March 20, 2023

DealBook | The Trade: An Asset So Toxic They Called It ‘Nuclear Holocaust’

The headquarters of Morgan Stanley in Manhattan.Richard Drew/Associated PressThe headquarters of Morgan Stanley in Manhattan.

On March 16, 2007, Morgan Stanley employees working on one of the toxic assets that helped blow up the world economy discussed what to name it. Among the team members’ suggestions: “Subprime Meltdown,” “Hitman,” “Nuclear Holocaust” and “Mike Tyson’s Punchout,” as well a simple yet direct reference to a bag of excrement.

Ha ha. Those hilarious investment bankers.

Then they gave it its real name and sold it to a Chinese bank.

We are never going to have a full understanding of what bad behavior bankers engaged in in the years leading up to the financial crisis. The Justice Department and the Securities and Exchange Commission have failed to hold big wrongdoers to account.

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We are left with what scraps we can get from those private lawsuits lucky enough to get over the high hurdles for document discovery. A case brought in a New York State Supreme Court in Manhattan against Morgan Stanley by a Taiwanese bank, which bought a piece of the same deal the Chinese bank did, has cleared that bar.

The results are explosive. Hundreds of pages of internal Morgan Stanley documents, released publicly last week, shed much new light on what bankers knew at the height of the housing bubble and what they did with that secret knowledge.

The lawsuit concerns a $500 million collateralized debt obligation called Stack 2006-1, created in the first half of 2006. Collections of mortgage-backed securities, C.D.O.’s were at the heart of the financial crisis.

But the documents suggest a pattern of behavior larger than this one deal: people across the bank understood that the American housing market was in trouble. They took advantage of that knowledge to create and then bet against securities and then also to unload garbage investments on unsuspecting buyers.

Morgan Stanley doesn’t see the narrative as the plaintiffs do. The firm is fighting the lawsuit, contending that the buyers were sophisticated clients and could have known what was going on in the subprime market. The C.D.O. documents disclosed, albeit obliquely, that Morgan Stanley might bet against the securities, a strategy known as shorting. The firm did not pick the assets going into the deal (though it was able to veto any assets). And any shorting of the deal was part of a larger array of trades, both long and short. Indeed, Morgan Stanley owned a big piece of Stack, in addition to its short bet.

Regarding the profane naming contest, Morgan Stanley said in a statement: “While the e-mail in question contains inappropriate language and reflects a poor attempt at humor, the Morgan Stanley employee who wrote it was responsible for documenting transactions. It was not his job or within his skill set to assess the state of the market or the credit quality of the transaction being discussed.”

Philip Blumberg, the Morgan Stanley lawyer who composed most of the names, meet the underside of a bus, courtesy of your employer.

Another Morgan Stanley employee sent an e-mail that same morning, suggesting that the deal be called “Hitman.” This might have been an attempt to manage up, because “Hitman” was the nickname of his boss, Jonathan Horowitz, who helped head the part of the group that oversaw mortgage-backed C.D.O.’s. Mr. Horowitz replied, “I like it.”

Both Mr. Blumberg and Mr. Horowitz, now at JPMorgan, declined to comment through representatives at their banks.

In February 2006, Morgan Stanley began putting together the Stack C.D.O. According to an internal presentation, Stack “represents attractive business for Morgan Stanley.”

Why? In addition to fees, another bullet point listed: “Ability to short up to $325MM of credits into the C.D.O.” In other words, Morgan Stanley could — and did — sell assets to the Stack C.D.O., intending to profit if the securities backed by those assets declined. The bank put on a $170 million bet against Stack, even as it was selling it.

In the end, of the $500 million of assets backing the deal, $415 million ended up worthless.

“While investors and taxpayers all over the world continue to choke on Wall Street’s toxic subprime products, to this day not a single major Wall Street executive has been held accountable for misconduct relating to those products,” said Jason C. Davis, a lawyer at Robbins Geller who is representing the plaintiff in the lawsuit. “They are generally untouchable, but we are pleased that the court in this case is ordering Morgan Stanley to turn over damning evidence, so that the jury will get to see what Morgan Stanley really knew about the troubled nature of its supposedly ‘higher-than-AAA’ quality product.”

Why might Morgan Stanley have bet against the deal? Did its traders develop a brilliant thesis by assessing the fundamentals of the housing market through careful analysis of the public data? The documents suggest something more troubling: bankers found out that the housing market was diseased from their colleagues down the hall.

Bankers were getting information from fellow employees conducting and receiving private assessments of the quality of the mortgages that the bank would purchase to back securities. These reports weren’t available to the public. It would be crucial information for trading in securities backed by those kinds of mortgages.

