Wall Street and the Financial Crisis: Anatomy of a Financial Collapse


A. Background

Historically, investment banks helped raise capital for business and other endeavors by helping to design, finance, and sell financial products like stocks or bonds. When a corporation needed capital to fund a large construction project, for example, it often hired an investment bank either to arrange a bank loan or to raise capital by designing, financing, and marketing an issue of shares or corporate bonds for sale to investors. Investment banks performed these services in exchange for fees.

Today, investment banks also participate in a wide range of other financial activities, including providing broker-dealer and investment advisory services, and trading commodities and derivatives. Investment banks also often engage in proprietary trading, meaning trading with their own money and not on behalf of a customer. Many investment banks are structured today as affiliates of one or more banks.

Under the Glass-Steagall Act of 1933, certain types of financial institutions had been prohibited from commingling their services. For example, with limited exceptions, only brokerdealers could provide brokerage services; only banks could offer banking; and only insurers could offer insurance. Each financial sector had its own primary regulator who was generally prohibited from regulating services outside of its jurisdiction. |1240| Glass-Steagall also contained prohibitions against proprietary trading. |1241| One reason for keeping the sectors separate was to ensure that banks with federally insured deposits did not engage in the type of high risk activities that might be the bread and butter of a broker-dealer or commodities trader. Another reason was to avoid the conflicts of interest that might arise, for example, from a financial institution pressuring its clients to obtain all of its financial services from the same firm. A third reason was to avoid the conflicts of interest that arise when a financial institution is allowed to act for its own benefit in a proprietary capacity, while at the same time acting on behalf of customers in an agency or fiduciary capacity.

Glass-Steagall was repealed in 1999, after which the barriers between banks, brokerdealers, and insurance firms fell. U.S. financial institutions not only began offering a mix of financial services, but also intensified their proprietary trading activities. The resulting changes in the way financial institutions were organized and operated made it more difficult for regulators to distinguish between activities intended to benefit customers versus the financial institution itself. The expanded set of financial services investment banks were allowed to offer also contributed to the multiple and significant conflicts of interest that arose between some investment banks and their clients during the financial crisis.

Investment banks typically play a variety of significant roles when dealing with their clients, including that of market maker, underwriter, placement agent, and broker-dealer. Each role brings different legal obligations under federal securities law.

Market Maker. A "market maker" is typically a dealer in financial instruments that stands ready to buy and sell for its own account a particular financial instrument on a regular and continuous basis at a publicly quoted price. |1242| A major responsibility of a market maker is filling orders on behalf of customers. Market markers do not solicit customers; instead they maintain buy and sell quotes in a public setting, demonstrating their readiness to either buy or sell the specified security, and customers come to them. For example, a market maker in a particular stock typically posts the prices at which it is willing to buy or sell that stock, attracting customers based on the competitiveness of its prices. This activity by market makers helps provide liquidity and efficiency in the trading market for the security. |1243| It is common for a particular security to have multiple market makers who competitively quote the security.

Market makers generally use the same inventory of assets to carry out both their marketmaking and proprietary trading activities. Market makers are allowed, in certain circumstances specified by the SEC, to sell securities short in situations to satisfy market demand when they do not have the securities in their inventory in order to provide liquidity. Market makers have among the most narrow disclosure obligations under federal securities law, since they do not actively solicit clients or make investment recommendations to them. Their disclosure obligations are generally limited to providing fair and accurate information related to the execution of a particular trade. |1244| Market makers are also subject to the securities laws' prohibitions against fraud and market manipulation. In addition, they are subject to legal requirements relating to the handling of customer orders, for example using best execution efforts when placing a client's buy or sell order. |1245|

Underwriter and Placement Agent. If an investment bank agrees to act as an "underwriter" for the issuance of a new security to the public, such as an RMBS, it typically purchases the securities from the issuer, holds them on its books, conducts the public offering, and bears the financial risk until the securities are sold to the public. By law, securities sold to the public must be registered with the SEC. Underwriters help issuers prepare and file the registration statements filed with the SEC, which explain to potential investors the purpose of a proposed public offering, the issuer's operations and management, key financial data, and other important facts. Any offering document, or prospectus, given to the investing public in connection with a registered security must also be filed with the SEC.

If a security is not offered to the general public, it can still be offered to investors through a "private placement." Investment banks often act as the "placement agent," performing intermediary services between those seeking to raise money and investors. Placement agents often help issuers design the securities, produce the offering materials, and market the new securities to investors. Offering documents in connection with private placements are exempt from SEC registration and are not filed with the SEC.

