Burned Investor in S&P-Affirmed CDO Prescribes Prison Jumpsuits

Five years after his bank’s investment in a collateralized debt obligation rated mostly AAA by Standard & Poor’s got wiped out, Peter Groninger says of the Justice Department’s $5 billion lawsuit against the world’s largest credit ratings company: “It’s about goddamn time.”

Groninger, 61, who retired this month from his post as a money manager after 25 years at the bank unit of Chicago-area First Midwest Bancorp Inc., said that in his opinion, “they should put those sons of bitches in jail. I feel duped, I feel lied to.”

In 2007, Groninger and his team poured about $8.8 million of First Midwest Bank’s holdings into a slice of Acacia Option ARM 1 CDO Ltd., underwritten by UBS AG and graded A, below the top level while still investment grade, by S&P. It “seemed to be commensurate with other deals we looked at,” he said. “We looked at, or tried to, to the best of our abilities look at, the underlying quality of the actual securities that were behind the bond. And it still blew up in our face.”

They lost almost all of their money when the CDO defaulted in May 2008, according to the complaint.

There’s one thing Groninger says he finds “absolutely incredible” about the subprime mortgage disaster: “Ain’t nobody wearing orange jumpsuits for it. No one’s gone to jail, and I find that absolutely staggering. It’s not just the rating agencies -- they haven’t really gone after the investment houses.”

Deliberately Misstating

The world’s leading financial institutions suffered more than $2.1 trillion of writedowns and losses after soaring U.S. mortgage defaults caused the credit crunch starting in 2007.

Acacia Option is one of dozens of deals listed in a Justice Department lawsuit against S&P and its parent, New York-based McGraw-Hill Cos. The Justice Department accused the ratings company of deliberately misstating the risks of mortgage bonds to keep its share of ratings in the booming business of repackaging home loans for sale as securities.

The suit, filed Feb. 4 in federal court in Los Angeles, seeks penalties that may amount to more than $5 billion, based on losses suffered by federally insured financial institutions including First Midwest Bank.

Ratings Cut

McGraw-Hill had its credit grade cut two steps yesterday to Baa2 by Moody’s Investors Service, its biggest rival, which cited the lawsuit and the loss of earnings from its planned $2.5 billion sale of its education unit.

John Piecuch, an S&P spokesman, and Megan Stinson of UBS, both in New York, declined to comment on the performance of the CDOs.

In May 2007, S&P put its best possible grade, AAA, on 84 percent of the $500 million CDO named for a thorn tree, 98 percent of which was subprime residential mortgage-backed securities, according to the complaint.

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 debt 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.

The bubble was inflated by CDOs, which pool assets such as mortgage bonds and package them into new securities with varying risks. Revenue from the underlying bonds or loans is used to pay investors.

‘Colossally Stupid’

While about 21 percent of the collateral backing the Acacia CDO was mortgages taken out by borrowers with poor credit, S&P rated about $420 million of the CDO AAA, and about $470 million A or above. The rating company confirmed its grades on Oct. 3, 2007. Less than two weeks later, S&P downgraded almost 14 percent of the underlying collateral of subprime residential mortgage-backed securities.

“With the benefit of 20-20 hindsight, it was a colossally stupid thing to do, but we had a lot of company,” Groninger said of the investment. “The most difficult part of investing in something new is if you don’t know what you don’t know, you don’t completely know what questions to ask, and that was a big problem.”

Groninger grew up in Aurora, Illinois, west of Chicago, where his father owned a chain of coin laundries. He graduated from Yale University in 1974 with a history degree, and was first exposed to commodities markets at Continental Grain Co. before joining Elmhurst National Bank, which later became Old Kent Bank, which was in turn purchased by Fifth Third Bancorp.

Not JPMorgan

In 1987, about a month after the October market crash, he joined First Midwest, and stayed there until retiring on Feb. 1.

First Midwest, whose Itasca, Illinois-based parent had a market capitalization of $971 million at the end of 2008, at one point had $65 million of asset-backed CDOs, and “lost virtually every penny over a two year period,” he said.

“We aren’t JPMorgan with hundreds of billions of dollars in our securities portfolio,” Groninger said. “Obviously we’re a much smaller institution: $65 million didn’t threaten the safety of the institution certainly, but you don’t want to do that. It makes for some very bad days.”

First Midwest had a net loss of $26.9 million in the fourth quarter of 2008, in part because of impairment charges tied to investments. Three CDOs, with face value of $39 million, were written down by $25 million, and the company cited an unrealized loss of about $18 million on $46 million of CDOs that were temporarily impaired.

Acacia CDO

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 of 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 government said in November 2011.

Acacia Option ARM 1 was sponsored and managed by Redwood Trust Inc., the 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, it 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. 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.

Michael McMahon, a spokesman for Mill Valley, California-based Redwood, declined to comment.

58 Examples

S&P said in in a Feb. 4 statement that all of the 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.

S&P’s CDO group ignored warnings and data from its mortgage securities unit that their mortgage-backed securities 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. Even with 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 the statement.

Smart Enough

“Nobody expects them to be perfect, but you at least expect to have a modicum of intellectual integrity, if nothing else,” Groninger said. The CDO implosion didn’t impact his career trajectory, and no one at First Midwest blamed him, he said.

“You can make an argument that nobody saw the depth or degree of the train wreck that was hurtling at the economy, but we still all got caught up in the train wreck,” said Groninger, who earned his MBA at Northwestern University. “Yeah, I wish I had been smart enough to ask more questions, even though I’m not sure what questions I could have asked.”

Groninger said that “the most disappointing part of that whole period is that you think that people at the top would have to know that what they were doing was wrong and that it was all a house of cards, but nobody had the balls to stand up and say, ‘this is wrong, we aren’t going to participate.’”

Invisible Hand

Groninger said he believes in Adam Smith, author of “Wealth of Nations” and his invisible hand theory that free markets will lead to efficiency. “Somewhere along the line that invisible hand disappeared,” because what’s bad for customers and the economy should also have been bad for business, he said.

The cases need to “be part of the public record” instead of a settlement with the perpetrators paying “a big fine, or a small fine relatively speaking, without confirming or denying the charges against them,” Groninger said. “I hope to God they don’t settle this one on the courthouse steps. The truth needs to come out.”

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