In one e-mail from Oct. 21, 2005, a Morgan Stanley employee warned a banker that the mortgages Morgan Stanley was buying from loan originators were troubled. “The real issue is that the loan requests do not make sense,” he wrote. As an example, he cited “a borrower that makes $12K a month as an operation manger (sic) of an unknown company — after research on my part I reveal it is a tarot reading house. Compound these issues with the fact that we are seeing what I would call a lot of this type of profile.”

In another e-mail from March 17, 2006, another Morgan Stanley employee wrote about a “deteriorating appraisal quality that is very flagrant.”

Two of the employees who received those e-mails joined an internal hedge fund, headed by Howard Hubler, that was formed only the next month, in April 2006. As recounted in Michael Lewis’s “The Big Short,” Mr. Hubler infamously bet against the subprime market on Morgan Stanley’s behalf, a fact that Morgan Stanley’s chief financial officer conceded in late 2007. Mr. Hubler’s group was supposed to be separate from the rest of Morgan Stanley, but the two bankers continued to receive similar information about the underlying market, according to a person briefed on the matter.

At no point did they receive material, nonpublic information, a Morgan Stanley spokesman says.

I struggle to see how the private assessments that the subprime market was imploding were immaterial.

Another of Morgan Stanley’s main defenses is that it couldn’t have thought the investment it sold to the Taiwanese was terrible because it, too, lost money on securities backed by subprime mortgages. As the Morgan Stanley spokesman put it, “This deal must be viewed in the context of a significant write-down for Morgan Stanley in 2007, when the firm recorded huge losses in its public securities filings related to other subprime C.D.O. positions.”

This is a common refrain offered by big banks like Citigroup, Merrill Lynch and Bear Stearns to absolve them of any responsibility.

But does losing money wipe away sin?

Yes, Mr. Hubler made his bets in what turned out to be a deeply disastrous way. As part of a complex array of trades, he bet against the middle slices of subprime mortgage C.D.O.’s. He bought the supposedly safe top parts. The income from the top slices helped offset the cost of betting against the middle slices. But when the market collapsed, the top slices — called “super senior” because they were supposedly safer than Triple A — didn’t hold their value, losing billions for Mr. Hubler and Morgan Stanley. Mr. Hubler did not respond to requests for comment.

So Morgan Stanley lost a great deal of money.

But let’s review what the documents suggest is the big picture.

In the fall of 2005, bank employees shared nonpublic assessments of how the subprime market was a house of tarot cards.

In February 2006, the bank began creating Stack in part so that it could bet against it.

In April 2006, the bank created its own internal hedge fund, led by Mr. Hubler, who shorted the subprime market. Among the traders in this internal shop were people who helped create Stack and other deals like it, and at least two employees who had access to the private due diligence reports.

Mr. Hubler’s group had no investment position in Stack, according to the person briefed on the matter, but it sure looks as if the bank saw what was coming and tried to position itself for a subprime market collapse.

Finally, by early 2007, the bank appeared to realize that the subprime market was faring even worse than it expected. Even the supposedly safe pieces of C.D.O.’s that it owned, including its piece of Stack, were facing losses. So Morgan Stanley bankers set to scouring the world to peddle as a safe and sound investment what its own employees were internally deriding.

Morgan Stanley declined to comment on whether it made money on its Stack investments over all. But it looks to have turned out well for the bank. In Stack, it managed to fob off a nuclear bomb to the Taiwanese bank.

Unfortunately for Morgan Stanley, it had so many other pieces of C.D.O.’s, so many nuclear warheads, that it couldn’t find nearly enough suckers around the world to buy them all.

And so when the real collapse came, Morgan Stanley was left with billions of dollars in losses.

That hardly seems exculpatory.

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The Trade: Pruning Hedge Fund Regulation Without Cultivating Better Rules

John Paulson is famous for having shorted the housing bubble, making billions. Then his returns nose-dived.Eduardo Munoz/ReutersJohn Paulson is famous for having shorted the housing bubble, making billions. Then his returns nose-dived.

Fresh from having declined to constrain money market funds, the Securities and Exchange Commission has moved to loosen marketing constraints on hedge funds.

Two weeks ago, the agency threw up its hands and said it would not be able to defend millions of investors from money market funds that do things like invest in dodgy European bank bonds yet proclaim themselves to be perfectly safe.

Instead, the S.E.C. — mandated by Congress through its misnamed and harmful JOBS Act — proposed rules last week to lift advertising restrictions for hedge funds and other kinds of private investment offerings. The rules haven’t been completed, but we can look forward to an ad featuring a wizened couple in matching tubs overlooking a sunset, holding hands and talking about how they just put money with the next George Soros.

