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Six Wall Street Excuses for Shady CDO Sales That Won't Survive Criminal Probes

A federal probe into whether Goldman Sachs (GS) and Morgan Stanley (MS) deceived investors in mortgage-backed derivatives has exploded into a full-blown criminal dragnet. And the banks on the receiving end of this unwelcome attention have a lot to be worried about.

Joining those two investment banks in the hot-seat are, well, practically everybody who's anybody in the collateralized debt obligation world: Citigroup (C), JPMorgan Chase (JPM), Deutsche Bank (DB), UBS. Expect the inquiry to suck in more banks and investment firms as things progress. If I were Tiger Woods, I'd watch my back.

Unlike Tiger, though, the banking firms face not only the court of public opinion, but one of law. Although such cases are notoriously complicated and hard to prove, the root charge here is simple as can be: Bankers lied. They're alleged to have withheld key information from investors to gull them into betting on CDOs.

Indeed, it's the defense that could prove complicated, especially if Goldman front-runs rivals by settling with the the SEC first. Things are really staring to resemble "analyst-gate." As you'll recall, that was New York AG and man-about-town Eliot Spitzer's jihad against equity analysts, who were found guilty of hyping stock during the tech boom so their investment banking brethren could snag lucrative underwriting business.

The issue today, as in 2002, centers on faulty disclosure and conflict of interest. Specifically, investment banks caught up in the CDO sting appear to have put their financial interests, and those of preferred clients such as John Paulson, ahead of other clients.

Here's why the bankers should be worried -- their excuses stink. Let's examine them for a moment:

  • We did nothing wrong. This defense turns on the spurious idea that in a synthetic CDO, like Goldman's infamous Abacus, someone always wins and someone always loses. Not really. That's no more true for a CDO than it is for a plain-vanilla stock. As Steve Randy Waldman has explained, investors may short a CDO, or they may not. And that decision naturally may hinge on what a bank chooses to reveal about the investment. So the contention that banks were simply acting in their capacity as market-makers here doesn't wash.
  • Everybody does this. And cannibals have to eat. So what? It may well have been "industry practice" on Wall Street to keep CDO investors in the dark regarding the structure and content of these products. That doesn't make it ethical or legal.
  • We lost money too. Again, so? Whether banks made or lost dough on their CDO deals is immaterial. During the dot-com crash, underwriters occasionally lost money on IPOs they'd illegally flipped to special clients. That doesn't make them innocent. The question is if banks misled investors. If firms like Goldman did take a hit on their CDOs, many of which appear to have been unfairly manipulated, that would simply attest to their incompetence, along with their alleged dishonesty.
  • Investors should do their homework. Right on. Trouble is, that doesn't do any good if the test is rigged. Again, banks are accused of withholding the very information CDO buyers would need to properly assess their value.
  • Banks don't have a fiduciary duty to clients. This may be Wall Street firms' strongest argument, given that brokerage firms operate under a less rigorous standard called "suitability" duty. But banks that sell CDOs aren't like hardware salesmen recommending a sump pump; they custom-built these suckers and spun tales to attract buyers. That's where the court of public opinion, and politics, come into play -- people have little interest in making distinctions between abstruse legal standards. All they know is that someone got screwed (And, as during analyst-gate, the feds have the emails to prove it.) That means the screwer has got to pay.
  • Bad apples did it. Goldman implied as much when it hung lead Abacus schlepper Fabrice Tourre out to dry last month, telling clients that it "would never condone one of its employees misleading anyone, certainly not investors, counterparties or clients." Nice try. Unless Fabulous Fab was moonlighting at every other bank now under federal scrutiny, the CDO scam was systemic.
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