In the years leading up to the financial crisis, RMBS securities were registered with the SEC, while CDOs were sold to investors through private placements. Both of these securities were also traded in a secondary market by market makers. Investment banks sold both types of securities primarily to large institutional investors, such as other banks, pension funds, insurance companies, municipalities, university endowments, and hedge funds.

Whether acting as an underwriter or placement agent, a major part of the investment bank's responsibility is to solicit customers to buy the new securities being offered. Under the securities laws, investment banks that act as an underwriter or placement agent for new securities are liable for any material misrepresentation or omission of a material fact made in connection with a solicitation or sale of those securities to investors. |1246|

The obligation of an underwriter and placement agent to disclose material facts to every investor it solicits comes from two sources: the duties as an underwriter specifically, and the duties as a broker-dealer generally. With respect to duties relating to being an underwriter, the U.S. Court of Appeals for the First Circuit observed that underwriters have a "unique position" in the securities industry:

    "[T]he relationship between the underwriter and its customer implicitly involves a favorable recommendation of the issued security. … Although the underwriter cannot be a guarantor of the soundness of any issue, he may not give it his implied stamp of approval without having a reasonable basis for concluding that the issue is sound." |1247|

In addition, Section 11 of the Securities Act of 1933 makes underwriters liable to any investor in any registered security if any part of the registration statement "contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading." |1248|

Broker-Dealer. Broker-dealers also have affirmative disclosure obligations to their clients. With respect to the duties of a broker-dealer, the SEC has held:

    "[W]hen a securities dealer recommends a stock to a customer, it is not only obligated to avoid affirmative misstatements, but also must disclose material adverse facts to which it is aware. That includes disclosure of ‘adverse interests' such as ‘economic self interest' that could have influenced its recommendation." |1249|

To help broker-dealers understand when they are obligated to disclose material adverse facts to investors, the Financial Industry Regulatory Authority (FINRA) has further defined the term "recommendation":

    "[A] broad range of circumstances may cause a transaction to be considered recommended, and this determination does not depend on the classification of the transaction by a particular member as ‘solicited' or ‘unsolicited.' In particular a transaction will be considered to be recommended when the member or its associated person brings a specific security to the attention of the customer through any means, including, but not limited to, direct telephone communication, the delivery of promotional material through the mail, or the transmission of electronic messages." |1250|

There is no indication in any law or regulation that the obligation to disclose material adverse facts is diminished or waived in relation to the level of sophistication of the potential investor. |1251|

Over time, investment banks have devised, marketed, and sold increasingly complex financial instruments to investors, often referred to as "structured finance" products. These products include residential mortgage backed securities (RMBS), collateralized debt obligations (CDOs), and credit default swaps (CDS), including CDS contracts linked to the ABX Index, all of which played a central role in the financial crisis.

RMBS and CDO Securities. RMBS and CDO securities are two common types of structured finance products. RMBS securities contain pools of mortgage loans, while CDOs contain or reference pools of RMBS securities and other assets. RMBS concentrate risk by including thousands of subprime and other high risk home loans, with similar characteristics and risks, in a single financial instrument. Mortgage related CDOs concentrate risk even more by including hundreds or thousands of RMBS securities, with similar characteristics and risks, in a single financial instrument. In addition, while some CDOs included only AAA rated RMBS securities, others known as "mezzanine" CDOs contained RMBS securities that carried the riskier BBB, BBB-, and even BB credit ratings and were more susceptible to losses if the underlying mortgages began to incur delinquencies or defaults.

Some investment banks went a step farther and assembled CDO securities into pools and resecuritized them as so-called "CDO squared" instruments, which further concentrated the risk in the underlying CDOs. |1252| Some investment banks also assembled "synthetic CDOs," which did not contain any actual RMBS securities or other assets, but merely referenced them. Some devised "hybrid CDOs," which contained a mix of cash and synthetic assets.

The securitization process generated billions of dollars in funds that allowed investment banks to supply financing to lenders to issue still more high risk mortgages and securities, which investment banks and others then sold or securitized in exchange for still more fees. This cycle was repeated again and again, introducing more and more risk to a wider and wider range of investors.

Credit Default Swaps. Some investment banks modified still another structured finance product, a derivative known as a credit default swap (CDS), for use in the mortgage market. Much like an insurance contract, a CDS is a contract between two parties in which one party guarantees payment to the other if the assets referenced in the contract lose value or experience a negative credit event. The party selling the insurance is referred to as the "long" party, since it profits if the referenced asset performs well. The party buying the insurance protection is referred to as the "short" party because it profits if the referenced asset to perform poorly.