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The old rules for hedge funds make little sense. Surely, hedge funds should be able to promote themselves to investors with data about their returns and methods. But there’s a problem: The S.E.C. does not have any new resources and has not put in place any policies to police these promotions.

Letting slip the dogs of advertising comes as some professional investors and academics doubt that the industry can continue to produce outsize investment returns — if, in fact, it ever did. As they get bigger, hedge funds struggle to score good results. As investments have become increasingly correlated and interrelated, it gets harder to execute safer and unique strategies.

In a perfect world, hedge fund advertising would improve the world of investing. Hedge funds, after all, are wildly misunderstood. A good hedge fund seeks steady returns in good markets and bad. Many of the best-managed funds aren’t actually trying to beat the market in its best years. And many of the good funds seek uncorrelated results, so that the returns don’t move in lock step with the stock market.

And, honestly, few things could be worse than mutual funds, which in aggregate underperform the stock market and charge too much to do it.

The problem is that the way this loosening looks on paper and the way it will play out in the real world are a tad different.

If Groucho Marx were alive today, he’d say that he would never want to invest in a hedge fund that would have him as a limited partner. One doesn’t see Le Bernardin and Château Lafite filling the airwaves during N.F.L. games. The ban on law firm advertising was lifted in the 1970s. Today, Jacoby Meyers advertises on television; Sullivan Cromwell does not. Drug ads have wrought a parade of patients demanding new (high margin) medicines from their doctors that often offer few benefits over the old (off patent) ones.

Even professionals have a problem in evaluating hedge fund performance, because distinguishing skill from luck and excessive risk-taking is extremely difficult. For instance, funds often don’t even let their own employees know how much leverage they are taking.

Take the case of John Paulson, who is famous for having shorted the housing bubble, making billions. The result is that many, surely including Mr. Paulson, were convinced of his brilliance.

Before his world-renowned score, he was a grinder, eking out decent returns with a relatively small fund. Afterward, his fund grew exponentially to tens of billions under management.

Then his returns nose-dived. His main fund plunged 36 percent last year and has dropped another 13 percent this year, according to The Wall Street Journal.

Last week, after Citigroup’s private bank pulled out of his fund, Mr. Paulson convened a conference call with Bank of America investment advisers and their clients to explain what was going so horribly wrong with his funds.

It turns out that Mr. Paulson was like the Old Man in the Hemingway novel: He happened to be the guy, through some skill and some luck, to land the biggest fish in the world. How much of each did he have? No one can know.

Another lesson from Mr. Paulson’s experience is that even if a fund manager is smart, people who put their money into them are dumb. Citigroup and Bank of America look as if they were typical. Average investors chase performance, putting in money after the great years. Then they panic, pulling their money out at the bottom.

Look for this to be replicated frequently when hedge funds start advertising. Simon Lack, in an important recent book “The Hedge Fund Mirage” (Wiley), argues that hedge funds have been great for hedge fund managers and not so great for their investors. The managers get huge fees. Investors would have been better off investing in Treasury securities, he says.

The hedge fund trade group says that Mr. Lack has it all wrong. Their logic, however, hasn’t been persuasive. Felix Salmon, a blogger for Reuters, wrote that the hedge fund group’s complaints had “convinced me of the deep truth of Lack’s book in a way that the book itself never could.”

At least hedge funds specialize in separating people from their money through excessive fees. Other types of offerings prefer to do so through less savory means. The opening of hedge fund advertising has garnered much of the attention, because of the tantalizing idea that we will all soon be able to invest with the best minds on the planet. But the S.E.C. is also lifting rules on other kinds of securities offerings from small companies. Many of these will require less disclosure and will be particularly ripe for fraud.

So the best case from the agency’s move is a bunch of Paulsons, while the worst case is a bunch of Madoffs. It doesn’t seem like a great bargain.

The S.E.C. declares in a fact sheet that it will keep the rules about who can invest. Yet the victims of Bernard L. Madoff, who orchestrated the largest Ponzi scheme in history, were accredited investors. The agency does not plan to mandate any new process to ensure that investors are accredited, or whether their investments are appropriate for them.

This is all harks back to a precrisis specialty: get rid of supposedly outdated regulation, but create no new limits or powers to keep things from blowing up.

Jesse Eisinger is a reporter for ProPublica, an independent, nonprofit newsroom that produces investigative journalism in the public interest. Email: Follow him on Twitter (@Eisingerj).

