Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street

Chapter 6.

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My client later reminded me of those words when a.s.sociate Justice of the Supreme Court, Antonin Scalia, told 60 Minutes 60 Minutes that torture (such as waterboarding) is not "punishment," that torture (such as waterboarding) is not "punishment,"20 implying that the const.i.tutional prohibition against cruel and unusual punishment wouldn"t apply to torture. My client joked that investment banks would like to waterboard me to implying that the const.i.tutional prohibition against cruel and unusual punishment wouldn"t apply to torture. My client joked that investment banks would like to waterboard me to prevent prevent me from talking. me from talking.

My loss projections were higher than anything coming out of the U.S. government or Wall Street. It turns out I was predicting the greatest losses, and I was too optimistic. Housing speculators and overreaching homeowners took risk, seemingly with "eyes wide shut." Many others were lured with the promise of homeownership. Predatory lenders targeted minorities and lower-income people who were intellectually and financially mugged, then dumped on the side of the road. The motto of predatory lenders is "every minority left behind."

Before meeting Warren, I wrote about industry problems, but only in a general way. Warren"s subtle encouragement helped me find my voice. Now I specifically challenged the Federal Reserve Bank and major investment banks on national television.

I told CNBC"s Joe Kernen that I advocated a temporary moratorium on subprime foreclosures, followed by mortgage restructurings.That meant first first reappraising to lower values reflecting the devastation caused by predatory lending and reappraising to lower values reflecting the devastation caused by predatory lending and then then restructuring mortgages to an affordable fixed rate. In some areas, the reappraised values will be drastically lower and the mortgage terms radically different.This protects misled homeowners. Borrowers complicit in fraud, or who willfully overleveraged, should not be given the same protection but could unintentionally benefit. Helping fraudsters is not anyone"s idea of a solution but having a few of them slip through the cracks was preferable to the ruination of entire neighborhoods.The devastation was already well underway and needed to be halted. restructuring mortgages to an affordable fixed rate. In some areas, the reappraised values will be drastically lower and the mortgage terms radically different.This protects misled homeowners. Borrowers complicit in fraud, or who willfully overleveraged, should not be given the same protection but could unintentionally benefit. Helping fraudsters is not anyone"s idea of a solution but having a few of them slip through the cracks was preferable to the ruination of entire neighborhoods.The devastation was already well underway and needed to be halted.

In some parts of the Midwest every third home is vacant in minority neighborhoods. Housing prices have plummeted. Fixing the problem for innocent homeowners will mean losses must be born by lenders, including subprime mortgage bankers, investment banks that provided financing to the mortgage bankers, and the investors in subprime mortgages and securitizations backed with subprime mortgages. There is no reason for U.S. taxpayers to bail out the sophisticated financiers.

It is counterintuitive, but limiting losses by reappraising and rewriting mortgages would result in a higher recovery rate that would be good for everyone and limit overall losses.

Servicers collect and record loan payments and credit loan accounts. In the summer of 2007, a major Midwest-based servicer of mortgage loans told me the rating agencies" subprime recovery rates were much too optimistic.The servicer said modifying a mortgage was highly preferable to recovering zero or negative value negative value after foreclosure fees and depressed a.s.set prices took their toll on recovery of relatively low loan balances. These were geographically diverse U.S. subprime loans, but they were alike in risk characteristics.The servicer"s staff worked frantic 13-hour days to salvage value. The servicer underreported delinquencies, overdue payments, which were usually reported one month behind prime mortgages already. The day a homeowner missed a payment, the servicer got on the phone trying to work out a new deal. The servicer allowed skipped payments and did not report them as delinquencies. The servicer discovered that if homeowners missed two payments, the loan was virtually doomed to default because most homeowners gave up after that. It aggressively "re-aged" mortgages-ignoring missed payments urging borrowers to make even one payment so the loan could appear alive. If this practice was typical, the scope of the subprime problem was underreported.The servicer restructured loans doomed to fail in the future. It sold loans for pennies (3 cents to 6 cents) on the dollar. Some of the loans had negative equity (the homeowner owed more than the home was worth) at the time of delinquency. The servicer avoided foreclosure, because legal costs relative to low loan balances and long delays ate up more money than it recovered. a.s.sets included trailers, mobile homes, and homes in areas with depressed prices. after foreclosure fees and depressed a.s.set prices took their toll on recovery of relatively low loan balances. These were geographically diverse U.S. subprime loans, but they were alike in risk characteristics.The servicer"s staff worked frantic 13-hour days to salvage value. The servicer underreported delinquencies, overdue payments, which were usually reported one month behind prime mortgages already. The day a homeowner missed a payment, the servicer got on the phone trying to work out a new deal. The servicer allowed skipped payments and did not report them as delinquencies. The servicer discovered that if homeowners missed two payments, the loan was virtually doomed to default because most homeowners gave up after that. It aggressively "re-aged" mortgages-ignoring missed payments urging borrowers to make even one payment so the loan could appear alive. If this practice was typical, the scope of the subprime problem was underreported.The servicer restructured loans doomed to fail in the future. It sold loans for pennies (3 cents to 6 cents) on the dollar. Some of the loans had negative equity (the homeowner owed more than the home was worth) at the time of delinquency. The servicer avoided foreclosure, because legal costs relative to low loan balances and long delays ate up more money than it recovered. a.s.sets included trailers, mobile homes, and homes in areas with depressed prices.

If this sounds odd, consider that in 2008 a plethora of banks started recla.s.sifying loans on their balance sheets (Astoria Financial,Wells Fargo & Co., and others) or began using more optimistic data (Wachovia Corp. and Washington Mutual). If you don"t like the numbers, just change the definition. If you don"t like the numbers, just change the definition. In July 2008,Wells Fargo stock price jumped 33 percent when its losses were less than expected, but it announced that, as of April 2008, it would wait an additional two months before writing off a loan (180 days instead of 120 days) saying it did not affect its earnings announcement. At the time Wells Fargo"s portfolio of home equity loans was $83.6 billion and it was showing signs of stress. In July 2008,Wells Fargo stock price jumped 33 percent when its losses were less than expected, but it announced that, as of April 2008, it would wait an additional two months before writing off a loan (180 days instead of 120 days) saying it did not affect its earnings announcement. At the time Wells Fargo"s portfolio of home equity loans was $83.6 billion and it was showing signs of stress.2122 JPMorgan Chase"s CEO Jamie Dimon is a master at balancing the short game of earnings announcements with the long game of running a bank. He steered away from most of the mortgage madness, but announced that "jumbo" mortgages (large balance mortgages to good credits) showed increasing losses. Dimon announced that these prime mortgages to the bank"s best customers had losses of 0.95 percent (up from 0.05 percent the prior year), and the losses could triple. For example in California, housing prices had collapsed leading to higher loan losses even for prime (good credit) borrowers. He said JPMorgan may have waded back into the mortgage market early: "We were wrong.We obviously wish we hadn"t done it."23 [image]

The Federal Reserve kept interest rates low for years seemingly complacent in light of consumer lending problems in the late 1990s and the early part of the twenty-first century. In April 2005, then Fed Chairman Alan Greenspan said mortgage lenders efficiently judged the risk.24 Instead, Greenspan should have raised the alarm about foolish mortgage lending. The Fed compounded its errors when it bailed out Countrywide, the second largest subprime lender in the United States, which is regulated by the Office of Thrift Supervision. Countrywide is also a primary dealer, authorized to trade U.S. government and other select securities with the Federal Reserve System.The Fed should have revoked Countrywide"s primary dealer status and let it fend for itself. Instead, Greenspan should have raised the alarm about foolish mortgage lending. The Fed compounded its errors when it bailed out Countrywide, the second largest subprime lender in the United States, which is regulated by the Office of Thrift Supervision. Countrywide is also a primary dealer, authorized to trade U.S. government and other select securities with the Federal Reserve System.The Fed should have revoked Countrywide"s primary dealer status and let it fend for itself.