The short party, or CDS buyer, typically pays periodic premiums, similar to insurance premiums, to the long party or CDS seller, who has guaranteed the referenced assets against a loss in value or a negative credit event such as a credit rating downgrade, default, or bankruptcy. If the loss or negative credit event occurs, the CDS seller is required to pay an agreed upon amount to the CDS buyer. Many CDS contracts also tracked the changing value of the referenced assets over time, and required the long and short parties to post cash collateral with each other to secure payment of their respective contractual obligations.

CDS contracts that reference a single, specific security or bond for protection against a loss in value or negative credit event have become known as "single name" CDS contracts. Other CDS contracts have been designed to protect a broader basket of securities, bonds, or other assets.

By 2005, investment banks had standardized CDS contracts that referred to a "single name" RMBS or CDO security. Some investment banks and investors, which held large inventories of RMBS and CDO securities, purchased those single name CDS contracts as a hedge against possible losses in the value of their holdings. Other investors, including investment banks, began to purchase single name CDS contracts, not as a hedge to offset losses from the RMBS or CDO securities they owned, but as a way to profit from particular RMBS or CDO securities they predicted would lose value or fail. CDS contracts that paid off on securities that were not owned by the CDS buyer became known as "naked credit default swaps." Naked CDS contracts enabled investors to bet against mortgage related assets, using the minimal capital needed to make the periodic premium payments and collateral calls required by a CDS contract.

The key significance of the CDS product for the mortgage market was that it offered an alternative to investing in RMBS and CDO securities that would perform well. Single name CDS contracts instead enabled investors to place their dollars in financial instruments that would pay off if specific RMBS or CDO securities lost value or failed.

ABX Index. In January 2006, a consortium of investment banks, led by Goldman Sachs and Deutsche Bank, launched still another type of structured finance product, linked to a newly created "ABX Index," to enable investors to bet on multiple subprime RMBS securities at once. The ABX Index was administered by a private company called the Markit Group and consisted of five separate indices, each of which tracked the performance of a different basket of 20 designated subprime RMBS securities. |1253| The values of the securities in each basket were aggregated into a single composite value that rose and fell over time. Investors could then arrange, through a broker-dealer, to enter into a CDS contract with another party using the ABX basket of subprime RMBS securities as the "reference obligation" and the relevant ABX Index value as the agreed upon value of that basket. For a fee, investors could take either the "long" position, betting on the rise of the index, or the "short" position, betting on the fall of the index, without having to physically purchase or hold any of the referenced securities or raise the capital needed to pay for the full face value of those referenced securities. The index also used standardized CDS contracts that remained in effect for a standard period of time, making it easier for investors to participate in the market, and buy and sell ABX-linked CDS contracts.

The ABX Index allowed investors to place unlimited bets on the performance of one or more of the subprime RMBS baskets. It also made it easier and cheaper for investors, including some investment banks, to short the subprime mortgage market in bulk. |1254| Investment banks not only helped establish the ABX Index, they encouraged their clients to enter into CDS contracts based upon the ABX Index, and used it themselves to bet on the mortgage market as a whole. The ABX Index expanded the risks inherent in the subprime mortgage market by providing investors with a way to make unlimited investments in RMBS securities.

Synthetic CDOs. By mid-2006, there was a large demand for RMBS and CDO securities as well as a growing demand for CDS contracts to short the mortgage market. To meet this demand, investment banks and others began to make greater use of synthetic CDOs, which could be assembled more quickly, since they did not require the CDO arranger to find and purchase actual RMBS securities or other assets. The increasing use of synthetic CDOs injected even greater risk into the mortgage market by enabling investors to make unlimited wagers on various groups of mortgage related assets and, if those assets performed poorly, expanding the number of investors who would realize losses.

Synthetic CDOs did not depend upon actual RMBS securities or other assets to bring in cash to pay investors. Instead, the CDO simply developed a list of existing RMBS or CDO securities or other assets that would be used as its "reference obligations." The parties to the CDO were not required to possess an ownership interest in any of those reference obligations; the CDO simply tracked their performance over time. The performance of the underlying reference obligations, in the aggregate, determined the performance of the synthetic CDO.

