Morgan Stanley Under Criminal Investigation for Using CDOs to Bet Against Clients

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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.

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  1. ndk

    Took ’em long enough. I wondered when they’d finally get some revenge after Steve Roach kept fighting their efforts to get the RMB valuation changed. I thought they’d come after MS first, to be honest.

    1. MindTheGAAP

      I wonder how much pressure this puts on the other Financials? The government has been too aggressive towards them be able to settle everything now and save face. I don’t know how this one against MS ends up, but I think it puts GS more under the gun (and Jamie Dimon, you’ll notice, has shut up ever since the SEC announced a charge against Goldman. It might actually be worth having the SEC bring up all sorts of random charges just to keep that guy in his hole..).

      Are there any lawyers here? What are the requirements for RICO? Does filing criminal charges against all the banks for similar things help the government to start applying racketeering charges against all of them?

  2. mindthegaap

    “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.”

    I took the leaks as a way of gauging how popular these ideas are with the public, not within the particular agencies.

    For example, Cramer floated a $2-3bn Goldman settlement, which I took as a trial balloon (probably on Goldman’s behalf, not the SEC’s).

  3. Abhishek

    Till the times are good no wonder cares about the fine lines in the contract.When things turn around everyone wants to put the blame on everyone else.I don’t think these clients of Morgan and Goldman were totally clean either.No doubt that these banks held the biggest information advantage and used it unethically if not illegally.But I don’t think these prosecutions will bring out the whole dirt.At most the regulators will put a nominal fine and the whole game will go on

  4. craazyman

    Didn’t Pres. Obama somewhat famously say in a talk show interview that “no crimes have been committed” by Wall Street?

    I didn’t see that interview and can’t now recall if that was before or after the election, but I think he said something to that effect.

    Maybe he’ll be called as a witness for the defense if it goes that far. Which I would doubt it will. But who knows where it goes when the Id energy is out of the bottle.

  5. Richard Kline

    This is the financial innovation which our elected officials are so determined must retain unfettered, unbrooked, and sacrosant, beyond a little ‘We’re trying, folks’ bunting. What I wonder is when are some of these investigations going to find their way back to the pockets of said elected officials?

    While this story is in the foreground, in the background the Big Four just had a perfect trading quarter; each of them. The game is more rigged than ever: are we going to read in two years’ time how _Q1 09_ was gamed, ‘but nothing criminal’ just as we read these stories? When is our government going to get out in front of these problems and terminate these odious zombies? I get the sense that these investigations are intended to force ‘the bad apples’ out while ‘saving the institutions which make our country great.’ Hey, the faces change but the theft remains the same.

  6. David Wells

    Interesting to note the bet was also against commercial-mortgage backed securities.

  7. Brett

    What we’re going to find is that deals like these and ABACUS were the norm, and the market for products of financial “innovation” and the hedges against them were a significant part of our economic “growth” for the last 10-12 years at least, and that without the mortgage-ABS-CDO-CDS merry-go-round, the US economy remained ominously flat.

    In other words, Greenspan made the markets safe for speculators. It’s about time we learned more just how much o the banks’ business was, and is, driven by a speculative business model, and the extent to which these “banks” were dressed up hedge funds.

    The question remains whether investment “banks,” who are the market for bonds, such as Greece’s, but who are simultaneously shorting the Euro, and whether their hedge fund desks are the main consideration driving their business decisions.

    1. Evelyn Sinclair


      You brought up our ‘economic “growth” for the last 10-12 years.’

      When I found out a few years ago that debt is part of our GDP I was shocked. A friend explained how it is that mortgages are considered somehow part of our domestic “production.”

      That friend recently sent me his estimate that “mortgages alone are 56% of the GDP” but I think they’re more like about 80%, based on the IMF’s chart “Mortgage Debt Outstanding (percent of GDP) ” I found here:

      You can see how the percentage of mortgage debt increases dramatically from 1990 to 2006, nearly doubling from around 40% to nearly 80% of GDP in that time.

      It scares me when people talk about how it’s OK for the US to have some kind of huge deficit because, well look at our nice big GDP! We can have national debt because we’ve individually run up huge debts???

      Still amazed about this. Remembered Paul Krugman said something about how we could afford stimulus spending that was (?)% of GDP and did a Google search. That turned up this:

      “Is GDP Indicative of a Country’s Ability to Pay off Debt?

      “Krugman states, “What you have to bear in mind is that the economy — and hence the federal tax base — is enormous, too. Right now GDP is around $14 trillion.” (added 8/24/09 for clarity).

      “But does GDP really indicate federal tax base? How much does a debtor country’s GDP really say about their financial health? Fifty years ago, GDP included our strong manufacturing base. Today it includes massive government entitlement programs, war, and financial products that provide zero real value to the economy. In 2007 financial services represented 40% of corporate profits in America. Will medicare, social-security, the War on Terror, CDS, and CMBS increase productivity and pay the bills? Hell no. ….”

      (See site for nice charts.)

      What it looks like to me is that you’re right that Groqth of “the economy” has been growth of that big derivatives bubble, and it also looks to me like the “growth” of the GDP was the mortgage bubble.

  8. Lyle

    Naming anything after James Buchanan should be a red flag, he dithered his way into leaving Lincoln with a civil war, and is generally recognized as the worst president. If this is the level of intelligence in MS they deserve to go down. Obviously a fairly uneducated bunch (they may have had a lot of schooling but little of it stuck apparently). Did we have Franklin Pierce or Andrew Johnson CDO’s as well? It seems that if these were designed to shaft the customer, at least in the case of Buchanan they sort of gave the game away.

  9. Paul Repstock

    Yves wrote – 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.-

    Well…What is going to happen? Even if you find the right people to do the investigation, and assuming that they can get access to the evidence…NOTHING!

    We need to build some gallows and start streching a bit of rope.

    Until these people understand that there really are consequences for all the harm they have done and all the lives they have ruined, it will just be business as usual. Look at the Goldman case: they closed ranks around the company. Even the Oracle of Omaha knows where his bread is buttered and probably doesn’t want to be implicated either.

    We cannot play by the rules they have created or perverted and still have any chance of changing things. I’m not preaching revolution, just fundamental change. A system where there is neither the incentive or the opportunity to engage in fraud or breach of trust. We must find a way to stop selling our kid’s futures to finance this circus.

  10. KnotRP

    If the law is ever brought firmly to bear on any of these
    investment companies, they’ll be pre-looted down to the last red stapler by insiders and the stock/bond holders (pensions,
    mutual funds, 410k captives) will be the only ones who pay (yet again) the price for the shennanigans of the insiders.
    Think Enron. Nobody got anything out with anything but a box of momentos, except the insiders.

    But the host is largely being attended to by parasites in medical gowns, so maybe none of this matters any more…feels like we’re headed for an economic reset,
    where everyone starts from zero again.

  11. KnotRP

    I lack the drawing time or skill, so picture this comic:

    Uncle Sam lying on a gurney.
    A doctor and a nurse attend to Sam.

    The doctor is labelled “government” and the nurse is labeled “bankers”, both drawn with mosquito heads on them.

    Government Mosquito says: “Sam’s looking pale, and getting worse”.

    Lobbyist mosquito says: “The Economist Mosquito says
    the bleeding was a good idea,
    but it needs to be bigger to
    save him”

    Government Mosquito says: “Oh goody. I was getting hungry.”

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