UBS’s Acacia CDO With S&P’s Safest Grade Stung Midwest Investors

Standard & Poor’s slapped its best possible grade on 84 percent of a $500 million collateralized debt obligation named for a thorn tree, 98 percent of which was subprime residential mortgage-backed securities. The sting came a year later.

About $420 million of Acacia Option ARM 1 CDO Ltd., underwritten by UBS AG, received a credit rating of AAA in May 2007, according to a Justice Department complaint against S&P and its parent, McGraw-Hill Cos., filed Feb. 4 in federal court in Los Angeles. A bank unit of Chicago-area First Midwest Bancorp Inc., a federally insured financial institution, lost almost all of its $8.8 million investment in the CDO when it defaulted in May 2008.

Acacia Option is one of dozens of deals listed in the government’s lawsuit that received S&P’s highest AAA grade. The U.S. is accusing the world’s largest credit rater of deliberately misstating the risks of mortgage bonds to keep its share of the booming business of repackaging home loans for sale as securities. The lawsuit seeks penalties that may amount to more than $5 billion, based on losses suffered by federally insured financial institutions.

S&P was aware of its influence over such firms, and knowingly “devised, participated in, and executed a scheme to defraud investors,” according to the complaint.

Ed Sweeney, an S&P spokesman, and Megan Stinson of UBS, both in New York, declined to comment.

Subprime Collateral

So-called option adjustable-rate mortgages, a type of loan that allowed borrowers to pay less than the monthly interest due with the shortfall added to the balance, were among the “toxic” debt that the Financial Crisis Inquiry Commission said was at the center of the “corrosion of mortgage-lending standards” that helped fuel the housing boom and subsequent bust.

While about 21 percent of the collateral backing the CDO was subprime RMBS taken out by borrowers with poor credit, S&P rated about $420 million of the CDO AAA, and about $470 million A or above. It confirmed these ratings on October 3, 2007. Less than two weeks later, S&P downgraded almost 14 percent of the underlying subprime RMBS collateral.

First Midwest Bank, whose Itasca, Illinois-based parent had a market capitalization of $971 million at the end of 2008, lost almost all of its $8.8 million investment in an A portion of the CDO by May 2008 when Acacia Option had defaulted.

‘Very Disappointed’

First Midwest had a net loss of $26.9 million in the last quarter of 2008, in part from higher impairment charges tied to investments. Three trust-preferred CDOs, with face value of $39 million, were written down by $25 million, and the company also cited an unrealized loss of about $18 million on another $46 million of trust-preferred CDOs that were “temporarily impaired.”

“We are very disappointed in the necessity of these actions and their impact on our 2008 performance,” Michael Scudder, chief executive officer, said in a regulatory filing on Jan. 22, 2009. “However, these are extremely difficult economic times with consumers and businesses falling under increasing strain. The severity of the times requires that we address the problems of the day head on.”

First Midwest lost $193.7 million of cash from investing in the second quarter of 2008, and $6.4 million and $312 million in the next two periods, according to data compiled by Bloomberg. By 2009, the bank had $915.8 million inflows from investing, and it was able to repay $193 million in Troubled Asset Relief Program bailout funds to the U.S. Treasury Department, the department said in November 2011.

Changed Accounting

Acacia Option Arm 1 was sponsored and managed by Redwood Trust Inc., the Mill Valley, California-based jumbo-mortgage specialist.

Redwood delayed filing its 2007 annual report to evaluate declines in the value of securities it held, after the fourth quarter’s total negative fair-value adjustments of $956 million, Redwood said in a statement on Feb. 29, 2008.

At the beginning of 2008, Redwood adopted a new accounting standard that changed the way it accounted for assets and liabilities at its Acacia CDO entities.

Demanding Information

The Securities and Exchange Commission demanded information about its Acacia CDO business in May 2010 on topics including “trading practices and valuation policies,” Redwood said in an August 2010 filing with the agency.

CDOs pool assets such as mortgage bonds and package them into new securities with varying risks in which revenue from the underlying bonds or loans are used to pay investors.

S&P’s CDO group ignored warnings and data from its mortgage securities unit that their MBS ratings, used in grading CDOs, were proving flawed, according to the complaint. The lawsuit includes at least 58 examples of S&P executives taking steps to appease issuers or acknowledging how pressure from banks could lessen the quality of its grades or delay downgrades.

The ratings company contests the suit’s allegations. Despite its best efforts to “keep up with an unprecedented, rapidly changing and increasingly volatile environment,” the severity of “what ultimately occurred” was “greater than we - - and virtually everyone else -- predicted,” the company said in a Feb. 4 statement.

S&P said in the statement that all of its CDOs cited by the Justice Department received the same ratings from a competitor. Moody’s granted $420 million of Acacia Option ARM 1 CDO the same AAA as S&P in May 2007.

Acacia is a genus of often-thorny trees and shrubs in the Fabaceae family, with many species native to Australia and Africa, according to Encyclopedia Britannica. It’s also a fraternity founded in 1904, with chapters at colleges including Cornell University and Pennsylvania State University.

The Justice Department case is U.S. v. McGraw-Hill, 13-00779, U.S. District Court, Central District of California (Los Angeles).