In just six months, Standard & Poor’s AAA blessing for a slice of a $1.5 billion collateralized debt obligation cost Citigroup Inc. its $15 million investment.
The Vertical ABS 2007-1, a mezzanine cash flow structure built with asset-backed securities underwritten by UBS AG (UBSN), is one of dozens of deals listed in the Justice Department’s Feb. 4 lawsuit against S&P and its parent McGraw-Hill Cos. that received the ratings firm’s highest AAA grade. Internal UBS e-mails referred to CDOs “as ‘crap’ at the same time that the bank was selling them,” Senator Carl Levin said in an April 2010 subcommittee hearing on the causes and consequences of the financial crisis.
Federally insured Citigroup’s Citibank unit bought into what was supposed to be the safest portion of the CDO, relying in part on S&P’s assessment of the securities, according to the complaint. It lost the entire investment when the CDO defaulted on Oct. 19, 2007.
“Oh, well,” S&P employee Bujiang Hu wrote in response to Moody’s Investors Service’s October 2007 downgrade of Vertical ABS CDO 2007-1, according to the Senate subcommittee report on the role of credit rating firms. “The cat is out of the bag.”
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.
Ed Sweeney, an S&P spokesman, and Megan Stinson of UBS, both in New York, declined to comment.
“Don’t see why we have to tolerate lack of cooperation” from UBS’s James Yao, the UBS banker who asked S&P and Moody’s to rate the CDO, an S&P analyst wrote in an e-mail to colleagues, according to Levin and the subcommittee report. The deal’s “likely not to perform.”
In an April 5, 2007, e-mail, an S&P analyst said the deal was closing the following Tuesday, “but our rated equity tranche (BBB) is failing in our cash flow modeling.” After another employee tried “a lot of ways” to have the model pass, “unfortunately we are still failing” by one basis point, the analyst wrote. In a March e-mail appended to the report the analyst wrote that Yao said S&P was “jeopardizing the deal.”
The next day the analyst wrote the “model is passing now” after finding a “mistake in the waterfall modeling that was more punitive than necessary.”
Vertical Capital LLC, a New York-based CDO manager that oversaw more than $10 billion at the time, chose and supervised the assets “leveraging on the experience of its investment officers in the U.S. structured finance market,” according to the January 2007 prospectus. Kem Blacker, a partner at Vertical Capital, declined to comment.
The pitch to investors assumed a weighted average life of 5.5 years of the collateral, according to the prospectus.
“Current deals are performing well,” according to the prospectus. “To date, no classes in the CDOs managed by Vertical have been downgraded or placed on watch since issuance.”
Vertical is “politically closely tied” to Bank of America Corp., “and is mostly a marketing shop -- helping to take risk off books” for the Charlotte, North Carolina-based bank, according to an S&P analyst’s e-mail, the Senate subcommittee report shows.
“We sold our minority ownership interest in Vertical nearly a year before the e-mail was written and this deal was done,” William Halldin, a spokesman for Bank of America, said in a telephone interview. “We had no role in structuring this CDO.”
Vertical’s management purchased Bank of America’s 48 percent stake in the CDO manager in July 2006, according to the prospectus.
The Vertical ABS CDO consisted of 75 percent subprime residential mortgage-backed securities from 2006, 8 percent from 2007, and 6 percent from 2005, according to the lawsuit. More than a third of the collateral backing it was RMBS rated BBB or below.
Citibank purchased $15 million of an AAA rated portion of Vertical 2007-1. The CDO defaulted on Oct. 19, 2007, and Citibank lost its full $15 million investment, the Justice Department said in the lawsuit.
Pursuit Partners LLC, a Greenwich, Connecticut-based hedge fund which had invested in the CDO, sued “over the CDO’s quick demise,” Levin, a Michigan Democrat, said in the subcommittee hearing, and the court ordered UBS to set aside $35 million for a possible award to the investor.
Frank Canelas, a principal at Pursuit Partners, declined to comment because the firm is still involved in litigation.
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 the top $1.14 billion of Vertical ABS a AAA grade in April 2007.
The Justice Department case is U.S. v. McGraw-Hill, 13-00779, U.S. District Court, Central District of California (Los Angeles).
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