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II. BACKGROUND
D. Investment Banks
Historically, investment banks helped raise capital for business and other endeavors by helping to design, finance, and sell financial products like stocks or bonds. When a corporation needed capital to fund a large construction project, for example, it often hired an investment bank either to help it arrange a bank loan or raise capital by helping to market a new issue of shares or corporate bonds to investors. Investment banks also helped with corporate mergers and acquisitions. Today, investment banks also participate in a wide range of other financial activities, including offering broker-dealer and investment advisory services, and trading derivatives and commodities. Many have also been active in the mortgage market and have worked with lenders or mortgage brokers to package and sell mortgage loans and mortgage backed securities. Investment banks have traditionally performed these services in exchange for fees.
If an investment bank agreed to act as an "underwriter" for the issuance of a new security to the public, it typically bore the risk of those securities on its books until the securities were sold. By law, securities sold to the public generally must be registered with the SEC. |57| Registration statements explain the purpose of a proposed public offering, an issuer's operations and management, key financial data, and other important facts to potential investors. Any offering document or prospectus provided to the investing public must also be filed with the SEC. If an issuer decides not to offer a new security to the general public, it can still offer it to investors through a "private placement." |58| Investment banks often act as the "placement agent" in these private offerings, helping to design, market and sell the security to selected investors. Solicitation documents in connection with private placements are not required to be filed with the SEC. Under the federal securities laws, however, investment banks that act as an underwriter or placement agent may be liable for any material misrepresentations or omissions of material facts made in connection with a solicitation or sale of a security to an investor. |59|
In the years leading up to the financial crisis, RMBS securities were generally registered with the SEC and sold in public offerings, while CDO securities were generally sold to investors through private placements. Investment banks frequently served as the underwriter or placement agent in those transactions, and typically sold both types of securities to large institutional investors.
In addition to arranging for a public or private offering, some investment banks take on the role of a "market maker," standing willing and able to buy or sell financial products to their clients or other market participants. To facilitate client orders to buy or sell those products, the investment bank may acquire an inventory of them and make them available for client transactions. |60| By filling both buy and sell orders, market makers help create a liquid market for the financial products and make it easier and more attractive for clients to buy and sell them. Market makers typically rely on fees in the form of markups in the price of the financial products for their profits.
At the same time, investment banks may decide to buy and sell the financial products for their own account, which is called "proprietary trading." Investment banks often use the same inventory of financial products to carry out both their market-making and proprietary trading activities. Investment banks that trade for their own account typically rely on changes in the values of the financial products to turn a profit.
Inventories that are used for market making and short term proprietary trading purposes are typically designated as a portfolio of assets "held for sale." Investment banks also typically maintain an inventory or portfolio of assets that they intend to keep as long term investments. This inventory or portfolio of long-term assets is typically designated as "held for investment," and is not used in day-to-day transactions.
Investment banks that carry out market-making and proprietary trading activities are required—by their banking regulator in the case of banks and bank holding companies |61| and by the SEC in the case of broker-dealers |62| —to track their investments and maintain sufficient capital to meet their regulatory requirements and financial obligations. These capital requirements typically vary based on how the positions are held and how they are classified. For example, assets that are "held for sale" or are in the "trading account" typically have lower capital requirements than those that are "held for investment," because of the expected lower risks associated with what are expected to be shorter term holdings.
Many investment banks use complex automated systems to analyze the "Value at Risk" ("VaR") associated with their holdings. To reduce the VaR attached to their holdings, investment banks employ a variety of methods to offset or "hedge" their risk. These methods can include diversifying their assets, taking a short position on related financial products, purchasing loss protection through insurance or credit default swaps, or taking positions in derivatives whose values move inversely to the value of the assets being hedged.
Shorting the Mortgage Market. Prior to the financial crisis, investors commonly purchased RMBS or CDO securities as long-term investments that produced a steady income. In 2006, however, the high risk mortgages underlying these securities began to incur record levels of delinquencies. Some investors, worried about the value of their holdings, sought to sell their RMBS or CDO securities, but had a difficult time doing so due to the lack of an active market. Some managed to sell their high risk RMBS securities to investment banks assembling cash CDOs.
Some investors, instead of selling their RMBS or CDO securities, purchased "insurance" against a loss by buying a credit default swap (CDS) that would pay off if the specified securities incurred losses or other negative credit events. By 2005, investment banks had standardized CDS contracts for RMBS and CDO securities, making this a practical alternative.
