Big banks made big bucks selling CDOs, which are pools of mortgage or other kinds of loans, not only during the housing boom, but even after the market came unglued. Here's how they did it: As residential prices started falling in 2006, investors who once had gobbled up CDOs started pulling back because of fears that the underlying loans might go bad. Banks didn't want to abandon the business, however, since an average CDO could earn firms up to $10 million, roughly half of which eventually found its way to employees in the form of bonuses.
To keep the gravy train rolling, securities giants such as Citigroup (C), Goldman Sachs (GS), Merrill Lynch and others came up with a simple solution, reports ProPublica, a not-for-profit (and Pulitzer Prize-winning) publisher of investigative journalism: banks "created fake demand" for CDOs:
[T]he banks created -- and ultimately provided most of the money for -- new CDOs. Those new CDOs bought the hard-to-sell pieces of the original CDOs. The result was a daisy chain that solved one problem but created another: Each new CDO had its own risky pieces. Banks created yet other CDOs to buy those....When the market for CDOs dried up, in other words, Wall Street firms created the illusion that one still existed. They were able to do that by creating CDOs that invested in other CDOs -- owned by the same bank! Merrill Lynch, which was bought by Bank of America (BAC) in late 2008 after nearly collapsing under the weight of its housing-related losses, led the way in this self-dealing. Nearly half of Merrill's CDOs bought parts of other Merrill CDOs, some of which were hawked to retail investors. ProPublica offers a helpful chart depicting how this worked (also see below).
An analysis by research firm Thetica Systems, commissioned by ProPublica, shows that in the last years of the boom, CDOs had become the dominant purchaser of key, risky parts of other CDOs, largely replacing real investors like pension funds. By 2007, 67 percent of those slices were bought by other CDOs, up from 36 percent just three years earlier. The banks often orchestrated these purchases. In the last two years of the boom, nearly half of all CDOs sponsored by market leader Merrill Lynch bought significant portions of other Merrill CDOs.
Even by the spring of 2007, well after home prices had started tumbling and foreclosures were on the rise, banks kept their foot on the gas. In the first quarter of that year, Wall Street firms spewed $70 billion worth for mortgage-backed CDOs. Bankers' claims that no one could've seen the crash coming were never credible, but such figures drives a stake through this phony alibi once and for all.
Another element of the scheme was how banks colluded with CDO management firms, the folks ostensibly responsible for picking the bonds that go into the loan pool. Typically, such managers are supposed to be independent. They're paid by the CDO, not the bank that hires them to oversee the investment.
But to keep priming the pump, Wall Street firms needed CDO managers to pick the riskier mortgage-backed securities that banks hadn't been able to dump on investors. Banks did this in three ways: 1) Steering lucrative CDO business to preferred managers; 2) lending money to managers so the firms themselves could buy a piece of the CDO; 3) Telling managers which bonds to include in the CDO. According to the story:
"I would go to Merrill and tell them that I wanted to buy, say, a Citi bond," recalls a CDO manager. "They would say 'no.' I would suggest a UBS bond, they would say 'no.' Eventually, you got the joke." Managers could choose assets to put into their CDOs but they had to come from Merrill CDOs. One rival investment banker says Merrill treated CDO managers the way Henry Ford treated his Model T customers: You can have any color you want, as long as it's black.Merrill Lynch and Citi, which ProPublica calls the "biggest perpetrators" in the kind self-dealing it describes, eventually lost $26 billion and $34 billion, respectively, on their CDO sales. Both required massive taxpayer bailouts. As we know, CDOs provided tinder for the housing sector, driving millions of people into foreclosure.
Perhaps the most disturbing part of this sorry tale is that it's not clear that any laws were broken. The SEC continues to investigate the Street's CDO practices, but no firm has been convicted of wrongdoing. It's also unclear if the Dodd-Frank financial reform law gives regulators enough authority to prevent such episodes in future.
When fraud appears legal, you know something is broken.
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