Marschdorf Forensics

Project

Diversification is not Always Good

During the course of the so-called financial crisis, between 2008 and 2010, many communities across the globe found themselves owning Collateral Debt Obligations in default, despite the fact that they were regulated by laws or governance structures not to invest in such structured financial instruments. How could that have happened?

It often started with the concept of cross-border leasing, which was used to finance large infrastructure projects such as hospitals, water clarification plants, public transport systems or telecom infrastructure, to name just a few, at reduced capital cost taking advantage of tax shelter opportunities in the United States. These complex models with contracts, which were easily 2,000 pages thick, involved, amongst other arrangements, that investors purchased and held top-rated investments as collateral to secure their obligations from such financing arrangements. Typically, such collateral consisted of bonds with high ratings, at least Aa2 on the Moody’s scale. Thousands of communities and corporations worldwide used this form of financing for their infrastructure projects.

Although cities and counties were in many cases prohibited from buying structured financial products, there was a common perception that this did not apply to replacements of existing investments with the intention to mitigate risks.

Recognizing the opportunities from existing cross-border leasing models, large internationally operating banks started to market structured financial products to communities arguing that such products would diversify default risks by putting the burden not just on the shoulder of one particular bond, but distributing it on many shoulders, an unwarranted simplification as it turned out.

The primary instrument used in replacing bond investments of communities and counties was the Synthetic Collateral Debt Obligation (CDO). A CDO is a security, which amalgamates a multitude of claims from bonds to loans to credit card obligations with varying default risks in a trust. The trust then structures entitlement to proceeds from the trust’s cash and risk of default into tranches with different access to cash distributions and allocations of default risks. High-risk tranches would be affected first by defaults of claims amalgamated in the trust, followed by medium risk tranches and low risk tranches. A CDO is called synthetic when it does not actually amalgamate real claims, but involves a credit default swap, essentially an insurance contract, on a virtual reference portfolio. It is a mathematically founded bet with complex reward and risk calculations.

Decision makers were presented with the simple argument that the risk of default of a single bond held to secure obligations from cross-border leasing should be diversified by CDOs, which supposedly distributed that risk on many shoulders. Doing this, they were told, did not only diversify the risk, but also promised a net payout to the community. It was too good to be true: Reduced risk combined with increased payout. And indeed, it wasn’t true.

Some communities bought the argument and essentially sold their bonds and invested into tranches of synthetic CDOs with credit ratings, which seemed to be only marginally worse than the ratings of the original bonds and still considered “Prime”. For example, in one case an Aa3 bond was exchanged for an A3 tranche of a CDO. Both ratings are considered “Prime”, but the default risk associated with an A3 rating is 10 times the default risk of Aa3. Needless to say, these weren’t outright transactions. Instead, they involved buying insurance on the existing bonds and accepting the CDO risk through a credit default swap, essentially ensuring a virtual portfolio with the initiating big international bank as counterparty. The increased risk resulted in cash payouts to the communities, which engaged in such transactions, but it was sold as a payout at equivalent risk levels, PRIME risk levels.

Add to this that the financial models, on which the concept of CDOs was based, were flawed. The ratings of tranches were based on the assumption that the risks of the individual claims amalgamated in the trust were independent of each other and not systematic. However, this assumption proved to be inadequate to reflect risk patterns in a recession or depression and the default point – the professional term is “Attachment point” – kicked in faster than anticipated by the models. As a consequence, communities around the globe have found themselves with obligations to pay out on their bets in the aftermath of the financial downturn in the late 2000s. Such obligations could at times reach the billion-dollar mark.

Now, where does the fraud investigator fit into the assessment of bad bets? The international banks marketed their services through third-party brokers, often the same structures, which brokered the original cross-border leasing transactions. The success fees were high, high enough to share with decision makers. As usual, when third parties are used for making corrupt payments, nothing enters the record as to what intermediaries do with their inflated fees. And it helped that these brokers themselves often did not understand what they were selling. Plausible deniability for the banks was the result of these structures. This is where a fraud investigator comes and came into play. Find the bribes if paid. Prove knowledge about the discrepancy between what the banks knew about the risk distributions and what they allowed the bank customers to believe.

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