Countrywide posted its expanded interest-only programs on its Web site in September 2003 (and appeared to remove it in 2007). Few borrowers are savvy enough for interest-only loans, since mortgage borrowers paid no princ.i.p.al on loans, just interest. Many hoped housing prices would rise so they could refinance or take a profit.The program included NINA (no doc.u.mentation: no income verification, no a.s.set verification), No Ratio (no income information, so no debt to income ratio is calculated allowing the borrower to a.s.sume a greater debt load than would be allowed with a traditional mortgage), and SISA (stated income, stated a.s.sets) loans. The FHA guaranteed some Countrywide loans, and presumably they conformed to FHA"s requirements. But FNMA and FHLMC were the chief buyers of Countrywide"s loans, and many of these loans were problematic.

On August 5, 2007, I told CBS"s Thalia a.s.suras that the mortgage lending relationship with investment banks is one of the largest "Ponzi schemes in financial history" and "risky mortgage products were made to people who couldn"t afford them."25 I misspoke. I meant to say it is I misspoke. I meant to say it is the largest Ponzi scheme in the history of the capital markets. the largest Ponzi scheme in the history of the capital markets.

By the end of 2006, Countrywide"s loans showed signs of trouble. The week of August 6, 2007, rumors. .h.i.t the market that Countrywide was looking for a "white knight," a deep pocket investor to either take it over or to provide a liquidity injection, but it had no success. On August 7, 2007, the Federal Open Market Committee issued an economic outlook statement saying that inflation, not the mortgage market problems, were the chief concern, and it would not cut the federal funds rate (the borrowing rate) to inject more liquidity into the market. But just two days later, on August 9, the European Central Bank injected around $130 billion into the European banking system, and the Federal Reserve pumped $24 billion into the U.S. banking system through the Federal Reserve"s Open Market Trading Desk.

On August 10, 2007,Warren and I spoke on a different topic, and-without naming names-he mentioned that two large companies had come to him hat in hand needing billions.There would be a couple of major blow-ups since they were running out of options. I independently guessed that Countrywide was one of the beggars.

One of the ways Countrywide got money was by issuing commercial paper (a.s.set-backed commercial paper or ABCP) backed by its loans. The week of August 13, 2007, investors shunned Countrywide"s debt. Nervous investors demanded higher interest rates. Countrywide told its creditors (investment banks) it wanted to borrow money (by drawing on its credit card-like credit lines). Countrywide wanted to borrow $11.5 billion from a 40-bank syndicate. Countrywide was in a desperate situation. Market rumors were that the banks refused to lend the money, and asked the Fed for concessions. or ABCP) backed by its loans. The week of August 13, 2007, investors shunned Countrywide"s debt. Nervous investors demanded higher interest rates. Countrywide told its creditors (investment banks) it wanted to borrow money (by drawing on its credit card-like credit lines). Countrywide wanted to borrow $11.5 billion from a 40-bank syndicate. Countrywide was in a desperate situation. Market rumors were that the banks refused to lend the money, and asked the Fed for concessions.

On August 15, 2007, I wrote Warren that investors were nervous because Canadian money market funds found their investments (not necessarily related to Countrywide) were backed by risky leveraged subprime products. Prices plummeted as investors realized they would lose princ.i.p.al on AAA rated products.26 The banks got their concessions, and lent to Countrywide. On Thursday, August 16, 2007, the stock market (Dow) fell more than 340 points as Countrywide borrowed $11.5 billion. It seemed to me that on Thursday, one or more of the banks leaked the news ahead of the Fed"s announcement on Friday because, near the end of trading on Thursday, the market rebounded from the 340 point nosedive to finish down only 15 points. On Friday, August 17, 2007, the Fed announced its concessions-a cut of 50 basis points (bps) in the discount rate to 5.75 percent from 6.25 percent along with news of relaxed borrowing terms. The Fed agreed to accept investments backed with (Countrywide"s) mortgage loans as long as they had the now-suspect AAA rating. The Fed also extended the "overnight" discount window borrowings to 30 days. On Friday, August 17, 2007, the stock market marched upward.

The Fed"s terms mirrored those that nervous investors refused when they stopped buying Countrywide"s debt.The Fed bailed Countrywide out of its liquidity problems by lending to the banks who lent to Countrywide using Countrywide"s collateral to back the loans. This ma.s.sive liquidity bailout was the first Fed bailout related to the subprime mortgage lending crisis (as far as I know). The Federal Reserve Bank could have exercised its authority to demand Countrywide modify mortgage loans.The Fed was a pushover. Ben Bernanke had dangled raw meat in the face of hungry wolves. More bailouts were coming.

Investors felt pressure from all angles. Quant funds reported losses. I told CNBC"s Carl Quintanilla that quant funds put on Dead Man"s Curve trades, and "model masturbation makes quants go blind."Warren Buffett and Charlie Munger warned this would happen. They talk about value and price; they don"t talk about betas, correlations, and volatilities. Steve Forbes of Forbes Forbes magazine opposed any bailouts. He noted the Fed had kept rates low, fueling the problem. He cautioned that we should "resist the temptation to bail these people out," and specifically referred to the Fed"s bailout of Long-Term Capital. magazine opposed any bailouts. He noted the Fed had kept rates low, fueling the problem. He cautioned that we should "resist the temptation to bail these people out," and specifically referred to the Fed"s bailout of Long-Term Capital.27 On August 17, 2007, CNBC aired a series of stories that Warren Buffett might be eyeing Countrywide, but they were all incorrect stories. 28 28 "It is better to be a bad manager of a good business," Warren always says, "than a good manager of a bad business." "It is better to be a bad manager of a good business," Warren always says, "than a good manager of a bad business."29 He seeks good managers of good businesses. I told the He seeks good managers of good businesses. I told the Journal Inquirer Journal Inquirer that the Fed should have asked Countrywide for a quid pro quo in exchange for the bailout: "Given Countrywide"s contribution to the problems in the mortgage loan market, and given company head Angelo Mozilo"s denial of that role, the Fed should have pressured Countrywide"s board to replace him." that the Fed should have asked Countrywide for a quid pro quo in exchange for the bailout: "Given Countrywide"s contribution to the problems in the mortgage loan market, and given company head Angelo Mozilo"s denial of that role, the Fed should have pressured Countrywide"s board to replace him."30 Warren wrote me that he agreed with my comments. Warren wrote me that he agreed with my comments.

