The case centres on a $3.5 billion portfolio of AAA-rated sub-prime mortgage bonds known as ABN1. The portfolio contained cash bonds and CDS, which were valued at approximately $4.7 billion at December 31, 2007.
As the market began to implode in the summer of 2007, Kareem Serageldin, global head of structured credit trading at Credit Suisse, directed David Higgs, head of hedge trading, to mismark the book. The scheme seems to have been triggered by bank management, concerned about weakness in the sub-prime market, instigating the requirement for real-time flash reporting of P&L movements.
When Financial Times Interactive Data prices showed that the ABN1 portfolio was down around $75 million by the end of August 2007, Higgs directed that the bonds should be re-marked to achieve the flat result that Serageldin wanted.
Indeed, when the initial re-marks only managed to reduce the loss to $40 million, Higgs demanded that the trader go through the book and re-mark again to eliminate the P&L deficit.
Conscious that these re-marks would attract scrutiny, Higgs then proceeded to get third-party marks from other dealers to back them up. When, not surprisingly, marks from two other dealers were substantially lower than the marks on ABN1, trader Salmaan Siddiqui contacted a dealer at a “smaller shop”, telling him the prices they wanted.
Indeed, he went as far as to email the dealer the list of prices he wanted, which the salesman subsequently emailed back to him as genuine third-party input.
The ABN1 portfolio was continually mismarked throughout September and October, until Serageldin ordered the traders to begin “quietly” selling the bonds in the portfolio in late October.
He also bought a $1 billion short position against the ABX to hedge against the price declines. But instead of marking the bonds down to their correct level, he recognized positive P&L on the ABX hedges alongside the artificially inflated price marks on the portfolio.
Clearly getting nervous by the end of November, Serageldin ordered a comprehensive analysis of the portfolio, comparing the weighted average price of each bond to the corresponding ABX vintage. This showed that, on aggregate, the portfolio was marked 19% higher than if it had been marked to the ABX.
Despite marking the bonds down by approximately $35 million in the first half of January, it became clear that the fraud was nearing its inevitable implosion. This happened in spectacular style on February 19, 2008, when Credit Suisse was forced to announce that the net income of CHF8.55 billion it had announced a week earlier was wrong.
After an internal review, the bank was forced to reduce this figure to CHF7.76 billion after having recognized a write-down on the ABN1 book of $1.3 billion. The inflated values for the cash bonds in the ABN1 trading book had overstated the bank’s income before tax by 33% for the fourth quarter and 4% for the full year. The bankers involved were immediately fired.
Even in early January, when the writing was most certainly on the wall for the sub-prime market in general and Serageldin’s mismarking scheme in particular, his focus on the wood rather than the trees seems inconceivable.
“People are expecting us to make money,” he told Higgs in a phone call. “Paul Calello [head of Credit Suisse’s investment bank at the time] knows what our positions are. Today we have to be up at least 10 bucks.”
Higgs and Salmaan Siddiqui have pleaded guilty to the fraud, saying they were working at Serageldin’s direction. A second trader, Faisal Siddiqui (unrelated), was named in the complaint. Serageldin, a US citizen resident in the UK, is considering his options.
The fraud is another example of the breathtaking detachment from reality that had gripped the ABS market by the time it finally collapsed and fell to earth in 2008. The court documents state that the bankers’ hopes for multi-million dollar year-end bonuses were what drove them, along with a highly coveted promotion in Serageldin’s case. He did, indeed, earn $7.27 million in salary and other compensation in 2007.
Episodes such as this will therefore only underscore the urgent need to address incentive structures in bankers’ pay.