Buffett, Tavakoli Flag Scheme Bigger Than Madoff’s

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March 5 (Bloomberg) -- Bernard Madoff could face 20 years in jail if convicted of what prosecutors are calling the biggest Ponzi scheme in history. But his $50 billion ploy pales next to the one created by Wall Street during the past decade: the securitization machine.

In “Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street,” Janet Tavakoli explains that securitization process, and how regulators, politicians and the government ignored all kinds of warnings from people who saw it for what it was.

Tavakoli uses her 2005 lunch with billionaire investor Warren Buffett and their ensuing correspondence as the backbone of her analysis of the current financial crisis. Buffett, who read a draft of the book as early as last July, told Tavakoli he would feature it “prominently” at Berkshire Hathaway Inc.’s annual meeting in May.

“I think you’re in for a lot of fun,” Buffett wrote the author in a December e-mail.

Tavakoli, 55, spent 22 years working in the structured- finance departments of Wall Street firms, securitizing mortgages and other loans. She has been the head of her own small advisory firm, Tavakoli Structured Finance Inc., since 2003 and has written books about the mechanics of securitization including collateralized debt obligations, the most infamous of all.

Securitization consists of bundling loans and slicing them into packages with different risk profiles to be sold separately. Collateralized debt obligations take already securitized loans and further bundle them into packages. CDO- squareds do the same process all over again.

How We Got Here

Rating agencies, which were being paid by the investment banks doing the securitization, would smack their best credit grade of AAA on the top tranches of these bundles. Many of those ratings have been cut to junk in the past two years as defaults surged.

Tavakoli doesn’t think the concept of securitization is flawed; she says it was abused by greedy financiers and turned into the monster that led to the collapse of the financial system.

In a telephone interview, the seasoned financial engineer talked about how we got here, and the future of securitization.

Tavakoli: It was a massive Ponzi scheme with many players involved. At times you’d have the CDO manager, an investment bank and a hedge fund involved, all of them knowing they were doing the wrong thing. These people all wanted to get in on the fees, so they all went along with this stuff. Some of the CDO- squareds that came out in 2007 were nothing more than a way of avoiding acknowledging losses. It’s a scandal.

‘It Was Massive’

When you raise money from new investors to pay off old investors -- if you’re an investment bank and you have these rotting loans, and you package them up and feed them to new investors so you can pay your bonuses and dividends -- that’s a Ponzi scheme. By every definition, this is as bad as what Madoff was doing. It was massive, bigger in size.

Onaran: Why didn’t the regulators realize this?

Tavakoli: They were all sleeping -- the Securities and Exchange Commission, the Federal Reserve, the Congress, the Senate banking committee and a number of other people. I wrote the SEC in February 2007, complaining about rating agencies.

In August of 2005, the SEC was investigating Bear Stearns Cos. for mortgage securitization. Then they dropped the matter. The New York attorney general had an investigation and he dropped it too.

‘People Got Greedy’

Onaran: Why did you choose to use your correspondence with Warren Buffett as the peg for your analysis of the crisis -- besides the marketing power of his name, of course?

Tavakoli: I wanted to show that you can prosper in the financial world without ripping off other people. If I just told the story, it would be so darn depressing. But if you do it by comparing it to somebody like Buffett, you see that there’s a sane way to do finance.

The reason we’re in such a mess is that people got greedy. They were using leverage and structured products to hide problems, to make it look as if they were making huge profits when they really weren’t. These banks were paying high bonuses and high dividends on phantom profits.

Warren has always warned about leverage. His shareholder letters are a chronological history of his warnings. I thought maybe they won’t listen if I just talk about these things, but how could you not listen to Warren Buffett?

Onaran: How is the new government handling the problem?

Rewrite Mortgages

Tavakoli: One proposal I do agree with, although you might be surprised, is President Obama’s proposal to rewrite the mortgages. If you had a subprime option-ARM (adjustable rate mortgage), just turn it into a fixed-rate loan. We should redo these mortgages but not help out speculators and the people who bought a bigger house than they could afford.

Onaran: What’s the future of securitization? Will it ever make a comeback?

Tavakoli: What should happen with securitization, if we want to go back to using it as a tool of finance, we might have to bust up some existing securitizations. It might be unprecedented but we’ve already done a lot of unprecedented things.

We have to unwind, just completely rip apart, the CDO- squareds, the CDOs and go right back to the residential mortgage-backed securities but then vet all the loans in the portfolio. You have to do a rigorous statistical sampling of each lot. I would say bust up all the bad securitizations that have been done, then you can really value it, when you go back to the basic loans.

“Dear Mr. Buffett” is published by Wiley (282 pages, $24.95).

To contact the reporter on the story: Yalman Onaran in New York at yonaran@bloomberg.net.

Last Updated: March 5, 2009 08:37 EST