J.P. Morgan Is Dead And So Are A Bunch Of Presidents

Amir Efrati, Susan Pulliam, Serena Ng and Aaron Lucchetti at the Wall Street Journal:

U.S. prosecutors are investigating whether Morgan Stanley misled investors about mortgage-derivatives deals it helped design and sometimes bet against, people familiar with the matter said, in a step that intensifies Washington’s scrutiny of Wall Street in the wake of the financial crisis.

Morgan Stanley arranged and marketed to investors pools of bond-related investments called collateralized-debt obligations, or CDOs, and its trading desk at times placed bets that their value would fall, traders said. Investigators are examining, among other things, whether Morgan Stanley made proper representations about its roles.

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 said. Morgan Stanley helped design the deals and bet against them but didn’t market them to clients. Traders called them the “Dead Presidents” deals.

The probe is at a preliminary stage. Bringing criminal cases involving complex Wall Street deals is a huge challenge for prosecutors. The government must prove beyond a reasonable doubt that a firm or its employees knowingly misled investors, a high bar. The government launches many criminal investigations that end without any charges being filed.

Tracy Alloway at Financial Times:

If those deals sound familiar to you it’s because, well, they should.

In addition to being named after the US’s only bachelor and duelling presidents, respectively, they also made a cameo appearance — along with Goldman Sachs’ Abacus deal — in a December New York Times article. From “Banks Bundled Bad Debt, Bet Against It and Won” :

Banks also set up ever more complex deals that favored those betting against C.D.O.’s. 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.

Felix Salmon:

I’d love to know more about this feature. I’m not looking for a quick one-sentence summary which can be dropped into a newspaper article, but a detailed explanation of exactly what it was and how it worked. Does anybody have offering documents from Citi or UBS for these deals which might include such a thing?

I think this shows the limitations of print-based journalism, and the long way we have yet to go before newspapers fully embrace the web. Both the WSJ and the NYT give the impression that they have seen and understood the structures in question, and that they’re simply summarizing them in order to make their stories easier to read for a broad audience. That’s fine — but once you’ve done that, do please give the full details online to finance geeks who want to understand the deals on a finer-grained level.

There were lots of synthetic CDOs structured and sold at the end of the subprime boom, but the ones being singled out by regulators and prosecutors seem to be the unusual ones — first the Goldman deal which was created at the behest of John Paulson, and now the Morgan Stanley deal with this mysterious embedded structure. It would be a great service if the news media, rather than just trying to report the news, also published primary documents and full details of what they’re writing about, so the rest of us can come to our own conclusions.

Naked Capitalism:

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.

Charlie Gasparino at Fox News:

As of today, neither Citi, Deutsche Bank nor Morgan Stanley have received so-called Wells Notices issued to either firm. A Wells Notice indicates that the commission’s enforcement staff is recommending to the full commission that the firms should be charged with civil securities fraud.

That said, people with knowledge of the matter say the probes are ongoing.

The SEC’s increased interest would also signal that the Justice Department’s probe of the sale of CDOs is actually wider than the two firms in the news as preliminary targets of federal prosecutors, Goldman Sachs and Morgan Stanley. The SEC regularly refers to the Justice Department cases which it considers significant.

The wider interest by the government increases the chances that Wall Street and federal officials may ultimately reach a “global settlement” with the securities industry as it finds a pattern of allegedly improper conduct in the sale of these so-called structured products. In such a settlement, each firm will pay a fine based on the level of alleged misconduct.

The SEC declined to comment on possible investigations into Morgan Stanley, Citi and Deutsche Bank. The banks also declined to comment.

The last high-profile global settlement was crafted by former New York Attorney General Eliot Spitzer and the SEC over Wall Street’s use of fraudulent stock research to entice small investors into buying Internet stocks, many of which went bust or declined significantly in value during the 2000-2001 collapse of the technology market.

In addition to all the big firms settling the matter with the SEC and Spitzer, two prominent stock analysts, Henry Blodget, formerly of Merrill Lynch, and Jack Grubman, formerly of Citigroup, were also charged and banned from the securities industry. Sources say Grubman is a telecommunications industry consultant, while Blodget has re-emerged as a journalist.

Tiernan Ray at Barron’s:

Shares of Morgan Stanley (MS) are off $1.36, or 5%, at $27.02 following the front page story in The Wall Street Journal by Amir Efrati, Susan Pulliam, Serena Ng, and Aaron Lucchetti that the firm is being investigated by federal prosecutors regarding its mortgage-backed derivatives contracts, citing anonymous sources.

Morgan Stanley says that it didn’t misrepresent its position in the collateralized debt obligations, known as the “dead presidents,” even though it bet against some of them, according to the authors.

In an online update of the story, MS CEO James Gorman at a press conference in Tokyo stated tjat the firm has not been contacted by the justice department and has no knowledge of an investigation, the authors write.

Colin Barr at Street Sweep:

The investment bank’s stock sank early Wednesday on reports that it was facing a probe of its dealings in subprime-related debt. The Securities and Exchange Commission sued Goldman Sachs (GS) last month over its handling of a similar deal, known as a collateralized debt obligation, and investors have since been on the lookout for the next bank to face a federal investigation of bubble-era shenanigans.

The thought that Morgan Stanley (MS) might be the next to face the music seemed likely, given a jump this morning in the cost of insuring against a default on the firm’s debt. The annual price of buying protection on Morgan bonds rose 8% in morning trading to $206,000 per $10 million of five-year debt, according to CMA.

But the firm’s assertion that it hasn’t been contacted by the Justice Department seems to have won the day. By the end of the day, Morgan Stanley shares were down just 2% and its credit default swap spreads were actually a bit narrower than they were at the end of the day Tuesday, indicating that there is less of a perceived risk for Chairman John Mack (right) and company.

With the stock trading near book value and everyone expecting additional scrutiny of questionable trades, it will take more than a mere report of a probe to move the needle. “We think downside potential is relatively limited from current levels,” Citi analyst Keith Horowitz wrote Wednesday morning. He rates Morgan Stanley hold.

That makes sense, for the moment. But given the backlash against the banks and the extent of bubble-era envelope-pushing on Wall Street, “hold onto your seats” might be the more apt rating for the big banks.


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