Less than a year after the August 2007 bailout, Daniel Bailey Jr. got a surprise email reply after asking Countrywide to modify the terms of his adjustable rate mortgage. Bailey Jr. wrote he had not understood how the loan worked; he had been told he could refinance after a year; and now he cannot deal with the payments. Mozilo apparently hit "reply" rather than "forward" when emailing. Mozilo wrote it is unbelievable that most of the letters Countrywide receives seem like form letters. "Obviously they are being counseled by some other person or by the Internet. Disgusting."31 I can understand the email SNAFU. One Sat.u.r.day, I sent my nephew, Kenneth, a link to a cheesy but oddly entertaining David Ha.s.selhoff video.Three hours later, Kenneth C. Griffin, CEO of Citadel Investment Group, replied, "Did you hit my address by accident?" I know Ken Griffin is a gentleman. He promised not to embarra.s.s me by revealing my mistake. I now also know we are both fans of KITT (Knight Industries Two Thousand), the talking car in Knight Rider. Knight Rider. KITT protected Michael Knight, Ha.s.selhoff "s character, but no one seems to protect borrowers from predatory lenders. I understand how easy it is to miss-send an email. But I cannot understand why Mozilo was still CEO of Countrywide and in a position to send it. Mozilo stayed on as Countrywide"s CEO until the week after its acquisition by Bank of America was approved by Countrywide"s shareholders on June 25, 2008. KITT protected Michael Knight, Ha.s.selhoff "s character, but no one seems to protect borrowers from predatory lenders. I understand how easy it is to miss-send an email. But I cannot understand why Mozilo was still CEO of Countrywide and in a position to send it. Mozilo stayed on as Countrywide"s CEO until the week after its acquisition by Bank of America was approved by Countrywide"s shareholders on June 25, 2008.32 Warren is a fan of buying large positions in good stocks, and he is also a fan of Mae West, who once said: "Too much of a good thing can be wonderful." I am pretty sure Mozilo"s delayed retirement is not what either of them had in mind. Warren is a fan of buying large positions in good stocks, and he is also a fan of Mae West, who once said: "Too much of a good thing can be wonderful." I am pretty sure Mozilo"s delayed retirement is not what either of them had in mind.

By the spring of 2008, it was painfully clear that mortgage loan losses would be much higher than the Fed"s earlier highest projections, and my numbers were closer to reality. The overall size of the U.S. residential mortgage loan market is around $11.5 trillion, of which a little more than 11 percent is subprime and more than 10.4 percent is Alt-A (with credit scores in between subprime and the higher prime borrowers). John Paulson of Paulson & Co. compiled data from LoanPerformance and the Mortgage Bankers a.s.sociation in a public presentation showing that between March 2007 and March 2008, subprime delinquencies had soared to 27.2 percent in the $1.3 trillion subprime market, an increase of around 163 percent, and in the $1.2 trillion Alt-A market, delinquencies soared to 9.1 percent, a year over year change of around 380 percent. Prime mortgage delinquencies were up to 3.2 percent, a 2.1 percent increase from fourth quarter of 2006 to 2007.

Given the gravity of the loan problems, investment banks should have been reporting large losses much earlier. For example, on October 8, 2007, I told clients that Merrill"s mal de MER mal de MER was just beginning. At the time a friend asked me where Merrill stock would be in six months. I responded: "In someone else"s portfolio." was just beginning. At the time a friend asked me where Merrill stock would be in six months. I responded: "In someone else"s portfolio." Not mine and not Warren Buffett"s. Not mine and not Warren Buffett"s. Jeff Edwards, Merrill"s CFO had made rosy statements in July 2007. Astute shareholders, not to mention the SEC and Merrill"s board, might have wondered why the ma.s.sive losses reported in third quarter had not shown up much earlier. Stan O"Neal, the CEO, appeared to have a big problem. Jeff Edwards, Merrill"s CFO had made rosy statements in July 2007. Astute shareholders, not to mention the SEC and Merrill"s board, might have wondered why the ma.s.sive losses reported in third quarter had not shown up much earlier. Stan O"Neal, the CEO, appeared to have a big problem.

On October 10, 2007, I reminded David Wighton of the Financial Times Financial Times that Merrill was one of the lenders to the mortgage-backed securities hedge funds managed by Bear Stearns a.s.set Management that collapsed in August 2007. Creditors had challenged BSAM"s mark-to-market valuations in April, and that is what got the ball rolling for the downfall of the funds: "Merrill was not so finicky when it came to marking its own books." that Merrill was one of the lenders to the mortgage-backed securities hedge funds managed by Bear Stearns a.s.set Management that collapsed in August 2007. Creditors had challenged BSAM"s mark-to-market valuations in April, and that is what got the ball rolling for the downfall of the funds: "Merrill was not so finicky when it came to marking its own books."33 Merrill began reporting ma.s.sive losses, but in my view, they were quarters quarters late. I was amazed O"Neal was still in his CEO chair. On October 24, CNBC"s Joe Kernen, with GE"s former CEO, Jack Welch, covered Merrill"s earnings report. I appeared on a segment with Charlie Gasparino, CNBC"s online editor. late. I was amazed O"Neal was still in his CEO chair. On October 24, CNBC"s Joe Kernen, with GE"s former CEO, Jack Welch, covered Merrill"s earnings report. I appeared on a segment with Charlie Gasparino, CNBC"s online editor.

I led off: "Way back in first quarter" I had called this and said Merrill"s risk managers should "get out and short. Short Merrill"s positions." Short Merrill"s positions."34 Gasparino a.s.serted: "When we we were reporting this about three weeks ago, ahead of everybody . . . we reported there was going to be a larger third quarter loss." were reporting this about three weeks ago, ahead of everybody . . . we reported there was going to be a larger third quarter loss."

I countered that O"Neal has a big problem: "They were not hedging properly in first quarter. first quarter." I added: "I laughed in disbelief" when I saw second quarter earnings. "It is an Enronesque Enronesque kind of problem, it is a business management problem, not a risk management problem." kind of problem, it is a business management problem, not a risk management problem."

Gasparino said he wouldn"t go that far and focused on the CFO (Jeff Edwards) and the potential ouster of a risk manager instead of picking up on my a.s.sertion about O"Neal. He said the problem with getting rid of Ahma.s.s Fakahany: "Fakahany (the risk manager) and Stan O"Neal are very close."

