Tom Adams: “TCW and Gundlach – Missing the Real Dirty Laundry”

By Thomas Adams, at Paykin Krieg and Adams, LLP, and a former managing director at Ambac and FGIC.

The ugly mess at TCW over chief investment officer Jeff Gundlach’s recent departure, has prompted a number of headlines lately. I was surprised to learn that Gundlach had a number of dirty secrets, and not just the illicit material found in his office. But I’m even more surprised that both reporters and people in the industry have missed the real story, which has been in open view for the last year.

In the classic Wall Street tradition of failing upwards, Gundlach maintained a stellar reputation despite his role as a leading creator of toxic CDOs that did considerable harm to investors and to AIG, and therefore the US taxpayer. Somehow, through the magic of CDO s, many of the creators of these toxic bonds have been able disclaim any responsibility for their performance and still command paychecks that would make the average Goldman Sachs employee blush. TCW touted their superior experience, diligence and expertise in mortgage assets which turned out to be great for their own funds but not for the CDOs. Instead of getting returns comparable to TCW’s managed funds, most of the investors in TCW’s CDO’s got blown up.

TCW, a subsidiary of Societe Generale, is one of the largest investors in mortgage backed securities in the world and had, prior to the start of this mess in December, over $110 billion of assets under management. TCW was also the world’s biggest issuer of collateralized debt obligations, especially those backed by mortgage backed securities. As of 2007, TCW had over $64 billion of CDOs outstanding. TCW issued CDOs under the deal names of Davis Square, Everest, South Coast Funding and Westways Funding.

Gundlach was fired at the beginning of December and his departure was followed by a series of ugly events, including departures of many of TCW’s top employees and many of its investors. Gundlach formed his own investment firm, with start up money from another group of disgruntled former TCW folks now at an investment firm called Oak Tree. Soon after, law suits and accusations were flying, including allegations of client and employee poaching, theft of proprietary information and illicit goods found in company offices.

Considering the performance of ABS CDOs and their role in the financial crisis, I was surprised to find out that the chief investment officer responsible for TCW’s CDOs was still employed. Prior to the financial crisis, TCW was considered one of the best managers of CDOs backed by mortgage bonds. A CDO manager establishes investment criteria for the deals, scours the market for bonds to buy, makes the investments and then, with the help of their investment bank, convinces investors to purchase the new bonds backed by the collateral. Unlike many newcomers that were jumping into the CDO market in 2006 and 2007, TCW had the skills, experience, procedures and expertise to set them apart from the pack and earn the distinction of being both the largest and the best manager of ABS CDOs. In 2006, Fitch Investors Service assigned them a “Cam 1” rating, their top ranking for CDO managers (.http://findarticles.com/p/articles/mi_m0EIN/is_2006_April_17/ai_n16126102/). In 2007, for the second year in a row, “Total Securitization” magazine named TCW the CDO manager of the year (http://www.allbusiness.com/services/business-services/4328694-1.html). Total Securitization cited TCW’s innovation as a big reason for the honor, noting that the company had issued a fully synthetic CDO-squared called Visage.

With hindsight, such honors and praise seem almost funny, though it is no laughing matter for the investors in Visage or the many other CDOs issued by TCW. Many of the ABS CDO issued by TCW have been downgraded to junk or hit events of default. Some formerly AAA bonds from similar CDOs are now worth as little as ten cents on the dollar.

According to various news reports, Gundlach invested most of the firm’s money without leverage in prime quality, agency and non-agency mortgage backed securities and registered outstanding performance over the past several years, despite the financial crisis. However, the investors in his firm’s CDOs did not fare nearly as well. One such investor was AIG, which acted as the insurer for at least eleven TCW issued CDOs (specifically, Davis Square I, II, III, IV, V, VI, and VII and South Coast IV, V, VII and VIII). At issuance, TCW’s deals which received insurance for some or all of the senior classes from AIG had an aggregate par at issuance of over $15 billion and they probably represented 15-20% of AIG’s CDO portfolio. These deals, and many others, are what blew a hole in AIG last year and caused the Fed to step in and bail out the insurer.

Soc Gen, TCW’s parent, was the largest recipient of bailout money from AIG, receiving approximately $16.5 billion as well as being one of the largest recipients of posted collateral from AIG prior to the bailout. Interestingly, Soc Gen was the investor in two TCW Davis Square deals which AIG insured and, based on the significant write downs the deals had experienced at the time of the notorious internal AIG memo obtained by CBS (http://www.cbsnews.com/htdocs/pdf/collateral_b.pdf), Soc Gen probably received taxpayer money for two deals that were assembled by its own subsidiary.

Many institutions that invested in CDOs backed by mortgage bonds, even those bonds that were rated AAA, subsequently incurred massive losses and were severely damaged. Many of the investors required bailouts or recapitalization as a result of the toxic bonds and the people making the investment decisions lost their jobs. I would have assumed that the companies responsible for assembling the mortgage bonds and selling CDOs backed by the bonds would have suffered similar fates. In the case of TCW, I would have been at least partially wrong.

In the year following a massive meltdown triggered by ABS CDOs, many of which were issued by TCW, the chief investment officer for the firm was paid $40 million. Over the past five years he was paid over $135 million. While he delivered excellent results for investors in TCW managed funds, for which he deserves praise, he delivered toxic bonds and destruction to investors in his firm’s CDOs. For which he received no meaningful loss of reputation or personal earnings. In fact, many of TCW’s investors, as well as it’s employees, have followed Gundlach to his new firm where he will presumably be in a position to earn even more money.

In addition, despite TCW’s terrible CDO track record, the investment firm was one a select few that was picked to participate in the government’s public-private partnership plan for investing in distressed assets known as the PPIP. It seems strange that the Obama administration rewarded TCW with this designation even though they had helped create billions of dollars worth of distressed deals themselves. Since Gundlach’s departure, TCW has announced that it will wind down its PPIP fund.

I don’t know Gundlach, I’ve never invested in or insured any of his deals and I don’t care to comment further on the allegations about drugs or movies he was allegedly keeping in his office. However, I am amazed that he and his mortgage team have managed to keep such stellar reputations and paychecks despite issuing and selling deals that led to billions of dollars of losses, contributed to the collapse of AIG and prompted the funneling of bail out funds to AIG’s bank counterparties, including TCW’s own parent.

Andrew Cuomo and members of Congress have focused on the bonus and compensation packages at the bailed out institutions like AIG and Citigroup. Firms like TCW, which built and sold the bonds that contributed to the losses at those institutions, have sailed under the radar screen apparently untouched. If not for the ugly mess surrounding Gundlach’s departure from TCW I wouldn’t have know about his generous bonus packages either. Hopefully, at some point investigators will become curious about some of the other pieces of the financial crisis puzzle and we will learn more about how the toxic CDO bonds were packaged and sold and what role companies like TCW had in the melt down. Until then, we can check out the salacious details of the Gundlach lawsuit.