One thing that would probably be fun would be reading the internal emails sent around at the places that bought terrible RMBS CDOs in the end times of 2006-2007. What did they say? Was it “these mortgages are worth twice what Morgan Stanley is selling them for! We are ripping their faces off”?1 Was it “I looked through a representative sample of the mortgages underlying the collateral in this deal and I think the yield more than justifies the risks”? Was it “my asset-level diligence was light because my macro view is that house prices will go up a lot in the next 18-24 months”? Was it “we have to invest $100mm somewhere and this gets 2bps more yield than other AAA-rated options”? Was it “I don’t know that much about mortgages but I sure am glad we can trust our friends at Morgan Stanley to put us in such a high quality product as this here CDO”? The possibilities are endless and, I think, fascinating: each trade has two sides, and each side has a view, even if that view is sometimes more of a vacant stare.
But the arrow of lawsuits runs only one way so instead we get this:
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,” “Mike Tyson’s Punchout,” and the simple-yet-direct: “Shitbag.”
The shitbag email chain is part of a collection of internal documents produced in China Development Industrial Bank’s lawsuit against Morgan Stanley over this “Stack 2006-1″ CDO deal that Jesse Eisinger describes today in DealBook and ProPublica. Morgan Stanley has issued the standard “these emails were just a joke and have nothing to do with anything” statement,2 and while normally that is just a meaningless lie that you say after your employees are caught sending around emails saying “this deal is shit, no, I mean it, this deal is composed of actual feces, I am not kidding, come look” – the emails here aren’t that bad. Basically they were like “ugh we gotta name this deal before we print it” and everyone was all “what about Macalester Albermarle Roundtree Paddington Pemberley Structured Finance Limited” and one dope replied with some gallows-humor names. In March 2007. When it was A SUPER DUPER SECRET that subprime mortgages were in trouble:3
Immediately after the shitbag email chain in the documents is Morgan Stanley’s CDO Trading Committee Presentation seeking permission to provide a warehouse for what became the Stack/Shitbag deal. That presentation – which I at least don’t find particularly inflammatory – is dated February 2006.
Look at that chart again. If you worked on the desk that got approval to warehouse subprime in February 2006, and you went and bought some subprime bonds over the course of 2006, and you were selling the resulting deal in March 2007, would you maybe be moved to use harsh words like “meltdown” and “shitbag”? I mean, yeah, the guy buying in March 2007 would end up feeling even worse, but you’d feel plenty bad already.
And oh sure maybe it would occur to you “wow, things could get even worse in subprime, I better dump this shitbag,” but that could occur to anyone, because … well, one, because that is a thing that could always happen and so should always occur to everyone (important Dealbreaker Pro Investor Tip: investments can lose value!), and two, because, like, if a formerly boring par-ish fixed income asset class lost 20-30% of its value in the last couple of months, you really can’t go around thinking “well but it’s a totally safe boring asset class now.” No: now it’s a volatile asset class that some people think is a great value buy, and that others think is, um, a shitbag. (It’s Herbalife!) At that point, you pretty much have to pick a side.
The rest of the article is the usual pillorying of a bank with bad emails about RMBS or CDOs, though it has a surprisingly high quotient of gibberish: elsewhere at Morgan Stanley, in 2005, people were questioning the underwriting of some of the loans that were going into private-label RMBS deals that had nothing to do with this Stack 2006-1 deal; and still elsewhere at Morgan Stanley, a guy started an internal hedge fund, which “had no investment position in Stack, according to a 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,” and, ehhhhhhh. Of course it looks like that after the fact.
Wait, no, it actually doesn’t, because, as Eisinger notes, “when the real collapse came, Morgan Stanley was left with billions of dollars worth of shitbags.” This Stack deal – in which Morgan Stanley bet against the very securities it was creating, to use the popular but not quite accurate locution4 – got Morgan Stanley slightly closer to flat, but still left it catastrophically long mortgages. But it knew the collapse was coming! In 2005! Or whatever!
Nobody knows anything,5 every trade has two sides, some people are wrong ex post and look dumb, other people are right ex post and look mean, the end.
That’s a boring end. Bonus ending! This paper is several months old but sort of amusing for its abstract:
Conventional wisdom and empirical evidence often suggest that banks value their reputation, and this gives them an incentive to work in the best interest of their clients. We develop a model of reputation and complexity, where strategic underwriters with high reputation will often produce complex assets that harm investors. The securities will perform well during good states but underperform during market downturns. We examine these predictions using a unique sample of $10 trillion dollars of CLO, MBS, ABS, and structured finance CDOs issued between 2000 and 2010. Contrary to the conventional view, we find that securities issued by more reputable banks did not outperform, but rather exhibited faster rating deterioration and default. The underperformance is present because high reputation underwriters issued more securities in the poorest performing parts of structured finance, and because within the MBS, ABS, and CDO markets they issued poorly performing securities.
The authors control for some sector-mix issues – CLO vs. CDO, cash vs. synthetic – but at a pretty rough level; one way to explain the counterintuitive result is to imagine that high-reputation underwriters push to do more innovative deals and leave boring copycat deals to the middle-of-the-league-table schlubs.6 You get a little sense of that from Morgan Stanley’s CDO committee deck:
Yay! Innovation! That’s the first transaction strength. (“Dump garbage on unsuspecting clients” didn’t even make the list, though remember that this was in February 2006, before the garbage was evidently garbage.) And why shouldn’t it be? Your reputation as a structured product underwriter comes from bringing clients new ideas that they can’t get anywhere else: that’s why they’re willing to pay you the higher fees that you charge on novel and innovative products. Your reputation doesn’t come from your clients not losing money in the future, for a variety of reasons including (1) your clients are aware that there are two sides to every trade and (2) the future is a long time from now.
So how do you build reputation? You innovate. You take RMBS and make CDOs, you take CDOs and make CDO-squareds, you take CDS and make synthetic CDOs so that you or your evil Paulsony clients can bet against etc. etc. All of those particular things worked out badly – worse than their more-vanilla versions – though there are biases to the sample.7 Which I guess is no good for those banks’ reputations. The emails don’t help either.
Explosive Charge: Morgan Stanley Peddled Security Its Own Employee Called ‘Nuclear Holocaust’ / Financial Crisis Suit Suggests Bad Behavior at Morgan Stanley [ProPublica / DealBook]
Complex Securities and Underwriter Reputation: Do Reputable Underwriters Produce Better Securities? [SSRN]
Update/endorsed: In Defense of Morgan Stanley’s ‘Nuclear Holocaust’ [NetNet / John Carney]
1. No, it was not.
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.”
4. Not quite accurate because building a synthetic CDO where you are the protection buyer is not “betting against the securities you create”; rather it is “creating securities out of your bet against mortgages” – the bet is not extrinsic to the securities – the securities exist as one side of a bet of which you are the other side. If you didn’t bet against them they wouldn’t be there. Here that is partially true – MS’s short was like $170mm of the $500mm notional – but it is entirely true to the extent of that bet; without it there would only be $330mm notional.
6. Other ways include “the reputation ranking is a little screwy” and “a lot of the results are not statistically significant or all that large.” Yet another is “a reputation for fair dealing is the sort of thing that banks talk about a lot but that no longer actually seems to be a thing”; this is more cynical than I’d go though not by much.
7. What’s the last article you read about “company did a derivative and it worked and they’re pleased and are coming back for more?” (Other than on Dealbreaker.) For me, it was this one, though I’m biased because I used to sell this product that Harvey Schwartz apparently invented (?). But note that even here the story is “guy is important, once created derivative,” not “derivative is good, made guy important.”