Feb. 6 (Bloomberg) -- In May 2007, Standard & Poor’s confirmed its initial AAA ratings on $772 million of a collateralized debt obligation known as Octonion I. Within 10 months, the Citigroup Inc. deal defaulted, costing investors and the bank almost all their money.
The CDO, which repackaged mortgage-backed securities and other similar bundles of debt, was among dozens of transactions valued at tens of billions of dollars in 2007 that the ratings firm never should have blessed, the Justice Department said Feb. 4 in a lawsuit filed in Los Angeles.
Octonion I underscores how inflated grades during the credit boom contributed to more than $2.1 trillion in losses at the world’s financial institutions after home-loan defaults soared and residential prices plummeted. The U.S. is seeking penalties against S&P and its New York-based parent, McGraw-Hill Cos., that may amount to more than $5 billion, based on losses suffered by federally insured banks.
“During this period, nearly every single mortgage-backed CDO that was rated by S&P not only underperformed but failed,” Attorney General Eric Holder said yesterday at a news conference. “Put simply, this alleged conduct is egregious, and it goes to the very heart of the recent financial crisis.”
Even after the market for subprime mortgages began to melt down and following months of internal warnings that its ratings on securities backed directly by the loans were due for sweeping downgrades, May 2007 was a lucrative month for the CDO group at S&P, according to documents cited in the government’s complaint.
U.S. CDO issuance was expected to generate $24.48 million in revenue, “the highest total for the month of May to date,” Patrice Jordan, then a managing director at the ratings firm who headed global CDOs, said in an internal report cited in the government’s lawsuit. The revenue followed $74.82 million in January through April, about double the figure in the corresponding period of 2006, she wrote.
Surging volumes of CDOs were the result of “the effect of the subprime RMBS situation,” Jordan wrote, referring to the residential mortgage-backed securities based on loans to borrowers with the worst credit that were packaged into CDOs.
David Tesher, head of one of S&P’s CDO groups, had communicated internally in March that the firm should brace for a rush partly because some investors might have already signed up for the deals, according to the complaint. Even if the CDOs never were sold, he said, banks benefited from being able to create them rather than hold the underlying securities in “raw form” because that would allow for smaller writedowns.
S&P’s CDO group enabled the boom to continue by ignoring warnings and data from its RMBS group that their ratings, which it relied on in grading CDOs, were proving flawed, according to the complaint.
S&P denied wrongdoing in an e-mailed statement.
“Claims that we deliberately kept ratings high when we knew they should be lower are simply not true,” wrote Catherine Mathis, a spokeswoman. “We will vigorously defend S&P against these unwarranted claims.”
A telephone message left at a number for Jordan and e-mails to addresses for Jordan and Tesher weren’t returned.
Octonion I was created in February 2007, according to data compiled by Bloomberg, the same month that subprime provisions by HSBC Holdings Plc and a planned restatement by lender New Century Financial Corp. signaled an accelerating meltdown. Octonion is a mathematical term.
S&P said in its statement that all of its CDOs cited by the Justice Department received the same ratings from a competitor. Moody’s Investors Service granted the various portions of Octonion I the same grades as S&P, Bloomberg data show.
S&P offered the typical post-issuance confirmation of Octonion I’s grades because CDOs aren’t completely filled at the time the debt is created, according to the complaint.
The $1 billion CDO was filled approximately 76 percent with subprime RMBS from 2006 at the same time as S&P’s surveillance group was tracking how the early defaults on underlying loans were proving the worst ever and pushing for downgrades, according to the complaint.
About 62 percent of the total was subprime and other non-prime RMBS rated below BBB+, S&P’s third-lowest level of investment grade, according to the complaint.
Two months after confirming the CDO’s ratings, S&P downgraded almost 11 percent of the underlying non-prime RMBS collateral, the government complaint says. By February 2008, Octonion I defaulted.
One bond placed in Octonion I was a $10 million slice of a subprime RMBS created in December 2006 by Merrill Lynch & Co., according to a Moody’s monitoring report and Bloomberg data. S&P finally cut the class by 10 levels in January 2008 to CC from its initial BBB- ranking.
At issuance, the securitization known as SURF 2006-BC5 was backed by 4,560 loans, Bloomberg data show. About 64 percent were refinancings in which borrowers had tapped their home equity. Appraisals showed about 15 percent of borrowers had less than 10 percent equity to start, according to a prospectus.
Almost 7 percent were riskier second-lien home equity loans, according to a prospectus. Loan-to-value ratios on that debt averaged 99.45 percent, meaning borrowers put nothing down to buy a home or extracted all of their home’s value in a cash-out refinancing.
S&P’s Jordan in the internal report in May 2007 said that her group was analyzing previously issued CDOs, assuming that second-lien subprime collateral would “default with zero recovery,” according to the government report.
The loans backing the Merrill bonds reflected the loose lending of the era in other ways.
Borrowers “stated” income or assets, rather than providing documentation, on 50.5 percent of the loans, according to the prospectus. More than 15 percent were interest-only loans. California loans accounted for 24 percent of the bond, while Florida mortgages represented 8.2 percent.
Losses on the underlying loans began wiping out the class of SURF 2006-BC5 placed in Octonion I in November 2008 and it was worthless three months later, Bloomberg data show.
Issuers of other RMBS with slices packaged into Octonion I include New Century, Washington Mutual Inc. and Bear Stearns Cos., all of which collapsed during the financial crisis as their loans and bonds soured faster than those of some rivals.
Other collateral not mentioned in the government complaint included lower-rated slices of similar mortgage-tied CDOs that Citigroup had also arranged, such as 888 Tactical Fund Ltd., Bloomberg News reported in 2010.
Wing Chau’s Harding Advisory was the manager responsible for picking the collateral of both Octonion I and 888 Tactical, which was also mentioned in the S&P suit, Bloomberg data show.
In a lawsuit filed in March 2009, a hedge fund manager who once was the head trader of asset-backed bonds at Citigroup said he lost almost all of his $3 million investment in Octonion I in six months because Chau allowed Citigroup to repackage “unsellable junk” instead of serving as a watchdog.
The judge in the case granted the bank’s motion to dismiss the suit by Alan Brody’s Epirus Capital Management LLC before discovery. Chau said in an e-mail in 2010 that suggestions he constructed CDOs to benefit banks were “outrageous.”
Another CDO’s slice included in Octonion I came from Class V Funding III. In 2011, Citigroup, also that CDO’s underwriter, agreed to pay $285 million to settle Securities and Exchange Commission allegations it had exercised too much influence over what went into Class V, and then “took a proprietary short position against those mortgage-related assets from which it would profit if the assets declined in value.”
The bank didn’t admit or deny wrongdoing.
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