Just How Rotten Were Morgan Stanley’s Mortgage Deals?

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James Buchanan: Past President, Toxic Deal

Eh tu, Morgan Stanley? The Wall Street Journal is reporting this morning that the Securities and Exchange Commission is looking into whether Morgan Stanley, too, broke securities laws when it structured mortgage securities and then made money by betting against them. The SEC already has brought a similar case against Goldman.
But this really shouldn’t come as any surprise to anyone. Every major firm on Wall Street had a hand in structuring a Goldman-like deal. In my story a few weeks ago about the SEC’s case against Goldman I said that these bogus mortgage deals became common on Wall Street.
Morgan Stanley had the so-called dead-Presidents deals, named Buchanan and Jackson. Another Morgan deal, one called Libertas, defrauded investors in the U.S. Virgin Islands, according to a lawsuit. JPMorgan Chase played procurer for Magnetar, a hedge fund so artful in profiting from the meltdown that Northwestern’s Kellogg School of Management praised it last year in a case study. A firm run by Lewis Sachs, until recently a top Treasury Department adviser, and UBS, until recently a tax-cheat favorite, created junky bonds that investors who bought them now claim were going bad even before the deals were closed. Bank of America too is being sued for a deal that was set up by its Merrill Lynch subsidiary with a manager who is now under investigation by the SEC.
Here’s what the Journal had to say this morning:
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.
Even before the SEC sued Goldman, people had identified Morgan Stanley’s “Dead Presidents” as particularly troubling. According to an early 2008 profile of hedge fund manager Kyle Bass in Dallas’ D Magazine, Bass tried in September 2007 to tell a top Moody’s official that he thought Moody’s and Wall Street had broken their client’s trust and potentially the law with the “Dead President” deals.
So Bass never got to warn Moody’s about the “Dead President” CDOs, a series of investment vehicles concocted by the property group at one of America’s largest financial services firms—though Bass declines to name the firm. Each CDO was named for a deceased U.S. commander in chief, and they were all doomed to fail. Like a two-headed coin, a Dead President gave little chance to whoever bet “tails” on the other end of the transaction. Moody’s approved them anyway, because the agency wasn’t astute enough to spot the tricks hidden in various provisions. (For history buffs, the most devious Dead President CDO, according to Bass, was called “Buchanan.”) Bass calls the whole caper a billion-dollar fraud, as yet unpublicized.
“It was bad, but it’s so complex that you couldn’t possibly write about it,” Bass says. “The Journal couldn’t even write about it. That’s how complex it is. It would take teams of lawyers reading indentures, complex flow charts. And then people would look at you with cross-eyes, even if you understood it all. They’d go like, ‘Yeah, well, I don’t see it.’ ”
The question is who is really in trouble here. Besides being more complicated, the Dead Presidents deals are different than the one Goldman structured with hedge fund manager John Paulson. In that case, Paulson picked the bonds that went into the doomed CDO, and then Goldman sold the CDO to investors. Paulson then bet against the CDO, called Abacus. The SEC is suing Goldman because it didn’t disclose to investors that Paulson, a housing market bear, had picked the bonds. In the case of the Dead Presidents, Morgan Stanley picked the bonds that went into the CDOs and then bet against the deals. But, unlike Goldman, it didn’t sell the deals to investors. Instead, it hired Citigroup and UBS to do that part of the dirty work. So it might actually be one of those two firms that are in hot water with the SEC, since they would have had the duty to disclose, and not Morgan. Either way, it is clear that this is not the last we have heard from the SEC on Wall Street’s rotten mortgage machine.