Goldman, Citigroup CDOs were tip of iceberg

Mark Whitehouse published a view on Bloomberg in which he discussed a study of CDOs that strongly supports the idea that banks chose the bonds to include in the CDOs for their benefit.

Regular readers know that it was not by chance that the bonds backing the CDOs performed worse than the bonds that were not bundled into CDOs.

Wall Street firms, because of their ownership of subprime mortgage originators and servicers, had access to information that was useful in selecting the worse performing bonds.

Of equal importance, because of the opacity of the CDOs and their underlying bonds, this was information than other market participants did not have access to.

Naturally, Wall Street used its informational advantage to generate significant earnings for itself.  Earnings that had there been ultra transparency for structured finance securities would not have been possible.

The complex mortgage instruments at the center of the 2008 financial crisis went so spectacularly wrong that many observers have said they were designed to fail. A new paper by Oliver Faltin-Traeger of the investment firm Blackrock and Christopher Mayer of Columbia Business School lends a lot of credence to that assertion. 

Faltin-Traeger and Mayer -- who are scheduled to present their preliminary results Saturday at the annual meeting of the American Economic Association -- focus on collateralized debt obligations tied to asset-backed securities, or ABS CDOs. For the most part, these were mortgages that had been pooled into bonds, which in turn were repackaged into CDOs.

The process typically resulted in the creation of triple-A rated securities, but also made it difficult for investors to understand what those securities actually contained. 

Hundreds of billions of dollars in CDOs went bad as of 2007, causing heavy losses for investors and banks and triggering a broader panic that ultimately sent the global economy into recession. 

Using a unique database published by the investment firm Pershing Square Capital Management, Faltin-Traeger and Mayer identified the underlying bonds in some 528 ABS CDOs issued between 2005 and 2007, and compared their performance to similar bonds that weren't included in CDOs. 

They found that the bonds in the CDOs performed a lot worse. Even if one holds observable characteristics such as initial ratings and yields constant, the bonds in the CDOs suffered ratings downgrades that were 50 percent to 90 percent more severe. 

As of June 2010, for example, bonds with initial triple-A ratings had been downgraded by an average 11.84 notches, compared to 5.99 for those not in CDOs. The bonds in the CDOs were also more likely to have been rated by all three major credit-rating firms. 

The research provides strong support for the idea that banks -- with the help of pliant ratings agencies -- put together the CDOs and sold them to investors in a premeditated effort to get rid of some of their most toxic assets, or to provide vehicles for clients who wanted to bet against the worst possible assets. 

Not to mention for the traders to bet against the toxic assets.

As the authors put it: "It would have been very hard to randomly choose securities with such poor ex-post performance." 

This narrative has already driven various lawsuits and two high-profile cases. Last year, Goldman Sachs Group Inc. agreed to pay $550 million to settle a case in which the Securities and Exchange Commission accused it of defrauding investors in selling an ABS CDO called Abacus 2007 AC-1. 

Citigroup Inc. is currently embroiled in a separate SEC battle over a $1 billion ABS CDO it created....

Interestingly, the authors found that the performance of bonds in Goldman's Abacus CDOs, while undoubtedly bad, was actually better than average among all bonds that had been similarly packaged. 

More broadly, the bonds in CDOs created by big, highly regulated U.S. and foreign banks performed significantly worse than those in CDOs issued by investment banks or smaller firms.