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Yesterday, New York State Attorney General Andrew Cuomo sent a letter to AIG. Cuomo is annoyed that at the same time AIG was asking to be bailed out by the federal government it was sending its executives to England to hunt partridges on the company jet (and how they got on the company jet ...). Cuomo tells AIG to recover the money, or he will.
His purported weapon is section 274 of the NY Debtor and Creditor law. Briefly, s. 274 says that a conveyance is a fraud on creditors if it (1) is made without fair consideration and (2) left the transferor without sufficient capital. There are similar provisions in most state laws, the Uniform Fraudulent Transfers Act and the federal bankruptcy code. For a good treatment see FLETCHER-CYC s. 7412 and 7405 and NY Jur 2d Creditors Rights s. 363.
Presumably, Cuomo is brandishing 274 instead of the Martin Act (NY BCL s. 352c and 353) because the Martin Act requires proof of fraud. Under 274, the determination is made without regard to actual intent. Even with that lowered threshold, Business Law Prof calls it "a stretch."
On October 9th, Wachovia (WB) filed an 8-K announcing its merger with Wells Fargo. A number of merger-related agreements were attached. Exhibit 2.1 is the merger agreement, exhibit 2.2 is a share exchange agreement and exhibit 4.1 is a modification of Wachovia's poison pill.
Can we talk about the old days? Back in the old days, when a bank wrote a mortgage, the bank took a risk. If you didn't make your payments, the bank had to contend with the expensive process of taking your house and reselling it at auction. To avoid that result, the bank did its best to determine your ability and willingness to pay it back.
No longer. Our new world, created by Fannie Mae and apotheosized by Lehman Brothers and Bear Stearns, is a place where consequences become wholly untethered from actions. The risk formerly carried by your mortgage bank is titrated into a kind of default-risk toxic sludge and sold to AIG.
This then, is a brief explanation of how the geniuses on Wall Street unglued the risk from mortgage banking. First, investment banks bought the mortgage portfolios of mortgage banks. Then, the investment banks organized special-purpose corporations (SPVs) and sold the mortgages to them. With the mortgages, the SPVs also acquired the associated default risk.
The SPVs were created as mortgage-backed security conduits (for more on mortgage-backed securities see this post). The SPV-issued securities were multi-tiered, with some tiers backed by riskier mortgages than others. The securities backed by the most stable mortgages were sold to the public. The worst went back to the investment bank; the default risk that started with the mortgage bank was distilled and acquired by the investment bank.
To protect itself from these risky securities, the investment bank bought default insurance. Because this insurance swapped default risk for insurance premiums, it was called a credit default swap. Who was the largest insurer? AIG. Thus, the default risk that originated when you borrowed money to buy a house was shifted onto the policyholders of AIG, and finally, to the taxpayers.
Since I'm in recappin' mode, here are a couple items of interest from this week's BNA Securities Regulation Law Report (BNA-SRLR on Westlaw):
PEQUOT
BNA has obtained a copy of an internal SEC report about the insider trading investigation of Pequot Capital (40 SRLR 1634). For more about the Pequot investigation and about Gary Aguirre, the whistle blower lawyer who brought the whole thing to light, see this article in San Diego Magazine and this article on the WSJ blog.
CREDIT DEFAULT SWAPS
On page 1633, BNA reports on the SEC's call for Congress to regulate the credit default swaps market. The article also outlines the present state of CDS regulation (40 SRLR 1633).
Just added to the Westlaw front page is a clearinghouse for financial crisis-related documents. There's a notable tilt toward litigation. Here's today's crop:
Financial Crisis Resources:
President Bush Signs Bailout Law, PL 110-343.
Standing room only at Lehman Brothers bankruptcy hearing. Read the transcript: 2008 WL 4378192.
Citigroup files $60B suit against Wells Fargo, Wachovia: 2008 WL 4457346.
Wachovia files suit in Federal Court: 2008 WL 4456335.
Ousted Fannie Mae executives face shareholder securities fraud suit accusing them of hiding the company's subprime losses. Read the Andrews article 14 No. 10 ANSLRR 3 and the complaint 2008 WL 4153695.