"I don"t think O"Neal survives this," I responded.There is no problem getting rid of O"Neal"s friends if he is gone, and O"Neal will have to answer to shareholders and the board about failure to report losses in second quarter. Within a few days, O"Nal resigned. I added that the rest of Wall Street had underestimated how horrific the losses due to low recovery rates would be in subprime.35 [image]

After the collapse of the stock market technology bubble and the outing of Enron"s and Worldcom"s problems, Stan O"Neal wrote an opinion piece for the Wall Street Journal Wall Street Journal saying,"In any system predicated on risk-taking, there are failures, sometimes spectacular failures. But for every failure to be viewed as fraudulent or even criminal bodes ill for our economic system." saying,"In any system predicated on risk-taking, there are failures, sometimes spectacular failures. But for every failure to be viewed as fraudulent or even criminal bodes ill for our economic system."36 I agree with O"Neal"s words on the face of it. It"s great to have an open mind, but don"t leave it so open that your brains fall out. O"Neal might have added that taking foolish risks and then failing to examine risk in one"s own portfolio makes for poor financial management. CEOs can read the newspapers just like anyone else, and the implosion of mortgage lender after mortgage lender was well publicized.Warren Buffett is a voracious a.n.a.lytical reader, and he told me that he considers risk management one of his key responsibilities as CEO of Berkshire Hathaway.

If O"Neal did not have time to read the papers, he might have asked a few more questions of his managers about Merrill"s involvement with failed mortgage lenders like Ownit. How could Merrill resell or securitize those loans and earn the same profits healthy loans produce?

The Department of Justice and the Federal Bureau of Investigation (FBI) issued a press release on June 19, 2008: "From March 1 to June 18, 2008, Operation Malicious Mortgage resulted in 144 mortgage fraud cases in which 406 defendants were charged." Cases have been brought across the United States with losses of approximately $1 billion induced by alleged fraud.37 When Bank of America Corp agreed to buy Countrywide in January 2008, the all-stock transaction was valued at $4 billion. By the time Countrywide"s shareholders approved the sale on June 25, 2008, the shares of Bank of America had slumped and the value was around $2.8 billion. But Bank of America may not have gotten a bargain. Also on that day, Illinois, California, and Washington State Department of Financial Inst.i.tutions filed lawsuits against Countrywide, and other states soon followed.3839 Illinois Attorney General Lisa Madigan was the first to file, and the Illinois suit named Angelo Mozilo in addition to Countrywide. She noted that Mozilo has a.s.sets. She alleged there was a "pattern of deception." Countywide had the "worst practices" and the "highest volume" of troubled mortgage loans in Illinois, and the "most toxic product (option ARMS), which she said makes up one-third of Countrywide"s portfolio. "Countrywide broke the law. Homeowners did not." Illinois Attorney General Lisa Madigan was the first to file, and the Illinois suit named Angelo Mozilo in addition to Countrywide. She noted that Mozilo has a.s.sets. She alleged there was a "pattern of deception." Countywide had the "worst practices" and the "highest volume" of troubled mortgage loans in Illinois, and the "most toxic product (option ARMS), which she said makes up one-third of Countrywide"s portfolio. "Countrywide broke the law. Homeowners did not."40 Eric Mozilo, the CEO"s son, blamed the media, protesting, "All we try to do is put people in homes."41 He may be correct. That may be He may be correct. That may be all all Countrywide did for many borrowers. But if that is all Mozilo was trying to do, he would have served many borrowers better by inviting them to stay overnight at his place. Giving someone a bad mortgage loan only puts someone in a home temporarily, and, left many borrowers worse off than before they ever heard of Countrywide. Countrywide did for many borrowers. But if that is all Mozilo was trying to do, he would have served many borrowers better by inviting them to stay overnight at his place. Giving someone a bad mortgage loan only puts someone in a home temporarily, and, left many borrowers worse off than before they ever heard of Countrywide.

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Countrywide set up IndyMac (Independent National Mortgage) in 1985. The two thrifts split in 1997 and became compet.i.tors. In July 2008, IndyMac became the third largest bank to fail in the history of the United States, and in September 2008, $307 billion Washington Mutual (Sold to J.P. Morgan) became the largest to fail. The Federal Deposit Insurance Corporation (FDIC) is drawing on its $53 billion deposit-insurance fund.

Thrifts are regulated by the Office of Thrift Supervision (OTS). John Reich, head of the OTS, seemed to think U.S. Senator Charles E. Schumer bore some responsibility for IndyMac"s failure because the senator wrote a letter to the OTS with concerns about IndyMac"s solvency. He also made it public, which in my opinion is like yelling "Fire! " in a crowded theater. In my mind, it also begged the question as to why Senator Schumer did not seem compelled to speak up earlier about predatory lending and problems at other inst.i.tutions-say, Fannie Mae, Freddie Mac, or Countrywide. Senator Schumer countered that if the OTS had reigned in Indy Mac"s "poor and loose lending practices," the thrift would not have failed, and that the regulator should "start doing its job." " in a crowded theater. In my mind, it also begged the question as to why Senator Schumer did not seem compelled to speak up earlier about predatory lending and problems at other inst.i.tutions-say, Fannie Mae, Freddie Mac, or Countrywide. Senator Schumer countered that if the OTS had reigned in Indy Mac"s "poor and loose lending practices," the thrift would not have failed, and that the regulator should "start doing its job."42 Instead of acting like a sheriff of Mortgage Lenders, the Office of Thrift Supervision behaved like the sheriff of Nottingham. Instead of acting like a sheriff of Mortgage Lenders, the Office of Thrift Supervision behaved like the sheriff of Nottingham.

The Office of Thrift Supervision had reason to intervene long before mortgage lenders started dropping like flies. If they did not read Berkshire Hathaway"s annual reports, they could read a report from the St. Louis Federal Reserve Bank. It noted in 2005 that all all loans (subprime, Alt-A, and prime) have a higher default rate when the homeowner has little to lose-a low or zero down payment, for example. The report suggested that subprime loans with no down payment are an especially bad idea: "Serious delinquency (60 and 90 days) is especially sensitive to homeowner equity and origination." loans (subprime, Alt-A, and prime) have a higher default rate when the homeowner has little to lose-a low or zero down payment, for example. The report suggested that subprime loans with no down payment are an especially bad idea: "Serious delinquency (60 and 90 days) is especially sensitive to homeowner equity and origination."43 Loosely translated, that meant that thrifts would have a much harder time getting paid back if they offered risky mortgage loans to people with no down payment and low credit scores. Loosely translated, that meant that thrifts would have a much harder time getting paid back if they offered risky mortgage loans to people with no down payment and low credit scores. So where was the OTS when no (or low) down payment subprime loans combined with other risky features were being made? So where was the OTS when no (or low) down payment subprime loans combined with other risky features were being made?