The synthetic CDO made or lost money for its investors by establishing a contractual agreement that they would make payments to each other, based upon the aggregate performance of the underlying referenced assets, using CDS contracts. The "short" party essentially agreed to make periodic payments, similar to insurance premiums, to the other party in exchange for an agreement that the "long" party would pay the full face value of the synthetic CDO if the underlying assets lost value or experienced a defined credit event such as a ratings downgrade. In essence, then, the synthetic CDO set up a wager in which the short party bet that its underlying assets would perform poorly, while the long party bet that they would perform well.

Synthetic CDOs provided still another vehicle for investors looking to short the mortgage market in bulk. The synthetic CDO typically referenced a variety of RMBS securities. One or more investors could then take the "short" position and wager that the referenced securities as a whole would fall in value or otherwise perform poorly. Synthetic CDOs became a way for investors to short multiple specific RMBS securities that they expected to incur delinquencies, defaults, and losses.

Synthetic CDOs magnified the risk in the mortgage market, because arrangers had no limit on the number of synthetic CDOs they could create. In addition, multiple synthetic CDOs could reference the same RMBS and CDO securities in various combinations, and sell financial instruments dependent upon the same sets of high risk, poor quality loans over and over again to various investors. Since every synthetic CDO had to have a "short" party betting on the failure of the referenced assets, at least some poor quality RMBS and CDO securities could be included in each transaction to attract those investors. When some of the high risk, poor quality loans later incurred delinquencies or defaults, they caused losses, not in a single RMBS, but in multiple cash, synthetic, and hybrid CDOs whose securities had been sold to a wide circle of investors. |1255|

Conflicts of Interest. Investment banks that designed, obtained credit ratings for, underwrote, sold, managed, and serviced CDO securities, made money from the fees they charged for these and other services. Investment banks reportedly netted from $5 to $10 million in fees per CDO. |1256| Some also constructed CDOs to transfer the financial risk of poorly performing RMBS and CDO securities from their own holdings to the investors they were soliciting to buy the CDO securities. |1257| By selling the CDO securities to investors, the investment banks profited not only from the CDO sales, but also eliminated possible losses from the assets removed from their warehouse accounts. In some instances, unbeknownst to the customers and investors, the investment banks that sold them CDO securities bet against those instruments by taking short positions through single name CDS contracts. Some even took the short side of the CDO they constructed, and profited when the referenced assets lost value, and the investors to whom they had sold the long side of the CDO were required to make substantial payments to the CDO.

The following two case studies examine how two investment banks active in the U.S. mortgage market constructed, marketed, and sold RMBS and CDO securities; how their activities magnified risk in the mortgage market; and how conflicts of interest negatively impacted investors and contributed to the financial crisis. The Deutsche Bank case history provides an insider's view of what one senior CDO trader described as Wall Street's "CDO machine." It reveals the trader's negative view of the mortgage market in general, the poor quality RMBS assets placed in a CDO that Deutsche Bank marketed to clients, and the fees that made it difficult for investment banks like Deutsche Bank to stop selling CDOs. The Goldman Sachs case history shows how one investment bank was able to profit from the collapse of the mortgage market, and ignored substantial conflicts of interest to profit at the expense of its clients in the sale of RMBS and CDO securities.


1240. Federal law has never established a "super- regulator" with jurisdiction to police 1240 compliance and conduct across banking, brokerage, investment advisory, and insurance sectors, and that remains the case today. [Back]

1241. See Section 16 of the Banking Act of 1933, Pub. L.73- 66 (also known as the Glass- Steagall Act). [Back]

1242. Section 3(a)(38) of the Securities Exchange Act of 1934 1242 states: "The term "market maker" means any specialist permitted to act as a dealer, any dealer acting in the capacity of block positioner, and any dealer who, with respect to a security, holds himself out (by entering quotations in an inter- dealer communications system or otherwise) as being willing to buy and sell such security for his own account on a regular or continuous basis." See also SEC website, http://www.sec.gov/answers/mktmaker.htm; FINRA website, FAQs, "What Does a Market Maker Do?" http://finra.atgnow.com/finra/categoryBrowse.do. [Back]

1243. See SEC website, http://www.sec.gov/answers/mktmaker.htm; FINRA website, FAQs, "What Does a Market Maker Do?" http://finra.atgnow.com/finra/categoryBrowse.do. [Back]

1244. 1/2011 "Study on Investment Advisers and Broker- Dealers," study conducted by the U.S. Securities and Exchange Commission, at 55, http://www.sec.gov/news/studies/2011/913studyfinal.pdf. [Back]

