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Unreal: Banks' Created Fake Demand to Boost Profits and Yearly Bonuses

Over the last two years of the housing bubble, Wall Street bankers perpetrated one of the greatest episodes of self-dealing in financial history.

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Greywolf declined to comment. One of the investors, Basis Capital of Australia, filed a civil lawsuit in federal court in Manhattan against Goldman over the deal. The bank maintains the lawsuit is without merit.

By March 2007, the housing market's signals were flashing red. Existing home sales plunged at the fastest rate in almost 20 years. Foreclosures were on the rise. And yet, to CDO buyer Peter Nowell's surprise, banks continued to churn out CDOs.

"We were pulling back. We couldn't find anything safe enough," says Nowell. "We were amazed that April through June they were still printing deals. We thought things were over."

Instead, the CDO machine was in overdrive. Wall Street produced $70 billion in mortgage CDOs in the first quarter of the year.

Many shareholder lawsuits battling their way through the court system today focus on this period of the CDO market. They allege that the banks were using the sales of CDOs to other CDOs to prop up prices and hide their losses.

"Citi's CDO operations during late 2006 and 2007 functioned largely to sell CDOs to yet newer CDOs created by Citi to house them," charges a pending shareholder lawsuit against the bank that was filed in federal court in Manhattan in February 2009. "Citigroup concocted a scheme whereby it repackaged many of these investments into other freshly-baked vehicles to avoid incurring a loss."

Citigroup described the allegations as "irrational," saying the bank's executives would never knowingly take actions that would lead to "catastrophic losses."

In the Hall of Mirrors, Myopic Rating Agencies

The portion of CDOs owned by other CDOs grew right alongside the market. What had been 5 percent of CDOs (remember the "bucket") now came to constitute as much as 30 or 40 percent of new CDOs. (Wall Street also rolled out CDOs that were almost entirely made up of CDOs, called CDO squareds[11] .)

The ever-expanding bucket provided new opportunities for incestuous trades.

It worked like this: A CDO would buy a piece of another CDO, which then returned the favor. The transactions moved both CDOs closer to completion, when bankers and managers would receive their fees.

Source: Thetica Systems

Source: Thetica Systems

ProPublica's analysis shows that in the final two years of the business, CDOs with cross-ownership amounted to about one-fifth of the market, about $107 billion.

Here's an example from early May 2007:

  • A CDO called Jupiter VI bought a piece of a CDO called Tazlina II.
  • Tazlina II bought a piece of Jupiter VI.

Both Jupiter VI and Tazlina II were created by Merrill and were completed within a week of each other. Both were managed by small firms that did significant business with Merrill: Jupiter by Wing Chau's Harding, and Tazlina by Terwin Advisors. Chau did not respond to questions about this deal. Terwin Advisors could not reached.

Just a few weeks earlier, CDO managers completed a comparable swap between Jupiter VI and another Merrill CDO called Forge 1.

Forge has its own intriguing history. It was the only deal done by a tiny manager of the same name based in Tampa, Fla. The firm was started less than a year earlier by several former Wall Street executives with mortgage experience. It received seed money from Bryan Zwan, who in 2001 settled an SEC civil lawsuit over his company's accounting problems in a federal court in Florida. Zwan and Forge executives didn't respond to requests for comment.

After seemingly coming out of nowhere, Forge won the right to manage a $1.5 billion Merrill CDO. That earned Forge a visit from the rating agency Moody's.

 
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