What did Wall Street used to be like, before the Securities Act of 1933? Michael Perino’s new book on Ferdiand Pecora, which I reviewed here, reminds us. For instance, there was National City Bank’s Peru deal.
National City’s South American experts had reported that the government’s finances were “positively distressing”, with the treasury “flat on its back and gasping for breath” and the president surrounded by “rascals”. Yet, inevitably, National City decided to underwrite a series of bonds from Peru. Nowhere in the prospectus was there any indication of National City’s view on the country; meanwhile, National City’s ads stated that “when you buy a bond recommended by The National City Company, you may be sure that all the essential facts which justify the Company’s own confidence in that investment are readily available to you”.
Perino continues:
National City kept right on offering Peruvian bonds in 1927 and 1928, even though one of its own South American experts continued to conclude that he had “no great faith in any material betterment of Peru’s economic condition in the near future”. The political situation, he wrote, was “equally uncertain,” with “revolution” a distinct possibility. Would the public have purchased these bonds, Pecora asked, if that information had been included in the prospectus? “I doubt if they would,” Baker replied.
Pecora did something similar with a bond offering for the Brazilian state of Minas Gerais. National City used much of the proceeds to pay off a loan due to itself, without telling telling investors that it was using their money to exit the very credit they were buying into. And that’s not all:
How Minas Gerais would use the proceeds of the bond offering was not the only misrepresentation in the prospectus. Pecora put George Train, the man who originally urged National City to underwrite these bonds, on the stand. Train, it seemed, was willing to play fast and loose with other crucial facts in order to get the deal done. In 1927, analyzing Minas Gerais’s history of bond offerings in Europe, Train was amazed at the shoddy way the government had handled its obligations. The “laxness of the State authorities,” he wrote in an internal company memorandum, “borders on the fantastic”. His review of Minas Gerais’s history “showws the complete ignorance, carelessness and negligence of the former State officials in respect to external long-term borrowing.” It would, he wrote, “be hard to find anywhere a sadder confession of inefficiency and ineptitude than that displayed by various State officials.” Despite those conclusions, Train wrote in the prospectuses for the bond offerings, “Prudent and careful management of the State’s finances has been characteristic of successive administrations in Minas Gerais.”
I’m quoting Perino at length, here, because I’m getting a lot of pushback from various commenters to my assertion that pretty much every major investment bank in the world withheld material nonpublic information when they failed to pass on to investors the results of the due diligence tests that Clayton did on mortgage loan pools.
Kid Dynamite says that we’re not talking about material nonpublic information here. But of course we are: it’s information, it’s nonpublic, and it’s certainly material, since it resulted in the investment banks negotiating down the price of the loan pool in question.
The Securities Act came into law largely in reaction to exactly the kind of behavior that Pecora uncovered with the Peru and Minas Gerais bonds. The banks knew bad stuff about the bonds they were selling, but they didn’t pass on that information to investors. And so the Securities Act was written to put an end to such shenanigans.
The Clayton reports were much more than mere opinion, like the ratings agencies pretend to be. (And in any case, credit ratings are public information.) Clayton did detailed empirical research on the loan pools, and when the banks didn’t like what they saw, they used that information to their own advantage — by asking for a discount on the loans from the originator.
The whole point of the Securities Act was to ensure that information like that was passed on to investors. That’s why bond prospectuses are so long: they include every conceivable piece of information, and every conceivable risk factor, that might possibly be relevant to the price of the bond.
Yet the MBS prospectuses for the loan pools that Clayton examined didn’t include the fact that Clayton had done due diligence on them, didn’t say what Clayton’s results were, and certainly didn’t disclose that those results had allowed the underwriter to buy the loans from the originator at a discount.
If Ferdinand Pecora were alive today, he would recognize all this behavior — and be shaking his head at the way in which banks simply ignored the spirit of the laws which FDR put into place in the wake of the Pecora Commission.
Did the banks behavior violate the letter of the law? I think there’s a good case that they did; they certainly broke the law as it exists today. But let’s find out! Come on, prosecutors — file some suits, here, and see what happens. This crisis has yet to reach the stage at which people start going to jail. And we need to pass through that stage before it’s all over. So let’s get to it.
Can’t wait for the securities litigation on this matter. When asked on the stand whether a prudent investor would find the default rate material, what would YOU say?
against my better judgment, I need to comment on this, and set a few facts straight regarding material non-public information.
