Securitisation outfit fined USD125m for obtaining false credit ratings

In my pre­vi­ous post I asked some­what rhet­or­ic­ally what else banks had felt able to do dur­ing the credit crunch if the belief had arisen that “mar­ket sta­bil­ity” (sc. bank sur­vival”) trumped crim­inal law. The U.S. Secur­it­ies and Exch­nage Com­mis­sion (“SEC”) has obli­gingly provided an example.

Yes­ter­day (19 July 2012) the Secur­it­ies and Exchange Com­mis­sion charged the U.S. invest­ment bank­ing sub­si­di­ary of Japan-​based Mizuho Fin­an­cial Group and three former employ­ees with mis­lead­ing investors into pur­chas­ing a col­lat­er­al­ised debt oblig­a­tion (“CDO”) by using “dummy assets” to inflate the deal’s credit rat­ings. The SEC also charged the firm that served as the deal’s col­lat­eral man­ager and the per­son who was its port­fo­lio man­ager.¹

Accord­ing to the SEC’s com­plaint against Mizuho Secur­it­ies USA, Inc., the firm made approx­im­ately USD10 mil­lion² in struc­tur­ing and mar­ket­ing fees in the deal. Mizuho agreed to pay $127.5 mil­lion to settle the SEC’s charges, and the oth­ers charged also agreed to settle the SEC’s actions against them.

The SEC alleges that Mizuho struc­tured and mar­keted Del­phinus CDO 2007 – 1, a CDO that was backed by subprime bonds at a time when the hous­ing mar­ket was show­ing signs of severe dis­tress. The deal was con­tin­gent upon Mizuho obtain­ing credit rat­ings it used to mar­ket the notes to investors. When its employ­ees real­ized that Del­phinus could not meet one rat­ing agency’s newly announced cri­teria inten­ded to pro­tect CDO investors from the uncer­tainty of rat­ings down­grades, they sub­mit­ted to the rat­ing firm a port­fo­lio con­tain­ing mil­lions of dol­lars in dummy assets that inac­cur­ately reflec­ted the col­lat­eral held by Del­phinus. Once the firm rated the inac­cur­ate port­fo­lio, Mizuho closed the trans­ac­tion and sold the notes to investors using the mis­lead­ing rat­ings. Del­phinus defaul­ted in 2008 and even­tu­ally was liquid­ated in 2010. Mizuho sus­tained sub­stan­tial losses from Delphinus.

“This case demon­strates once again that bankers and mar­ket par­ti­cipants who embrace a ‘get the deal done at all costs’ strategy will be iden­ti­fied, charged, and pun­ished,” said Robert Khuzami, Dir­ector of the SEC’s Divi­sion of Enforce­ment. Inter­est­ingly, he added:

“This is a con­stant theme through­out the many SEC enforce­ment actions arising out of the fin­an­cial crisis, and is one that every­one involved in secur­it­ies trans­ac­tions and our fin­an­cial mar­kets would be well-​advised to respect.”

Accord­ing to the SEC’s com­plaint against Mizuho filed in fed­eral court in Man­hat­tan, all of the col­lat­eral assets for Del­phinus had been pur­chased by July 17, 2007, and the trans­ac­tion was sched­uled to close on July 19. How­ever, around noon on July 18, Stand­ard & Poor’s (S&P) issued a press release announ­cing changes to its CDO rat­ing cri­teria requir­ing cer­tain cat­egor­ies of subprime res­id­en­tial mortgage-​backed secur­it­ies (“RMBS”) to be adjus­ted down­ward for pur­poses of cal­cu­lat­ing their default prob­ab­il­ity. The Mizuho employ­ees knew that Delphinus’s actual port­fo­lio con­tained a sub­stan­tial amount of RMBS that were sub­ject to the down­ward rat­ings, and that Del­phinus, as con­struc­ted, could not meet its rat­ing tar­gets under these tougher stand­ards. To enable Del­phinus to close any­way, the Mizuho employ­ees e-​mailed mul­tiple altern­at­ive port­fo­lios to S&P that con­tained dummy assets that were super­ior in credit qual­ity to the assets that had been actu­ally acquired for the CDO. Once the neces­sary rat­ings were secured by the use of dummy assets, the Del­phinus trans­ac­tion closed by mid-​afternoon on July 19 and secur­it­ies were sold based upon these higher rat­ings. Investors were thus misled to believe that the Del­phinus notes had achieved the advert­ised rat­ings that the actual clos­ing port­fo­lio would not support.

Accord­ing to the SEC’s com­plaint, in con­nec­tion with Delphinus’s sub­sequent request for a required rat­ing con­firm­a­tion from S&P, Mizuho employ­ees provided and arranged for oth­ers to provide fur­ther inac­cur­ate inform­a­tion about the com­pos­i­tion of Delphinus’s assets. Primar­ily, they mis­rep­res­en­ted that Delphinus’s effect­ive date was August 6 rather than July 19. S&P then provided Del­phinus with the rat­ings con­firm­a­tion using the improper effect­ive date of August 6.

Every­one charged by the SEC agreed to set­tle­ments without admit­ting or deny­ing the charges.

On the egre­gious­ness scale this is not as bad as the case of Crown Cor­por­a­tion, the Lon­don lis­ted entity the entire assets of which allegedly lay in the form of a single bond in a South Amer­ican bank, which bond did not and had never exis­ted. It is how­ever more con­crete than the anec­dot­ally repor­ted incid­ences, albeit com­mon, of rat­ing agen­cies revis­ing their rat­ings of notes on the basis of whether struc­tur­ers have provided suf­fi­cient cor­por­ate hos­pit­al­ity. Your author asks whether the SEC will extend its arm to pos­sible instances where struc­tur­ers have trans­ferred assets into SPVs for the pur­poses of rat­ing and issu­ance, only to trans­fer them back whence they came when the notes had got away.

This entry was posted on 20 July 2012 at 8:32 am and is filed under Capital, Finance & the Economy. Published under Creative Commons (CC) Attribution-NonCommercial-ShareAlike 3.0 Unported License: You are welcome to share and remix this content for non-commercial purposes. Kindly acknowledge and hyperlink the source.