Special Report: For some people, CDOs aren't a four-letter word

NEWARK, Delaware Thu May 27, 2010 11:17am EDT

Donald Puglosi is seen in a handout photo. REUTERS/University of Delaware/Handout

Donald Puglosi is seen in a handout photo.

Credit: Reuters/University of Delaware/Handout

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NEWARK, Delaware (Reuters) - Collateralized debt obligations are as hard to love as they are to fathom. The scourge of the financial world, these complex subprime mortgage-linked securities caused hundreds of billions of dollars in losses for banks, hedge funds and insurers.

But CDOs have been very good to Donald Puglisi, a retired University of Delaware finance professor who remains fond of them. In fact, he and others are still making decent money from the bundled securities, even though Wall Street long ago stopped churning out new ones and most of the existing 2,000 odd deals have lost half their value.

Some financial experts chalk it up as just one more only-on-Wall Street absurdity of the worst financial crisis since the Great Depression.

Puglisi, a 64-year-old grandfather who left teaching a decade ago, serves as the sole independent director on the Delaware-based corporations behind more than 200 mostly subprime-backed CDOs. And for every deal, Puglisi still collects a modest annual fee of several thousand dollars for reviewing and signing the initial transaction documents and continuing to handle mostly routine clerical matters.

He pockets those annual fees -- which structured finance experts say can range from as little as $2,000 to as much as $10,000 -- as long as a CDO hasn't been dissolved and is still generating cash flows from the underlying mortgage-related assets. And fortunately for Puglisi, most of the deals he's been involved in are still ticking, although some are on life support.

Puglisi won't discuss his CDO earning power. But using the most conservative back of envelope calculation he is taking in at least $400,000 in director's fees. And that doesn't include any fees he's collecting on the more than 100 CLOs -- collateralized loan obligations -- he services in a similar capacity.

In the United States, Puglisi just may be the dean of CDOs -- he figures he has served as an independent director on more of these mortgage-linked securities than any other person and most in the industry don't dispute the claim.

But as jobs go it is not nearly as taxing or time-consuming as the title might imply. That's because in the world of structured finance, independent directors are like the Wall Street equivalent of a notary public, with no real power or authority over deals they get involved in.

In light of that limited role, independent directors like Puglisi have managed to walk away largely unscathed by the damage unleashed by collapse of the CDO market on the world financial system. And they continue to draw their fees.

In all, with some 2,300 CDOs issued during the height of the subprime lending craze, independent directors as a group have raked in millions of dollars in fees, said several people familiar with the structured finance industry. To make a killing, these experts said, volume is the name of the game for anyone working as an independent director.

That's why you'll find Puglisi's name on so many CDO prospectuses, including ones underwritten by Goldman Sachs Group and Morgan Stanley, including a Goldman deal U.S. securities regulators have filed a civil fraud suit over.

It's this potential for independent directors to keep collecting fees on deals that have seriously soured that is prompting some to question whether the position ultimately serves any real purpose. One U.S. judge has even raised questions about the credentials of some of the people who serve as independent directors.

"Currently independent directors do not seem to have a meaningful role as a gatekeeper," and they do not serve as a "fiduciary with respect to the underlying quality of the investment," said Jill Fisch, a University of Pennsylvania Law School professor, who specializes in corporations.

In light of those limitations, she said one could rightly ask, "Why not just get rid of them?"

IN THE DEAN'S OFFICE

On a recent warm day in May, Puglisi, dressed casually in shorts, sneakers and a short-sleeve shirt, made no apologies for making money off badly tarnished securities that have become synonymous with big bank write-downs.

Seated in a chair in his small office in Newark, Delaware, a lively college town, Puglisi still sounds a little bit like a believer in the financial alchemy that Wall Street banks used to turn subprime mortgages into supposedly Triple A-rated securities.

"I don't think the CDO market caused the crash in housing prices or the mortgage market," said Puglisi, whose four-person shop, Puglisi and Associates, serves as an independent director to roughly 500 Delaware-based structured finance companies. "The deterioration in the housing and mortgage markets would have happened even if there had never been a CDO market."

In light of the meltdown in the CDO market, there's been some talk in the structured finance world of giving independent directors the authority to keep check on the bankers that construct these complex transactions. But experts say any move to empower independent directors is probably easier said than done.