As of 2008, although subprime loans are only $1.3 trillion (over 11-13 percent depending on how you define subprime) of the $11.5 trillion U.S. residential market, they are the most troubled. In May 2008, Standard & Poor"s announced that subprime loans originated in 2005-2007 looked awful, and loans made in 2007 were the worst of the bunch. Where was the OTS? Where was the OTS? Delinquencies for 2005 vintage subprime loans were 37.1 percent and had increased 2 percent from the previous month; 37.1 percent of 2006 vintage subprime loans were delinquent, a rise of 4 percent from March; 25.9 percent of subprime loans originated in 2007 were delinquent, a 6 percent jump from March to April 2008. The 2007 loans were "unseasoned" or young but were already at least a couple of months late in payments. Delinquencies for 2005 vintage subprime loans were 37.1 percent and had increased 2 percent from the previous month; 37.1 percent of 2006 vintage subprime loans were delinquent, a rise of 4 percent from March; 25.9 percent of subprime loans originated in 2007 were delinquent, a 6 percent jump from March to April 2008. The 2007 loans were "unseasoned" or young but were already at least a couple of months late in payments.4445 In the second quarter of 2008, a Mortgage Banking a.s.sociation survey revealed that 9.2 percent of mortgages for single family to four-family homes were a month or more overdue or in foreclosure. In the second quarter of 2008, a Mortgage Banking a.s.sociation survey revealed that 9.2 percent of mortgages for single family to four-family homes were a month or more overdue or in foreclosure.46 It was the worst result in the 39-year history of the survey. In the month of August 2008, foreclosure filings in the U.S. rose to a record high of more than 303,000 properties as the continued drop in home prices, combined with tighter lending standards, made it harder for homeowners to refinance their mortgages, with and an estimated supply of unsold homes of 11 months. It was the worst result in the 39-year history of the survey. In the month of August 2008, foreclosure filings in the U.S. rose to a record high of more than 303,000 properties as the continued drop in home prices, combined with tighter lending standards, made it harder for homeowners to refinance their mortgages, with and an estimated supply of unsold homes of 11 months.47 The direct and indirect costs to the U.S. taxpayer will be difficult to a.s.sess because of creative accounting that delays the recognition of the true problem. For example, banks and thrifts announced they were delaying their recognition of losses by allowing delinquencies of up to 180 days before taking a writedown on loans, and Fannie Mae and Freddie Mac said that in the past they wrote down loans when they were 90 days past due, but sometime in 2008 they decided to wait two years. two years.48 On July 16, 2002, Alan Greenspan commented on the corporate shenanigans after the tech-bubble burst saying "infectious greed seemed to grip much of the business community," and it was a once-in-a-generation frenzy of speculation." On July 16, 2002, Alan Greenspan commented on the corporate shenanigans after the tech-bubble burst saying "infectious greed seemed to grip much of the business community," and it was a once-in-a-generation frenzy of speculation." 49 49 That was after the mini-frenzies of Drexel Burnham Lambert, Long-Term Capital Management, charged-off credit card receivables, manufactured housing loans, and more. Perhaps Alan Greenspan has found a way to accelerate the human lifecycle. That was after the mini-frenzies of Drexel Burnham Lambert, Long-Term Capital Management, charged-off credit card receivables, manufactured housing loans, and more. Perhaps Alan Greenspan has found a way to accelerate the human lifecycle.

Fortunately for Berkshire Hathaway shareholders, Warren Buffett is the CEO. At year-end 1999, Berkshire Hathaway was Freddie Mac"s largest shareholder; it owned around 8.6 percent.50 Warren Buffett may prefer to hold onto stocks forever but only if he finds an investment that can go the distance with him. In his 2000 shareholder letter he wrote: "we sold nearly all of our Freddie Mac and Fannie Mae shares." Warren Buffett may prefer to hold onto stocks forever but only if he finds an investment that can go the distance with him. In his 2000 shareholder letter he wrote: "we sold nearly all of our Freddie Mac and Fannie Mae shares."51 Warren later told me that Fannie Mae and Freddie Mac began emphasizing revenue targets of around 15 percent per year. He did not feel this double digit growth was sustainable just based on operating earnings alone. More than that, value investors are not impressed by revenues alone. Anyone can use leverage to inflate revenues.The Warren later told me that Fannie Mae and Freddie Mac began emphasizing revenue targets of around 15 percent per year. He did not feel this double digit growth was sustainable just based on operating earnings alone. More than that, value investors are not impressed by revenues alone. Anyone can use leverage to inflate revenues.The quality quality of the revenues is paramount, since that is what will sustain profitability. of the revenues is paramount, since that is what will sustain profitability.

Berkshire Hathaway"s Clayton Homes seems to have avoided the contagion. I toured one of the manufactured homes at the Berkshire Hathaway annual meeting in 2006. Potential homeowners are not encouraged to buy a palace. Clayton Homes offers affordable housing at lending terms designed to help ensure the borrower will be able to pay off the loan. It is the chance for people to live a decent life, and there is dignity in being able to live within one"s means while bettering one"s circ.u.mstances. Most of Clayton"s earnings come not from its manufactured housing, but from its loan portfolio. Warren reports its results in the finance section of the Berkshire Hathaway annual report. At the end of 2007, Clayton had an "$11 billion loan portfolio, covering 300,000 borrowers."52 Berkshire Hathaway provides the financing (instead of, say, an investment bank that would buy the loans, package them up, and resell them). In contrast to the rest of the mortgage loan market, "[d] elinquencies, foreclosures and losses" have stayed constant and the "Clayton portfolio is performing well." Berkshire Hathaway provides the financing (instead of, say, an investment bank that would buy the loans, package them up, and resell them). In contrast to the rest of the mortgage loan market, "[d] elinquencies, foreclosures and losses" have stayed constant and the "Clayton portfolio is performing well."53 Unfortunately, for many others in the global financial markets, false promises and broken dreams were part of many investment portfolios.The MADness spread across the globe as if it were a hypercontagious flu virus.

Chapter 6.

Sh.e.l.l Games (Beware of Geeks Bearing Grifts) I"ve looked at the prospectuses, and they are not easy to read. If you want to understand the deal you"d have to read around 750,000 pages of doc.u.ments.

-Warren Buffett to Janet Tavakoli, January 10, 2008

On August 5, 2005, two days after Warren and I set up our meeting, Matthew ("Matt") Goldstein, at the time a senior writer for TheStreet.com, wrote about problems with mortgage-backed CDOs. Eliot Spitzer, then New York Attorney General, had just sent Bear Stearns Co. (Bear Stearns) a subpoena. Hudson United, a small New Jersey bank, had tried to sell mortgage-backed CDOs it bought in 2002 back to Bear Stearns, the underwriter and seller of the CDOs. Hudson discovered its CDO investments were worth only a small fraction of the "market prices" that Bear Stearns had supplied Hudson up until it tried to sell them back. wrote about problems with mortgage-backed CDOs. Eliot Spitzer, then New York Attorney General, had just sent Bear Stearns Co. (Bear Stearns) a subpoena. Hudson United, a small New Jersey bank, had tried to sell mortgage-backed CDOs it bought in 2002 back to Bear Stearns, the underwriter and seller of the CDOs. Hudson discovered its CDO investments were worth only a small fraction of the "market prices" that Bear Stearns had supplied Hudson up until it tried to sell them back.

