Joseph Cassano insisted American International Group Inc. would be fine.
The insurer had quit guaranteeing securities tied to U.S. subprime loans in 2005, before lenders got reckless, the head of AIG's derivatives unit told investors on Dec. 5, 2007, as home prices plummeted and mortgage losses mounted.
Cassano didn't mention Lou Lucido, 61, a guitar-playing bond buyer at TCW Group Inc. in Los Angeles with a taste for the Rolling Stones. Throughout 2006 and 2007, Lucido had been buying bundles of subprime loans for an investment pool that AIG was bound by contract to insure against failure.
In one such purchase, 11 months before Cassano, 55, reassured shareholders, Lucido's team bought $7 million of a mostly subprime bond. They put it in a $1.5 billion fund managed by TCW called Davis Square Funding III Ltd., which was created by Goldman Sachs Group Inc. and registered in the Cayman Islands. A few months later, Lucido bought $3 million more.
By May 2008, the bond was worthless.
Without having to ask AIG's permission, firms such as TCW, hired to oversee funds called collateralized debt obligations, replaced maturing assets with junk that quickly went bad. Managers including Lucido said they didn't realize how severe the mortgage crash would be and were called upon by CDO contracts to reinvest. At the same time, buying riskier assets could mean bigger paydays.
"The incentive was perverse," said Michael Lea, a finance professor at San Diego State University and former chief economist at mortgage giant Freddie Mac. "The fee structure encouraged TCW to put lower-rated bonds into CDOs over time."
A look at the month-by-month transactions in one CDO -- Davis Square III, named for a difficult-to-navigate section of Somerville, Massachusetts, near Harvard University -- shows how collateral replacements helped drive New York-based AIG to the brink of disaster. The insurer ended up paying $616 million to make up for Davis Square III's loss in value and more than $35 billion overall, liabilities that helped push it into insolvency in September 2008.
Lucido's team, following criteria set by Goldman Sachs, changed almost one-third of the collateral in Davis Square III after the CDO's creation in 2004, according to data compiled by Bloomberg from Moody's Investors Service reports. The securities were mostly backed by the types of newer loans that are going bad at more than twice the rate of older ones. By November 2008, after U.S. taxpayers rescued AIG with a bailout that later swelled to $182.3 billion, even the highest-rated parts of Davis Square III had lost almost half their value.
"Mortgage underwriting standards fell so much that replacing a bunch of 2004 bonds with 2006 and 2007 bonds definitely screwed AIG," said Thomas Adams, a former managing director at bond insurer Ambac Financial Group Inc. and now a partner at New York law firm Paykin Krieg & Adams LLP.
CDOs were at the heart of the financial crisis that sparked the highest U.S. jobless rate in a generation. They were among the largest contributors to the $1.8 trillion of losses at the world's largest financial firms since the start of 2007, according to data compiled by Bloomberg.
The U.S. Securities and Exchange Commission is investigating how Wall Street banks bet against mortgage-linked securities to profit as their clients took losses, according to people familiar with the matter. As part of its examination of the market, the agency is looking at collateral replacement, said an SEC official with knowledge of the probe who asked not to be identified because he wasn't authorized to comment.
Replacing good collateral with bad helped erode Davis Square III's value. Declines in quality added to the cash AIG had to pay to holders of its insurance because its Financial Products division, headed by Cassano, made agreements with banks that included what are called collateral triggers. That was a feature other bond insurers didn't offer, Adams said.
The triggers kicked in when the value of the CDOs declined or if a rating company downgraded AIG's creditworthiness. By December 2008, the insurer had paid out more than $35 billion, according to a list of collateral provided by AIG to Congress.
When the Financial Products unit agreed to guarantee certain top-rated CDO pieces, it didn't envision that assets added later could cause losses, according to a person with knowledge of AIG's thinking who spoke on condition of anonymity because he wasn't authorized to comment.
