Alt-A Mortgage Class the Next Shoe to Drop?

For credit rating purposes, the class above subprime is known as "Alt-A". It is likely Alt-A bonds is the next shoe to drop… that is if it hasn't already.

Issuances of Alt-A mortgages has tumbled, according to a Dow Jones report, however, "the mortgages still made up 28 percent of all mortgages originated in the quarter, the same level as two years earlier." The lending industry's continued appetite for these loans is still alarmingly high considering Alt-A delinquencies are rising at a rapid pace:

After 18 months, Alt-A loans originated in 2006 had a delinquency rate of 4.71 percent, versus 1.97 percent for such loans from 2005 and 1.07 percent for 2004. The trend for 2007 loans is even worse than 2006, suggesting last year could be "the worse ever for the Alt-A market," S&P said.

This is terrible news for hedge funds, fund-of-funds and individual investors that have billions invested in Alt-A bonds. In 2006 alone $400 billion Alt-A loans were originated and likely sold to investors.

The fall-out of a collapse in this market will likely mirror that of the subprime loan market. Amidst the subprime rubble, allegations of hidden risks and omissions have been commonplace as well as accusations that Wall Street unloaded toxic subprime debt on unsuspecting investors. We could see a similar legal landscape in the near future.

According to our sources, Alt-A investments were pitched in a comparable fashion as subprime. Brokers and managers told clients Alt-A investments were backed by secure assets and were steady gainers, unlike tech stocks of the late 90s. Alt-A securitized investments in reality are backed by loans requiring little documentation regarding salary and other assets that would determine a consumer's credit worthiness. The phrasing is interesting: "Alt-A mortgages typically got to borrowers whose credit is deemed good enough to forgo proof of claimed assets or income."

Analysts are also eyeing the Alt-A market suspiciously. In a Marketwatch story from earlier this month, Mark Adelson, head of structured finance research at Nomura Securities International, calls "Alt-B" products:

"The Alt-A market has absorbed and disguised a portion of the subprime space," he said. "You can debate how to define these loans, but many have ended up being an Alt-A product with subprime deficiencies…"In the past few years, Alt-A loans were made to weaker and weaker borrowers and the sector expanded downward along credit spectrum," he said. "In doing that, you draw up into the Alt-A space some of the problems that are affecting the subprime space."

In other words, "Alt-A" isn't simply the next subprime, it could be subprime.

Financial Regulators Missed the ARS Market, But That’s Par for the Course

I can’t help but note the irony of David Brown, executive director of the New York State Dormitory Authority, lambasting Wall Street for allowing the collapse of the auction rate securities market.

“As a whole, this is not the finest hour of the investment-banking community,” the Wall Street Journal quoted Mr. Brown as saying. Auction dealers “are refusing to make a market in the securities, saying publicly the product is dead and everyone has to get out of it,” then recommending debt restructurings “where they will earn yet another investment banking fee.”

I applaud Mr. Brown for sounding his criticisms, as I already have voiced the same concerns. But let’s be honest here: As a whole, this also isn’t the finest hour for regulators and some former prosecutors, including Eliot Spitzer, who served as New York’s attorney general before being elected governor.

Mr. Brown was a deputy attorney general under Mr. Spitzer. He was the person who spearheaded a probe of mutual fund trading abuses that ultimately resulted in some $3 billion in fines. There’s no questions that is a severe penalty, but regulators gave a pass to the executives ultimately responsible for the wrongdoing. To Mr. Spitzer’s credit, he at least took some action to punish the mutual fund industry for its improper market timing trading; the practice was well known and reported in 1997 by then Wall Street Journal reporter Charlie Gasparino (no link available), who quoted SEC officials as saying they would investigate the matter. The agency did nothing until Mr. Spitzer stepped in.

