[Editor's Note - This is a new post with relevant excerpts from a previously Wall Street Law Blog publication about fraud, complexity, and a David Faber interview with Alan Greenspan]
IS IT REASONABLE TO BELIEVE WALL STREET USED COMPLEXITY TO FOOL SOPHISTICATED INVESTORS ABOUT THE QUALITY OF BONDS BACKED BY NONCONFORMING MORTGAGES DURING THE HOUSING BUBBLE ERA?
In a word - ABSOLUTELY.
Indeed, there was so much comlexity in the various methods Wall Street used to package and repackage mortgage bonds in the 2000s that it was nearly impossible for anyone outside the big banks that engineered and sold the products to know the truth about how risky they really were. And the truth was that these products were extremely risky.
Indeed the vast majority of mortgage bonds sold to investors during the 2000s were junk, toxic waste. The problem is that these investments were packaged and sold by issuer banks, with the help of rubber stamped credit ratings, as high quality (safe) securities.
Were the risks disclosed in prospectuses, as some have argued? In a word, nope.
Sure, there were boilerplate risk disclosures. Tons of 'em in fact. But there was no loan level data. No specifics about the actual mortgages. And the actual mortgages were the root of the problem.
Oh, and the issuing banks concealed real known problems from investors by cloaking the problems as risk factors. What the heck does that mean? Glad you asked. It means that risk factors in a prospectus are warnings about potential hazards. A hazard that has already come to fruition at or before issuance is in fact already a problem. Because there is no longer anything "potential" about a risk, it is fraud to label it as a risk factor.
Still confused? That's ok. The whole idea was to confuse investors. Here is an example of what we mean:
One risk factor in every mortgage bond prospectus we've read is about potential liquidity problems with CDO investments. In other words, a prospectus would warn investors that there is no assurance that there would be a secondary market for the bonds. Unlike stocks, mortgage-based derivatives don't trade on an exchange. Market demand could dry up, and if it did, investors who wanted to sell their bonds might be out of luck.
By late spring 2007, there was virtually no secondary market for CDOs. Technically, it was probably possible to sell them, but almost exclusively to bottom feeders at distressed prices (nowhere near face value). And yet, there were tons of new CDO offerings in 2007. The issuing banks concealed the absence of a real secondary market because they wanted to unload as much of their inventories of bad mortgages and mortgage bonds before the jig was up.
The issuers - banks like Bear Stearns and Merrill Lynch and Lehman Brothers (to name a few) - knew that there were big problems in the secondary market. Instead of disclosing the fact that the after-market was well on its way to being totally frozen, these issuers kept right on including the same old generic risk factor about the possible absence of a secondary market.
Also, there is ample evidence that the big banks (a) created the false appearance of market demand for CDOs by selling the investments to each other, and (b) that, when the mortgage bond market was imploding, these same big banks colluded to hold bad mortgage investments on their balance sheets so they could report artificially high maket prices and avoid/delay taking true mark-to-market writedowns.
Just how confusing were CDO's to investors? Consider the following excerpts from an interview that David Faber conducted with Alan Greenspan.
September 4, 2008
David Faber: I would think you're one of the few people who might understand what a CDO really is...
Alan Greenspan: But some of the complexities of some of the instruments that were going into CDOs bewilders me.
I didn't understand what [the banks that produced CDOs] were doing or how they actually got the types of returns out of the mezzanines and the various tranches of the CDOs that they did. And I figured if I didn't understand it -- and I had access to a couple hundred PhDs -- how the rest of the world is going to understand it sort of bewildered me.
But here I am observing all of these very sophisticated investors trying to buy more of this stuff than existed.
David Faber: Yes, but this goes to my original point in my question to you- If Alan Greenspan can't understand how they are getting to where they are getting on these particular structured products, then how are any of these investors supposed to understand?
Alan Greenspan: Well, we learned the answer to that. THEY DIDN'T.
By Brett Sherman, The Sherman Law Firm