They were the black boxes of the subprime era, byzantine creations of the brightest minds on Wall Street that made — and then lost — vast fortunes.
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But now, after so much financial pain, Wall Street is nervously tallying the potential legal costs from its misadventures in collateralized debt obligations, known as C.D.O.’s, among the most toxic financial instruments ever devised.
C.D.O.’s, which produced much of the financing for the mortgage explosion, are at the heart of the Securities and Exchange Commission’s civil fraud case against Goldman Sachs — as well as a broader S.E.C. investigation of sales and disclosure practices at many Wall Street firms.
Until the bottom fell out, these instruments also powered an age of riches on Wall Street. Initially, bundling mortgage bonds into C.D.O.’s helped open the spigot of easy money that allowed Americans to buy more house than they could afford.
But Wall Street, as it is wont to do, took the concept to another level, creating securities that allowed investors to make side bets on the housing market. Known as synthetic C.D.O.’s, they did not raise money for home loans or serve any other broad economic purpose.
Instead, like a casino offering blackjack along with slot machines and Texas hold ’em, they were just one more way to bet against the housing market.
Now, the question in Washington is whether other banks, in addition to Goldman, might face legal action stemming from their role in this market. Bank analysts on Wall Street, too, are trying to figure out who might have done deals similar to Goldman’s, exposing them to potential liabilities.
C.D.O. transactions are not publicly traded, so it is difficult to get a full picture of the market’s size. But research suggests it is huge. Thomson Reuters estimates that sales of C.D.O.’s peaked at $534.2 billion in 2006, from $68.6 billion in 2000. Even in 2007, when the housing market was starting to crumble, Wall Street created an estimated $486.8 billion in new C.D.O.’s.
Synthetic C.D.O.’s accounted for just over 10 percent of total C.D.O. issuance in 2007, according to an analysis by the Securities Industry and Financial Markets Association. Traditional cash bond C.D.O.’s made up most of the rest.
Many banks on Wall Street and in Europe were even bigger players in the types of complex investment deals that Goldman is now defending. Merrill Lynch was at the top of the heap, assembling $16.8 billion worth between 2005 and 2008, according to a new report by Credit Suisse.
UBS put together $15.8 billion worth of similar products, according to the Credit Suisse estimates, while JPMorgan Chase and Citigroup each created more than $9 billion worth. Goldman Sachs was a comparatively small issuer, at $2.2 billion.
While Wall Street tallies who issued what, and how much money might be on the line at each firm in the event of lawsuits, the S.E.C. has been conducting an industrywide investigation of how banks sliced and diced mortgages, raising fears that more federal suits may be coming.
The S.E.C. has a team of about 40 investigators focusing on C.D.O. market practices, and regulators are examining a broad array of subprime mortgage-related issues at Wall Street banks. Those include the timely disclosure of losses, accounting irregularities and possible conflicts of interest. A spokesman for the S.E.C. declined to comment on its investigations.
Crucial to the case against Goldman is the question of whether the firm should have disclosed that an investor who was betting against the securities in the portfolio also helped select them. In legal filings, Goldman argues that it was not standard industry practice to make such a disclosure.
Magnetar, a Chicago hedge fund, also invested in C.D.O.’s that it then bet against, without disclosing its role, according to an investigation by ProPublica, a nonprofit journalism organization. Magnetar has denied that it picked individual securities, however, adding that its investment strategy was market-neutral.
The threat of more litigation represents the abrupt end to what was a golden era on Wall Street. The C.D.O. business has been a vital engine in the money machine at many firms for much of the last decade.
Big investors became addicted to the extra yield. Rating agencies earned windfall profits from evaluating the securities. Investment banks enjoyed hefty fees from ready buyers of the assets. And C.D.O. dealmakers racked up huge bonuses, regardless of whether their products later imploded.
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