Bloomberg is reporting Merrill Sued for Fraud by Massachusetts Over CDO Sale.

Merrill Lynch & Co. violated Massachusetts securities laws by selling the city of Springfield “inappropriate” collateralized debt obligations that lost 91 percent of their value, Secretary of State William Galvin alleged in a lawsuit filed today.

The sale was “illegal,” Galvin’s enforcement office said in a 25-page complaint. The regulators are seeking sanctions against New York-based Merrill and the two brokers who sold the CDOs to Springfield, Carl Kipper and Manuel Choy. The brokers no longer work for Merrill, the firm said today.

“At the time of the sale Kipper and Choy did not discuss the risks of owning CDOs with the city even though those risks were well know to Merrill Lynch,” the complaint alleges. Galvin declined to comment on the lawsuit.

Springfield joins a growing list of governments and their agencies, from Florida to Washington state, that have been burned by mortgage-linked securities such as CDOs. The market for CDOs has collapsed amid surging subprime loan defaults, hurting their credit ratings and, in the case of Springfield, making them virtually impossible to sell.

“We are puzzled by this suit,” said Mark Herr, a Merrill spokesman, in a statement. “We have been cooperating with Mr. Galvin’s office in its inquiry.”

“After carefully reviewing the facts, we have determined the purchases of these securities were made without the express permission of the city,” Merrill said in a statement yesterday after agreeing to reimburse the city. “As a result, we are making the city whole and we have taken appropriate steps internally to ensure this conduct is not repeated.”

Hornet’s Nest Of Litigation Opened

Merrill Lynch (MER) may have opened a legal hornet’s nest by agreeing to reimburse Springfield $13.9 million.

Merrill Lynch & Co. will pay the city of Springfield $13.9 million to settle a dispute over investments that soured and became the focus of investigations by state regulators, the two sides said Thursday

The brokerage firm said in a statement released late Thursday that it settled after a review showed Springfield officials never gave explicit permission to invest in the securities, many of which were related to the troubled subprime mortgage market.

“Merrill Lynch is crediting the city of Springfield with approximately $13.9 million in cash, the full original purchase price of CDO investments that have been under dispute,” Mayor Domenic J. Sarno, Springfield Finance Control Board Chairman Chris Gabrieli and Coakley said in a joint statement.

Is the situation unique to Springfield?

By agreeing to reimburse Springfield for any reason, lawsuits are bound to be pouring in from everywhere. The case of Springfield centers around authorization as well as failure to deliver a prospectus.

However, once the lawsuits start flying, Merrill Lynch will have to prove in court that Springfield was unique. Also coming into play will be the question of whether or not Merrill Lynch knew the investments it was selling were inappropriate.

Not only were they inappropriate, Merrill Lynch and others were caught up in their own Ponzi scheme.

Wall Street CDO Hairball

The Columbia Journalism Review is reporting WSJ shines light on Wall Street ‘hairball’.

The Wall Street Journal on December 27 headlined “Wall Street Wizardry Amplified Credit Crisis.” Reporters Carrick Mollenkamp and Serena Ng dive into how Merrill Lynch created a so-called mezzanine CDO (made up of middle-rated bonds) named “Norma,” recruited a Long Island penny-stock impresario to run it, and in its small way helped to undermine the global financial system. It’s one of the best explanatory pieces yet on how these financial instruments that were supposed to spread risk concentrated it instead.

As the Journal says:

But Norma and similar CDOs added potentially fatal new twists to the model. Rather than diversifying their investments, they bet heavily on securities that had one thing in common: They were among the most vulnerable to a rise in defaults on so-called subprime mortgage loans, typically made to borrowers with poor or patchy credit histories. While this boosted returns, it also increased the chances that losses would hit investors severely.

Why would anyone buy it? To get a higher rate for a bond with the same safety rating as corporate or Treasury bonds. Why would rating agencies (e.g. Standard & Poor’s, Moody’s) rate them so highly? Well, not to be too cynical, but the companies seeking the ratings pay the bills.

Tangled hairball. House of cards. Call it what you will, it was spit out or stacked up by the shamans on Wall Street, who used this financial voodoo to earn huge fees from underwriting these securities.

That’s how the $1.5 billion Norma CDO came about.

A key to the Journal story’s success is that it scored an interview with Corey Ribotsky, the Long Island-based penny-stock broker, whom Merrill set up as a “CDO manager” to recruit investors and administer Norma. Ribotsky hooked up with Merrill at a Long Island club after meeting a criminal defense lawyer who introduced him to a Merrill bond salesman.