But imposing fines on Wall Street firms has hardly proven to be a deterrent for Wall Street, particularly since most of the penalties are puny to begin with. The SEC in 2006 charged 15 Wall Street firms with wrongdoing relating to auction rate securities and let them off with a $13 million fine, which didn’t even constitute a wrist slap. So no one should be surprised that some of the wrongdoing continued. Wall Street executives regard regulatory and prosecutorial fines as simply the cost of doing business.

Wall Street cannot be reformed until regulators and prosecutors begin taking legal action against the top executives at the major firms. Most, if not all, the top Wall Street executives knew about market timing and it’s highly unlikely there weren’t aware of the wrongdoing taking place in the auction securities market. Federal prosecutors have done an impressive job garnering convictions of CEOs and other top executives at companies involved in wrongdoing; if Mr. Brown laments Wall Street’s ways, his criticisms should also be directed at the SEC and Mr. Spitzer.

Auction Rate Securities Round-Up

The financial media is moving the needle forward with regard to the auction rate securities crisis. Both the New York Times and Dow Jones have interesting takes today:

• Floyd Norris reports that auctions continue to fail and that municipalities as a result will likely pay more to borrow money. The article reports that that some auctions - such as those issued by leveraged municipal bond funds - are in dire straits.

• Dow Jones reports that as far back as 1992, auction rate securities triggered arbitration panels to award claims to investors. An arbitration panel awarded an investor group $2.2 million siding with them over Goldman Sachs who allegedly hid the risk associated with ARSs. A second, separate arbitration award was later granted to an investor with similar claims.

Arbitration awards as far back in 1992 are significant. Recall that it wasn’t until 2006 that the SEC made its illusionary attempt to reform the auction rate securities market. With evidence of alleged widespread bid rigging and arbitration awards due to inadequate risk disclosures, regulators turned a blind eye to what has developed into a $350 billion debacle.

Auction Rate Securities: A Scandal Made Possible by the SEC

The SEC's Division of Enforcement has never been considered a tough minded regulator. But the collapse of the auction rate securities market underscores just how frighteningly ineffective the division really is.

On May 31, 2006, the SEC's Division of Enforcement issued a news release trumpeting that it had settled with 15 broker-dealer firms for what essentially amounted to rigging the auction rate securities market between January 2003 and June 2004. Here's an excerpt from that release:

The SEC order finds that, between January 2003 and June 2004, each firm engaged in one or more practices that were not adequately disclosed to investors, which constituted violations of the securities laws. The violative conduct included

• allowing customers to place open or market orders in auctions;

• intervening in auctions by bidding for a firm's proprietary account or asking customers to make or change orders in order to


• prevent failed auctions, to set a "market" rate, or to prevent all-hold auctions;


• submitting or changing orders, or allowing customers to submit or change orders, after auction deadlines;


• not requiring certain customers to purchase partially-filled orders even though the orders were supposed to be irrevocable;


• having an express or tacit understanding to provide certain customers with higher returns than the auction clearing rate; and


• providing certain customers with information that gave them an advantage over other customers in determining what rate to bid.

The release also noted:

Some of these practices had the effect of favoring certain customers over others, and some had the effect of favoring the issuer of the securities over customers, or vice versa. In addition, since the firms were under no obligation to guarantee against a failed auction, investors may not have been aware of the liquidity and credit risks associated with certain securities (emphasis mine). By engaging in these practices, the firms violated Section 17(a)(2) of the Securities Act of 1933, which prohibits material misstatements and omissions in any offer or sale of securities.

In justifying the paltry $13 million fine the SEC imposed, a spokesperson said the agency "considered the amount of investor harm and the firms' conduct in the investigation to be factors that mitigated the serious and widespread nature of the violations." In particular, the firms voluntarily disclosed the practices they engaged in to the SEC, upon the staff's request for information, which allowed the SEC to conserve resources.

With the advantage of hindsight, it's clear that the SEC never understood the inherent and significant damage that was created by brokerage firms rigging the auction in the first place. It's also worth noting that if Wall Street firms simply cooperate with the SEC that partially justifies a wrist slap. Finally, if SEC still mistakenly believes that the their "cease and desist" order prompted the big brokerage firms to warn investors of the risks in buying auction rate securities, I have some clients they should definitely meet.

