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.

Show 2 foot­notes

  1. http://​www​.sec​.gov/​l​i​t​i​g​a​t​i​o​n​/​c​o​m​p​l​a​i​n​t​s​/​2​0​1​2​/​c​o​m​p​-​p​r​2​0​1​2​-​1​3​9​.​pdf
  2. as we have said many times

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