Should UBS Be Held Accountable For Selling Toxic CDOs?

UBS is in some more trouble. A Superior Court judge has ruled that it sold collateralized debt obligations (CDOs) that it knew to be toxic and is liable for damages. The Wall Street Journal reports that the judge believes that UBS had material nonpublic information that was used in the decision to sell the securities to hedge fund Pursuit Partners. I'm not convinced.

First, it's not illegal for a trader to sell a security that he believes will perform more poorly the market expects. That's kind of the point of selling a security. If you thought it would meet or exceed expectations, you'd hang onto it. What is illegal is when a trader sells a security that he knows will perform poorly, based on some nonpublic information. That's called insider trading. So the question is whether or not that really happened here. Let's look at the facts, based on the WSJ article.

The story begins in the spring of 2007. That's when anyone who worked in finance began to realize that something might be going terribly wrong in the world of asset-backed securities. Banks had already begun recognizing billions of dollars in mortgage-related losses. It was only a matter of time before similar losses hit the securities that were created based on those mortgages.

In May 2007, UBS began to see losses occurring in one of its own hedge funds. So did pretty much everybody else. It began to worry.

That month, according to the judge's ruling, UBS "had reason to believe that Moody's was changing its methodology and that would result in the downgrading of certain asset-backed securities."

That "reason to believe" is a little vague. But it's only relevant if that reason was based on nonpublic information that their traders had received. A few months later:

On July 11, 2007, Moody's said it would review for possible downgrade a small percentage of the universe of CDOs, just after it cut ratings on subprime-mortgage bonds -- the building blocks for many CDOs.

Mr. Morelli sent an email on that day telling colleagues to "put today in your calendar." Mr. Morelli later said in the case the day "was essentially the beginning of the end of the CDO business, meaning the bonds were getting downgraded, they were probably going to get downgraded further, and we were going to lose a lot of money," according to a court transcript cited in Judge Blawie's decision.

This announcement should have clued everyone -- not just Mr. Morelli (a UBS bond salesman) -- in that there was a storm coming. As that excerpt mentions, mortgage-backed securities (MBS) were already being downgraded. Anyone who buys CDOs should have realized that if they were based on MBS -- and many were -- then they could be next to feel the pain.

I would also note Morelli implied that the day could be significant and that other CDOS were "probably" going to be downgraded. This doesn't sound like concrete insider knowledge to me. An example of such information would be if you caught wind of an acquisition that was about to be announced, so you bought stock in the target company. That's tangible. This seems like a case where, after an announcement that Intel had created a defective microchip, a trader told his staff to sell their positions in all computer makers, because recalls would affect their profits. That's not insider trading. That's using public information and analysis to draw investment conclusions.

On July 26, UBS instructed employees to "reduce cdos ... no need to publicly relay this," the decision says. That day, Pursuit started its purchases from UBS.

Again, no investment strategy, unless it includes nonpublic information, need be publicly disclosed. If it were, then it wouldn't be much of a strategy. At this point, I would argue that, even if the knowledge back in May about Moody's potentially changing its rating methodology were nonpublic, by July, the financial community should have known better than to believe all AAA CDOs were in the clear. The July 11th announcement and deterioration of the mortgage market all should have made that obvious.

On Aug. 28, Mr. Morelli said in an email that he had "sold more crap to Pursuit," according to the decision. On Sept. 24, as the October downgrades neared, an unnamed UBS employee emailed a UBS banker and referred to CDO inventory on UBS's books. "OK still have this vomit?" the employee asked.

Sales to Pursuit Partners continued through October 1. Does the fact that these traders referred to the securities as "vomit" and "crap" mean they knew it was worthless? Not really. They may have believed it was. But unless they had a crystal ball, they couldn't have known how it would turn out. If they considered it junk based on other market conditions, then getting rid of it is perfectly acceptable. It's only if that knowledge was based on nonpublic information that it matters.

I might have more sympathy for the investor who got sold this stuff it we were talking about amateur investor Bob Smith from Lima, Ohio. We aren't. We're talking about a hedge fund. They're privy to all of the same market information as UBS. So, again, unless UBS was acting here with some kind of nonpublic revelation, Pursuit only has itself to blame.

I don't mean to make it sound like the UBS traders were saints for selling this stuff. But no Wall Street trader is in business to make the world a better place. They're trying to make a profit. That's their game. Anyone trading with such individuals knows that, particularly hedge funds. Unless UBS was using nonpublic information, then they were just playing the game, and Pursuit lost.