The Latest Investment Bank Scam

The banks just never do quit, do they?

July 8 (Bloomberg) -- Morgan Stanley plans to repackage a downgraded collateralized debt obligation backed by leveraged loans into new securities with AAA ratings in the first transaction of its kind, said two people familiar with the sale.

Morgan Stanley is selling $87.1 million of securities that it expects to receive top AAA ratings and $42.9 million of notes graded Baa2, the second-lowest investment grade by Moody’s Investors Service, according to marketing documents obtained by Bloomberg News. The bonds were created from Greywolf CLO I Ltd., a CDO arranged in January 2007 by Goldman Sachs Group Inc. and managed by Greywolf Capital Management LP, an investment firm based in Purchase, New York.

Let's translate this into english for the less-financially-literate.

We're going to take this trash that was originally rated "AAA" by all the major ratings agencies that we bought the rating from (and paid for it too - booya!), got downgraded, and cost investors millions, and wave our arms around.

Through the magic of re-securitization (while extracting a few more basis points in a second set of fees for ourselves!) we will make this Baa2 (nearly junk) debt back into pristine "AAA" credit once again, according to the bought-and-paid for (again) ratings agencies, and then we will sell it to the same suckers that got ripped off the first time!

The sad part is that they will probably find people who are dumb enough to get screwed not once, but twice, even though the bank has managed to extract a second set of fees from the original credit margin in the deal.

Back to basics folks - when a set of loans are made the true risk-adjusted return is a fixed amount. Every person who touches the deal demands something for their trouble, as nobody works for free.

Therefore the more levels of indirection and complexity are layered on, the lower the total return of the deal has to be, because the fees have to come out of the total income stream.

It cannot be any other way; you cannot create more value than was originally there (claims otherwise are equivalent to claiming to have discovered perpetual motion) and as such there is no possible way in aggregate for anyone except the bank that does the securitizing to benefit from securitization, and, in fact, everyone who owns that "stuff" is giving up some of what they could otherwise obtain by buying this crap.

P.T. Barnum was right.

Comments

[CautiousInv...:]

It's the same old financial alchemy at play but this time mixing tranches issued peviously under a new cash flow model with the imprimatur of geuss who? Yes, the ratings agencies.

Jul 08 12:13 PM

[Jason722:]

Isn't that a bit of a "baby with the bathwater" argument?

Sure, "securitization" is a dirty word these days, but the principle of securitization is not inherently bad. Securitization was never supposed to "create more value". It is a tool used to reduce risk and increase liquidity. If transparent and unmanipulated and PROPERLY RATED, securitization is a good thing.

You wrote:
>> It cannot be any other way; you cannot create more value than was originally there (claims otherwise are equivalent to claiming to have discovered perpetual motion) and as such there is no possible way in aggregate for anyone except the bank that does the securitizing to benefit from securitization, and, in fact, everyone who owns that "stuff" is giving up some of what they could otherwise obtain by buying this crap.

Jul 08 12:21 PM

[Philip Gvinter:]

Properly rated securitization is equivalent to conflict of interest free investment banking transaction. Theoretically this is possible but it has not been seen in a long time and is not likely to be seen again.

Jul 08 12:38 PM

[hampden:]

the division between equity and senior investors is hardly "arm waving" or alchemy or magic. it is the principle behind every company in the FTSE and every mortgage in the land. some investors are prepared to take small portions of equity risk in the hope of huge returns while others will only lend money if the deal has enough subordination in it to make their loan 'safe'. capital markets are all about helping get borowers and lenders together and this little piece of 'alchemy' has been the underpinning of post-war prosperity.

Jul 08 12:57 PM

[KIT:]

I have been waiting for a wave of law suits over rating agencies in reguards to sub prime and flawed CDOs. It many be total damage has been hard to quanitfy

Jul 08 01:16 PM

[Vuke:]

Jolly good one old man. Now, explain that to the unemployed and working retirees.

On Jul 08 12:57 PM hampden wrote:

this little piece of 'alchemy'
> has been the underpinning of post-war prosperity.

Jul 08 01:17 PM

[jambo:]

That same underpinning turned into the wooden stake through the heart of the mortgage bubble. which, as we all know was manufactured in part by the bastardization of market rules, the unbridled and rampant disregard for what could happen to the guy at the end of the string. Perhaps that guy could or should've known better but that whole system was based on them not knowing and being the one without the chair when the music stopped.

