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A Wipeout That Didn't Have to Happen

This weekend the New York Times' Gretchen Morgenson wrote an article about the recent FINRA award against Banc of America Securities for their LCM VII CLO. We have blogged about this case before, and have put together a research paper describing the underlying issue of warehousing assets in structured credit derivatives. We are very grateful to the New York Times and Gretchen Morgenson for giving this story the attention it deserves.

The fundamental problem with structured credit and many other financial products is not necessarily their position in regards to market movements-any market can move up or down unexpectedly, and being caught on the wrong side of volatility is the risk all market participants must accept. The real problem with many of these securities is their enormous complexity, which can mean investors do not fully understand their position in the market and can provide ample opportunity for misleading or fraudulent structuring of deals. FINRA has released a notice recently on that very subject.

In Mr. Hayes' case, the description of the warehoused assets were on page 42 of a 145 page prospectus, and was phrased in complex legalese which required bouncing around several other sections of the document to figure out what exactly the 'warehoused facilities' were and how they were valued. For reference, it took three PhDs at our firm about two weeks to track it all down.

In addition, while Banc of America Securities priced the LCM VII portfolio daily, it would have been effectively impossible for Mr. Hayes to have realized that the leveraged loan market was eroding at that time, by how much, and if those losses affected the warehoused LCM VII assets. This information asymmetry is typical of many of the complex products we see in our casework, and reflects a major opportunity for financial institutions to tilt the table in their favor.

Certainly, most financial institutions and practitioners are honest and fair-dealing and provide a critical service to the global economy. Our point is merely that there exists in many innovative financial products enormous opportunity for manipulation and deceit, and that further efforts towards transparency, supervision, and education could go a long way in protecting investors when things do go wrong. And they do go wrong-we see it every day.