In June 2006, a year before the subprime mortgage market collapsed, Morgan Stanley created a cluster of investments doomed to fail even if default rates stayed low -- then bet against its concoction.
Known as the Baldwin deals, the $167 million of synthetic collateralized debt obligations had an unusual feature, according to sales documents. Rather than curtailing their bets on mortgage bonds as the underlying home loans paid down, the CDOs kept wagering as if the risk hadn’t changed. That left Baldwin investors facing losses on a modest rise in U.S. housing foreclosures, while Morgan Stanley was positioned to gain.
“I can’t imagine anybody would take that bet knowingly,” said Thomas Adams, a former executive at bond insurers Ambac Financial Group Inc. and FGIC Corp. who is now a partner at New York-based law firm Paykin Krieg & Adams LLP. “You’re overriding the natural process of risk-mitigation.”
Morgan Stanley and rivals remain embroiled in a Securities and Exchange Commission probe, started at least a year ago, that’s examining whether Wall Street misled investors when selling mortgage-linked securities.
The agency has been looking for abuse “across the spectrum,” enforcement chief Robert Khuzami said April 16, when the SEC sued Goldman Sachs Group Inc., accusing the firm of fraud in the sale of a CDO. While federal prosecutors are also scrutinizing the market, Morgan Stanley isn’t the subject of a formal criminal investigation, according to a person familiar with the government’s review.
SEC spokesman John Nester declined to comment on Morgan Stanley’s CDOs. Mark Lake, a spokesman for the firm, also said he couldn’t comment.
Baldwin CDOs shared their atypical structure with an earlier series of Morgan Stanley CDOs called ABSpoke and two groups of deals, named after U.S. presidents, later sold by other banks, according to offering documents.
The feature meant investors could lose big even if subprime defaults stayed near historical averages and didn’t jump to record levels, said Adams, who worked in structured-finance divisions at Ambac and FGIC. Since June 2006, the share of subprime loans that are delinquent, in foreclosure or have been turned into seized properties has more than quintupled to almost 45 percent, according to data compiled by Bloomberg.
Morgan Stanley disclosed the quirk on page 61 of a 98-page offering circular for a vehicle used to sell $18 million of its Baldwin 2006-III Segregated Portfolio.
Some investors decided to bet against the bonds instead of buying them. Two mutual funds run by Pacific Investment Management Co. LLC entered into $6 million of bets against Baldwin notes through credit-default swaps as early as September 2006, according to a securities filing.
Morgan Stanley created the Baldwin CDOs in June 2006, according to Bloomberg data. The bank was the underwriter and said in offering documents that asset manager GSC Group would select the mortgage bonds referenced by the transactions.
Alex Wright, a managing director at Florham Park, New Jersey-based GSC Group, declined to comment, saying that “the team that managed those isn’t here any longer.”
In its suit against Goldman Sachs, which the bank called unfounded, the SEC said that disclosures about the selection of collateral were insufficient.
The Baldwin 2006-III securities, which pay 0.75 percentage point more than the three-month London interbank offered rate, were originally granted Moody’s Investors Service’s fourth- highest credit rating. Last April the ranking was cut to the firm’s lowest, given to debt “typically in default, with little prospect for recovery of principal or interest.”
The investors in Baldwin 2006-III would start losing money if only $235 million of the $2.3 billion portfolio of mortgage bonds it referenced went sour, according to the offering document. They’d get wiped out after $18 million more of losses.
It’s unclear what percentage of Baldwin notes were placed with investors or retained by Morgan Stanley. At least $15 million of Baldwin was bought by a CDO underwritten by Merrill Lynch & Co. in September 2006, according to data compiled by RBS Securities Inc.
The same structural quirk was also found in at least $500 million of ABSpoke CDOs that the bank created from February 2005 through April 2006, according to offering documents and Bloomberg data. Those CDOs, as well as the Baldwin deals, sold credit-default swap protection on mortgage bonds to Morgan Stanley, the documents show. Such swaps pay off if the underlying securities don’t.
