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The World of Wall Street CDOs or “Don’t Lie to Me”

Posted by Larry Doyle on May 13, 2010 2:18 PM |

News that the SEC and federal prosecutors are further investigating Wall Street firms involved in the structuring and distribution of CDOs (collateralized debt obligations) is not a surprise. Although Goldman Sachs has been targeted initially for its marketing of an Abacus transaction in conjunction with Paulson and Co., the simple fact is Goldman was not anywhere close to the largest player in this space. Who was? Well, I should more appropriately ask, “Who wasn’t?” All of Wall Street jumped on the CDO gravy train.

The Wall Street Journal sheds some insights on this story by writing, Wall Street Probe Widens:

Federal prosecutors, working with securities regulators, are conducting a preliminary criminal probe into whether several major Wall Street banks misled investors about their roles in mortgage-bond deals, according to a person familiar with the matter.

The banks under early-stage criminal scrutiny—J.P. Morgan Chase & Co., Citigroup Inc.,Deutsche Bank AG and UBS AG—have also received civil subpoenas from the Securities and Exchange Commission as part of a sweeping investigation of banks’ selling and trading of mortgage-related deals, the person says. Under similar preliminary criminal scrutiny are Goldman Sachs Group Inc. and Morgan Stanley, as previously reported by The Wall Street Journal.

The Manhattan U.S. Attorney’s office and SEC are working hand-in-hand. At issue is whether the Wall Street firms made proper representations to investors in marketing, selling and trading pools of mortgage bonds called collateralized debt obligations, or CDOs.

Many major Wall Street banks created CDOs at the behest of players that made bets against the deals—and banks themselves sometimes bet against the deals. Bearish bets paid off when the mortgage market crashed.

The challenge for investigators and regulators in this investigation is melting the materials down to the point where they themselves can understand the intricate nuances and subtleties of the deals. Will these investigators and regulators comprehend the concept of a waterfall, overcollateralization, subordinate cash flows, credit supports, super-senior cash flow, equity, a trigger?

Why do you think members of Congress looked like such buffoons while questioning the representatives from Goldman Sachs? The crowd from Goldman was talking a foreign language. Do you really think legal eagles from the DOJ, or regulators from the SEC or FINRA stand a chance in discussing the nature of these transactions with CDO structurers? Not a chance.

As I write this piece, I recall the oft heard conversation from salespeople themselves who would engage those structuring the CDOs. The conversation would go something along these lines:

Salesperson: “Can you give me the breakdown in the collateral behind this deal? How about the geographic dispersion in the collateral? Please also tell me the level of credit supports?

Structurer: (rolls his eyes in a condescending and disparaging fashion): “Why so many questions? This deal is cheap.”

Salesperson: “Well, my client would like to know this information.”

Structurer: “OK, try this. Try telling your client that we are still pooling the collateral, but it looks to be good and we have a lot of interest in the deal. If he persists, then try telling him it is like this other deal.”

Salesperson: “What? What do you mean, try telling him….How about we try this, ‘You don’t lie to me.’ How about you start by telling me the truth, and then I’ll figure out how to sell the bonds.  Got it? How can I figure out what to tell my client if you’re lying to me?”

Structurer: “I hate dealing with you. Where are the dumb salespeople?”

Although this exchange is a bit of a parody, it is not all that far removed from what would often happen. The point being is that the individuals structuring deals were often mathematical geniuses who could figure out how to bury and disguise risk so it was not easily detected. The risks would then be exposed during periods of extreme volatility, much like what occurred during 2007-2008.

Not all of Wall Street was operated in this manner. Many market sectors were highly commoditized and transparent.

The world of CDOs was not one of those markets.


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  • divvytrader

    like i told you a week or so ago as you were in full throttle GS bashing mode , it wasn’t going to be long before your former boss ( Dimon ) would be in equal trouble …….

    so why is media leaving him alone ?

    we surely know why the lapdog media is leaving Citibank alone ….. Treasury still needs to sell alot of shares before they shut it down .

    • LD

      Divvy…Jamie is ultimately headed to Washington so its hands off.

      Actually in regard to JPM, the firm did plenty of CDOs but they were primarily high yield backed deals.

      JPM was a virtual odd lot in the sub-prime and ABS-backed deals.

      Dimon foresaw the risks in sub-prime and stayed away. Corporate credit deals was an entirely different deal. JPM was huge in that space.

      • divvytrader

        Larry : what does it matter whether its a corp credit or subprime synthetic CDO ? One has to find one side to get long and one side to get short . There was one JPM salesman extolling the virtues of getting long your synthetic CDO and there was another telling a different client what a crap deal it was to get him to buy the short position .

        Can you really articulate to me JPM was clean and GS dirty ? I hope not because smart people know its 100% same thing .

        GS has plenty of warts for SEC and others to go ask some pointed questions about but this synthetic CDO witch hunt was the wrong vehicle because JPM/C/UBS/BAC/etc,etc,etc were all doing the same thing .

        With all due respect , you got out a little over your ski tips seizing on the GS/CDO story as proof of their corruption / evilness / etc,etc,etc because your former employers were up to their hips in exact same game .

        oh , and just to be clear ? i have no problem with either GS or JPM making money in synthetic CDO game which by design requires a customer to get long and one to get short . The buyers are / were all ‘big boys ‘ and nobody made them do a thing .

        and for anybody with any form of memory , back in 2007 , John paulson was an obscure hedge fund who many on Street thought was going to blow himself up shorting subprime while none less than Ben Bernanke told us subprime was no big problem in same year . So why should JPM or GS get in trouble for facilitating Paulson in 2007 ? He was just a wild cowboy with a crazy bid to get short a sector at really rich levels !

        • LD


          I am not making excuses for JPM. All I am saying is that if this investigation is centered on ABS backed or synthetic ABS deals (which it seems to be) then they probably will not find much at JPM. I agree. That fact does not absolve JPM from likely doing the same thing in credit backed deals.

          Same restaurant, different tables.

  • Shark


    You are correct that nearly all the big players were knee deep in Synthetic CDO game. But when jig was up and everyone started realizing how bad these bonds were, GS had already nearly got back to even by dumping as much as they could on their customers. All while scrambling to pick up as much insurance or shorting(in the form on Credit default swaps) as they could get there hands on. They succeeded in these endeavors when everyone else was just beginning to catch on. Currently, congress is using them as the scape goat, but right now it appears the scape goat is getting the better of them.

    • divvytrader

      i assure you that GS sent over the propsectus on about 500 different synthetic CDO done by other major broker dealer and reminded them they can’t prosecute GS for the same crime every major broker dealer was obviously knee deep in .

      My money says SEC is so clueless about synthetic CDO that they had no clue about the extent it was done .

      Today , the major NY papers talk about a possibly a ‘ global settlement ‘ on synthetic CDO by SEC to be announced . This is further proof the SEC realizes it had no clue how deep this trade was and can’t possibly try and prosecute all the othe rmajor banks like it wants to screw GS .

      if the banks were all smart ? they would give the SEC the middle finger and tell them to ‘ come and get me ‘ ….. my money ssays SEC will back down and collapse like a house of cards …..

      add in fact XLF is down 12% in last few weeks and GS is so beaten up the talk of going private is rampant and i suspect SEC is losing all stomach to push this .

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