World Business

Mortgaging the future on bad loan bets

By Jody Shenn and Michael J. moore (China Daily)
Updated: 2010-05-17 10:23

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 the concoction.

Known as the Baldwin deals, the $167 million of synthetic collateralized debt obligations (CDOs) 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 US 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 (SEC) probe, started at least a year ago, that is examining whether Wall Street misled investors when selling mortgage-linked securities.

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The agency has been looking for abuse "across the spectrum", enforcement chief Robert Khuzami said on 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 is not 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 could not comment.

Baldwin CDOs shared their atypical structure with an earlier series of Morgan Stanley CDOs called ABSpoke and two groups of deals, named after US 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 ot 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.

Mark Porterfield, a spokesman for Pimco, based in Newport Beach, California, and which manages the world's largest bond fund, did not return a telephone call seeking a comment.

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 GSC Group, based in Florham Park, New Jersey, 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.

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The Baldwin 2006-III securities, which paid a 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 would get wiped out after $18 million more of losses.

It is 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 authors are Bloomberg journalists in New York