What did Wall Street know and When did they know it when selling CDOs?

In an excellent article, Jesse Eisinger looks at the questions of what did Wall Street know and when did they know it as it relates to the construction and sale of subprime mortgage-backed CDOs.

Specifically, Mr. Eisinger focuses on Morgan Stanley and a particularly toxic CDO called Stack 2006-1.

Regular readers know that Wall Street had the equivalent of "tomorrow's new today" that it used in the construction of these CDOs.  The source of this information was their subprime mortgage origination and servicing platforms.

Specifically, whether they bought the mortgages from a third party or originate the mortgages themselves, the Wall Street firms knew just how quickly the quality of the underwriting of the mortgages was deteriorating.

From their servicing of the mortgages, Wall Street could see that the poorly underwritten mortgages were defaulting at a faster rate than the models used to value subprime mortgage-backed securities predicted.

Of course, Wall Street used this information to its advantage when it came to constructing and selling CDOs.

That is why the market for non-government guaranteed structured finance securities is frozen.  Investors are on a buyers' strike until such time as this informational advantage is eliminated.

The only way to eliminate Wall Street's informational advantage is to require that the structured finance securities provide observable event based information and report all activities like payments or defaults involving the underlying collateral before the beginning of the next business day.

With this information, investors can know what they are buying and subsequently know what they own.  Otherwise, they are simply gambling on the value of the contents of a brown paper bag that Wall Street has sold to them at a price that is higher than the contents are worth.

As Mr. Eisinger describes it:

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.....

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....

It certainly helps when selecting assets to short if you have material information regarding their performance that the other side of the deal does not have.

Perhaps more importantly, the other side cannot get this material information unless it too happens to have a subprime mortgage origination and servicing platform.

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.

Please re-read the highlighted text as Mr. Eisinger nicely summarizes the source of Wall Street's informational advantage.  A source that would be able to provide insight into exactly what securities should be selected to maximize the profitability of the short.

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.

Readers might recall that Morgan Stanley owned a subprime mortgage origination and servicing firm called Saxon Capital.  The Wall Street Journal wrote about how information from Saxon informed Morgan Stanley's trades.

These reports weren't available to the public.

It would be crucial information for trading in securities backed by those kinds of mortgages.....

In fact, mortgage-backed securities are constructed to delay the public's access to data and give Wall Street a permanent information advantage.

By design, mortgage-backed securities report the performance of the underlying mortgages once per month.  These reports come out from 5 to 10 business days after the month ends.

Contrast this with the reports that a servicing firm generates.  They generate a report every single day.  At a minimum, Wall Street would know how all the loans in a deal performed several business days before investors and other market participants.

Wall Street showed with the CDOs that it was fully capable of using its access to "tomorrow's news today" to generate a lot of money.

Two of the employees who received those emails joined an internal hedge fund, headed by Howard Hubler, that was formed only the following 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 the 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.

It was not necessarily the private assessments that the subprime market was imploding that was material.  Rather, it was the data that showed the subprime market was imploding that was material.

Data that the origination and servicing platform would routinely generate.

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

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

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

In April 2006, the bank creates its own internal hedge fund, led by Mr. Hubler, who shorts the subprime market. Among the traders in this internal shop are 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 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. 

Finally, by early 2007, the bank appears to realize that the subprime market is cratering even worse that it expects. Even the supposedly safe pieces of C.D.O.'s that it owns, including its piece of Stack, are facing losses. So Morgan Stanley bankers set to scouring the world to peddle as a safe and sound investment what its own employees are 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.