The news is out. US prosecutors are investigating several Morgan Stanley CDOs. Like the Abacus inquiry at Goldman Sachs, the issue is what representations Morgan Stanley made to clients. How did the bank market those Weapons of Money Destruction? Here’s what The Wall Street Journal reports:
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.
So without further ado, I’d like to shout out to my friends at Morgan Stanley. I give you Little Walter and Dead Presidents:
I have no idea what Morgan Stanley said to its customers. But one thing is clear. The bank had no special insight into the collapse of sub-prime mortgages. Morgan Stanley lost $9 billion on mortgage bets during 2007.
In The Big Short, Michael Lewis explains the loss. Morgan Stanley bet against the worst sub-prime mortgages it could find. (I’m not sure whether these deals included the dead-president CDOs now under investigation.) To make this bet, the bank purchased credit default swaps—which required massive capital outlays every year in the same way that insurance policies require annual premium payments.
Then, Morgan Stanley invested in the “safest” tranches of CDOs. In theory interest income from “safe” investments would fund payments on the credit default swaps, the negative bets. At the time, it seemed like a reasonable theory. Uh-oh. There was one problem. Most sub-prime investments tanked during 2007—even the securities thought to be safe.
Details from the Morgan Stanley investigation have yet to emerge. But how can you accuse a firm of duping clients when that firm, in essence, made the same investment mistake as its clients?
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