The following article described the efforts of the New York Attorney general to address the break down of objectivity caused by competition for fees.

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Bond-Rating 
Shifts Loom 
In Settlement

N.Y.’s Cuomo Plans 
Overhaul of How 
Firms Get Paid
By AARON LUCCHETTI
June 4, 2008; Page C1

The three major bond-rating firms are set to overhaul the way they collect fees as part of a settlement with New York state’s attorney general, Andrew Cuomo, that could be announced as soon as this week, people familiar with the matter said.

If a deal is reached, it could change the $5 billion-a-year bond-rating industry as fundamentally as Mr. Cuomo’s predecessor Eliot Spitzer did six years ago with his settlement with Wall Street firms over stock-research analysts whose recommendations were compromised by investment-banking ties.

[Andrew Cuomo]

Terms of Mr. Cuomo’s settlement with Moody’s Corp.’s Moody’s Investors Service; McGraw-Hill Cos.’ Standard & Poor’s unit; and Fimalac SA’s Fitch Ratings deal with what many critics claim has been a chronic problem with bond ratings: They are paid for by the entities being rated. That financial dependence has been blamed for the industry’s failure to predict that risky subprime mortgages would crumble, resulting in losses and shaken confidence.

The accord attempts to change the incentive structure for the ratings firms. Now, while more than one ratings firm reviews most deals, not all of them always rate the deal and get paid. That gives the firms an incentive to go easy on their rating in order to win the business.

Under the Cuomo settlement, which would cover the hardest-hit portions of the mortgage market, the firms would get paid for their review, even if they didn’t end up getting hired to rate the deal. This would mean the firms would get paid even if they were tough. The plan, which requires final agreement by Mr. Cuomo’s office and the rating firms, wouldn’t dictate the exact fees rating firms could charge. But the firms would be required to charge more than a nominal fee for their preliminary work.

The bond-rating firms also have tentatively agreed to disclose on a quarterly basis the fees they are paid for nonprime-mortgage-backed securities, which include subprime mortgages and so-called Alt-A mortgages that have less documentation or don’t conform with prime-mortgage standards.

Such disclosures are seen as a potential red flag to help investors detect instances where bond issuers or their bankers may have essentially pitted different rating firms against each other in order to get a higher rating.

In an interview late last year, Brian Clarkson, then the president and chief operating officer of Moody’s Investors Service, acknowledged that “there is a lot of rating shopping that goes on…What the market doesn’t know is who’s seen” certain transactions but wasn’t hired to rate those deals. Last month, Mr. Clarkson, who once ran the Moody’s group overseeing mortgages and other structured-finance products, stepped down, effective in July.

The settlement is unlikely to satisfy critics who have urged that bond-rating firms stop being paid altogether by bond issuers or that the firms be permitted to rate any deal they choose, regardless of whether the issuer cooperates. Following the settlement, bond issuers still would get a strong say over which firms published the final rating, as well as those invited to look over a pool of loans in the first place.

For Moody’s, S&P and Fitch, the agreement largely eliminates the possibility of a nasty showdown with Mr. Cuomo, whose office has been investigating the industry for about nine months, poring through thousands of pages in documents and emails and interviewing senior executives at each of the three big rating firms, people familiar with the matter said.

Mr. Cuomo has leverage over the bond-rating industry partly because Moody’s and S&P are based in New York. The attorney general also has one of the most powerful legal tools in the nation: the 1921 Martin Act, which spells out a broad definition of securities fraud without requiring that prosecutors prove intent to defraud.

In a statement, Deven Sharma, S&P’s president, said the firm “is pleased to work with New York Attorney General Andrew M. Cuomo and other rating agencies on these important measures, which we believe will help ensure our ratings process continues to be of the highest quality.”

Rating-company shares rose after The Wall Street Journal reported news of the settlement talks Tuesday afternoon. In 4 p.m. composite trading on the New York Stock Exchange, Moody’s was at $38.45, up $1.80, or 4.9%. McGraw-Hill was up 38 cents at $41.20.

As the probe proceeded, attorneys in Mr. Cuomo’s office concluded that rating firms could be more effective if Wall Street had less control over which ones were paid, these people said. As part of the deal, the firms would cooperate with Mr. Cuomo’s continuing investigation into investment banks and other financial firms that issued mortgage-backed securities later plagued by high levels of defaults. The New York attorney general is trying to determine if banks intentionally overlooked or hid flaws in loans that were securitized and sold to investors.

The decision not to seek fines from the three major bond-rating firms partly reflects Mr. Cuomo’s firm but less-confrontational style than that of Mr. Spitzer. The 50-year-old Mr. Cuomo, elected in 2006, has promised to aggressively pursue financial wrongdoing, and the likely pact shows he believes investor confidence can be shored up without an all-out attack on the bond-rating industry.

Mr. Cuomo’s settlement will likely be structured in a way that doesn’t contradict rules being proposed by the Securities and Exchange Commission. It will take up to six months to implement and may also need to address antitrust concerns at investment banks or among smaller rating firms. “Without knowing all the details, I’m concerned it would entrench the three large rating firms,” said David Schroeder, chief operating officer of DBRS, a Toronto rating firm not included in the settlement talks.

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