For an immediate look at the legal, governmental, and economic ramifications of the government's takeover of Freddie Mac and Fannie Mae, see 2008 Aspatore Special Rep. 19
Available today, for free, on the Westlaw Busines website: Bailout 101
In yesterday's SEC Currents there was a story about the role played by the Resolution Trust Corporation in developing the asset securitization methods that investment banks have recently used to blow themselves up.
I thought this as good an opening as any to talk about asset securitization and about the Resolution Trust Corporation.
WHAT IS ASSET SECURITIZATION?
Asset securitization allows a business (called the "originator") to turn a steady trickle of cash into a great, huge whack of cash. The steady trickle is generally some kind of loan receivable like credit card or mortgage payments.
Let's imagine our originator is a bank with a portfolio of residential mortgages.
1. The bank organizes a new company called a special purpose vehicle (SPV).
2. The SPV buys all the bank's residential mortgages.
3. Then, the SPV sells securities (called asset-backed securities - ABS) on the public market.
The bank gets cash and relieves itself of the burden of policing mortgages or getting clobbered if borrowers default. The risk associated with the mortgages shifts to the SPV's shareholders.
Stop, I hear you cry - who in their right mind would buy these ABS? Good question! Not so many people it turns out, so originators developed ways to enhance the appeal of ABS. Some of the methods included:
* A guaranty by the originator
* Third party letters of credit
* Several tranches
The tranches enhancement segregates risk from gain - some tranches bear all potential losses and some get all the gain. Thus, the risk is shifted from the bank to the holders of only one tranche. And what poor unfortunates buy these all-risk securities? The originators, of course.
For a very nice treatment of the origin of ABS see: Culver, The Dawning of Securitization, Probate & Property, March/April 1994 (8-APR PROBPROP 34).
WHAT WAS THE RTC's ROLE?
Mortgage-back securities were invented by Ginny Mae and Fannie Mae in the 1970's. Ginny and Fannie pooled and sold only residential mortgages (in the example above, imagine the bank selling its mortgages to Fannie and Fannie organzing the SPV).
The Resolution Trust Corporation (RTC) came on the scene in 1989 to clean up after the collapse of many savings and loan banks in the late 1980's. RTC, created by the Financial Institutions Reform and Recovery Enforcement Act of 1989 (FIRREA, PL 101-54), was supposed to buy the assets of the failed S&Ls and resell them in hopes of making a little money for taxpayers.
RTC ended up owning a large portfolio of commerical mortgages. Because of the complexity involved, no one had attempted to package commerical mortgages as ABS. Realzing that the alternative of disposing of the mortgages individually would be even more difficult, RTC developed methods for packaging commercial mortgages as ABS.
To see an example of an RTC ABS deal see the S-11 filed by Lehman Structured Securities on 8/12/1996. The securties being sold are called Commerical Mortgage Pass-Through Certificates Series 1996-1. For something more recent, try Bear Stearns Alt-A Trust, 424B5, 2/01/06.
NEXT: Risk
As I mentioned in a previous post, the SEC has cancelled its Consolidated Supervised Entity program now that all the CSEs have gone bust, or elsewhere. Let the post-mortem begin. Please see this post on the Corporate Counsel blog about how the SEC edited the publicly-released version of a report to Congress.
To arrive at the numbers needed to express the capital adequacy ratios required by lenders and regulators, a company must put a dollar value on every asset it holds.
If you're using mark-to-market valuation you assign value based on what someone would pay for an asset now. Assets without a ready market must be valued using more obscure methods* (see this post and this post for more about valuation models).
Our hypothetical company has large holdings of an asset for which no market exists. So, it uses projections and mathematical models to assign value to these assets.
NEXT: Asset securitization
* This uncertainty is one reason some advocate book-value accounting over mark-to-market. Book-value = the price you paid - depreciation. So, the collapse of the market for your asset is irrelevant.
Yesterday, New York State Attorney General Andrew Cuomo sent a letter to AIG. Cuomo is annoyed that at the same time AIG was asking to be bailed out by the federal government it was sending its executives to England to hunt partridges on the company jet (and how they got on the company jet ...). Cuomo tells AIG to recover the money, or he will.
