naked capitalism

The Wall Street Journal reports that Morgan Stanley is under investigation for allegedly creating CDOs it used to wager against clients:

Among the deals that have been scrutinized are two named after U.S. Presidents James Buchanan and Andrew Jackson, a person familiar with the matter says. Morgan Stanley helped design the deals and bet against them, but didn’t market them to clients. Traders called them the “Dead Presidents” deals….

Among the Morgan Stanley deals that have been scrutinized are the Jackson and Buchanan CDOs, created in mid-2006. Those deals essentially were portfolios of derivatives that aped the performance of dozens of residential and commercial mortgage-backed securities. Morgan Stanley helped to create the deals, which each issued about $200 million in bonds and were underwritten and marketed to investors by Citigroup Inc. and UBS AG, respectively….

One feature of the Morgan Stanley deals was a structure that could increase the magnitude of the bullish investors’ exposures to the underlying mortgage bonds. This feature, which was disclosed in some offering documents, made it more likely that such investors could lose money if the underlying bonds performed poorly.

Morgan Stanley traders took the more profitable, bearish side of these transactions, according to traders. These positions weren’t disclosed in some deals. It couldn’t be determined how much money Morgan Stanley made with these wagers…

There have been several rounds of SEC subpoenas issued in the probe, a person familiar with the matter says. Last summer, the SEC asked Wall Street firms about any of their clients that were betting against CDOs, the person says. In the fall, Morgan Stanley provided offering documents to the SEC about CDOs, including its Dead Presidents deals. Morgan Stanley, among other firms, received a subpoena in December 2009 asking about its sale and marketing of CDOs, people familiar with the matter say.

Yves here. To give an idea how difficult it is to investigate bad practices in the CDO market, we had been told about the dead President deals (and a similar program by Citigroup) but were not able to find the offering documents through our normal research avenues. It is likely going to take continued investigation by prosecutors and lawsuits from private parties to unearth a good bit of what happened in this market.
Update 1:00 AM: From one of our CDO sources via an old e-mail:

And if anyone wants to do the digging, MS and C had their own mini-ABACUS programs as well. The MS deals were all named after US presidents and the C deals were all named “Franklin” I believe.

Another source just wrote us:

I did see a couple of deals with the long short feature described in the articles. Of course, these were marketed as a way for investors to get the benefit of a more bearish bet on the housing market.

The theory was that the CDO manager would use CDS to go short some portion of the MBS market as a hedge on the bullish bet. Usually the short bucket was limited to about 10% of the deal. This is consistent with the way senior bonds were marketed to investors (and insurers) in 2007 – by taking the top class, the investors were supposed to be making a conservative investment, remote from any mortgage credit risk, as opposed to investing at a more risk sensitive BBB level.

Wouldn’t it be ironic if this feature was put in so the equity could get a further leveraged short bet while the senior investors ended up with the long side.

It was not uncommon for prop desks to hire a different investment bank to be the lead on their deals. I came across that a couple of times with Morgan Stanley, in fact. It was pretty confusing, since the people at Morgan who were supposedly on the prop desk were the same people who you’d talk to on deals where they were acting as the lead banker for a deal. Even though they hired a third party lead bank for their prop deals, the individuals at the prop desk would still act like they were the bankers on the deals.

Finally, I am pretty confident that there is a direct connection between the mortgage deals that Morgan Stanley was trying to originate and sell and the bonds that went into these CDOs. The opportunity for manipulating the pricing on the mortgage deals would have been significant. By manipulating the price of the sub bonds on the mortgage deals, they could have influenced the pricing on the senior bonds of the mortgage deals that were going to real cash investors – especially the GSEs.

In this scenario, the investment bank brings a mortgage deal with loans they bought or originated. Their own CDO buys the sub bonds at artificially low prices. They place the sub bonds of the CDO into another CDO for which the investment bank is the warehouse provider, so they set the price on the CDO sub bonds at an artificially low level. The super senior of the CDO goes off to a bond insurer, and so the price is never disclosed or really tested in the market either.

In such an opaque market, there is a lot of bad stuff that could have gone on.

He also reminded me that another member our team, Andrew Dittmer, had found a Gretchen Morgenson mention of the Morgan Stanley transactions in her December 24 article, but like the Wall Street Journal story, lacking specific deal names and amounts:

Morgan Stanley established a series of C.D.O.’s named after United States presidents (Buchanan and Jackson) with an unusual feature: short-sellers could lock in very cheap bets against mortgages, even beyond the life of the mortgage bonds. It was akin to allowing someone paying a low insurance premium for coverage on one automobile to pay the same on another one even if premiums over all had increased because of high accident rates.

Given that the Wall Street Journal story indicated that Morgan Stanley received a subpoena about these transactions in December 2009, one has to wonder whether Morgenson was a recipient of a leak from a Department of Justice or SEC contact, and whether those parties might have been using the media to influence the decision-making within their own agency, as in to increase the public profile of these deals to create more support for going ahead.