FedUpUSA

Ah, It's About Time (CDO Lawsuits)

I was wondering how long this was going to take….

NEW YORK, Dec 29 (Reuters) – Morgan Stanley has been sued by a Virgin Islands pension fund that accused the Wall Street bank of defrauding investors by marketing $1.2 billion of risky mortgage-related notes that it expected to fail.

The lawsuit filed Dec. 24 in Manhattan federal court said
Morgan Stanley collaborated with credit rating agencies Moody’s Investors Service and Standard & Poor’s to obtain “triple-A” ratings for notes marketed in 2007 as part of a collateralized debt obligation (CDO) known as Libertas.

According to the complaint, the CDO was backed by low-quality assets, including securities issued by subprime lenders New Century Financial Corp, which quickly went bankrupt, and Option One Mortgage Corp, then owned by H&R Block Inc.

That’s the allegation…. and frankly, my stunner is that it has taken this long for these sorts of lawsuits to show up.

The complaint makes the specific allegation that

 “Morgan Stanley was betting the entire investment it was
promoting would fail,” according to the complaint, which was
made available on Tuesday. “The firm achieved its objective.”

Oh, who else was doing this sort of thing?  That would be most of the investment banks, right?

The interesting part of this filing from my perspective is that they didn’t sue the raters as well.  I’m quite surprised, actually, as one of the places that looks particularly fertile to me in these suits is an argument of collusive conduct between the ratings agencies and issuers.

Why? 

Because if such a case was able to be proved up it would open the floodgates for treble damages via a potential Racketeering suit.  The underlying fraud, if proved, would served as the predicate felony necessary to sustain such a claim.

We’re not getting that sort of reaction – yet – but I’m quite surprised.

Among the allegations in the suit are this:

The Dec. 24 complaint said Morgan Stanley knew securities in the Libertas CDO were suffering a dramatic rise in delinquencies, but provided a misleading “risk factor” in a prospectus that rising delinquencies “may” hurt values in the $1 trillion residential mortgage-backed securities market.

It called this representation “analogous to Captain Smith’s telling passengers of the Titanic that some ships have ‘recently sunk’ in the Atlantic and therefore ‘our ship may sink,’ without mentioning the facts that his ship struck an iceberg, had a hole in it, and was filling with water.”

Now that puts the basic premise of the case in a format that everyone can understand.

But what this and similar cases filed thus far seem not to bring up is the fact that the only way these deals made sense (for the issuing bank) was if they were improperly “rated” in the first place!

I go back to the fundamental mathematics of lending and business, as I have repeatedly explained over the last two years and change.  That is, the more people that touch a deal the less money there is available in that deal for the end purchaser.  What this means is that the maximum risk-adjusted return exists when one person loans another money – the more complex the deal gets than that, the less total return the end buyer of the debt, all-in, can obtain – UNLESS SOMEONE CHEATS.

But remember – no matter how you slice this whole deal up only 200 basis points of profit is in there over treasuries to make. You can change who eats the losses and how much the various “fingers in the pie” get to siphon off, but you can’t change the total amount of profit available.

OR CAN YOU?

Wall Street figured out that YOU CAN IF YOU ARE WILLING TO CHEAT.

All you have to do is find someone who will run your “deal” through a computer program and “grade” the quality of its debt. If you can find someone who will claim that the total risk of the deal is lower than it actually is, you make out like a bandit, because instead of 200 basis points of actual profit you suddenly “find” another 50 or 100!

That’s the essence of all this “financial engineering.”

The problem with suing on this basis is that it’s somewhat difficult to explain to a jury how this all worked.  If the jurors eyes glaze over you lose, you see.

I’ll make this offer – I’m willing to bet I can spend a half-hour on the phone with any of these attorneys and explain the fundamental scam in these “deals” in sufficiently-clear language that anyone of ordinary competence in the general public can understand it.

That should allow them, in turn, to do so to a jury.

And I won’t even charge for my time.

Call me folks.  Seriously.

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