One firm that was a major player in mortgage securities, Deutsche Bank AG, illustrates a pattern investigators are looking at. While creating and selling mortgage securities to some of its clients, the big German bank was not only advising other clients to bet the other way, but also sometimes doing so itself.
A Deutsche trader helped create an index that made it easy to bet against housing, and the bank itself then used the index to do just that.
After the collapse of mortgage securities led to a costly bailout of the firm that insured many such securities—American International Group Inc.—some of the federal cash that was sunk into AIG flowed to Deutsche, to cover bearish bets by its hedge-fund clients.
Deutsche's actions are a vivid example of potential conflicts on Wall Street—the way big financial firms play both sides of the fence with investors. The issue became more extreme during the mortgage bubble and subsequent bust because of the size of the bets on Wall Street and subsequent losses on Main Street.
Regulators now are grappling with whether the business-as-usual conduct at financial firms merely looks bad in hindsight, or whether there were misrepresentations or other legal issues that need to be further investigated and guarded against in the future. "This is a gray area that we need more investigation into," says Andrew Lo, a finance professor at Massachusetts Institute of Technology and a hedge-fund manager.
Deutsche says that helping investors bet either way—either for or against an asset—is part of doing business for a securities firm.
"Some clients sought more exposure to the housing market, while others sought less," a spokesman for Deutsche said. "We served clients whatever their investment objective, but only after being satisfied that they had arrived at their view after thorough consideration."
As for betting against housing with its own money, Deutsche, while acknowledging having made tens of millions of dollars doing that, says that overall, it "maintained a net long position in the housing market and ultimately suffered billions in losses, even after factoring in our hedges and offsetting positions."
Deutsche is just one of a number of financial firms whose roles in the mortgage boom and bust are being examined by the U.S. Securities and Exchange Commission, the Justice Department or the Financial Crisis Inquiry Commission set up by Congress.
In mid-July, the SEC reached a $550 million settlement with Goldman Sachs Group Inc. of civil charges that Goldman misled investors in a mortgage security, failing to tell them a bearish hedge fund had helped design the security and was betting against it. Citigroup Inc. last week agreed to pay $75 million to settle SEC charges of understating its subprime exposure in reports to investors.
Deutsche says it has been cooperating with a variety of mortgage-related inquiries but hasn't been told it is a target of any investigations. Deutsche recently settled charges by an industry self-regulatory group, the Financial Industry Regulatory Authority, that it misrepresented delinquency data in issuing subprime securities. In agreeing to a $7.5 million penalty, the bank neither admitted nor denied the charges.
Deutsche's disparate dealings with two investor clients in February 2007 illustrate how it played both sides of the mortgage-securities market.
That month, a time when the U.S. housing and mortgage markets were beginning to crack, Deutsche was helping put together bond deals backed by subprime mortgages.
They included loans originated by NovaStar Financial Inc., a Missouri subprime lender that Deutsche had financed. A promotional flier from NovaStar in 2003 said, "Ignore the Rules and Qualify More Borrowers with our Credit Score Override Program!" As housing boomed, NovaStar thrived.
But on Feb. 20, 2007, NovaStar reported a quarterly loss and said it was tightening the spigot on new loans. It was another piece of evidence the long-rising housing market was headed the other way. That evening, a senior Deutsche trader received an email from a hedge-fund manager with the subject line "Novastar" and the message: "It is like the plague."
The Deutsche trader, Greg Lippmann, encouraged the email writer to bet against subprime bonds, telling him "you should get some [courage] and do some shorts," because "these bonds are going much much lower....."
Deutsche, however, continued to market new mortgage-bond deals predicated on the mortgage-securities market staying strong. The very next day, M&T Bank Corp. of Buffalo, N.Y., poured $82 million into a Deutsche deal known as Gemstone VII.
Within 10 months, M&T lost 98% of its investment, according to a lawsuit it has filed against Deutsche.
By that time, NovaStar was out of the lending business.
"Some of our employees were bearish on the housing market," a Deutsche spokesman said, "but they were transparent with their views and spoke at dozens of conferences and client meetings and published more than a dozen research reports which were distributed to thousands of institutional investors." There's no indication Mr. Lippmann was among those at Deutsche encouraging others to buy.
Deutsche is fighting M&T's fraud-and-misrepresentation suit in a New York state court. A Deutsche spokesman described M&T as "an extremely sophisticated investor" and active player in the mortgage market.
Deutsche, founded in Berlin in 1870, and occupying a skyscraper at 60 Wall Street in recent years, had a major role in the frothy rise and later crumbling of the U.S. housing market. In 2007, a peak year for production of mortgage deals known as collateralized debt obligations, or CDOs, Deutsche arranged about $42 billion of them, compared with $25 billion by Goldman, according to Thomson Reuters.
Signing off on the deals were lawyers supervised by Robert Khuzami, who ran Deutsche's U.S. legal division. He is now the SEC's enforcement chief and has vowed to pursue any financial wrongdoing by financial firms in areas such as mortgage securities, recusing himself if any matters relate to his old employer. The SEC said Mr. Khuzami declined to comment.
Deutsche analysts also were among the first to flag weaknesses in the market, as early as 2005. In a June 2006 research report, a Deutsche analyst recommended that investors reduce their exposure to subprime mortgage securities.
