CDOs and First Jersey Securities
Apr 26, 2010
Posted by Jody Eisenman | Filed under Uncategorized
CDOs, of course, are Collateralized Debt Obligations. They are made up of either mortgages or credit default swaps (which are basically options on the value of underlying mortgages) which were sold to investors as safe yields secured by real estate. This of course ended in 2007-8 when real estate dropped and mortgages began to default at rates unseen since the depression in 1930s. First Jersey Securities was a firm run by convicted felon Robert Brennan, which sold penny stocks until they were shut down in 1987. What does one have to do with the other? They both seemed to have the same characteristics. I will explain.
First Jersey ran an incredibly efficient criminal enterprise. Their brokers would recruit clients to invest almost exclusively in companies that First Jersey underwrote. Almost invariably, these companies were not much more than a desk, a few chairs, and some fancy marketing. Here’s how a typical transaction might happen in the NYC office: Some fast talking First Jersey broker would call Joe Investor and try and convince him to buy stock in a company we will call ABC. Lets say the broker got Joe to agree to purchase shares at $1/share. Next month, the broker would call Joe and tell him something like this:
“Joe, I’ve got great news. ABC is now at $1.75. I suggest we take a profit”. Joe would eagerly agree; after all, didn’t he just make 75% in a month? Then the broker would tell him about his next idea, XYZ. XYZ would be selling at 4, and the broker convinced him it would soon explode. He would then try to convince Joe to send in much more money. Meanwhile, in the Chicago office, the brokers would be convincing their clients to buy ABC! However, the price wasn’t $1.75, it was 3. How is that possible? Simply because First Jersey and its’ affiliates were the only market makers in ABC (as well as everything else they pushed), and they price was whatever they said it was. Meanwhile, another office might be dumping XYZ at 2, and having the NYC office reselling it at 4. Eventually, Brennan was convicted and served time in prison.
OK, so what does this have to do with CDOs? Well, upon doing research, I discovered a curious fact. Very few people really knew exactly what was in any CDO. The CDO could consist of a hundred or more mortgage bonds, which in turn could have thousands of different loans. The rating agencies did very little die diligence into these, which made their ratings almost meaningless. However, it got even worse. Lets say an investment bank was trying to sell several tranches of a CDO called ABC. If they had problems selling the lower tranches, they might repackage these ugly tranches as part of a CDO called DEF. Another CDO called XYZ might contain pieces of ABC and DEF! If this sounds confusing, imagine how it sounds to the eventual buyer? I would venture that many, if not the majority of these buyers had no clue what was in the CDO they purchased. They simply relied on the investment bank, as well as the high rating issued by Moody’s or Standard and Poors. As I discussed last week (http://www.jodyeisenman.com/2010/04/the-securities-and-exchange-commission-vs-goldman-sachs/), these ratings were, by 2007, were simply wrong. A more jaundiced view might view them as criminal. These agencies were routinely giving AAA ratings to CDOS which managed to experience losses of most of their principal (sometimes all of it) in just a few short months. There are currently several lawsuits against these agencies still pending.
Meanwhile, the stock markets continue to “melt upwards”. After an inter day dip to 10,975 on the Dow Thursday, the markets rallied back strongly to close at 11,204 by the end of the week. The markets are now at an 19 month high, as earnings continue to be generally better than expected across the board. I have no idea where the top is, but thus far, every “expert” who has attempted to call the top has been dead wrong.