Much like insurance, the buyer of a CDS contract paid a periodic premium to the CDS seller, who guaranteed the referenced security against loss. CDS contracts referencing a single security or corporate bond became known as "single name" CDS contracts. If the referenced security later incurred a loss, the CDS seller had to pay an agreed-upon amount to the CDS buyer to cover the loss. Some investors began to purchase single name CDS contracts, not as a hedge to offset losses from RMBS or CDO securities they owned, but as a way to profit from particular RMBS or CDO securities they predicted would lose money. CDS contracts that paid off on securities that were not owned by the CDS buyer were known as "naked credit default swaps." Some investors purchased large numbers of these CDS contracts in a concerted strategy to profit from mortgage backed securities they believed would fail.
Some investment banks took the CDS approach a step further. In 2006, a consortium of investment banks led by Goldman Sachs and Deutsche Bank launched the ABX Index, which created five indices that tracked the aggregate performance of a basket of 20 designated subprime RMBS securitizations. |63| Borrowing from longstanding practice in commodities markets, investors could buy and sell contracts linked to the value of one of the ABX indices. Each contract consisted of a credit default swap agreement in which the parties could essentially wager on the rise or fall of the index value. According to a Goldman Sachs employee, the ABX Index "introduced a standardized tool that allow[ed] clients to quickly gain exposure to the asset class," in this case subprime RMBS securities. An investor – or investment bank – taking a short position in an ABX contract was, in effect, placing a bet that the basket of subprime RMBS securities would lose value.
Synthetic CDOs provided still another vehicle for shorting the mortgage market. In this approach, an investment bank created a synthetic CDO that referenced a variety of RMBS securities. One or more investors could take the "short" position by paying premiums to the CDO in exchange for a promise that the CDO would pay a specified amount if the referenced assets incurred a negative credit event, such as a default or credit rating downgrade. If that event took place, the CDO would have to pay an agreed-upon amount to the short investors to cover the loss, removing income from the CDO and causing losses for the long investors. Synthetic CDOs became a way for investors to short multiple specific RMBS securities that they expected would incur losses.
Proprietary Trading. Financial institutions also built increasingly large proprietary holdings of mortgage related assets. Numerous financial firms, including investment banks, bought RMBS and CDO securities, and retained these securities in their investment portfolios. Others retained these securities in their trading accounts to be used as inventory for short term trading activity, market making on behalf of clients, hedging, providing collateral for short term loans, or maintaining lower capital requirements. Deutsche Bank's RMBS Group in New York, for example, built up a $102 billion portfolio of RMBS and CDO securities, while the portfolio at an affiliated hedge fund, Winchester Capital, exceeded $8 billion. |64| Other financial firms, including Bear Stearns, Citibank, JPMorgan Chase, Lehman Brothers, Merrill Lynch, Morgan Stanley, and UBS also accumulated enormous propriety holdings in mortgage related products. When the value of these holdings dropped, some of these financial institutions lost tens of billions of dollars, |65| and either declared bankruptcy, were sold off, |66| or were bailed out by U.S. taxpayers seeking to avoid damage to the U.S. economy as a whole. |67|
One investment bank, Goldman Sachs, built a large number of proprietary positions to short the mortgage market. |68| Goldman Sachs had helped to build an active mortgage market in the United States and had accumulated a huge portfolio of mortgage related products. In late 2006, Goldman Sachs decided to reverse course, using a variety of means to bet against the mortgage market. In some cases, Goldman Sachs took proprietary positions that paid off only when some of its clients lost money on the very securities that Goldman Sachs had sold to them and then shorted. Altogether in 2007, Goldman's mortgage department made $1.2 billion in net revenues from shorting the mortgage market. |69| Despite those gains, Goldman Sachs was given a $10 billion taxpayer bailout under the Troubled Asset Relief Program, |70| tens of billions of dollars in support through accessing the Federal Reserve's Primary Dealer Credit Facility, |71| and billions more in indirect government support |72| to ensure its continued existence.