The bank, however, continued to build its mortgage-securities machine. It was a reliable assembly line, beginning with lenders like NovaStar, based in Kansas City, Mo. Deutsche agreed to provide a credit line to NovaStar in 2003, the year the home lender touted its "credit score override program." A co-founder of the lender says that it sought "to underwrite loans with a focus on ensuring the borrower could repay his or her debt."
As U.S. lenders churned out home loans, Deutsche bundled them into mortgage-backed bonds. It assembled these into CDOs, and built other CDOs out of derivatives that served as insurance on the bonds. Deutsche marketed the deals to conservative investors, such as insurers and banks, that had a positive view of the housing market.
Meanwhile, for hedge funds or other investors that wanted to bet on a housing downturn, Deutsche in 2005 and 2006 created a half-dozen deals that were collectively known as START.
One created in late 2005 was underpinned by about 100 home-mortgage bonds whose ratings were low investment grade. Deutsche put investors on notice that it "may deal in" any mortgage bond in the pool—that is, Deutsche might trade them itself.
Deutsche set up one 2005 START deal partly to facilitate bearish bets by Paulson & Co., the same hedge-fund firm whose role Goldman was accused of insufficiently disclosing, according to people familiar with the matter.
Paulson & Co. helped select assets that went into the Deutsche CDO and then bet against the assets, the people said. That was a role similar to the role Paulson played at Goldman.
Deutsche, like Goldman, didn't tell investors in its CDO that Paulson had helped pick the assets and was making a bearish bet.
A key difference: Goldman told investors that the assets were picked by an independent third party; Deutsche didn't use a third party or give its investors such assurances.
A spokesman for Deutsche said, "Both long and short investors were given the opportunity to select the specific collateral to which they were seeking exposure and mutually agreed on the CDO portfolio."
In the complicated START deals, Deutsche agreed to sell investors protection on mortgage securities, and then shielded itself by purchasing protection on those same securities. On two 2005 deals, including the one that helped facilitate Paulson's bets, the provider of the insurance was AIG.
For those deals, about $800 million of the federal bailout money given to AIG in 2008 was set aside to be paid to Deutsche as defaults occur. (In all, Deutsche received at least $8.5 billion from AIG, much of it for commercial real-estate deals.)
Conventional wisdom among investors had long held that it was difficult to short housing, that is, bet against it. But a new index called the ABX.HE made this much easier. It was created in January 2006 by Deutsche's Mr. Lippmann and bankers from 15 other big firms.
At a September 2006 dinner with hedge-fund clients at a Palm restaurant in New York, Mr. Lippmann said subprime-mortgage bonds were poised to fall.
By the end of 2006, Deutsche was using the ABX to make its own bearish housing bets.
The bank's finance chief told investors that as housing weakened in the first quarter of 2007, Deutsche avoided a net loss in part because of "a trading position, which was put on in...late 2006, shorting the ABX index, because our traders felt that the U.S. mortgage market was probably overheating and was potentially going to soften," according to a transcript of the May 2007 earnings conference call.
Deutsche's mortgage trading desk assembled other instruments that were tailor-made for betting on housing, either for or against. These were complex CDOs made up of derivatives linked to the performance of mortgage bonds plus some part of the ABX index.
Deutsche took the bearish side of these deals and sought to sell the bullish side of them to U.S. and European investors. The bank says the instruments weren't designed to enable it to short housing.
Not all investors who were pitched the bullish side were impressed. "My quick analysis of the portfolio suggests this is the biggest crock of s— I've seen yet!" one London trader who got the pitch responded by email to Deutsche. He added, "I won't be spending any more time on it, but wish you luck in moving some paper."
The client later was sent a new portfolio and found it improved, according to what one Deutsche employee told another one.
Then on Feb. 20, 2007, came word of the setbacks at NovaStar, the Kansas City subprime lender. In an email reply to hedge-fund manager Steve Eisman of FrontPoint Partners—the man who had described the worsening situation as "like the plague"—Deutsche's Mr. Lippmann encouraged Mr. Eisman to rev up his bets against mortgage bonds.
When Mr. Eisman asked for some recommendations, Mr. Lippmann wrote that he would have another bank employee send some.
"On CDOs, we think they are going much much wider," Mr. Lippmann wrote, referring to the already-widening cost of credit protection on mortgage bonds.
He said he was having trouble staying "short" housing because of a dwindling pipeline of mortgage products to bet against.
Mr. Eisman's bearish bets were lucrative for his hedge fund, which is owned by Morgan Stanley.
During this time, Deutsche continued trying to get other investors to go "long" the housing market—that is, it continued trying to sell them products likely to prosper if housing did.
M&T, the bank that agreed during this time to invest in a new Deutsche mortgage deal, alleges in its suit that a week before the purchase, a Deutsche salesman told it by phone that the "underlying structures in these bonds are built to withstand" adverse conditions.
In late 2007, M&T wrote down the value of its $82 million investment to just $1.9 million, according to its suit.
Deutsche said documents for the product had clearly warned that the assets in the pool were of poor quality.
As NovaStar's troubles mounted, it hired Deutsche in 2007 to help the subprime lender sell its mortgage-servicing operation. In late 2007, NovaStar abandoned home lending altogether.
Two months ago, Deutsche's Mr. Lippmann, the trader who had advised the hedge-fund manager to short mortgage bonds while his bank continued to push them, left to help form a hedge fund himself, one aimed at profiting from the mortgage mess.