First and foremost, I’m under the impression that, contrary to Felix’s claims, the underlying loan data WAS available. This is an essential point. (please ignore the references to Abacus etc below – that’s off topic, and it’s not the point – the point is that the data about the loans composing the MBS pools was available)
http://www.structuredfinancenews.com/new s/-205879-1.html
“Loan-level data about the mortgages pooled in those MBS was available to investors in Abacus and other such deals throughout the frothy heyday of CDOs, before the financial crisis struck full force in September 2008.
And that data would have provided investors with far more substantive information about the deal’s health than whether a hedge fund selected some of its loans. At least one technology vendor provided loan-level data for virtually all securitized mortgages. But instead most investors relied almost solely on the now discredited ratings from the ratings agencies, perhaps in part because they were bond investors unaccustomed to the nitty-gritty loan analysis traditionally performed by commercial bankers.
Those investors could have analyzed a wide range of metrics about the financial status of the borrowers and their loans, as well as the performance of the securities comprising those assets. So an investor in Abacus could have analyzed the real estate underlying each of the loans in JPMAC 2006-FRE1 M8 Midprime, a mortgage-backed security referenced by Abacus, as well as the underlying loans of the remaining 99 mortgage-backed securities in the CDO. The JPMAC security was serviced by JPMorgan and rated ‘BBB’ by Standard & Poor’s.
David Hurt, senior vice president of business development at Loan Performance, a unit of CoreLogic, says his firm has provided the relevant loan-level data and many of the tools to analyze it since before the housing bubble.”
So there goes any attempt to label any of this non-public. The information was NOT non-public. Felix, i think again you are confounding the loan information with Clayton’s INTERPRETATION of the loan information. The thoughts that sit in my head (or in this case, Clayton’s head) may be material – that doesn’t mean they have to be disclosed, as long as the information my thoughts are based on is available. This is not meant to be a semantics argument either.
The prospectus I looked at contains no information whatsoever about the issuer’s underwriting standards (except that they have a disclosure that a “SUBSTANTIAL” number of the loans did not meet the standards and required “Exceptions.”). Thus, how can it possibly be material that Clayton says x% of the loans don’t meet the underwriting standards? The reader doesn’t even know what the underlying standards ARE! The point of the prospectus is to provide the investor with data so that the investor can decide if HIS OWN underwriting standards are met! Get it? The MBS buyer is the one who is actually doing the “lending” here.
Felix is correct. The non-disclosure was a breach at least today, under the new rules, but maybe not pre-SOX. And investors said nothing. The RMBS market is a disaster in terms of investor rights, but you must defend your rights. Nobody read the PSAs.
I agree with Kid. Along with tour-de-force Yves Smith (not to mention the much-missed Tanta, queen of this topic), Felix is doing yeoman’s work on finding and explaining the structural facts and involved parties of the many heads of the mortgage mess hydra.
However, he would be much better served by talking to experienced lawyers in the arena, and developing his arguments with some legal guidance, if he wants to write as a journalist and not merely a provocateur. At least Barry Ritholtz trys to develop the general legal argument as well as the fact pattern.
I get it, the legal minutia is hard and writing about how the sky is falling is fun. But this stuff is legally complex, nuanced, and EXTREMLY fact specfic. And if you get it wrong (see Felix’s recent Rule 10b5-1 and Section 15(E) posts), then you lose credibility and your future arguments are dismissed as hyperbolic (c.f. some of Denninger).
Kid Dynamite has asked for a real example of the misrepresentation that everyone assumes was rampant. I reiterate that request, if only to confirm the problems, not to wave them away.
I understand, and agree with, the widespread belief that SOMETHING had to have happened in the RMBS/CDO sales channels that was at least civilly actionable, if not criminally prosecutable. But where is it? Prove your point with EVIDENCE.
Those prospectuses were mostly full of disclaimers about this very point – what information was available, what the investor could depend on and what they couldn’t or should investigate themselves, what reps & warranties were made by who to whom, etc.
So find them, read them, dissect them, talk about them with securities lawyers, and then bring a well-grounded argument to the table about how a specific party violated well-settled legal obligations to another party.
This has the potential to be another financial catastrophe, but it could also wind up like the GS/Abacus noise – terrible optics, and maybe there should be more obligations on the MBS conduit creators, but when you look at the actual facts along with actual law, there might not be much there, there.
More journalism, and less uninformed opinions. But in any event, keep it up, please – this was a ‘attaboy’ pep talk, not a condemnation.
