Lawbitrage

$7 Billion Citigroup Mortgage Bond Settlement Highlights Importance of Due Diligence

This week's record $7 billion settlement between the Department of Justice and Citigroup stemming from the bank's flawed mortgage-backed securities closes yet another chapter on the financial crisis of 2008.

Although the particular type of subprime mortgage securities involved in the case are no longer being issued by any bank, and overall private mortgage bond issuance is just a fraction compared to pre-crisis levels, the settlement has lessons for structured bond investors anytime valuing collateral poses real challenges.

According to the facts underlying the settlement, Citigroup misrepresented the quality of the mortgage bonds it sold investors and manipulated the process for determining their quality.

In accordance with usual market practice, Citigroup:

• represented that the loans backing the securities complied with lender guidelines and applicable regulations, and had certain loan-to-value ratios and other indications of quality;
  
  
• promised that it would not include any loans if it learned they failed to meet the standards set out in its representations and warranties.

However, Citgroup did not tell investors that during its own review of the loans it found a significant portion not to be originated in compliance with underwriting guidelines or regulations, missing essential documentation, and were so poor that they should have been kicked out of the mortgage pool. Instead, Citigroup directed their due diligence vendor to re-categorize such loans as conforming with their promised guidelines.

Citigroup also included loans that violated its own tolerance thresholds regarding a home's value. Citigroup was supposed to reject loans larger than their due diligence firm's estimate of the home or if there was more than a 15 percent difference between the firm's valuation of the property and the appaiser's valuation. Yet despite the due diligence firm finding loans that deserved to be rejected, Citigroup ended up securitizing loans that failed to live up to the valuation guidelines.

The broad lesson for securitization investors is clear: the integrity of the due diligence process matters. Investors should determine whether the seller (bank) relies on the firm or whether it second guesses or even overrides the firm's findings.

The potential for mischief at the due diligence stage suggests that investors should not blindly rely on the representations and warranties made about the assets in a securitization pool or the process for screening them. Investors should have some access to the findings made by due diligence firms and attempt to verify whether the due diligence firm is aware of the bank second guessing the firm's decisions.

Indeed, investors should require disclosure of disputes between the bank and its due diligence firm to obtain some indication that the value of the assets underlying their securities may be shaky. Likewise, as a summary of post-crisis due diligence requirements and suggested practices notes, investors should "verify and prove the independence of the valuer" when the valuation process itself may be questionable.

In an article about the structures and practices of securitization (and other credit risk transfer) markets, I noted that investors' failure to properly assess the credit risk of mortgage securities and assets was a contributor to the financial crisis. But the past isn't just behind us. If the record Citigroup settlement serves as any reminder, it is that investor due diligence still has room to improve.

Volcker's CLO Shadow

The Volcker Rule seems like a well-intentioned attempt to prevent banks from taking risks that are ultimately paid for by depositors and taxpayers.

Nonetheless, as the final Volcker Rule and banks' reactions to it begin to take shape, it should be increasingly clear that the Rule shifts risk around as much as it actually reduces it.

A case in point is how banks invest in funds that primarily own corporate loans (otherwise known as collateralized loan obligations, or "CLOs"). The Volcker Rule generally prohibits banks from owning (investing in) CLOs unless the CLO limits its investments only to corporate loans. CLOs that also invest in bonds or other securities are off limits.

While this rule may seem to limit bank risk taking, it may actually to do the opposite.

Overconcentration in Loans

By preventing banks from investing in CLOs that have securities, the Volcker Rule undermines the ability of banks to invest in diversified CLOs. Banks thereby may face a higher risk of overconcentrating their exposures to loans. And since CLOs that buy securities are off limits to banks, CLO managers might instead replace securities with loans that are even riskier than bonds to qualify for bank ownership, a point highlighted by the Financial Times' Tracy Alloway. There are also some legitimate concerns about investors already piling too strong into corporate loans. Unfortunately, the Volcker prohibition may artificially increase the demand for loans from CLOs seeking to be sold to banks.

Entrenched CLO Managers

Risk taking by banks may also be increased by the ways in which they may skirt the Volcker Rule prohibition on investing non-compliant CLOs. Despite "ownership" widely being understood to mean investing in equity, under the Volcker Rule bank ownership of a CLO includes investing in CLO debt that allows the investor to replace the CLO manager. Accordingly, removing the ability of CLO debtholders to replace the manager seems to allow a bank to invest in a CLO that otherwise would be off limits. Doing so, however, could help to create CLOs with managers that are less accountable to investors. 