Auction Rate Securities: An Investor Scandal of Significant Proportions

Our office has been flooded in recent days with inquiries from panicked investors who have suffered incredible harm because of the collapse of the auction rate securities market. All these investors vehemently insist they acquired auction rate securities because their brokers advised them they were as good as cash but would pay higher interest rates than government treasury bills or FDIC-insured savings accounts. Firsthand accounts from investors are posted on Dealbreaker, available here. Now that the market for auction rate securities has all but dried up, these investors can no longer make good on routine financial commitments such as monthly mortgage and credit card payments.

Although we are still sifting through mounds of evidence in preparation of filing our first claims, here is what we have already determined:

The investors we represent have provided irrefutable evidence that their brokers assured them that auction rate securities were as good as cash. Although Wall Street firms can cite some boilerplate warnings in their offering materials, they clearly marketed auction rate securities as being risk free, liquid investments. And indeed they were risk free, as long as Wall Street firms were willing to provide liquidity to prop up the market.

And therein lays the magnitude of this scandal.

One of the egregious blind spots of individual investors is they rarely take the time to understand the financial incentives behind the products Wall Street sells them. Underwriting or serving as a broker-dealer for auction rate securities was a hugely profitable business for the big brokerage firms, garnering them millions of dollars in fees. In addition to peddling auction rate securities to individual investors, the brokerage firms also bought these securities for their own proprietary accounts, yet another whopping conflict of interest.

And true to form, the big brokerage firms got caught manipulating the market. In May 2006, the big brokerage firms agreed to pay more than $13 million to settle SEC charges they were sharing confidential information between January 2003 and June 2004. The SEC said the violations were "serious and widespread."

The Big Four accounting firms clearly understood the inherent risks of auction rate securities. A year after the SEC settlement, the Big Four accounting firms warned their corporate clients to classify auction rate securities in their portfolios as "investments" rather than "cash equivalents." As of yet, we have found no evidence of any brokerage firm offering similar counsel or warnings to their clients.

The credit crunch that was sparked by the sub-prime mortgage mess – for which investors can also thank the big brokerage firms – has impaired the balance sheets of the big brokerage firms, so they no longer have the flexibility to provide liquidity and support for the $350 billion auction rate securities market. (Note to individual and corporate investors: the interests of a brokerage firm always take precedent over yours.) The repercussions and the extent of the fallout is not yet fully understood; in addition to individual investors that have been impaired, an untold number of corporations will likely be forced to join Bristol-Meyers Squibb ($270 million write-down) in taking massive write-downs relating to the auction rate securities on their books.

Merrill Lynch already has been sued by one of its corporate clients for peddling auction rate securities. Rest assured, when all the facts about the auction rates securities market are known and understood, the legal fallout could quite possibly be more formidable and damaging than Wall Street has ever before experienced.

Bear Stearns & Ralph Cioffi: Breaking Up is Hard to Do

We've obtained the termination "Form U-5" filed by Bear Stearns regarding the now departed portfolio manager, Ralph Cioffi, who guided the two hedge funds specializing in investing in mortgage backed securities into the abyss. My prior blog post anticipated this filing.

The document discloses Cioffi left the firm under a "mutual agreement" with Bear Stearns effective November 28, 2007. The U-5 further states that in June 2007 the firm initiated an internal investigation into Cioffi's "role and conduct" in the failed funds and that "in addition, Federal and state regulators and law enforcement are also investigating" the same hedge funds and "similar issues".

Bear Stearns clearly wanted an amicable departure. Often when firms are under investigation they look to scapegoat others. In this instance, Bear Stearns has a strong interest in keeping Cioffi "on-the-reservation" given the firm's exposure to allegations of fraud in criminal and civil proceedings. The firm stands to benefit so long as their interest and Cioffi's are aligned. Therefore Bear Stearns doesn't have any incentive to include "negative" disclosures which could shed light into how the hedge funds collapsed.

