The investment manager ridiculed in “The Big Short” is now under fire from the SEC

Image: Reuters/Rick Wilking
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If you’ve read Michael Lewis’s book “The Big Short: Inside the Doomsday Machine“—about the build-up to the housing crisis and credit bubble—then you’ll probably remember Wing Chau, a New Jersey-based investment manager who packaged and sold collateralized debt obligations (CDOs). Today it emerged that Chau is under fire from the US Securities and Exchange Commission (SEC), according to an enforcement action (pdf) issued against him and his firm, Harding Advisory, LLC.

According to the book, Chau is the person who ultimately convinced eccentric money manager Steve Eisman that the US was headed towards a housing and financial crisis:

Whenever Eisman set out to explain to others the origins of the financial crisis, he’d start with his dinner with Wing Chau. Only now did he fully appreciate the central importance of the so-called mezzanine CDO–the CDO composed mainly of triple-B-rated subprime mortgage bonds–and its synthetic counterpart: the CDO composed entirely of credit default swaps on triple-B-rated subprime mortgage bonds. “You have to understand this,” he’d say. “This was the engine of doom.” He’d draw a picture of several towers of debt. The first tower was the original subprime loans that had been piled together. At the top of this tower was the triple-A tranche, just below it the double-A tranche, and so on down to the riskiest, triple-B tranche–the bonds Eisman had bet against. The Wall Street firms had taken these triple-B tranches–the worst of the worst–to build yet another tower of bonds: a CDO. A collateralized debt obligation. The reason they’d done this is that the rating agencies, presented with the pile of bonds backed by dubious loans, would pronounce 80 percent of the bonds in it triple-A. These bonds could then be sold to investors–pension funds, insurance companies–which were allowed to invest only in highly rated securities. It came as news to Eisman that this ship of doom was piloted by Wing Chau and people like him. The guy controlled roughly $15 billion, invested in nothing but CDOs backed by the triple-B tranche of a mortgage bond or, as Eisman put it, “the equivalent of three levels of dog shit lower than the original bonds.” A year ago, the main buyer of the triple-A-rated tranche of subprime CDOs–which is to say the vast majority of CDOs–had been AIG. Now that AIG had exited the market, the main buyers were CDO managers like Wing Chau. All by himself, Chau generated vast demand for the riskiest slices of subprime mortgage bonds, for which there had previously been essentially no demand. This demand led inexorably to the supply of new home loans, as material for the bonds. The soy sauce in which Eisman double-dipped his edamame was shared by a man who had made it possible for tens of thousands of actual human beings to be handed money they could never afford to repay…

Wing Chau didn’t know he’d been handpicked by Greg Lippmann to persuade Steve Eisman that the people on the other end of his credit default swaps were either crooks or morons, but he played the role anyway.

As Lewis later describes, Chau sold off all but a small piece of the CDOs he managed to “German banks, Taiwanese insurance companies, Japanese farmers’ unions, European pension funds, and, in general, entities more or less required to invest in triple-A-rated bonds.” But Lewis depicts Chau as seeming to admire people on the other side of the trade, those who bet against the housing market. He quotes Chau as saying, “I love guys like [Eisman] who short my market. Without you I don’t have anything to buy.”

Unfortunately for Chau, it looks like that admiration might have gone a step too far. The SEC says Chau had a relationship with Illinois-based Magnetar Capital, a hedge fund that drew scrutiny for its bets on CDOs. ProPublica reporters Jesse Eisinger and Jake Bernstein explained—in part of a series that won them the 2011 Pulitzer Prize—how Magnetar essentially “sponsored” the creation of these CDOs, got great deals on the worst tranches, and then made billions betting against the better tranches.

According to the SEC’s enforcement action, Chau yielded Magnetar certain rights to determine what kinds of bonds would be included in Harding’s CDOs, including the power to overrule Chau and his team when they determined that a certain security was “ineligible” for the CDO.

The SEC alleges that Chau misled investors because he didn’t mention this arrangement in a circular describing the offering to would-be investors. The agency also believes that Chau violated his fiduciary duty to his investors because he purchased securities he thought were poor investments to prove he was a “team player” who “never forget[s] my true friends” (Chau’s alleged statements). The SEC is trying to determine if financial penalties are appropriate in this case.