We need, all of us, accountability and transparency in those twisted derivative laden transactions. There are plenty of ways to make money without fucking over people. These precious markets will suffer hugely for many years of backlash over this, affecting the honest and moral traders as well as the unscrupulous greed first crowd.


On Jul 08 12:57 PM hampden wrote:

> the division between equity and senior investors is hardly "arm waving"
> or alchemy or magic. it is the principle behind every company in
> the FTSE and every mortgage in the land. some investors are prepared
> to take small portions of equity risk in the hope of huge returns
> while others will only lend money if the deal has enough subordination
> in it to make their loan 'safe'. capital markets are all about helping
> get borowers and lenders together and this little piece of 'alchemy'
> has been the underpinning of post-war prosperity.

Jul 08 02:08 PM

[Mark Bern:]

And so it begins again. Goldman is just trying to get what they can before regulatory changes make it harder to do. Notice I did not say impossible. The likes of the Goldman Boys will always find a way.

The links between the Fed, Treasury and Goldman does make me wonder if there is "real" regulation coming for financial institiutions or just some feel good rules to make things harder for the smalls to play.

Jul 08 02:13 PM

[jambo:]

OOOPs, forgot to thank Karl for another eye opening piece! I follow your stuff with great interest and am never disappointed.

Jul 08 02:14 PM

[Graham and ...:]

"The more things change, the more they remain the same."

Jul 08 02:59 PM

[hampden:]

It's true that the massive growth of subprime ABS and CDOs of ABS led to an increased amount of inappropriate lending; and ultimately an asset bubble. But was it really the mechanics of funding, i.e. securitization of loans, that is to blame? When you borrow money from a bank to buy a house - where do you think the money comes from? In the US, 70% from securitization (closer to 90% if you're a low income or 1st time buyer).

If banks were really trying to screw people by making inappropriate loans and passing these risks on to investors then why did they buy so much of it themselves? Citigroup and ML were the biggest originators of CDOs and had almost $100bn of AAA CDO and subprime ABS debt on balance sheet (or supported SIVs) when the market crashed.

Forget the conspiracy theories it's the whole system at fault: limited liability, easy bankruptcy, easy buy-to-let mortgages, commission based selling of loans, bonus compensation for bankers and light-touch regulation.

Reform is necessary but is Luddism really the answer as Karl suggests?

Jul 09 03:57 AM

[Karl Denninger:]

Who said anything about Luddism?

How about disclosure of reality - that you can't "create value" through securitization, you in fact strip value, because the underlying inherent credit quality is all you have to start with, and everyone who touches the deal takes their fee.

Simply add up the margin on the entire deal "after securitization"; if that exceeds the margin on the entire deal BEFORE securitization, its fraudulent. Period.

This is math folks, and we're not talking complex math either - more like grade-school stuff.

Jul 09 08:22 AM

[hampden:]

You're right, there is always more margin before the deal than afterwards, but the bankers don't get it.

The arranger (investment banks) takes a fee, the manager takes a fee for selecting and managing the assets and an administrator takes a fee for making sure everything runs as it should. All these fees are fairly standardised and known.

There is a margin because there are more assets (loans) than securitized bonds, and as you point out, the total yield is higher before than after. But, the surplus goes to the equity holder who has the riskiest bond as an incentive to take the risk. Bond holders get paid a fixed amount regardless of performance but equity holders get any upside (they are also first to take any losses).The structure is the same as a simplified company with equity and bond holders on one side of the balance sheet and assets on the other.

The tricky bit is getting the balance right, how much surplus is needed to componsate for bad loans in the pool? Ratings agencies, investors, analysts managers, hedgefunds all thought 3-5% of surplus would be enough to cover potential subprime mortgage losses (based on history). Turns out they were all wrong - very wrong. During the bull market that margin got squeezed tighter and tighter and loans got riskier and riskier until the bubble burst.

Nobody wants the resulting mess. What do we do now, turn to the taxpayer? Fed funds investors to buy them? Govt support banks until loans pay off? Wouldn't it be better to restructure them so that specialist investors get interested again? Reduce the burden on banks, taxpayers and stimulate the economy.

Jul 10 12:19 PM