These comments might be more pertinent to the book review but you know how it goes:
1. For those despairing that the finance industry will ever actually be brought to heel (Dodd-Frank – don’t make me laugh), I would point out that the Pecora commission was the fourth investigation into the industry not the first. I would also point out the SEC eventually created by Roosevelt (inter alia) was the second attempt at regulation after the initial bill was beaten by industry pressure in congress.
2. Frank Partnoy’s bio of Ivar Kreuger, The Match King, is a great look into how wall street operated “back in the day”. To understand just how big the forgotten Kreuger was I would compare him to a combination of Warren Buffett, Richard Branson and Bernie Madoff only bigger than any of them. Highly recommended.
I can appreciate KD’s point, and could say that all the information that Clayton used was available. But let’s use an analogy here. Let’s say a big fast food chain Mickeys was buying beef from food company DeadBeefCo. DeadBeefCo used chemicals to process their beef, and Mickeys hired a consultant to find out if those chemcials were ok to be consumed. The consultant told Mickeys that some of those chemicals were very bad, but Mickeys bought the beef and sold burgers made with it anyway, because not all of the chemicals were bad.
People got sick and died from eating those burgers and lots of people sued Mickeys. Mickeys said anybody could have found out that DeadBeefCo used those chemicals in their beef, because DeadBeefCo mentions it in their SEC filings. Do you think that would keep Mickeys from successfully getting sued? I’m thinking no.
On the other hand, I don’t know what the buyers of these bonds were expecting. Nobody should have really needed anyone to tell them those bonds were garbage, because mortgages were being handed out like time bombs wrapped as candy. They were guaranteed to blow up.
So this is where my appreciation of some libertarian beliefs collides with my belief that a government can “form a more perfect union, establish justice, insure domestic tranquility” – in short, prevent stuff like this happening. I wouldn’t care so much about the buyers of the bonds getting burned if they didn’t burn the whole damn house down. So do you penalize them, or say “that wasn’t nice”, and foolishly expect they won’t do it again?
OnTheTimes – let’s start at a slightly different point: DeadBeefCo uses chemicals to process their beef. If I hire a consultant to test the chemicals and find out that they are toxic, and then I short MCD stock – that is NOT trading on material non-public information, even though the information is material, and it seems to not be in the public realm – it’s publicly available – it’s called good research on my part. If, however, I had dinner with the DeadBeefCo or MCD CEO, and either of them tell me “hey – you wouldn’t believe the toxic crap we’re putting in our beef – it’s a matter of time before it kills someone” – THAT would clearly be inside information.
Now, if MCD does these tests, finds out the beef is toxic, and sells it to comsumers as NON-toxic, then of course they will get sued. But what if MCD sells it to consumers saying “these are the chemicals in the beef, we make no representation that they will be good for maintaining a healthy lifestyle”?
of course, this is there food differs from bonds. We all agree that individuals cannot be expected to know that the beef they are eating is bad for them, and we have the FDA regulate it for us. They don’t allow MCD to sell food under the disclaimer “we make no representation that this food won’t kill you.” securities are different though!
with bonds, it’s why the prospectus constantly avoids making representations as to how they think the loans will perform, and instead focuses on telling you what the loans LOOK LIKE – so you can decide for yourself! YOU decide if you want to loan money to these loans with these LTV ratios and FICO scores – and if you need more information, it IS available (as indicated in my link above)
then again, this is all kinda silly, because I’m not a lawyer (although as I mentioned already, the lawyers I talked to tell me Felix is wrong about the material non-public information angle)
Felix – forget the non-public part and focus on the “omission of material information” angle you touched on in an earlier post. That’s also an interesting one, and again, with the IANAL caveat, I’d say that the INFORMATION is the important stuff to disclose, and not a specific party’s interpretation of the information (ie: Clayton’s)
which brings up a question I have – maybe a legal eagle out there can answer it: Barclays just underwrote a secondary offering of MGM stock. Many big Wall Street firms cover MGM as a company. They all have research reports and opinions about MGM available to their clients (although perhaps not PUBLICLY available). Do you know how many of these research reports Barclays referenced in the prospectus? Of course you do – NONE. Are they not “material” information? Is Barclays’ failure to tell potential investors what JPM or GS thinks of MGM, and what JPM or GS expects MGM to earn over the next 4 years an omission of material fact? No – I don’t think it is. Now the legal-eagles can explain WHY it isn’t…
Hi Felix:
And in a tangentially related way, Perry Mehrling (Fischer Black and the Revolutionary Idea of Finance) has a new book on deck called The New Lombard Street: How the Fed Became the Dealer of Last Resort.
It looks really good. http://press.princeton.edu/titles/9298.h tml
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