The deals named after U.S. presidents Andrew Jackson and James Buchanan Jr. had a similar feature.
Morgan Stanley held a short position and profited on the Baldwin, Jackson and Buchanan deals, according to a person familiar with the transactions.
Citigroup Inc. underwrote more than $300 million of Jackson CDOs in August and September of 2006, Bloomberg data show. UBS AG was underwriter on about $201 million of Buchanan CDOs beginning in October 2006, according to data compiled by Bloomberg and Moody’s. The banks were the initial buyers of protection from the CDOs, the documents show.
Mortgage-backed securities are created by pooling loans and then slicing them into debt with varying risks. Mortgage-bond CDOs do the same thing a second time with pools of those securities. Synthetic CDOs are filled with side bets on mortgage bonds, not actual debt.
Subprime-mortgage bonds are typically structured so that ones with higher ratings get some protection against loan defaults through a feature called triggers. None of the principal on debt ranked BBB+ or lower is usually returned for the first three years, ensuring more-senior classes get paid down more quickly.
After three years, if losses and delinquencies are low enough, some of the cash held in reserve accounts may be paid out to unrated and junk-rated classes, reducing the amount of protection for higher-ranked BBB+ through BBB- tranches. At the same time, those subordinated BBB-rated investment-grade classes begin to get paid down.
The credit-default swaps typically shrink at the same pace as the mortgage bonds they reference. With the Baldwin, ABSpoke, Buchanan and Jackson CDOs, the swaps on those BBB rated tranches remain the same until the debt gets reduced to 20 percent of its original size, according to offering documents.
That meant if defaults wiped out only the last 21 percent of a BBB bond, investors still would suffer 100 percent losses on the CDO’s bets. In return, they received higher premiums than they would have if the portfolio had shrunk.
“Part of the bet when you’re investing in a sub bond is that you’re going to get at least some of your principal back before all of your losses come in,” Adams said.
The Morgan Stanley deals were among bets on the subprime market made by former trader Howard L. Hubler that turned against him, according to two people familiar with the matter and Michael Lewis’s book “The Big Short” (W.W. Norton & Co.).
The wagers were overwhelmed after Hubler’s group took on the risk of $16 billion of AAA-rated slices of CDOs to provide the cash to pay for the insurance it was buying, according to the book. The bank reported the consequences with $7.8 billion in subprime-related losses in the fourth quarter of 2007.
“Virtually all writedowns this quarter were the result of trading by a single desk in our mortgage business,” Chairman John Mack said on a Dec. 18, 2007, conference call.
Hubler declined to comment, according to Greg Miller, a spokesman for Loan Value Group LLC, where he is chief executive officer. The Rumson, New Jersey-based firm sells a strategy meant to discourage homeowners from walking away from property where their debt exceeds the value, and related services.
One security referenced by Buchanan 2006-1 was part of a 2005 securitization of New Century Financial Corp. subprime loans underwritten by Goldman Sachs. The credit support for that security -- how much could be lost on the underlying loans before it loses principal -- began at 4 percent, Bloomberg data show.
Today, the security has been 67 percent paid off, meaning an investor who bought the bond has received that amount. Buchanan’s investors haven’t received that payoff and stand to be wiped out on the CDO’s wager, which remains at 100 percent of its original size. The support for the remaining 33 percent of the bond is now 2.1 percent, compared with 34 percent of the underlying loans being more than 60 days late.
Cumulative losses on subprime loans in 2003 and 2004 securities, made before lending standards loosened and home prices stopped soaring, so far total 1.7 percent and 3.1 percent, respectively, according to data compiled by Bethesda, Maryland-based Five Bridges Advisors LLC.
Even with the best subprime-loan pools, the last bit of mortgages is likely to “be just crappy houses, crappy loans,” because better borrowers will more quickly refinance or move, said Howard Hill, a former Babson Capital Management LLC executive who helped start securitization-related departments at four banks.
“It’s adverse selection writ large,” Hill said.