In April 2005, I addressed the International Monetary Fund in Washington about the hidden risks of off-balance-sheet vehicles, securitizations, and the failure of the rating agencies to reflect these risks in their ratings. Sophisticated investors are baffled by the complexity; even multistrategy hedge funds such as Chicago-based Citadel had contacted me about securitizations. I told Goldstein that investors seemed to rely on ratings and rarely ask how the underlying a.s.sets are priced or whether they will get full price if they need to sell the investment: "There are huge transparency issues. In some cases, investors have been taken in by hype."1 The U.S. Securities and Exchange Commission (SEC) launched a separate investigation into Bear Stearns" CDO activities. Like the New York Attorney General"s office, it wanted to know if Bear Stearns had mispriced mortgage-backed CDOs and harmed investors. Bear Stearns subsequently disclosed in a regulatory filing that the SEC intended to recommend action. Many financial professionals believed Bear Stearns would be charged for alleged improper pricing of CDOs it had sold to both a bank and an inst.i.tutional investor.2 Yet, despite increasing attention in the financial press, the New York Attorney General"s office dropped its case. The SEC"s rumored civil enforcement action involving Bear Stearns" CDO pricing practices fizzled, and the investigation was closed.3 The Slumbering Esquires Club rolled over and went back to sleep. The Slumbering Esquires Club rolled over and went back to sleep.

The SEC"s new head struck me as the Antichrist of investor advocacy. On July 26, 2005, just a few days before Goldstein"s article and my first reply to Warren Buffett, Christopher c.o.x attended a Congressional coffee klatch-commonly known as his confirmation hearing-for the post of chairman of the SEC. One of c.o.x"s former clients pleaded guilty and got a 10-year sentence in a case involving defrauded funds.4 c.o.x had worked on a separate public offering that was not implicated in the case. Among other things, c.o.x wrote a letter for his client saying it "would unfairly and unreasonably harm the investors" rate of return" c.o.x had worked on a separate public offering that was not implicated in the case. Among other things, c.o.x wrote a letter for his client saying it "would unfairly and unreasonably harm the investors" rate of return"5 to appraise pools of mortgages. c.o.x also wrote that suitability-a standard meant to ensure that naive investors did not get saddled with risky product-should not apply: "Because all of the trust fund loans are secured and overcollateralized, there is relatively low risk." to appraise pools of mortgages. c.o.x also wrote that suitability-a standard meant to ensure that naive investors did not get saddled with risky product-should not apply: "Because all of the trust fund loans are secured and overcollateralized, there is relatively low risk."6 c.o.x wrote his letter in 1985, and unbeknownst to c.o.x, his client"s fraud involving separate vehicles began in 1982 and continued until 1994. Appraisals may have stopped the fraud earlier. On July 29, 2005, Floyd Norris of the c.o.x wrote his letter in 1985, and unbeknownst to c.o.x, his client"s fraud involving separate vehicles began in 1982 and continued until 1994. Appraisals may have stopped the fraud earlier. On July 29, 2005, Floyd Norris of the New York Times New York Times reminded his readers of c.o.x"s letter, yet the Senate Committee unanimously confirmed c.o.x later the same day. It was time to short CDOs, since the value added by the SEC"s c.o.x seemed likely to shrivel. reminded his readers of c.o.x"s letter, yet the Senate Committee unanimously confirmed c.o.x later the same day. It was time to short CDOs, since the value added by the SEC"s c.o.x seemed likely to shrivel.

When I read prospectuses for CDO deals and CDO-squared deals, I felt as if I had opened a box of candies and found only one or two good pieces.The rest were either missing altogether, or had a bite taken out of them with someone else"s teeth marks. These were definitely not See"s Candies, a Berkshire Hathaway company. These were definitely not See"s Candies, a Berkshire Hathaway company. Some CDO-squared deals were so bad it left me thinking: Some CDO-squared deals were so bad it left me thinking: Where is the candy?! Where is the candy?!

To use an extreme example, if you only use subprime-backed fraud-ridden mortgage loans as collateral for residential mortgage-backed security deals, and the RMBSs lose 60 percent of portfolio value, if you use investment grade tranches but with ratings lower than the top AAA of these RMBSs as collateral for a CDO, all of the collateral of your CDO will vaporize. all of the collateral of your CDO will vaporize. If you use tranches of this defective CDO in yet another CDO called a If you use tranches of this defective CDO in yet another CDO called a CDO-squared, CDO-squared, you are starting out with nearly worthless collateral, so the entire CDO-squared is nearly worthless on the day the deal is brought to market. It seems to me that some investment banks knowingly partic.i.p.ated in predatory securitizations. you are starting out with nearly worthless collateral, so the entire CDO-squared is nearly worthless on the day the deal is brought to market. It seems to me that some investment banks knowingly partic.i.p.ated in predatory securitizations.

One does not need to read hundreds of pages of prospectuses or perform complicated modeling to know that. Warren looks at every investment as if it is a business, and the only "business" these investments have are the loans backing them. If the loans do not do well, the CDOs backed by them soon follow them down the tubes. If the loans do not do well, the CDOs backed by them soon follow them down the tubes.

It will be too obvious if all of the collateral you use is this bad, so you might mix it in with some Alt-A or even some prime collateral in an RMBS. That way, if you use this collateral for a CDO, it won"t look so bad, and it will be devilishly difficult to a.n.a.lyze. For example, if you use BBB rated tranches of RMBS deals backed by a variety of types of loans, you can mix in 30 percent risky subprime loans. It sounds pretty safe, but losses will probably still eat through the BBB rated tranches. Now you take those doomed BBB rated tranches and combine them with A and AA rated tranches to create a CDO. All of the BBB rated tranches will disappear and probably some or all of the single A. If you buy the AAA tranche of this CDO, and it has around 25 percent subordination, your princ.i.p.al may or may not be in jeopardy, but most of the tranches below it are in trouble. Now if you use those lower tranches to make a CDO-squared, most of those tranches will probably lose princ.i.p.al. In some deals, all of the tranches below the senior-most triple A will lose the entire princ.i.p.al amount, and the senior-most triple A will lose substantial princ.i.p.al.

Credit derivatives enable a further level of gamesmanship and opacity. The doc.u.mentation of many CDOs is dense with all sorts of cash flow tricks, and the contracts for the credit derivatives embedded in the CDOs are not included with the prospectuses. The ratings are completely meaningless. The ratings are completely meaningless.

In January 2007, I noticed that U.S. inst.i.tutional investors curtailed their buying of CDOs. But investment banks had created new types of structured investment vehicles called SIV-lites, SIV-lites, or structured investment vehicles with less protection (or lite protection). These vehicles invested in the overrated AAA tranches of CDOs backed by subprime debt, and the rating agencies rated the vehicles AAA. These vehicles, in turn, issued faux AAA a.s.set-backed commercial paper. or structured investment vehicles with less protection (or lite protection). These vehicles invested in the overrated AAA tranches of CDOs backed by subprime debt, and the rating agencies rated the vehicles AAA. These vehicles, in turn, issued faux AAA a.s.set-backed commercial paper.