This is stark contrast to allegations that Wall Street firms use Form U-5 to defame departing employees in order to scapegoat them for firm-wide wrongdoing or prevent them from competing on a fair level. I actually have clients that allege Bear Stearns did just that when the firm struck a $250 million settlement with the SEC over mutual fund market timing. The sordid tale was chronicled by Forbes in a story entitled "Fall Guys".

The message is that on Wall Street, you get the "kid-glove" treatment if you're either a Wall Street CEO, or as with Cioffi, the firm needs a friend for upcoming litigation.

My Subprime Litigation Speech

As previously posted about, I just wrapped up a speaking engagement sponsored by Bloomberg and Eversheds. To see my full remarks, click here.

The Impending Subprime Litigation Tsunami

Tomorrow I will be participating in a panel discussion hosted by Bloomberg News and Eversheds, one of the world's largest law firms. The conference is entitled "Sup-prime and global credit symposium: What will happen in 2008". Other participants include Matthew Allen, partner in the insurance and reinsurance group at Eversheds, Dr. Andrew Hilton, director of the Centre for the Study of Financial Innovation, Rolf Tolle, Franchise Performance Director at Lloyd's of London, Michael Fallon, MP for Sevenoaks and member of the Treasury Select Committee and Mark Gilbert, a Bloomberg news financial columnist.

I was asked to provide a view of the potential litigation. Here's what I will tell them:

The world is in for an unprecedented litigation tsunami. Subprime isn't the new dot-com, it's in a whole other class altogether. Wrongdoing is likely much more pervasive and egregious and claims will reach into the multi-billion dollar range. Already there are over 32 class actions filed against mortgage lenders, originators, and Wall Street brokerages alone and multiple civil and criminal probes.

There is one thing in common with the tech-bubble: investors were left holding the bag. I'll be posting my full remarks later this week.

Moody's Finds Religion: Too Little Too Late

It was announced that Moody's is weighing a new 21-point scale for rating structured finance securities. The firm is also considering adding a warning label that acknowledges the ratings' limitations. While I welcome any reforms that can prevent another subprime collapse, this to me falls into the too-little-too-late category.

Furthermore, the market for securitized financial instruments has all but dried up, so it's unclear to me what benefit the new system will have. In reading the news, I couldn't help but recall the asbestos litigation and subsequent regulation which required certain buildings to contain the phrase. CAUTION: ASBESTOS. HAZARDOUS. DO NOT DISTURB WITHOUT PROPER TRAINING AND EQUIPMENT.

My suggestion for the ratings agencies: "CAUTION: PURCHASING THIS SECURITY COULD GREATLY REDUCE YOUR PORTFOLIO."

Harvey Pitt on Individual Investors: Let Them Eat Cake

Former SEC chairman Harvey Pitt was no champion of individual investors. Pitt was in charge of the agency when the former New York Attorney General put the SEC to shame and took the lead in exposing Wall Street's conflicted research. Pitt was also among the regulators who signed off on Spitzer's wrist-slapping $1.4 billion global settlement.

So I guessed I should not have been surprised to hear Mr. Pitt tell CNBC viewers today that the Supreme Court's recent Stoneridge decision, which prevents investors from suing all parties involved in a fraudulent transaction and not just those who directly initiated it, would have no bearing on investors seeking legal recourse relating to the subprime mortgage meltdown. Mr. Pitt said that there were already enough primary violators to sue.

Mr. Pitt is badly mistaken. The Stoneridge decision will adversely affect the legal recourse available to subprime investors, as many potential avenues for discovery – where "smoking guns" are often discovered &ndash are now closed. My guess is that if CNBC had also asked Mr. Pitt about the Supreme Court's Tellabs decision, which requires "a strong inference of fraud" before a class action suit can be certified, he wouldn't have had any issues with that ruling either.

Credit Mr. Pitt at least for one thing: at least the regulatory lightweight's longstanding indifference to the issues and concerns of individual investors remains intact.