As long as managers adhered to investment criteria outlined in the prospectus, there was little AIG could do, according to Mark Herr, a spokesman for the insurer.
Joseph Warin, Cassano's lawyer, declined to comment.
Davis Square III's 209-page prospectus spelled out the risks for potential investors. "Characteristics" of replacement collateral wouldn't necessarily be the same as those of existing assets, it said.
It also spelled out Goldman Sachs's investment guidelines, which allowed as much as half of Davis Square III to be bonds backed by subprime mortgages, given to people with bad or limited credit histories. Among other constraints, TCW needed to meet collateral ratings requirements and maintain a mix of lenders and types of debt.
Lucido and his team followed the guidelines and avoided certain types of mortgages and particular issuers as the home- loan market got dicier, he said in an interview.
"We made informed decisions based on the underwriting criteria at the time and felt we were working toward our investors' best interests," he said.
Lucido left TCW in December to become executive vice president of DoubleLine Capital LP, a Los Angeles investment firm founded by his former boss, Jeffrey Gundlach.
Maiden Lane III
Erin Freeman, a spokeswoman for TCW, said her firm bought only collateral for Davis Square III that met the guidelines and didn't allow Goldman Sachs to dictate what to buy.
"TCW has managed these assets prudently and in the best interests of investors," Freeman said.
By December 2008, more than 170 AIG-insured pieces of CDOs, including parts of Davis Square III, had been taken over by a U.S. taxpayer-funded asset pool called Maiden Lane III after the street where the Federal Reserve Bank of New York is located.
Goldman Sachs and TCW's parent, Paris-based Societe Generale SA, were paid the most before and after the New York Fed reimbursed AIG's customers in full. Societe Generale got $16.5 billion, more than any other firm. Goldman Sachs was second with $14 billion. Together they accounted for almost half of the payouts.
New York-based Goldman Sachs was the biggest underwriter of CDOs taken over by Maiden Lane III. TCW managed about twice as many CDO assets that ended up in Maiden Lane III as anyone else, according to the AIG list and data compiled by Bloomberg.
Among other overseers of AIG-guaranteed CDOs were Ellington Management Group LLC's Michael Vranos, a former teen Mr. Connecticut bodybuilder who ran the top-ranked mortgage-bond underwriter in the early 1990s, and Michael Barnes, whose Tricadia Capital Management LLC is so secretive that, when asked to discuss CDO reinvestment, said, "We as a policy do not comment on anything."
That was the thing about CDOs, too. They were secretive. Prospectuses ran hundreds of pages yet often failed to detail a single purchase. What assets they held couldn't be seen publicly. And they gave banks the chance to repackage risky securities and market them as safe investments, at the same time allowing firms to bet that mortgages would fail.
CDOs are investment pools made up of anything that provides a flow of cash. They can contain loans to companies used in leveraged buyouts or securities backed by commercial and residential mortgages, auto loans, credit-card receivables, even pieces of other CDOs.
Underwriters such as Goldman Sachs split CDOs into classes, or tranches, categorizing them by how likely they were to continue paying. The biggest group, called the senior classes, accounted for 93 percent of Davis Square III and got top ratings from Moody's, according to a September 2004 Fitch Ratings analysis. In exchange for being first under the waterfall of payments, senior-class investors received less interest.
Calyon, a unit of Paris-based Credit Agricole SA, bought most of the senior portion of the CDO, which was insured by AIG.
Investors in a smaller tier, known as the mezzanine, were paid a higher rate because they got money only after the senior investors did. The "mezz" pieces made up a little more than 6 percent of Davis Square III and received lower credit ratings.
The tiniest slice, less than 1 percent in the case of Davis Square III, was made up of what's called equity, which wasn't rated by credit companies. Equity investors were paid only after everyone else. They received a higher return while the going was good because they took the most risk and were the first ones wiped out if borrowers quit paying their mortgages.