Notes
57. Securities Act of 1933, 15 U.S.C. § 77a (1933). [Back]
58. See, e.g., Securities Act of 1933 §§ 3(b) and 4(2); 17 CFR §230.501 et seq. (Regulation D). [Back]
59. Securities Act of 1933, §11, 15 U.S.C. § 77k; and Securities Exchange Act of 1934, § 10(b), 15 U.S.C. § 78j(b), and Rule 10b-5 thereunder. [Back]
60. For a detailed discussion of market making, see "Study & Recommendations on Prohibitions on Proprietary Trading & Certain Relationships with Hedge Funds & Private Equity Funds," prepared by the Financial Stability Oversight Council, at 28-29 (Jan. 18, 2011) (citing SEC Exchange Act Rel. No. 34-58775 (Oct. 14, 2008)). [Back]
61. See, e.g., 12 CFR part 3, Appendix A (for the Office of the Comptroller of the Currency), 12 CFR part 208, Appendix A and 12 CFR part 225, Appendix A (for the Federal Reserve Board of Governors) and 12 CFR part 325, Appendix A (for the Federal Deposit Insurance Corporation). [Back]
62. Securities Exchange Act of 1934, Rule 15c3-1. [Back]
63. Each of the five indices tracked a different tranche of securities from the designated 20 subprime RMBS securitizations. One index tracked AAA rated securities from the 20 subprime RMBS securities; the second tracked AA rated securities from the 20 RMBS securitizations; and the remaining indices tracked baskets of A, BBB, and BBB rated RMBS securities. Every six months, a new set of RMBS securitizations was selected for a new ABX index. See 3/2008 "Understanding the Securitization of Subprime Mortgage Credit," prepared by Federal Reserve Bank of New York, Report No. 318, at 26. Markit Group Ltd. administered the ABX Index which issued indices in 2006 and 2007, but has not issued any new indices since then. [Back]
64. For more information, see Chapter VI, section discussing Deutsche Bank. [Back]
65. See, e.g., Goldman Sachs Group, Inc., 2008 Annual Report 27 (2009) (stating that the firm had "long proprietary positions in a number of [its] businesses. These positions are accounted for at fair value, and the declines in the values of assets have had a direct and large negative impact on [its] earnings in fiscal 2008."); see also, Viral V. Acharya and Matthew Richardson, "Causes of the Financial Crisis," 21 Critical Review 195, 199-204 (2009) (citing proprietary holdings of asset backed securities as one of the primary drivers of accumulated risks causing the financial crisis); "Prop Trading Losses Ain't Peanuts," The Street (1/27/2010), http://www.thestreet.com/story/10668047/prop-trading-losses-aint-peanuts.html. [Back]
66. See, e.g., "Lehman Files for Bankruptcy; Merrill is Sold," New York Times (9/14/2008); and discussion in Chapter III of Washington Mutual Bank which was sold to JPMorgan Chase. [Back]
67. See, e.g., Capital Purchase Program Transactions, under the Troubled Asset Relief Program, U.S. Department of the Treasury, at http://www.treasury.gov/initiatives/financial-stability/investmentprograms/cpp/Pages/capitalpurchaseprogram.aspx. [Back]
68. For more information, see Chapter VI, section describing Goldman Sachs. [Back]
69. Id. Goldman's Structured Product Group Trading Desk earned $3.7 billion in net revenues, which was offset by losses on other desks within the mortgage department, resulting in the $1.2 billion in total net revenues. [Back]
70. See, e.g., Capital Purchase Program Transactions, under the Troubled Asset Relief Program, U.S. Department of the Treasury, available at http://www.treasury.gov/initiatives/financial-stability/investmentprograms/cpp/Pages/capitalpurchaseprogram.aspx and an example of a transactions report at http://www.treasury.gov/initiatives/financial-stability/briefing-room/reports/tarptransactions/DocumentsTARPTransactions/transactions-report-062309.pdf. [Back]
71. See data available at http://www.federalreserve.gov/newsevents/reform_pdcf.htm showing Goldman Sachs' use of the Primary Dealer Credit Facility 85 times in 2008. [Back]
72. See, e.g., prepared statement of Neil Barofsky, Special Inspector General of the Troubled Asset Relief Program, "The Federal Bailout of AIG," before the House Committee on Oversight and Government Reform (1/27/2010), http://oversight.house.gov/images/stories/Hearings/pdfs/20100127barofsky.pdf (noting that some firms, including Goldman Sachs, disproportionately benefited from the federal government's bailout of AIG). [Back]
Back to Contents C. Credit Ratings and Structured Finance E. Market Oversight
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