On February 1, 2008, the Massachusetts Securities Division filed a lawsuit against Merrill Lynch and two of its brokers, alleging that they defrauded the City of Springfield in connection with investing the City's $21 million budgetary surplus into three CDO's underwritten by Merrill Lynch. Massachusetts seeks to impose a fine, disgorgement of profits, a cease and desist order and other remedies.
According to the complaint, the City of Springfield retained Merrill Lynch to help it invest its surplus in November 2006. Massachusetts claims that the assets were supposed to be invested in "safe money-market-like investments authorized by City personnel." However, in April and June of 2007, Merrill Lynch's brokers invested $14 million into three different CDO's – The Center Square CDO, The South Coast Funding V CDO, and the Tabs CDO.
The complaint alleges that these securities, which were AAA rated at the time, lost almost all of their value soon after they were purchased, declining from $14 million to only $1.3 million by December 2007, approximately 90% of their value. Springfield then instructed Merrill Lynch to sell their investment in the CDO's, but the market had dried up and there were no takers.
The state argues that Merrill Lynch's brokers invested this money without the proper authorization, from the firm's own inventory of commercial paper and short-term debt instruments, "circulated periodically to its agents for them to sell."
The complaint further states that Springfield was not even told the investment was in CDO's until months after the investment, that Merrill Lynch never evaluated their suitability for Springfield, that its brokers never explained the nature of the investment or the risks, and they did not "make any attempt to understand what these CDOs were collateralized with."For its part, Merrill Lynch initially denied any liability (the letter is an exhibit to the complaint) because the accounts were not discretionary and the city had to authorize the investments, which Merrill Lynch claims it did. However, Merrill Lynch reversed its position, and just a day before Massachusetts filed the lawsuit, agreed to pay back the principal the city lost on its investment. Despite that commitment, the state is proceeding with its fraud lawsuit.
The Massachusetts lawsuit reveals how complex the structured finance vehicles had become by the time Springfield invested in these particular CDO's in mid-2007. The complaint alleges that the investments were CDO's that invested in other CDO's, sometimes referred to as "CDO-Squared," and "synthetic securities." Excerpts from the offering circular related to one of the CDO's purchased by Springfield is one of the exhibits to the complaint, and the risk factors describe "synthetic securities" as follows:
Synthetic Securities will be in the form of the Initial Credit Linked Security, the Reference Obligations of which are CDO Securities.... Investments in such types of assets through the Purchase of Synthetic Securities present risks in addition to those resulting from direct Purchases of such Collateral Debt Securities. A Credit Linked Security is a credit derivative transaction pursuant to which the Issuer [the CDO] Purchases a security from a Synthetic Security Issuer that Purchases one or more Embedded Credit Default Swaps with a Credit Linked Security Dealer Counterparty as part of the terms and conditions applicable to such Credit Linked Security. Each Synthetic Security will expose the Issuer to all the risks of the Reference Obligation, as well as the credit risk of the Synthetic Security Counterparty and risks arising from the terms of the Synthetic Securities.
These CDO-squared and two-tiered synthetic securities investments are susceptible to the "price cliffs" it appears Springfield may have experienced. Citing a Nomura Securities article, the D&O Diary blog explains (here) the increased risk of these CDO's that invest in other CDO's and synthetic securities: "Based on a very detailed analysis, the Nomura article concludes that 'higher default rates affect a CDO-squared tranche much more dramatically than the underlying CDO tranche.' The report goes on to state, among other things that, 'for example, the probability of a [CDO squared] tranche wipeout goes from 0.6% to 41.2% as the [CDO tranche] default rate goes from 1.0% to 1.5%.'"
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