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DealBook: Once Unthinkable, Breakup of Big Banks Now Seems Feasible

John A. Thain, chief of Merrill Lynch, left, and Kenneth D. Lewis, chief of Bank of America, in 2008.Bebeto Matthews/Associated PressJohn A. Thain, chief of Merrill Lynch, left, and Kenneth D. Lewis, chief of Bank of America, in 2008.

What was made can be unmade.

JPMorgan Chase and Wells Fargo may have venerable names, but they and the pseudo-venerable Citigroup and Bank of America are all products of countless mergers and agglomerations.

There is no rule of markets that requires a financial system dominated by four cobbled-together, lumbering behemoths.

Lawmakers and regulators have failed to remake our system with smaller, safer institutions. What about investors?

Big bank stocks have been persistently weak, making breakups that seemed politically impossible no longer unthinkable.

Bank of America’s recent quarterly earnings were so weak that investors and commentators wondered whether the bank should sell off Merrill Lynch, the investment bank for which it foolishly overpaid at the height of the crisis. Bank of America trades at half of its book value (the stated value of its assets minus its liabilities), an indication that investors view its asset quality and prospects just a notch below abominable, as Jonathan Weil of Bloomberg News pointed out last week.

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For Bank of America, the question is whether it will have to raise capital. Selling shares at such depressed prices would be costly. Regulators won’t push for it. They just gave stress tests to the biggest banks, and merely restricted the bank from paying out a dividend. The logical solution is that Bank of America shed business lines in a bid to improve its prospects in the eyes of Wall Street.

Citigroup’s stock, revenue and earnings have lagged for a decade.

“Look, if you can’t compete in the major leagues for over a decade, it’s time to go back to the minors,” said the always outspoken Mike Mayo, an analyst with CLSA. His chronicle of ruffling bank management feathers, “Exile on Wall Street” (Wiley), will be published in the fall.

JPMorgan Chase is as well managed as any gargantuan bank can be. But if you look at its businesses, it’s hard to see any area where it is clearly the best, something even its own executives concede. Not in credit cards, where the premier name is American Express. Not in money management, where you might offer up T. Rowe Price. Investment banking — Goldman Sachs (the last quarter notwithstanding). Back-office transactions, State Street.

Yet even JPMorgan is merely trading at book value. Put another way, the market regards the value that JPMorgan provides as a financial services conglomerate as zilch. How well do all of JPMorgan’s divisions work together? In presentations to investors, JPMorgan executives show how much revenue they gain from existing clients. But these measures are hardly unbiased. Executives have an incentive to defend their empires. Who is to say that a certain division of JPMorgan wouldn’t have won that business anyway? And nobody measures how much a bank loses through conflicts of interest.

Even in the face of investor pressure, there are forces that would hold bank breakups back. Mainly pay.

“The biggest motivation for not breaking up is that top managers would earn less,” Mr. Mayo said. “That is part of the breakdown in the owner/manager relationship. That’s a breakdown in capitalism.”

Institutional investors — the major owners of the banks — are passive and conflicted. They don’t like to go public with complaints. They have extensive business ties with the banks. The few hedge fund activist investors who aren’t cowed would most likely balk at taking on such an enormous target.

Also, there are reasons to think that smaller banks wouldn’t necessarily make the system safer. A wave of small bank failures can have systemic effects, as was the case in the Great Depression. Focused companies like Washington Mutual and Bear Stearns failed in the recent crisis, worsening it.

Making a nuanced argument, John Hempton, a blogger, investor and former regulator in Australia, says that it’s better for shareholders — and societies — to have large banks with lots of market power. That makes them more profitable and leads them to take less risk, making them safer and more enticing for investors.

Another oft-trotted-out argument against breakups: The United States needs global banks to service its giant, multinational corporations and to preserve our position in world markets.

Color me unconvinced. When a giant corporation wants to do a major bond offering or a big company goes public, the banks, despite their size, don’t want to shoulder all the risk themselves, preferring to share the responsibility.

If the stocks continue to lag for quarters upon years, these arguments will seem less convincing, while institutional reluctance will begin to erode.

Investors don’t care about size, they care about performance. It’s undeniable that smaller banks are easier to manage. And they are easier for regulators to unwind — and therefore less terrifying to trading partners — when they fail.

One of the most remarkable aspects of the debate about overhauling the financial system after the great crisis was the absence of serious contemplation of breaking up the largest banks.

It’s not a perfect solution. Banks responding to investor pressure would react haphazardly. But it’s a good start.

Jesse Eisinger is a reporter for ProPublica, an independent, nonprofit newsroom that produces investigative journalism in the public interest. Email: Follow him on Twitter (@Eisingerj).

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