These new ent.i.ties seemed like corporations, but the only "business" they have is investing in a.s.sets and those a.s.sets have to provide "earnings." Benjamin Graham"s disciples look for better quality of earnings and for earnings growth.

As the collateral in the structured investment vehicles inevitably took ma.s.sive downgrades, the vehicles had to liquidate their wasting collateral, and investors lost a significant amount of their princ.i.p.al. Mutual funds, bank portfolios, insurance companies, local government funds, private investment groups, and more lost billions. Canadians heavily invested, and our North American neighbors lost billions. Since these a.s.sets carried high ratings, European and Asian investors also took losses.

Despite their "efforts," investment banks were still stuck with tens of billions of unsold CDOs. They reduced exposures by buying bond insurance, buying credit protection from hedge funds, and doing a variety of leveraged sales. Some of that risk boomeranged back onto bank balance sheets.

The madness did not stop with mortgage loans. Collateralized debt obligations can be backed by any combination of debt: credit derivatives, a.s.set-backed securities, mortgage-backed securities, other collateralized debt obligations, hedge fund loans, credit card loans, auto loans, bonds, leveraged corporate loans, sovereign debt, or any kind of combination of actual or notional debt man can imagine and create.

Stephen Partridge-Hicks, co-head of Gordian Knot, probably the best run structured investment vehicles in the world, felt the effects of a nervous market reluctant to invest in the debt of any any investment vehicle. Risky overrated AAA commercial paper issued by risky structured investment vehicles caused investors to shun sound investments. He told me he bought investment vehicle. Risky overrated AAA commercial paper issued by risky structured investment vehicles caused investors to shun sound investments. He told me he bought zero zero subprime-backed investments and rejected a lot of other misrated AAA deals.Yet shortly after Lehman"s bankruptcy, Sigma, one of his two funds, collapsed. subprime-backed investments and rejected a lot of other misrated AAA deals.Yet shortly after Lehman"s bankruptcy, Sigma, one of his two funds, collapsed.

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If I had a large bonus in my sights and mischief on my mind, how would I unload toxic CDO tranches? This is all hypothetical, mind you, but here"s just one of a number of different gimmicks.

If you work at an investment bank and you stuff the toxic tranches of only only your own CDOs into another CDO, it will be too obvious.You need help from your friends who work for other investment banks, hedge funds, and CDO managers. Since you all have toxic CDOs and still want to earn high fees, you can all play investment banking your own CDOs into another CDO, it will be too obvious.You need help from your friends who work for other investment banks, hedge funds, and CDO managers. Since you all have toxic CDOs and still want to earn high fees, you can all play investment banking hawala hawala similar to the complex, but highly effective, money brokering system used in the Middle East. similar to the complex, but highly effective, money brokering system used in the Middle East. Hawala Hawala makes it virtually impossible to trace cross-border money flows. It will be hard for anyone, except the SEC or someone with subpoena power to examine your trade tickets, to figure out what you are doing. Since the SEC seems to have lost its will to exist, you are good to go. makes it virtually impossible to trace cross-border money flows. It will be hard for anyone, except the SEC or someone with subpoena power to examine your trade tickets, to figure out what you are doing. Since the SEC seems to have lost its will to exist, you are good to go.

There is just one more thing. As Warren told me at lunch, many people seem to have a perverse desire to make things overly complicated. Yet, the fundamentals of finance do not change. Most value investors will not be fooled, and they actually read your doc.u.ments. If you really think you can confuse unwary investors about the basics by hiding behind a label such as "synthetic CDO-squared," you are good to go.

Mix your toxic junk with your friends" toxic junk into a CDO-SQUARED. Now you have deniability. After all, why would you buy someone else"s CDOs if they were toxic? Now get the compliant rating agencies to rate a huge chunk of this risky hairball triple A. If you are lucky, you may find an investor to buy it. Failing that, you may find a bond insurer to insure it. Failing that, you may find an investment vehicle or hedge fund willing to do a credit derivative or other leveraged transaction.These diversions should get you through bonus season. After all else fails, your investment banks can beg the Federal Reserve Bank to take overrated AAA paper in exchange for treasuries.

There is one small problem with this. If you know or should know If you know or should know that you are not correctly pricing your balance sheet or if you knowingly sell overrated securities, you must disclose that, and you must be specific about it. If you know something is rated super-safe AAA; but it deserves a near-default rating of CCC, you cannot keep silent about it when you sell it. that you are not correctly pricing your balance sheet or if you knowingly sell overrated securities, you must disclose that, and you must be specific about it. If you know something is rated super-safe AAA; but it deserves a near-default rating of CCC, you cannot keep silent about it when you sell it.

When I pointed out to an investment banker that this is a cla.s.sic situation for fraud, he told me: "Our internal OGC [Office of General Counsel] disclaims virtually all liability for [our investment bank] and its bankers in small print fully disclosing the risks in the prospectuses." I knew what he meant, but he sounded like a smart 10-year-old parroting an adult.

"I did not attend law school," I responded, "but I am pretty d.a.m.n sure that just because you disclosed serious conflicts of interest, it does not protect you if you fail in your duty of care to investors.Your lawyers can"t give you a license to kill."

The moral hazard swamped any risk the rating agencies" models could capture. One investment banker crowed to me that the rating agencies are eager for fees and the investment bank"s structurers seeking ratings for their CDOs are "shrewd bullies."

One synthetic CDO deal with a notional amount of more than $2 billion went into liquidation, and less than 3 percent less than 3 percent of investors" money was recovered. Even the investor in the top-most "AAA," the super senior tranche, lost princ.i.p.al. Perhaps everyone involved with this deal, including the CDO manager, was just very unlucky. But do you want to do business with unlucky people? of investors" money was recovered. Even the investor in the top-most "AAA," the super senior tranche, lost princ.i.p.al. Perhaps everyone involved with this deal, including the CDO manager, was just very unlucky. But do you want to do business with unlucky people?7 CDO managers are supposed to be selling securities backed by actual actual a.s.sets-not a.s.sets-not imaginary imaginary a.s.sets. a.s.sets.

In November 2006, I told a.s.set Securitization a.s.set Securitization that CDO managers are unregulated, and only a handful of managers provide good value for the fees charged. Most do not have the expertise or resources to perform CDO management or surveillance. Many cannot build a CDO model. Many managers rely on the bank arranger both for structuring expertise and to take a lead role with the rating agencies to secure the initial ratings. Rating agencies rarely ask for background checks on CDO managers. that CDO managers are unregulated, and only a handful of managers provide good value for the fees charged. Most do not have the expertise or resources to perform CDO management or surveillance. Many cannot build a CDO model. Many managers rely on the bank arranger both for structuring expertise and to take a lead role with the rating agencies to secure the initial ratings. Rating agencies rarely ask for background checks on CDO managers.