Why was Merrill Lynch essentially setting up businesses for such outside CDO managers—and why Ribotsky, who’s being sued by three separate companies for manipulating their stocks? The Journal doesn’t answer this directly, and there may be another story there. Still, his quotes are priceless:

“It sounded interesting and that’s how we ventured into it,” Mr. Ribotksy says.

Well, there you go.

The Journal reveals that Norma was comprised of derivatives and securities that Merrill itself had underwritten:

Such cross-selling benefited banks, because it helped support the flow of new CDOs and underwriting fees. In fact, the bulk of the middle-rated pieces of CDOs underwritten by Merrill were purchased by other CDOs that the investment bank arranged, according to people familiar with the matter. Each CDO sold some of its riskier slices to the next CDO, which then sold its own slices to the next deal, and so on.

That circular cross-selling also multiplied the impact of housing defaults. The Journal cites a UBS study saying banks sold CDOs made up of derivatives worth three times more than the value of the underlying, asset-backed securities.

The banks are getting stuck with billions of dollars in losses in large part because they kept the “safest” parts of the CDOs on their books, since their low yields attracted few buyers. Since they concentrated CDOs in areas that have been slammed—like BBB-rated subprime securities—their values have taken huge hits. The Journal says mezzanine CDOs could account for up to three-quarters of the losses of the biggest banks like Citigroup and Merrill.

While the best mortgage-crisis stories may be yet to come, this one certainly helps untangle that hairball a bit.

What Hath “Norma” Wrought?

The Securities Law Firm of Klayman & Toskes placed this Notice to All Merrill Lynch Customers Who Invested in Norma CDO I Ltd on February 1.

The Securities Law Firm of Klayman & Toskes, P.A. announced today that it is investigating the damages sustained by institutional and retail customers in a collateralized debt obligation (“CDO”) called Norma CDO I Ltd. (“Norma”). Norma, brought into existence by Merrill Lynch, bet heavily on the success of the sub-prime market. Just nine months after it sold about $1.5 billion in securities to its investors, the value of Norma has been decimated in the collapse of the housing market and is reported to be worth only a fraction of its original value.

Presently, K&T; is investigating how Merrill Lynch and others marketed Norma, and whether the brokerage firm properly disclosed the risks of Norma to its customers. Further, K&T; is looking into whether Norma was suitable for the institutional and retail customers that invested in the product.

Hidden Swap Fees Hit School Boards

Bloomberg is reporting Hidden Swap Fees by JPMorgan, Morgan Stanley Hit School Boards.

This story involves cash the strapped Erie City School District in Pennsylvania. James Barker is the superintendent of the district.

In an “offer too good to be true”, and was, David DiCarlo, an Erie-based JPMorgan Chase banker, talked Barker and the school district into a credit default swap. The swap gave the school district an upfront $750,000 and a huge nightmare down the road. Let’s pick up the rest of the story from Bloomberg.

What New York-based JPMorgan Chase didn’t tell them, the transcript shows, was that the bank would get more in fees than the school district would get in cash: $1 million. The complex deal, which placed taxpayer money at risk, was linked to four variables involving interest rates. Three years later, as interest rate benchmarks went the wrong way for the school district, the Erie board paid $2.9 million to JPMorgan to get out of the deal, which officials now say they didn’t understand.

JPMorgan’s Chief Executive Officer Jamie Dimon declined to say if he thought the bank’s fee disclosure was proper and whether the bank acted in a fair, responsible and moral manner in Erie. Banker DiCarlo declined to comment.

My Comment: Declining to comment is a comment. Jamie Dimon has to know the fees in question are not fair and that JPMorgan dot act in a “moral manner” to the school districts. However, morals and legality are two different things. At the heart of the issue will be a legal requirement to disclose fees. This will no doubt be settled in court.

The Pennsylvania deals show that school districts routinely lose when making derivative deals. They pay fees to banks that are as much as five times higher than typical rates and overpay advisers by as much as 10-fold. That means banks often underpay schools on upfront amounts, as JPMorgan Chase did in Erie, public records show. And school officials aren’t always well served by their supposedly independent advisers, whose fees are paid by the banks selling the deals — only if the sale is made.

My Comment: This opens up still another legal attack. If the so called independent advisers represented the brokerage houses and/or proper disclosures were not made, both the brokerage houses and the independent advisers are going to find themselves in court.

Christopher Cox, chairman of the U.S. Securities and Exchange Commission, says he’s concerned that municipalities are taking on more risk than in the past when they raised money primarily from bond sales.

