More Examples of CDO Warehousing and Potential Fraud

Last month we had a blog post about Banc of America Securities selling investors CLOs which had already lost value before the CLO closing date. It seems that in July 2007 Banc of America transferred at least $35 million of previous losses to unsuspecting investors in two of its CLO offerings - LCM VII and Bryn Mawr II. In October 2008 when these two CLOs were liquidated investors lost nearly $150 million. But it is unlikely that these were the only structured deals that hid the true value of their holdings from investors.

Last April the SEC settled claims against Wachovia for allegedly violating the antifraud provisions of the Securities Act by selling the equity tranche of the Grand Avenue CDO II and misrepresenting the collateral acquisition process of the Longshore CDO Funding 2007-3. Both of the CDOs involved are residential mortgage-backed securities (RMBS), a complex financial product that is similar to CLOs.

According to the SEC order, the Grand Avenue CDO II was issued in October 2006 but Wachovia Capital Markets was not able to sell the equity tranche at the initial offering, which was then retained in Wachovia's inventory and marked at a value of 52.7% of par. However, a few months later,Wachovia sold $5.5 million of the equity trancheto the Zuni Indian Tribe and an individual investor at 90% and 95% of par. SLCG's Craig McCann has worked as an expert consultant for the Zuni Indian Tribe against Wachovia.

In addition, Wachovia allegedly transferred 40 RMBS securities (a total notional value of $250 million)it had obtained for another CDO into the warehouse for Longshore 3 at acquisition cost. Similar to the portfolio of loans warehoused in the LCM VII and Bryn Mawr II deals, these RMBS had already lost about $4.6 million in value between the acquisition and the transfer. Although required by the ABS CDO Investment Management Committee (the "IMC") to make certain disclosures to investors about the issue mentioned above, Wachovia allegedly failed to do so. According to the SEC Wachovia falsely claimed it acquired the collateral assets for Longshore 3 "on an arm's-length basis".

While Wachovia (now Wells Fargo) admitted no wrongdoing, the facts alleged by the SEC demonstrate that the problem of asset warehousing is not limited to Banc of America Securities or even CLOs, but could be pervasive in many forms of structured credit deals.