While Lucido said he didn't own a stake in Davis Square III, he said he did have his own money riding on the equity pieces of some CDOs.
Goldman Sachs did own an equity stake in Davis Square III, according to Michael DuVally, a spokesman for the firm, who declined to say how much it was. Even so, the bank didn't try to influence TCW's investment decisions, DuVally said.
It didn't have to. TCW was promised 20 percent of what was left over after equity investors got 10 percent returns, according to a Goldman Sachs sales pitch to potential equity investors dated September 2004. That was on top of its fee of 0.10 percent of the CDO's assets, according to the prospectus.
Such fees gave managers incentive to move riskier assets into CDOs because the higher returns they produced were likelier to trickle down to equity investors. That was especially true in 2006 and early 2007 when projected earnings on safer securities were dwindling, said Andrey Krakovsky, chief investment officer at New York-based asset manager Tacticus Capital LLC.
As existing collateral shrank because of mortgage prepayments, bond maturities and pay-downs, buying safer securities meant "equity investors would have gotten hammered because there wouldn't have been enough cash flow for them," Krakovsky said.
He said managers often owned equity pieces of CDOs and earned fees linked to their returns.
Howard Hill, a former Babson Capital Management LLC executive who helped start securitization-related departments at four banks, said CDO managers had little choice but to reinvest in what he called "crappier '06, '07 production'' because older, better-quality securities weren't available.
Underwriting standards deteriorated in those years. Cumulative loan losses as a percentage of original balances are expected to be 18.7 percent for subprime mortgages underlying 2005 bonds, 38.4 percent for 2006 bonds and 48.1 percent for 2007 securitizations, according to Moody's.
''The managers tried their best to be able to keep the thing alive and make money," Hill said. "The rules were written by the underwriters, weren't they?"
One of Lucido's earliest purchases for Davis Square III was a $12 million slice of Abacus 2004-1, a CDO created by Goldman Sachs in July 2004 and filled with credit-default swaps, according to the prospectus.
The swaps were side bets that paid off if an investment failed. Goldman Sachs or its customers were essentially using Abacus as a way to short, or bet against, certain mortgage bonds. They would sell the swaps as an investment to customers who took the other side of the bet, believing the mortgage bonds would keep paying. CDOs made up of these side bets and not the actual mortgages were called synthetic CDOs.
By 2007, Goldman Sachs had moved so many securities into Abacus 2004-1 that much of the collateral didn't exist when the CDO was created, according to data compiled by Moody's. While AIG insured parts of Abacus deals, Goldman Sachs didn't change the collateral in the pieces AIG insured, DuVally said.
Other swaps that Goldman Sachs used to bet against subprime mortgages were contained in the $7 million bond that Lucido bought in January 2007, according to the prospectus. The purchase was made a month after Gundlach, TCW's chief investment officer, told Barron's it was "silly optimism" to think housing prices had bottomed out.
The bond was known as GSCSF 2006-3GA C after its manager, New York-based GSC Group, whose chief executive officer, Alfred C. Eckert III, was a former Goldman Sachs executive. It paid 0.90 percentage point more than another subprime-backed bond issued the same month with the same rating, according to data compiled by Bloomberg.
It offered a higher return because it was a resecuritization, a repackaging of securities that bankers used to "shuffle the deck to hide the bad ace," according to Ann Rutledge, founding principal of R&R Consulting, a structured- finance adviser in New York. The bond was rated A2 by Moody's, the firm's sixth-highest rating.
Asset managers typically bought resecuritizations because of their credit ratings and didn't bother to examine the thousands of mortgages that made up each of the hundreds of bonds in the CDO, according to Rutledge, co-author of "The Analysis of Structured Securities," published in 2003 by Oxford University Press.
"Resecuritization has always been toxic," Rutledge said.
Between May 2005 and May 2007, Davis Square III's ownership of pieces of other CDOs rose to 11 percent of its total assets from 8.5 percent, according to data compiled by Moody's. Over the same period its credit ratings on investments drifted about a quarter of a grade lower, the data show.