“It’s a serious issue, not only in Pennsylvania but across the country,” says Cox, 55, who has headed the SEC since 2005. “That is what we have seen repeatedly. More often than not, the municipalities aren’t configured to have financial sophisticates in charge of these offerings — and the result is that the firms are the only ones who know what’s going on.”

The banks that arrange these deals create the swap contracts before pitching them to schools. Using software programs designed for valuing swaps, they calculate prices for which they can sell them after a school signs a contract. That’s how the banks make money. For example, if a bank agrees to pay a district $800,000 in a deal it valued at $2 million, it could reap $1.2 million for itself and middlemen.

“They load it off instantly,” says Taylor, who’s now on the advisory board of Rockwater Municipal Advisors LLC, an Irvine, California-based investment firm.

Banks hedge their risk in derivative deals by making trades to cover possible losses to school districts. The banks make their money from fees, regardless of interest rate movements.

The reason Erie and other districts don’t know how much the bank makes from a deal is because banks don’t tell them, the records show.

My Comment: These kinds of deals and the fees they generate are now dead in the water. Regardless of the litigation outcome, such predatory practices will stop. Together with collapsing leveraged buyouts (LBOs), and with commercial real estate headed into the sewer, what’s obvious is that profits at the brokerage houses has peaked this cycle.

While the SEC doesn’t regulate derivatives, it has authority to oversee how banks conduct transactions. SEC Chairman Cox says all financial firms should tell clients what their fees are before signing any deals.

“Brokers and advisers should disclose their compensation and conflicts of interest to their customers, and to the extent that they are regulated by the SEC, they must,” he says.

Cox also says school district officials have a responsibility to the public and to bond investors to ensure their advisers are actually independent and acting in the best interests of taxpayers. “To the extent that municipalities are participating in transactions they are not qualified for, there is an obligation to get good independent advice,” he says.

My Comment: What Cox seems to be saying is that both parties are at fault. There is plenty of ground here for future litigation.

In many cases, the banks repeatedly sell more derivatives to replace old ones. In Bethlehem, Pennsylvania, JPMorgan and Morgan Stanley sold the school district eight swaps on just two bond issues, records show.

“It sure looks a lot like churning,” Yang [head of research at financial advisory firm Andrew Kalotay Associates Inc.] says. Churning is a term used to describe how stockbrokers or insurance agents sometimes continually sell and resell the same or similar products to clients in order to make more in fees. “Doing more than one swap against a single bond issuance definitely benefited the swap adviser and bank, but probably not the school district.”

Other Pennsylvania school districts are paying banks excessive fees. Bethlehem, 50 miles north of Philadelphia, is also a former steel-making center. With a population of 72,000, the city has maintained its historic buildings.

So far, the [Bethlehem] district has taken in about $900,000 from the deals, Bloomberg data show. That compares with $3 million in transaction fees. Lestrange and Access made $630,000 each for arranging the swaps, according to school district records. New York-based Morgan Stanley made $840,000 and JPMorgan received fees totaling $900,000, Bloomberg data show.

Lestrange and Access earned a fee 10 times more than the Easton Area School District, Bethlehem’s neighbor, paid its adviser on a comparable interest-rate swap in 2004.

The rates the banks charged Bethlehem were twice the average for comparable swaps deals. In this kind of swap, in which both sides pay floating interest rates, a bank calculates its fees by subtracting an amount from the rate it will pay.

“It’s obscene,” says Peter Shapiro, managing director of South Orange, New Jersey-based adviser Swap Financial Group, who doesn’t advise Pennsylvania school districts. “What is going on in Pennsylvania?”

Hornet’s Nest Recap

  • Merrill Lynch, Citigroup, and others clearly sold products not suitable for retail customers to retail customers. However, these companies are likely to maintain they did so in “good faith”.
  • Fees and risks were not properly disclosed. The issue of undisclosed fees may prove to be extremely fertile ground for litigation.
  • Inappropriate relationships by so called “independent advisers” will come under legal scrutiny.
  • There will be grounds for lawsuits for recommendations that amount to “churning”.
  • A mammoth wave of lawsuits against Bear Stearns (BSC), Merrill Lync (MER), Citigroup (C), Lehman (LEH), Morgan Stanley (MS), Goldman Sachs (GC), JPMorgan (JPM) and others is likely on the way.
  • By agreeing to reimburse Springfield, Merrill Lynch may have inadvertently opened the door for more litigation.

Merrill Lynch, Citigroup and other got caught up in their own CDO Ponzi schemes once the pool of greater fools ran out. A hornet’s nest of litigation is now on the way. Legal bees will be buzzing over this for a long, long time.

Mike “Mish” Shedlock
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