1245. See Responses to Questions for the Record from Goldman Sachs at PSI_QFR_GS0046. [Back]

1246. See Sections 11 and 12 of Securities Act of 1933. See also Rule 10b- 5 of the Securities 1246 Exchange Act of 1934. See also, e.g., SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 201 (1963) ( "Experience has shown that disclosure in such situations, while not onerous to the advisor, is needed to preserve the climate of fair dealing which is so essential to maintain public confidence in the securities industry and to preserve the economic health of the country." ). See also SEC Study on Investment Advisers and Broker- Dealers at 51 (citations omitted) ( "Under the socalled ‘ shingle ' theory … , a broker- dealer makes an implicit representation to those persons with whom it transacts business that it will deal fairly with them, consistent with the standards of the profession. … Actions taken by the broker- dealer that are not fair to the customer must be disclosed in order to make this implied representation of fairness not misleading." ). [Back]

1247. SEC v. Tambone, 550 F.3d 106 (1st 1247 Cir. 2008) [citations omitted]. [Back]

1248. Section 11 of the Securities Act of 1933, codified at 15 U.S.C. § 77a. [Back]

1249. In the Matter of Richmark Capital Corporation , Securities Exchange Act Rel. No. 48758 (Nov. 7, 2003) (citing Chasins v. Smith Barney & Co., Inc ., 438 F.3d 1167, 1172 (2d Cir. 1970) ( "The investor … must be permitted to evaluate overlapping motivations through appropriate disclosures, especially where one motivation is economic selfinterest" )). [Back]

1250. FINRA Notice No. 96- 60. [Back]

1251. See FINRA Rules 2210(d)(1)(A) and 2211(a)(3) and (d)(1) (by rule all institutional sales material and correspondence may not "omit any material fact or qualification if the omission, in the light of the context of the material presented, would cause the communications to be misleading." ) . See also FINRA Rule 2310 and IM- 2310-3 (suitability obligation to institutional customers). [Back]

1252. CDO squared transactions will generally be referred to 1252 in this Report as "CDO2 ." Some Goldman materials also use the term "CDO^2." [Back]

1253. Each of the five indices tracked a different basket of subprime RMBS securities. 1253 One index tracked a basket of 20 AAA rated RMBS securities; the second a basket of AA rated RMBS securities; and the remaining indices tracked baskets of A, BBB, and BBB- rated RMBS securities. Every six months, a new set of RMBS securities was selected for each index. See 3/2008 Federal Reserve Bank of New York Staff Report No. 318, "Understanding the Securitization of Subprime Mortgage Credit," at 26. Markit Group Ltd. administered the ABX Index which issued indices in 2006 and 2007, but has not issued any new indices since then. [Back]

1254. Subcommittee Interview of Joshua Birnbaum (4/22/2010); Subcommittee 1254 Interview of Rajiv Kamilla (10/12/2010). [Back]

1255. See, e.g., "Senate's Goldman Probe Shows Toxic Magnification," Wall Street 1255 Journal (5/2/2010) (showing how a single $38 million subprime RMBS, created in June 2006, was included in 30 CDOs and, by 2008, had caused $280 million in losses to investors). [Back]

1256. See "Banks'self- Dealing Super- Charged Financial Crisis," ProPublica (8/26/2010), http://www.propublica.org/article/banks- self- dealing- super- charged- financial- crisis ( "A typical CDO could net the bank that created it between $5 million and $10 million – about half of which usually ended up as employee bonuses. Indeed, Wall Street awarded record bonuses in 2006, a hefty chunk of which came from the CDO business." ). Fee information obtained by the Subcommittee is consistent with this range of CDO fees. For example, Deutsche Bank received nearly $5 million in fees for Gemstone 7, and the head of its CDO group said that Deutsche bank received typically between $5 and 10 million in fees, while Goldman Sachs charged a range of $5 to $30 million in fees for Camber 7, Fort Denison, and the Hudson Mezzanine 1 and 2 CDOs. 12/20/2006 Gemstone 7 Securitization Credit Report, DB_PSI_00237655- 71 and 3/15/2007 Gemstone CDO VII Ltd. Closing Memorandum, DB_PSI_00133536- 41; Subcommittee interview of Michael Lamont (9/29/2010); and Goldman Sachs response to Subcommittee QFRs at PSI- QFR- GS0249. [Back]

1257. See, e.g., discussion of the Hudson CDO, below; Subcommittee interview of Daniel Sparks (4/15/10) (Goldman tried selling subprime loans but could not; it was easier and more efficient to securitize them and then sell the securitized product to transfer loans in bulk; it was also easier to sell CDOs than individual underlying positions). [Back]

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