Favoring Passive Over Managed CLOs

Another way to get around any limitations on CLO investment is to invest in a CLO structured as a passively-managed fund (under Rule 3a-7 of the Investment Company Act). Managers of passively-managed funds cannot trade the CLO's assets and must rely on the loans' cash flows to pay investors. Managed CLOs, on the other hand, are more nimble and permit the manager to buy and sell in response to market valuations of loan assets. While trading may cause its own problems, it does not seem wise for the Volcker Rule to effectively create an exception for banks that invest in CLOs that cannot sell their assets to cut losses.

The fact that a law has unintended consequences does not mean it should be repealed. But the fact that the financial crisis was more of a demonstration of how safe--as opposed to risky--CLOs truly are draws into question the need to tinker with how banks invest in CLOs in the first place.

 

As Bond Markets Evolve, Credit Default Swap Market Dwindles

Earlier this month, the International Swaps and Derivatives Association (ISDA) published a research report that began by noting the massive decrease in the notional value of credit default swaps (CDSs) in recent years. CDSs shrank from nearly $60 trillion in 2007 to $25 trillion by the end of 2012. That decline, suggested the Financial Times, means that CDSs are on their deathbed.

CDSs are not as useful as they have been in the past, especially for CDSs that only refer to a single bond or loan (single-name CDSs). Although canceling redundant trades explains much of the reduction in CDS notional value, behind the CDS market decline is a changing credit market landscape on several fronts. In a 2012 article, I noted the main reasons why CDSs are used:

• hedging an existing credit risk;
• reducing regulatory capital;
• speculation, including gaining exposure to a credit without having to buy the cash instrument;
• reducing (mark-to-market) income statement volatility;
• booking accounting profits through a negative basis trade; and
• trading the risk of mispriced (correlated) bonds.

In each of these categories, credit markets have made CDSs less useful.

As the FT article noted, corporate bond defaults are at historic lows, reducing the need to hedge credit risk with CDSs. Regulatory changes have also made it more difficult to use CDS hedges to reduce capital requirements. The main danger in bond markets right now is not credit risk but price risk from uncertainty about economic growth and the Federal Reserve's eventual reduction of its bond buying programs.

The CDS market also grew as a speculator's market. A 2008 estimate found that 80% were used by parties for a purpose other than seeking to insure against the default of a bond they actually owned. Recent years, however, have given traders less to spectulate on. Volatility in bond markets fell to a post-financial crisis low in 2012. Costly new margin regulations also means it will make less sense to use CDSs to speculate. And with less bond volatility, there is less of a need to use CDSs to reduce any corresponding income statement volatility.

The collapse of the private-label residential mortgage bond market further reduced the need for CDSs. Gone along with mortgage bonds is the demand for CDSs in synthetic securitizations and the opportunity to use CDSs in negative basis trades and correlation trades of mispriced mortgage-related bonds.

Although the CDS market may be down, it seems far from out. ISDA's report concluded that if we look at transactions that affect market risk, the CDS market is alive and well. From February to July 2013, transaction activity increased over the previous year by 15% to $17.3 trillion.

Subprime Securitization Returns--Without the Subprime

It was only a matter of time until credit markets sufficiently stabilized and investor appetite for risk grew that we would see the return of the types of securitization deals that were central to the subprime financial crisis of 2008.

One of these deal types is private-label mortgage securitization, which involves creating securities backed by pools of mortgages that are not insured by the federal government. The other deal type is synthetic securitization, which involves creating securities by grouping together the cash flows obtained by protection sellers in credit default swap derivatives.

Today, a Wall Street Journal piece by Al Yoon noted a new private-label securitization deal:

J.P. Morgan Chase & Co. is returning to a nearly deserted part of the credit markets with a sale of $616 million of securities tied to mortgages with no backing by the U.S. government. 

And writing for Bloomberg, Mary Childs reports on the return of synthetic securizations:

Citigroup Inc. is among banks that have sold as much as $1 billion of synthetic collateralized debt obligations this year, following $2 billion in all of 2012, according to estimates from the New York-based lender.

