First to understand the true implications of the Citigroup Settlement Deal -- it helps to understand CDO's -- which are just basically a 'fancy Bond Investment' -- to understand how they work -- or how CDO's are supposed to work.
CDO's (Collateralized Debt Obligations)
by Kimberly Amadeo, About.com Guide
Definition: CDO's, or Collateralized Debt Obligations, are sophisticated financial tools that repackage individual loans into a product that can be sold on the secondary market. These packages consist of auto loans, credit card debt, or corporate debt. They are called collateralized because they have some type of collateral behind them.
[...]
CDO's were created to provide more liquidity in the economy. It allows banks and corporations to sell off debt, which frees up more capital to invest or loan. [...]
However, the downside of CDO's is that it allows the originators of the loans to avoid having to collect on them when they become due, since the loans are now owned by other investors. This may make them less disciplined in adhering to strict lending standards.
Say hello, to Sub-Prime Loans. No Job, No prospects -- No Problem! Just as long as you can sign on the dotted line.
Clever investors, generally like clever investments. They rely on the fact that complete and open information on the free market, will eventually force an investment to "seek its true price". Just like water seeks its "true level". That's the theory anyways.
That is how it is suppose to work. Smart investors however, shy away opaque Companies, and overly-complex schemes, as Warren Buffet has famously done, most of his investing career. Schemes, where the "complete and open information" is usually buried in the fine print somewhere. Just like a mirage, off on the desert basin horizon.
The Smart Money usually avoids such scams ... or at least they used to ...
CDO Market – Rife With Collusion and Manipulation?
nakedcapitalism.com
by Tom Adams, an attorney and former monoline executive, and Yves Smith -- April 23, 2010
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If traditional cash investors and insurers were avoiding the mortgage securities market, who was driving the yields and spreads lower? Many industry participants agreed that the “CDO bid” was distorting the market.
The mechanism was the CDO managers, who assembled the assets for cash or hybrid deals [...]. They were effectively extensions of investment banks, dependent on substantial credit lines from them. Perhaps more important, it appears that many of the larger CDO managers bought much, perhaps all, of the AA to BBB tranches of entire subprime mortgage bond issues to be placed into CDOs.
Having a single affiliated party take down the riskiest layers of subprime deals means that normal arm’s length pricing was not operating, and the profit potential of CDO issuance, rather than investor demand, was driving the market.
That last line is important. It is the essence of Moral Hazard, a financial concept that used to put the brakes on "Junk Bonds" deals -- before they could ever get out of the gate. Michael Milken, back in the eighties, kind of made this Junk Bonds concept a household word.
Investments must be above board. Investments must be transparent, for Markets to work. Profits must not trump, free information. But in CDO bond packages, it was much too easy to mix in the BBB- Junk with the AAA+ Gold -- and who would be the wiser?
When the way a Contract is constructed, such that the Contract terms "motivates one of the parties" to cheat, to lie, to distort, in order to make a fast buck, at the expense of the other party -- then the instigator is said to have engaged in Moral Hazard. (ie. they are Stealing.) (ie. they should be punished.)
This Hazard used to be avoided like a Milken Triple-0 Junk Bond, by most of the Financial Markets ... but not anymore.
Not since we moved in an era, where the concept of Financial Risk, has become just another "outsourable" commodity. Just another derivative cost of business to be discounted away, to virtually nothing.
Just ask Citigroup ...
When there are No Real Consequences for bad behavior (ie. cheating, etc.);
Then there is No Real Risk, to engaging in such bad behavior.
(ie. there is No Real Hazard, financially, morally, or even legally, as we will see.)
Just another 'Parking Ticket' fine ... just another cost of doing mega-business in Casino America:
Citigroup settles for $285 million; no Wall Street exec jailed yet
by Kevin G. Hall and Greg Gordon, tri-cityherald.com -- Oct 21, 2011
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The SEC alleged that Citigroup's main broker-dealer subsidiary duped investors who had bought portions of a $1 billion offshore deal known as a collateralized debt obligation. CDOs are bundles of bonds tied to the performance of mortgages and other loans. The deal in question was precisely the kind of engineered financial product that blew up in 2008 and nearly brought down the global financial system.
In the complaint, the SEC alleged that Citigroup Global Markets selected about $500 million worth of assets in the deal, but in marketing materials suggested to investors that Swiss bank Credit Suisse had conducted the selection.
That gave the appearance that it was an arms-length transaction. In reality, said the SEC, Citigroup's subsidiary selected the assets and then bet against the investors in the very product it was selling. Betting that a bond will default is known as shorting, or going short.
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What's that last paragraph say? Citigroup gave investors the "appearance of impartiality", and then proceeded to "sell short" (ie. bet against) that very same CDO fund they where touting as AAA Investment grade?
That seems kind of wrong.
Here's a refresher on "short selling" -- it is one of the grand reasons our Financial Market seldom works anymore, to build up our Economy. Half the time, sometimes more, Financial Markets are placing standing bets to 'tear it down' ... America loses -- they win.
Short Selling
Investopedia explains Short Selling
Selling short is the opposite of going long. That is, short sellers make money if the stock goes down in price.
So why in the world would Citigroup "short" its own Mortgage-backed Security?
1) they knew the quality of the sub-prime junk they mixed into them (and when those ARM reset dates were scheduled). House of Cards -- Meet Fan.
2) they knew they could make Mega-bucks, mega-quickly, by follow the lead of other Hedge fund vampire players. (They don't call it "vulture capitalism" for nothing.)
Trader Of The Year: John Paulson Made Billions Shorting Subprime Mortgages
topgunfp.com -- April 8, 2008
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Funds run by Paulson, a hedge fund manager, were up $15 billion in 2007 and he is estimated to have made between $3-$4 billion himself.
How’d he do it? Paulson saw the housing debacle on the horizon long before others did and set up funds to essentially short subprime mortgage backed securities.
[...]
Paulson made a windfall the likes of which have never before been seen in the history of investing.
On Wall Street these days, John Paulson is pretty much God. In fact, he is so revered that Treasury Secretary Henry Paulson is now apparently known as “the other Paulson”.
What could be "more American" than driving a stake into heart of the American Mortgage Market -- and rake in Billions, by betting against it?
Citigroup apparently wanted a piece of the Billion dollar short-action. Citigroup wanted to be like Paulson.
And why shouldn't they, when the ultimate penalty-fine, is only a fraction of the Quick Profits to be made, by cutting a few corners ... by telling a few fibs.
It's only Business, right? Buyer Beware, right? ... Now how about Re-Fi-ing that Home Loan, at a low, low rate?
For Moral Hazard to work and actually restrain bad players, from acting badly, there must be some Real Consequences for their actual bad behavior.
But in today's wild west Era of Deregulation, bad players usually "get rewarded" for acting badly. That Risk has been marginalized. Much as, ordinary Americans' future opportunities ...
In this not-so-brave new commoditized-world, we are slowly discovering that:
Moral Hazard, is neither -- by jamess, Oct 21, 2011
[... neither Moral, or Hazardous, to today's No Limits players. Where's the Harm?]
... and we discovering this, much much too slowly, if you asked me. Sometimes discovering this, not at all.