Purveyors of C.D.O.’s maintain that buyers who lost billions in these mortgage-related instruments were, of course, sophisticated.
But as a recent report from the inspector general of the National Credit Union Administration shows, it is neither credible nor factual that only savvy investors bought C.D.O.’s.
The report analyzes the April 2009 collapse of the Eastern Financial Florida Credit Union. Based in Miramar, Fla., this state-chartered institution was created in 1937 to serve the Miami employees of what later became Eastern Airlines. The institution added other Florida employee groups and was serving 208,000 members when it failed last year.
Eastern Financial had $1.6 billion in assets at the end of 2008. The company was placed in conservatorship on April 24, 2009. It was taken over by the Space Coast Credit Union of Melbourne, Fla. The failure will cost the National Credit Union Share Insurance Fund, the federal agency that guarantees credit union deposits, an estimated $40 million.
Because it was based in Florida, the doomed credit union had its share of bad real estate loans on its books. But the inspector general’s autopsy report said that the major cause of the Eastern Financial collapse was its decision to dive head-first into toxic C.D.O.’s just as the mortgage mania was faltering.
Between March 2007 and June 22, 2007, the credit union committed nearly $100 million to buy 16 of these instruments; most contained dicey home equity loans.
The timing of these purchases is intriguing. The spring of 2007 was when Wall Street’s mortgage machinery was sputtering; New Century Financial, a big subprime lender, filed for bankruptcy that April. Brokerage firms that had provided funding to lenders like New Century and Countrywide began pulling in their credit lines. At the same time, it became a matter of some urgency for these firms to jettison mortgage-related securities in their pipelines.
Who sold Eastern Financial its toxic securities? Alas, the inspector general identifies neither the C.D.O.’s the credit union bought nor the firms that peddled them.
But the report did note that the instruments Eastern Financial bought were private placements, “which provided less readily available market data to perform analysis and provide better understanding of underlying assets and grading system, tranches, etc.” In other words, the most obscure C.D.O.’s imaginable.
“This situation illustrates yet again why over-the-counter securities and derivatives are not suitable for federally insured banks and other ‘soft’ institutional clients,” said Christopher Whalen, editor of The Institutional Risk Analyst. “Wall Street securities dealers who knowingly cause losses to federally insured depositories should go to jail.”
Credit unions are nonprofit entities and typically do not engage in the risky investing that bank executives did during the credit bubble. Federal credit unions are also limited in the types of securities they can buy. While they can purchase mortgage-backed securities, they are barred from buying C.D.O.’s.
State-chartered credit unions have more leeway to invest in exotic instruments if their home states allow it. Florida, California and Michigan are three such states. But according to the National Credit Union Administration, less than 1 percent of all credit union investments fall into the exotic category.
THOSE state-chartered institutions that can buy C.D.O.’s and other riskier investments must set aside reserves of 100 percent of mark-to-market losses in such securities when they decline in value. This is intended to deter credit union executives from venturing down the risk spectrum.
The Florida credit union met that requirement, but clearly the deterrence didn’t work. Eastern Financial’s failure may be an outlier, but it makes for a terrific case study.
Indeed, the inspector general’s analysis is depressingly familiar. Eastern Financial’s management and board “relied too heavily on rating agencies’ grading of C.D.O. investments,” it concluded, and failed to evaluate and understand their complexity.
Almost immediately after the credit union bought the C.D.O.’s, they fell in value. By September 2007, the credit union had recorded $63.4 million in losses on the products, almost two-thirds of the original investment. By the time of its failure, the credit union had charged off all 18 C.D.O. investments, resulting in total losses of nearly $150 million.
Richard Field, managing director of TYI, which develops transparency, trading and risk management information systems, says the Eastern Financial collapse is yet another example of why investors in complex mortgage securities need to be able to consult complete loan-level data on what is in these pools.
“A sizable percentage of the problems in the credit markets and bank solvency are directly related to this lack of information,” Mr. Field said.
But the Eastern Financial insolvency also illustrates why regulators should make Wall Street adhere to concepts of suitability for institutions as well as individuals, Mr. Whalen said.
“The dealers who sold the C.D.O.’s to this credit union should be sanctioned,” he said. “It might even be possible to pursue the dealer who sold the C.D.O.’s under current law. At a minimum, the Securities and Exchange Commission should impose retail investor suitability standards onto banks and public sector agencies to end the predation by large Wall Street derivatives dealers.”
Will the National Credit Union Administration pursue any of the credit union’s executives or the firms that sold it the toxic securities? “We always consider potential claims of third-party liability in cases of this magnitude,” said John J. McKechnie III, director of public and congressional affairs at the administration.
A Credit Union That Played With Fire Gretchen Morgenson, New York Times
In the present system, the more unrestricted the banks are, the more money they can generate “out of thin air,” and the more damage they can inflict upon the wealth-generation process. 
Missteps to Mayhem
Inside the Doomsday Machine with the outsider who predicted and profited from America’s financial Armageddon.
by Michael Burry, MD’97
I worry about the future of a nation that would refuse to acknowledge the true causes of the crisis. A historic opportunity was lost. America instead chose its poison as its cure, and the second “Greatest Generation” would never be born.
Today I expect the U.S. government to attempt continuing an easy money policy into the next presidential term—past the meat of the foreclosure crisis, and past the corporate and public financing humps that are upcoming. Junk bonds, incredibly, again are at all-time highs. Quantitative easing seems to be working for now. But this is an invalid validation of what America is doing, a Pyrrhic gamble. As we continue to debase our currency, Bernanke says he is not printing money. Yet I receive an email every day from the Fed saying we just bought another $7 billion or $8 billion in treasuries, monetizing the debt. The scope and breadth of quantitative easing raise severe questions about the Treasury’s needs.
Government borrowing of money for the purpose of injecting cash into society, bailing out banks, brokers and consumers, is an easy decision for a population that has not yet learned that short-sighted easy strategies are the route to long-term ruin. We never quite achieved the catharsis necessary to stoke a deep reevaluation of our wants, needs and fears.
Importantly, the toxic twins—fiat currency and an activist Fed—remain even more firmly entrenched with the financial reforms of last year. The Federal Reserve, having acquired new powers of regulation, has insisted that nothing in the field of economics or finance was of any help in predicting the crisis—period, no more comments. It’s a worthless conclusion that guarantees we’ll make the same mistake again and again.
We need better leaders, but frankly this isn’t going to happen. A problem cannot be solved if it is never acknowledged.
Taxes need to be raised, spending needs to be cut, and loopholes need to be shut if we are to have any hope of returning to a stable base. Home ownership should not be a policy of the U.S. government. The banking system needs substantial reform and bank breakups. Glass–Steagall needs a second run in a strong form. And 22.5 million public workers have no business unionizing against the taxpayer. The list of things that won’t happen—but should happen—goes on and on.
By 2020, interest expense on our national debt could very well exceed $1 trillion. All personal income taxes collected in the U.S. in one year do not total $1 trillion. Our country’s math is scary big, but even scarier is that it simply doesn’t work…
Read the rest here.