The lack of disclosure as to who is really doing what to whom is troubling, as is the BSAM/Credit Suisse deal you outlined. As you said, there is no reason on the surface to suspect something amiss. This may indeed simply be risk reduction on BSAM’s part. But it seems an awfully costly and convoluted way to go about it, which makes me wonder as to whether there were other motivations: changing the timing of income recognition? changing the characterization of income from interest to principal, or vice versa?

It’s very late at night, so I’m not up right now to pondering what might have been at work here. But you have given me some very useful food for thought. Thanks again!

A point that seems missing, here and in other discussions, however:

Often the buyers of the riskier tranches (whether equity or the lowest rated bond tranches) in a new asset-backed deal are an insider rather than a third-party investor.

That is, the typical presentation is that the Investment Bank has assembled a pool of collateral (or is offering to act as counterparty re a “synthetic” pool). And has scoured the world for third-party investors to buy the bond tranches issued re that pool. (Or perhaps assembled the pool to begin with because such an arm’s-length investor came to the bank looking for a finely tailored investment. Whatever.)

So the Bank assembles the pool and gets the deal on its feet. And hires a Portfolio Manager to manage the pool of collateral (or to monitor the pool in a synthetic) as the deal moves thru time.

So in the public presentation of the deal, the three main parties are the agent Bank, the Portfolio Manager, and the Investor.

But often — and MORE often than not across the past five years or so in my experience (drafting such deals on wall street) — the Investor in the riskier tranches is actually the Portfolio Manager or even the Bank.

For example. An insurance company is pushing regulatory limits on investments characterized as “debt”, whether due to under-performance of such debt or regulatory change or simply bad management.

So it goes to an investment bank, which offers to repackage say $500 million in bonds (perhaps a mix of basic corporate bonds and asset-backed securities like the mortgage-backed bonds that are troubling Bear Stearns) that the insurance company owns as a new CDO (collaterized debt obligation) bond to be sold to the public.

But it turns out that the Portfolio Manager is an affiliate/subsidiary of the Insurance Company.

And when the dust settles at closing it turns out that the low-end tranches of the new CDO are owned by an affliate/subsidiary of the insurance company. Perhaps the Portfolio Manager itself.

Or perhaps the BBB- tranche is bought by the Portfolio Manager and the Bank itself holds the equity piece.

So the net effect is that the insurance company’s books are $500 million lighter in the old debt instruments. But the riskier portion of that disposed pool is still backstopped by the insurance company and on the books as, say, $30 million in a BBB- rated tranche of the new CDO.

Almost all the deals I’ve worked on across the past several years were like this. And often the insider aspects were NOT divulged up front by the bank to the law firms drafting all the paper.

And, to return to the example: Whether the regulators of the insurance company realize the insider aspects — or, rather, just notate the new investments as $30 million BBB- and feel happy because the net load is down $470 million … Is a question.

I worked on a Bear Stearns High Grade deal in late 2005 like this.

The bank (Credit Suisse) presented the deal to the law firms as a typical arm’s-length investment vehicle, a synthetic CDO. And hired Bear Stearns Asset Management (the entity in the headlines the past few weeks) as the Portfolio Manager.

But as closing drew near we were informed that BSAM was buying ALL the tranches — buying the whole deal.

And then a dexterous drafter discovered that the “synthetic” pool was actually the portfolio of one of Bear’s High Grade funds. (I can’t recall which one — there are many.)

So the net effect of the deal was a huge credit default swap (via the swap provisions of the synthetic CDO — the heart of the deal) on the entire Bear pool. Which Credit Suisse was acting as backstop counterparty. No third-party investors at all. Just the Bank offering to “insure” the Bear portfolio for its closing fees and the tidbit “premiums” paid to the bank as counterparty across time. And meanwhile Bear drew the coupon interst on the tranches so long as the pool performed well.

I’m not saying there is obviously something wrong here. Just that the public presentation of the deal — even to the lawyers who crafted it — was not the economic reality of the deal.

Economic reality: Bear was feeling at risk, and Credit Suisse for a pound of flesh was willing to share some of the risk. That was the entire deal. No public investment.