There are several important differences between these new deals and their subprime counterparts, however.

And the differences make them safer.

First and foremost is the fact that they are not transferring the risk of subprime mortgages. The JP Morgan deal is bundling relatively safe jumbo prime mortgages where borrowers put down 35% of the downpayment and have high credit scores. And while the deal's relatively weaker repurchase liability for JP Morgan seems to make it riskier for investors, that characteristic seems more like a feature than a bug. That's because it had the effect of the deal carrying a greater level of loss buffers (credit enhancement) than similar deals, which is probably ultimately more valuable to investors than any right to put the securities back to the issuer.

For its part, the Citigroup synthetic deal transfers the risk of corporate loans, which is a class of credits far less risky and much better understood than subprime mortgages. It is also not a rated transaction that creates "securities" per se, which removes any problem with investors improperly relying on inflated credit ratings. 

Synthetic and private-label securitization structures are not inherently risky. But they were given a very bad reputation by the mispriced subprime risk they attempted to transfer. Accordingly, these types of deals should be viewed with at least some optimism for potentially reflecting the maturing of credit markets and the positive evolution of securitization.

Court Tells Goldman Sachs to Not Always Be Closing

The March 2012 New York Times editorial by former Goldman Sachs executive Greg Smith accused the firm's culture and practices of being centered around "ripping their clients off." Smith followed-up on his editoral yesterday by publishing a full-length book on his time at Goldman and an editorial criticizing much of the financial services industry.

While the soundness of Smith's criticisms leave much to be desired, last week the New York State Supreme Court refused to dismiss an October 2011 lawsuit against Goldman that, much like Smith, faulted Goldman for "putting profits above integrity...to the detriment of its own clients."  The case is Basis Yield Alpha Fund (Master) v. Goldman Sachs Group Inc et al., New York State Supreme Court, New York County, No. 652996/2011.

The suit was brought by a hedge fund claiming that Goldman sought to reduce its exposure to subprime mortgages by selling mortgage-related securities to the fund as sound investments without disclosing Goldman's negative view of the securities or its economic interest in their failure. 

The court refused to dismiss the fraud claims because it found that the fund laid out in sufficient detail specific misrepresentations by Goldman.* 

But the court went further. It held that the fund's fraud claim was also supported by Goldman's overly optimistic opinions about the value of the transactions allegedly made to the fund. These opinions included statements that the transaction was "attractive" and "rock solid."

Goldman argued in a motion that, even if the opinions were actually stated, they don't lay the basis for a fraud claim because they were merely sales talk and puffery--as distinct from misrepresentations of actual fact. A general principle of business and securities law is that opinions cannot serve as the basis for a fraud claim. Moreover, Goldman argued, any statements of opinion are irrelevant in light of the specific disclaimers that were made about the risks of the transactions. 

But the court didn't buy Goldman's arguments.

Relying on prior cases finding that it is fraudulent for a seller to state an opinion that's unreasonable or that the seller does not genuinely believe, the court found as sufficient the fund's allegations that Goldman believed the securities it sold were toxic and that Goldman was motivated to remove the securities from its balance sheet. Likewise, the court found the disclaimers in the transaction's offering documents insufficient to dispose of the fund's fraud claim. This is because of other allegedly fraudulent statements Goldman made outside of the offering documents--in emails to, and calls with, the fund.

A primary lesson from the case thus far is that, to avoid civil liability, firms that use securitization vehicles to transfer risk should not opine as to the quality of securities they are issuing. They should also give the buyer a breakdown of the transactions directly related to the securitization that they are involved in, as well as their relationship with third parties that help structure the vehicle.

A major problem with the opinion is that it allows sophisticated parties like hedge funds to bring suits on the basis of having relied upon opinions, albeit insincere ones. In doing so, it undermines the incentive for sophisticated buyers to do their own research and negotiate for more disclosures and favorable deal terms.

A primary cause of the subprime mortgage crisis was investors' failure to perform their own research or hire independent parties, and the court's decision does not alleviate that problem. To the contrary, it gives implicit approval to buyers to rely on the opinions of sellers when they probably should be ignoring them altogether.

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*Those allegations relate to Goldman's internal valuation of the securities, the independence of the underlying asset selection process, and whether Goldman's interests were really aligned with the fund's.