Too Big to Fail or Too Big to Jail?

If you knew your broker called a stock “toxic waste” and nicknamed it as “Subprime Meltdown”, “Hitman” “Nuclear Holocaust” and “Mike Tyson’s Punchout” (a reference to a bag of human waste), would you buy it? 

According to an article by Jesse Eisinger of ProPublica, on March 16, 2007, team members of Morgan Stanley suggested these nicknames for a financial derivative known as a collateralized debt obligation (CDO), the very products that were at the center of the systemic collapse in 2008.  Then they renamed it and sold it as gold to their investors.  Human waste into gold.  That’s some alchemy.

Not one Too Big To Fail (TBTF) bank has been held accountable for torpedoing the economy back in 2008.  The Justice Department and the Securities and Exchange Commission are seemingly unable to find any wrongdoing despite reams of evidence.   

The banks were bankrupt and had to be bailed out by the taxpayer.  Unsuspecting investors bought mortgage-backed securities and other fancy financial mechanisms that the banks knew were worthless.  But it took a Taiwanese bank, one of those unsuspecting investors, to overcome the high hurdle of document discovery to give us a glimpse of TBTF criminality.

The lawsuit concerned a $500 million collateralized debt obligation created by Morgan Stanley and named Stack 2006-1.  To understand what a CDO is, first you have to understand the mortgage-backed securities market.  Financial firms would buy mortgages from lenders (aka originators), pool them, and then slice and dice them into categories of risk known as tranches.  Each slice was a mortgage-backed security (MBS) which a firm could hold, trade and sell.   

To make a CDO, they pooled the mortgage-backed securities and sliced and diced them.  Both the MBSs and the CDOs inevitably received a triple-A gold plated rating from one of the three credit rating agencies: Standard & Poor’s, Moody’s or Fitch’s, who were being paid by the actual issuers of these derivatives so there may have been a conflict of interest in their analysis (you think)?

According to the documents revealed in court, Morgan Stanley knew the subprime mortgage market would collapse.  They then put together the worst MBSs they could to create Stack 2006-1 and short them (bet that they would default), and then sell them to unsuspecting investors who had no idea the bank’s first loyalty was to itself, not its clients.

The standard defense against this widespread double-dealing chicanery is that the buyers were sophisticated and should have known what was happening in the subprime market.  Besides, it was buried deep and wide somewhere in Stack 2006’s thousand-page deliberately opaque description that the bank might bet against the CDO.  The banks think this is symmetrical—each party has the same information--Morgan Stanley versus Taiwanese bank with both sides balancing the scales of justice.  But the information was asymmetrical with the investors left holding the bag and grievously harmed by lack of vital inaccessible information.

According to the disclosures, Morgan Stanley had private knowledge which led it to short Stack 2006-1 while they were extolling its value to its investors.  Does the definition of being a “sophisticated buyer” include being unaware that your bank is going to screw you by trading for itself and dumping its losses on you?

In an internal presentation to Morgan Stanley employees, the Stack 2006-1 was praised as displaying “attractive business opportunities for Morgan,” and “the ability to short up to $325 million of credits into the CDO.”

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

For its part, Morgan Stanley didn’t have to be very sophisticated to find out about the tanking of the subprime market.  They just walked down the hall to their colleagues who were conducting private assessments of the quality of the mortgages used in the CDOs.  These reports weren’t available publicly, another example of asymmetrical balance.  Morgan Stanley was holding all the cards and getting true information straight from the horse’s mouth:

In one email 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 $12,000 a month as a operations manager 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 call a lot of this type of profile.”

What did the bankers know and when did they know it?

TIMELINE

Fall 2005:  Bank employees shared private assessments about the future tanking of the subprime mortgage market.

February 2006:  Morgan Stanley created Stack 2006-1 with the very same mortgages it knew would deteriorate expressly for the purpose of shorting it.

April 2006:  Morgan Stanley created an internal hedge fund consisting of employees who could assess which mortgages were more likely to fail and employees with access to private due diligence reports.

Early 2007:  Morgan Stanley realized that the subprime market was deteriorating even more rapidly than they thought.  They then went out to sell Stack 2006-1 CDOs touting them as safe and value-creating investments even though their proprietary bets went in the opposite direction.

To this day no financial firm has been held accountable for their bad (some say criminal) behavior.  As far as the future goes, we the people can look forward to mountains of toxic waste ready to bury us.