Chris Ricciardi, CEO of Cohen & Company, read my commentary and wrote me: "I LOVED it." He had been thinking about how to be "the best CDO manager in the business," had independently come to the same conclusions, and found my "insight very compelling." Yet in April 2008, Cohen & Company"s CDO management arm, Strategos Capital Management, led managers with CDOs in default. The total original amount of the CDOs it managed that had events of default (with as yet undetermined recoveries) was $14.2 billion.8 On December 7, 2007, I wrote Warren that many a.s.set-backed securitization CDO prospectuses are finance comic books. For example, Adams Square Funding I closed December 15, 2006. It was an "a.s.set-backed" deal, a collateralized deal. It was rated by Moody"s and S&P. Yet, before 2008 ended, the CDO unwound, meaning all of the underlying a.s.sets were sold in an attempt to pay investors back. Unfortunately, there was not enough cash after selling the loans to go around. According to S&P, investors in Adams Square Funding I got less than 25 percent of par value-more than a 75 percent loss-on average. Investors were wiped out, except for the investor in the seniormost AAA tranche.9 Since the prospectus shows that the seniormost tranche made up 29 percent of the deal, it appears those investors may have lost some money, too. It is reminiscent of the opening scenes of the movie Since the prospectus shows that the seniormost tranche made up 29 percent of the deal, it appears those investors may have lost some money, too. It is reminiscent of the opening scenes of the movie Cliffhanger, Cliffhanger, in which a climber"s supports snap one-by-one ending in a spectacular steep fall. That last plastic buckle was AAA rated. Adams Square Funding I is not an isolated example, just a handy one, because it unwound. It is not even close to being the funkiest deal I have seen. in which a climber"s supports snap one-by-one ending in a spectacular steep fall. That last plastic buckle was AAA rated. Adams Square Funding I is not an isolated example, just a handy one, because it unwound. It is not even close to being the funkiest deal I have seen.

Warren"s ability to say "no" when the risk is not priced correctly is a tremendous advantage to any investors.

The prospectus for Adams Square Funding I disclosed the conflicts of interest between the investors, Credit Suisse Alternative Capital (CSAC), and other Credit Suisse affiliated ent.i.ties, including the Leveraged Investment Group (LIG) of Credit Suisse Securities (CSS).10 I always recommend that investors eliminate this kind of moral hazard by insisting on changes to the deal. Conflicts of interest do not mean that there is anyone doing anything wrong, but when the moral hazard is enormous, things never seem to end well for investors. Rating agency models do not capture these huge risks, yet, the rating agencies never seem to refuse to rate these deals. I have written books and articles on this problem for years; the ratings on deals with this kind of risk are totally meaningless. Yet the rating agencies continue to defend their indefensible methods. I always recommend that investors eliminate this kind of moral hazard by insisting on changes to the deal. Conflicts of interest do not mean that there is anyone doing anything wrong, but when the moral hazard is enormous, things never seem to end well for investors. Rating agency models do not capture these huge risks, yet, the rating agencies never seem to refuse to rate these deals. I have written books and articles on this problem for years; the ratings on deals with this kind of risk are totally meaningless. Yet the rating agencies continue to defend their indefensible methods.

Among many cla.s.ses of bad deals, the problems of CDOs named after constellations were well publicized. Approximately $35 billion of these CDOs had been underwritten by Citigroup, UBS, Merrill Lynch, Calyon, Lehman, and others.They are mostly fallen stars. I told the Wall Street Journal Wall Street Journal that Norma, a Merrill-underwritten CDO comprised mostly of credit derivatives linked to BBB rated tranches of other securitizations, "is a tangled hairball of risk." that Norma, a Merrill-underwritten CDO comprised mostly of credit derivatives linked to BBB rated tranches of other securitizations, "is a tangled hairball of risk."11 It had come to market in March 2007, and by December 2007, it was worth a fraction of its original value. The rating agencies slashed its ratings to junk. I added "[A]ny savvy investor would have thrown this...in the trash bin." It had come to market in March 2007, and by December 2007, it was worth a fraction of its original value. The rating agencies slashed its ratings to junk. I added "[A]ny savvy investor would have thrown this...in the trash bin."12 Constellation deals were not the only cla.s.s of dicey deals, and it seems that CDOs bought in the last half of 2006 and during 2007 were particularly awful. Investment banks found they had a huge credibility problem with investors. Merrill Lynch was not alone in having credibility problems, but I happened to review all of their 2007 CDOs that I could track. I looked at 30 CDOs and CDO-squared deals with a notional amount of $32 billion that Merrill Lynch underwrote in 2007. As of June 10, 2008, all of the deals I captured were in trouble at the AAA level. all of the deals I captured were in trouble at the AAA level. One or more of the originally AAA rated tranches had been downgraded to junk (below investment grade) by one or more rating agencies. Merrill Lynch was not alone in having a poor track record, but this sort of unprecedented performance was hard to beat. CDO managers had nothing to be proud of, either, and many saw their streams of fee income dwindle.The securitization market was in a dead calm. One or more of the originally AAA rated tranches had been downgraded to junk (below investment grade) by one or more rating agencies. Merrill Lynch was not alone in having a poor track record, but this sort of unprecedented performance was hard to beat. CDO managers had nothing to be proud of, either, and many saw their streams of fee income dwindle.The securitization market was in a dead calm.13 I made my concerns public. I made my concerns public.1415 As far as I was concerned, the Hall of Shame looked overcrowded. Losing trust was not the only problem. Financial inst.i.tutions lost hundreds of billions of dollars. As far as I was concerned, the Hall of Shame looked overcrowded. Losing trust was not the only problem. Financial inst.i.tutions lost hundreds of billions of dollars.

Bloomberg keeps daily tabulations of subprime related losses worldwide. I told Yalman Onaran that although some mark-to-market losses may be reversed as markets recover, most of the losses are permanent impairments caused by surging defaults: "[O]f course we can"t tell how much . . . may actually be good stuff that will pay back at maturity." keeps daily tabulations of subprime related losses worldwide. I told Yalman Onaran that although some mark-to-market losses may be reversed as markets recover, most of the losses are permanent impairments caused by surging defaults: "[O]f course we can"t tell how much . . . may actually be good stuff that will pay back at maturity."16 By June 18, 2008, Bloomberg estimated that global bank balance sheet losses due to write-downs and charge-offs at $396 billion. That figure may have been tainted with denial. By October 16, 2008, it nudged past $660 billion. Citigroup had written down $55.1 billion, Merrill Lynch $58.1 billion, and UBS $44.2 billion. Wachovia topped the list with losses of $96.7 billion; Washington Mutual"s losses were $45.6 billion. The list was long and sobering.1718 Risky loans made to both risky borrowers and prime (high credit score) borrowers were only part of the problem. Predatory securitizations amplified losses. As a result, the entire landscape of global investment banking changed. Risky loans made to both risky borrowers and prime (high credit score) borrowers were only part of the problem. Predatory securitizations amplified losses. As a result, the entire landscape of global investment banking changed.

The damage to the global markets was much

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