'Deals Go Bad'
"A lot of managers and equity investors were looking for ways to make sure these deals cash-flowed," said James Frischling, president of NewOak Capital LLC, a New York investment and advisory firm, and former head of CDO groups at two European banks.
"That really does explain why seasoned deals go bad," he said, referring to CDOs that have been around a while.
At the same time TCW bought the GSC bond for Davis Square III, it purchased a $5 million bundle of Alt-A home loans underwritten by Goldman Sachs. Alt-A mortgages were available to borrowers who didn't show proof of income. That security, GSAA 2007-1 M2, also quit paying, according to Moody's.
In February and March 2007, after London-based HSBC Holdings Plc, Europe's biggest bank, announced it was setting aside more money to cover losses on U.S. subprime mortgages, Lucido's team bought $29.7 million of subprime bonds.
"It's not that we're arrogant, or that we've got a lot of hubris," Lucido told the Los Angeles Times in March 2007, "but we think we've got the position and the talent in place to be able to analyze and manage through this period."
Bonded Blues Band
One of TCW's March 2007 purchases, consisting of loans originated by Option One Mortgage Corp., then a unit of H&R Block Inc., quit paying by the end of October 2008.
Between April and May 2007, TCW bought another $48 million of securities for Davis Square III, including three bundles of Alt-A mortgages underwritten by New York-based Morgan Stanley. Two of those bonds have stopped paying.
The asset manager also bought a subprime-mortgage-backed bond called HASC 2007-HE2 2A4, underwritten by HSBC. It was rated Aaa by Moody's, its top ranking. As of the end of January, 67 percent of the borrowers of mortgages backing the bond were at least two months late with payments, according to data compiled by Bloomberg.
"Unfortunately, things deteriorated in an industry way that went beyond even our worst range of forecasts," said Lucido, who's on the dean's executive board at New York University's Stern School of Business and who performed with other mortgage-securities executives in the Bonded Blues Band in the 1990s.
In June and July 2007, while two Bear Stearns Cos. hedge funds unraveled as a result of subprime-linked investments, Lucido's team bought a $10 million piece of another mostly subprime-mortgage CDO, Stockton CDO Ltd., underwritten by Brussels-based Fortis Securities LLC. Moody's gave it a top rating. It failed within a year.
As central banks around the world made emergency loans to financial firms in August 2007 to thaw a freeze in lending triggered by the failure of subprime mortgages, TCW continued to buy bonds backed by risky loans. From July 30 to Oct. 24, it purchased about $50 million of such bonds, according to Moody's.
Between May 2005 and November 2008, when the New York Fed agreed to buy pieces of Davis Square III, TCW put in about $400 million of assets originated after 2004 that weren't guaranteed by government-backed companies such as Freddie Mac.
'Apples to Oranges'
While TCW was adding bonds made up of risky loans, its biggest mutual fund took a more ambivalent approach. TCW Total Return Bond Fund shrank its mortgage holdings not guaranteed by government-sponsored firms to 15.9 percent in July 2007 from 18.8 percent three months earlier, according to company filings.
As early as August 2006, Gundlach was preparing to act on his prediction that U.S. home prices would continue their slide. He announced that TCW was putting together a $1.5 billion fund to invest in bad mortgages.
Gundlach wouldn't comment on Davis Square III and referred questions to Lucido, who said he was hindered from talking because he no longer had access to TCW's files.
Freeman, the TCW spokeswoman, said the bond fund, which beat 99 percent of competitors over the past five years, catered to individual investors and had different investment objectives than Davis Square III. Any comparison is "apples to oranges," she said.
She praised TCW's performance in managing Davis Square III.
"Through the worst credit environment in our lifetimes, this CDO is still performing," she said. "It's still paying interest to investors, and it hasn't had any event of default, which is a credit to TCW's skill in security selection."