"If you require independent directors to take on more responsibility or make them liable for the performance of a security, you may have a hard time getting anyone to take the job," said Kingman Penniman, president of KDP Asset Management, a bond manager and research firm.

Wall Street bankers and other structured finance proponents maintain that if independent directors were permitted to second-guess deals, it would only further delay a rebound in securitization, making it harder for companies and consumers to obtain credit.

In a typical securitization, a company, or special purpose entity, is set-up by a bank as the legal issuer of bonds backed by a pool of mortgages, credit card loans and other assets. The independent director's main job is to make sure the SPE issuing the bonds operates within its narrow legal charter and determine when it is appropriate for a company to be placed into bankruptcy.

But independent directors play no role in picking the underlying assets that back the bonds, nor do the directors have any authority over the firms hired to manage the portfolio.

"Independent directors are basically there just as a rubber stamp," said Janet Tavakoli, a Chicago-based structured finance consultant.

Puglisi, for instance, was the independent director on the U.S. based entity involved in the 2007 Abacus CDO deal that has become the focal point of a U.S. Securities and Exchange Commission civil fraud lawsuit against Goldman Sachs. He also was the independent director on a CDO called Timberwolf, another Goldman-managed CDO that a former Wall Street executive famously described as "one shitty deal" in a private email.

In the Goldman lawsuit, there's nothing to indicate the SEC ever focused on Puglisi's role in the transaction. And structured finance experts said that's not surprising given the largely administrative role independent directors play.

"They are basically paper pushers," said Arturo Cifuentes, a former CDO analyst, now teaching finance at the University of Chile.

CDO CRED

Of course, Puglisi is by no means the only one to reap the benefits of the structured finance gravy train.

Giant corporate registration firms Corporation Service Company Inc. and CT Corp, a division of Wolters Kluwer, also have a lot at stake in preserving the largely passive role of the independent director.

CSC and CT long have dominated the business of helping businesses incorporate in Delaware in order to take advantage of the state's management-friendly laws and courts. In recent years, the two companies have moved aggressively to provide independent directors to serve on hundreds of specialized trusts and other SPEs.

On its website, CSC describes itself as "a national leader in Independent Director Services." Yet last year U.S. Bankruptcy Judge Allan Gropper voiced some concern about the credentials and background of some of the people CSC uses as independent directors.

Gropper, who is presiding over the General Growth Properties Inc (GGP.N) bankruptcy case, caused a bit of stir in the structured finance world when he upheld a decision by the operators of the bankrupt real estate investment trust to oust dozens of independent directors that CSC had tapped to sit on around 150 real estate-related special trusts. The operators of the regional shopping mall company wanted to replace the CSC managers because they wanted SPE directors with more expertise in preparation for General Growth's eventual bankruptcy filing.

In siding with General Growth, the judge wrote: "It does not appear these managers had any expertise in the real estate business ... CSC supplies these directors in the same fashion as it provides filing and other ministerial services for corporations."

A CSC lawyer disputes the notion that its directors are any less qualified than those working for other firms.

"We take our fiduciary duties very seriously. We don't just roll over," said CSC assistant general counsel Andrea Unterberger. "We serve the needs of our clients and pick the appropriate individual to meet their needs."

Meanwhile, in the Cayman Islands, where the vast majority of CDOs originated in order to take advantage of the Caribbean nation's favorable tax laws, an affiliate of the law firm Maples and Calder serves as an independent director on hundreds of mortgage-linked securities. The law firm said most of the independent directors it appoints are lawyers and accountants.

In fact, there's been a good deal of overlap on CDO deals between the Maples firm and Puglisi. On many deals that Puglisi is serving as an independent director for a Delaware-based CDO company, representatives from Maples are the independent directors for a closely-related Cayman's based company.

The dual CDO structure was used by many banks to make it easier for U.S. institutions to invest in nominally offshore deals.

"Ultimately it is up to the investors to decide if they want directors to do more and that will come at a cost to the deal," said Alasdair Robertson, a Maples and Calder partner. "If you want more oversight from independent directors, it will cost more in fees."

For his part, Puglisi said he would welcome any move to give independent directors more authority. Puglisi said his more than three decades of teaching finance at the university level and over 25 years experience of work on structured finance deals puts him in good stead to take on any added responsibility.

"This is what I've been doing most of my adult life," he said.

(Reporting by Matthew Goldstein; editing by Jim Impoco and Claudia Parsons)

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