Financial Alchemy at Morgan Stanley: Greywolf A3 CDOs now Aaa bonds

Submitted by Edward Harrison of Credit Writedowns.

The Online Merriam-Webster Dictionary describes alchemy as “a power or process of transforming something common into something special” or “aiming to achieve the transmutation of the base metals into gold.”  Well, it seems Morgan Stanley is engaging in some financial alchemy because it is about to trade near-junk rated paper for Aaa gold-standard bonds (hat tip Max Keiser and Stacy Herbert).

Morgan Stanley plans to repackage a downgraded collateralized debt obligation backed by leveraged loans into new securities with AAA ratings in the first transaction of its kind, said two people familiar with the sale.

Morgan Stanley is selling $87.1 million of securities that it expects to receive top AAA ratings and $42.9 million of notes graded Baa2, the second-lowest investment grade by Moody’s Investors Service, according to marketing documents obtained by Bloomberg News. The bonds were created from Greywolf CLO I Ltd., a CDO arranged in January 2007 by Goldman Sachs Group Inc. and managed by Greywolf Capital Management LP, an investment firm based in Purchase, New York.

Here’s the problem.  In June, Moody’s downgraded the Aaa tranche of this CDO six notches to A3 because the default rate for loans in the tranche soared to 7 percent.  So, now, Morgan Stanley has been able to re-package this paper, and…voila this debt is Aaa again.  Everybody’s doing this repackaging.  Goldman plans to sell over $200 million of repackaged Commercial mortgage-backed paper very soon.

So, when earnings start coming in this quarter and you are wondering how these banks aren’t writing down huge losses due to events like this and this, you now have one more reason why.  Here are two more reasons here and here. The question is whether investors will be fooled.

ps. – I am sure Morgan Stanley added credit enhancement, collateral, reduced the poorly performing assets, etc, etc.  But, nevertheless, you have to wonder how this stuff gets a Aaa rating when substantially the same loan pool was just downgraded six notches.


Morgan Stanley Plans to Turn Downgraded Loan CDO Into AAA Bonds – Bloomberg

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About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward


  1. shiloh1862

    I find it hard to believe any entity but another bank will buy this crap.

    Pickdog III

  2. chasd00

    Is Morgan Stanley in the too big to fail camp? If so then why wouldn't investors jump all over the CDO's, after all, they're backed by the full faith and credit of the US.

    Same goes for Goldman Sachs.

  3. Alan

    But, nevertheless, you have to wonder how this stuff gets a Aaa rating when substantially the same loan pool was just downgraded six notches.

    There's still a very large inelastic demand for "investment grade" paper. Leo K can help illuminate where it comes from. So long as that demand exists "Wall Street" will continue to manufacture a supply to meet it.

    Demand will dry up once enough jurisdictions and people figure out that alternate retirement arrangements are needed. Arrangments that intentionally exclude "Wall Street" and its works from the process.

  4. Kid Dynamite

    yeah, but Alan – haven't buyers of AAA paper learned that you can't take A3 ingredients and make AAA results out of them? Wasn't that the most important lesson of the last 18 months?

    i saw this article on bloomberg this morning and expected it to be something from The Onion. I'm shocked that the reporter didn't give so much of a whisper as to how this is any different from what just blew up.

  5. RTD

    Just make the equity tranche a little larger and throw in a CDS, and the result is money good.

    I have an idea, set a standard permissible default rate for every rating category and make ratings agencies liable when the default rate of securities they assign a particular rating exceeds the standard default rate. The shens will stop in a heartbeat.


  6. "DoctoRx"

    It isn't necessarily loony. The average rating remains about the same. This far into the downturn, 93% of the stuff appears to be performing.

    There actually are technical issues with the ratings both on the AAA side and on the downgrade side that make kibitzing from the outside of uncertain accuracy.

  7. Hugh

    Dreck! Dreck! Get your fresh hot dreck right here!

    –Psst! Don't worry, kid. They're so drunk they'll never know that this is the same dreck I couldn't sell last week. Besides it's in shiny new wrappers.–

    Dreck! Dreck! Get your fresh hot dreck right here!

  8. Hugh

    "There's still a very large inelastic demand for "investment grade" paper."

    I'm assuming that inelastic demand is a synonym for "greater fool" and investment grade paper means "crap".

    So I take your point to be that there are still fools out there who would buy this crap. It will be interesting to see if this is true.

  9. 6p011570e9b13c970c

    What's the big deal? They're throwing the bottom part of the originally AAA rated bond to the wolves, so that the top part has higher credit enhancement. Where is the alchemy here?

  10. AmericanGoy

    Haven't we seen this movie before?

    Are there people anywhere in the world stupid enough to fall for this – again?

    Even hicks from some fjord in Norway are too smart for scam this now.

  11. 6p011570e9b13c970c

    Your original bond is AAA and attaches at say, 30%. That is, you start losing money when the losses in the pool are larger than 30%. Now, defaults are already running high, so the agency downgrades the bond.

    So what do you do, you split the AAA bond in two, and the top part now attaches at say, 45%. That is, there is an additional 15% cushion compared to the original bond. Wouldn't you say that this process warrants an upgrade.

    The catch is that the bottom part is now super risky since it's more levered (it's taking most of the risk that was in the larger original tranche despite a much smaller size). But that one is rated what, BBB? And likely to go south as things evolve but that shouldn't be an issue since the paper is likely going to some high octane fast money buyer.

  12. Hugh

    This only makes a certain modicum of sense if you think the real estate market has bottomed out or is near to doing so. I think with all the negatives and uncertainties in the economy that is far from a safe bet. So I think any value or sell price put on the CDO would be highly problematical.

    As for the crap tranche, I can't see this going anywhere but eventually back on to the bank's balance sheet and remaining the toxic waste it is.

  13. Carlosjii

    Transmogrified is a word I always liked – to change in appearance or form, esp. strangely or grotesquely; transform.

  14. Brick

    Yes these have all the hallmarks of REMIC's in that the bonds are split into a risky one with a low rating and high yield which would take much of the first losses and a high rating one with low yield which would be more protected from losses. This works fine so long as things do not deteriorate much and seems to be more about shifting stuff to the FED rather than any return of securitisation. If things do not improve the risky part of the bond will most likely be wiped out and the higher rated bond will see some loses which will wipe out the value of the low yield. You end up with AAA Rated bonds with no real yield and low value, but since the taxpayer will pick up the losses it is not that risky for the bank. If the FED insists on guarantees on value and yield as well as rating I doubt whether this will take off.

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