'High Default Risk'
The CDO's maturity date is 2039, so any declaration of success is premature, said Rutledge of R&R Consulting.
"A man who jumps off a 100-story building can pass the 98th floor and say, 'So far, so good,'" she said.
Davis Square III continues to deteriorate as more U.S. mortgage borrowers quit paying their monthly bills. Fitch Ratings in February 2009 downgraded the safest class of Davis Square III to CCC, meaning it's a "high default risk."
More than $16 billion of CDOs managed by TCW have defaulted, been liquidated or stopped paying some investors, according to RBS Securities Inc.
TCW now finds itself defending Gundlach's team at the same time it's suing him for having "no understanding or respect for the obligations of a fiduciary," according to a complaint filed Jan. 7 in Los Angeles Superior Court.
In the suit, TCW accuses Gundlach and three other employees of stealing data on 24,000 clients and prospects, as well as proprietary trading information, to start their own firm. Lucido wasn't named in the TCW complaint.
TCW also said in its complaint that Gundlach, a former company director, kept marijuana and "12 sexual devices, 34 hardcore pornographic magazines, 17 hardcore sexually explicit DVDs and 19 hardcore sexually explicit videocassettes" in his two offices.
Gundlach, now CEO of DoubleLine, denied the allegations that he stole client data or used proprietary information. He countersued in February, claiming TCW owed him as much as $1.25 billion in compensation.
As for the drugs, porn and sex toys, Gundlach said in an interview with Bloomberg Markets in January that they were relics from a closed chapter in his life being used by TCW to damage his reputation.
"It's ancient stuff, like a box in an attic," he said.
A dispute over replacement collateral landed in New York Supreme Court in 2008. Hamburg-based HSH Nordbank AG, the world's biggest shipping financier, said in a complaint that UBS AG had been "deliberately selecting inferior quality" assets for a synthetic CDO called North Street 2002-4.
Doug Morris, a spokesman for Zurich-based UBS, declined to comment.
Ellington Management, the asset-management firm founded by Vranos in Old Greenwich, Connecticut, was another manager that replaced collateral in CDOs insured by AIG. The firm bought $11.5 million of bonds backed by mortgages originated by Irvine, California-based New Century Financial Corp. at least two months after the subprime lender declared bankruptcy in April 2007, placing them in a CDO called Duke Funding VII.
About $3.4 billion of the CDOs that ended up in Maiden Lane III were managed by Ellington. Their value had fallen by $1.9 billion.
Steve Bruce, a spokesman for the firm, declined to comment.
Tricadia Capital, the asset-management affiliate of New York-based Mariner Investment Group, also managed CDOs containing collateral that didn't exist when they were created. One was TABS 2005-4, which bundled mostly subprime mortgages and was underwritten by Morgan Stanley in January 2006. AIG guaranteed $248.8 million of the CDO, which lost almost three- quarters of its value by the time it was bought by the New York Fed for Maiden Lane III.
Tricadia told investors it might bet against bonds it put into CDOs -- even ones in which it owned equity stakes.
In AIG's Dec. 5, 2007, presentation, Cassano said the Financial Products unit had conducted "a highly selective review" of investment managers and their incentives and didn't expect to make any payments on the insurance it wrote on the senior classes of subprime CDOs.
"We are highly confident that we will have no realized losses on these portfolios during the life of these portfolios," Cassano said. "Vintages within the subprime sector are key, and we do not have a lot of exposure in our portfolio to the '06 and '07 subprime issuance.''
AIG underestimated the repercussions caused by asset managers trading collateral after CDOs were issued, said Gene Phillips, director of PF2 Securities Evaluations, an advisory firm in New York.
''As it turns out, the ramifications were quite drastic,'' Phillips said.
To contact the reporters on this story: Bob Ivry in New York at firstname.lastname@example.org; Jody Shenn in New York at email@example.com.