Morgan Stanley Plans to Turn Downgraded Loan CDO Into AAA Bonds

[Joanne98]

July 8 (Bloomberg) -- Morgan Stanley plans to repackage a downgraded collateralized debt obligation backed by leveraged loans into new securities with AAA ratings in the first transaction of its kind, said two people familiar with the sale.

Morgan Stanley is selling $87.1 million of securities that it expects to receive top AAA ratings and $42.9 million of notes graded Baa2, the second-lowest investment grade by Moody’s Investors Service, according to marketing documents obtained by Bloomberg News. The bonds were created from Greywolf CLO I Ltd., a CDO arranged in January 2007 by Goldman Sachs Group Inc. and managed by Greywolf Capital Management LP, an investment firm based in Purchase, New York.

Two years after the credit markets began to seize up, costing the world’s biggest financial institutions $1.47 trillion in writedowns and losses, banks are again taking so- called structured finance securities and turning them into new debt investments with top credit ratings. While the Morgan Stanley deal is the first to involve CDOs of loans, banks have been doing the same with commercial mortgage-backed securities in recent weeks.

A lot of banks and insurers “cannot buy anything but AAA,” said Sylvain Raynes, a principal at R&R Consulting in New York and co-author of “Elements of Structured Finance,” which is due to be published in November by Oxford University Press. “You’re manufacturing AAA out of not AAA, therefore allowing those people who have AAA written on their forehead to buy.”

Copying Re-REMICs

New York-based Morgan Stanley is copying a financing structure known as Re-REMICs that bundle mortgage securities into new bonds that often offer investors an additional layer of protection, or collateral, from downgrades. Credit-rating cuts may sometimes force investors to sell the debt and cause financial institutions that own the bonds to increase capital.

Jennifer Sala, a spokeswoman for Morgan Stanley, and Gregory Mount, a Greywolf partner, declined to comment.

http://www.bloomberg.com/apps/news?pid=20601109&sid=aeTzfvEedKpQ

[DJ13]

1. ........

"Insanity is doing the same thing over and over again and expecting a different result."

-Albert Einstein

[Me.]

The First Step On The Road To Another Bailout?

Haven't We Been Here Before?

[valerief]

2. How many trillions will they ask for in the next bailout? Why isn't this illegal? nt

[indepat]

3. 'cause 'pukes and some Dems don't want securities' fraud to be illegal,

want the good ole boys to be able to peddle their purloined securities unfettered by the heavy hand of government. :P

[econoclast]

4. CDO's for dummies

It would advance the discussion if folks understood more of just what these CMO,CDO structures are...

Imagine you are in a bar at a table with friends.

You order pitches of beer. The waitstaff tells you that this is OK, but when they bring the pitcher to the table, there are some firm rules.

1.They HAVE TO fill the mugs in a PARTICULAR order. The mugs on the table are labeled A,B,C,D,E and they have to fill them in alphabetical order.

2. A mug has to be filled up to the top before they can move on to the next.

3. You have to keep the mug you started with.

As long as the pitchers they bring are full, it really doesn't matter who's mug gets filled first, everyone gets a full mug every time.

But eventually they bring a pitcher that isn't quite full. They explain that they are running out of beer and can't bring full pitchers any more.

If you happen to be drinking from mug A or B ..... you don't care. But if you are drinking from mug D or E you care plenty!

But if you are drinking from mug A or B, the pitchers can be really be pretty empty and you are still getting full mugs. Your friends with mugs C,D and E however, are out of luck.

This little analogy is how CMO's CDO's and the like work, in general. Each CDO is not really one security, but several "tranches" The A trance gets paid off first. That means that ALL the principal payments on the entire CDO go to tranche A first. After A is paid the principal payments get directed to B second and down the line.

So the early tranches what are called the "top of the capital structure" CAN INDEED be rated AAA because just like mug A and B, defaults have to get pretty darn bad before those tranches feel the pinch.

The later tranches, of course, can be and often are, schlock. There is a fixed and constant amount of risk in each deal. If some tranches are constructed to be less risky, that risk doesn't just vanish. It gets concentrated in the later tranches.

So, even if the underlying securities are impaired, as long as there is SOME cash flow, the top of the CDO capital structure can be AAA because the early tranches get first dibs.

So, the fact that Morgan is creating things, some of whose pieces will be AAA is NOT shocking at all. Someone will buy them ....and probably make money if they take the time to research and understand what they are buying.

[On the Road]

5. So Econoclast,

are you saying that the tranches these CDOs were based on were the most senior (so to speak) to begin with, or were they reconfigured in some way to make them more senior? If they were originally high-grade to begin with, why is it necessary to re-market them?

I understand your analogy and unlike most it was actually helpful. I just didn't grasp the specifics very well from the article.

[econoclast]

8. OK .... more

Ok … lets go back to our example…..

You are the guy drinking from mug C, and after the beer shortage your mug only gets half filled. Your friends D and E are high and dry.
Kind’a sucked the life out of the party. You’re thinking about going home, but you’d also like to get some of your money back. Maybe you can sell your rights to the next few half mugs? But who wants to buy half a beer?

Then you get an inspiration ….. BEER SHOTS!!!

You’ll sell shots of beer. You basically replicate the rules the bar has for selling pitchers, but you are selling off the half mug you keep getting poured.

You will sell shot glasses of beer. Shot glass “a” gets filled first, then “b” then “c” and so on.

Even if the beer shortage gets worse, the person buying beer shot “a” has a pretty good chance of continuing to drink. The person buying “b” somewhat less of a chance, etc.

Why would someone buy beer shot “g” – the bottom of the capital structure? Well it probably only costs a few pennies and ….. just think of the bonus they’ll get if the beer truck finally shows up!!!!

This is what Morgan is up to. They have some CDO that is already impaired. (Mug C)
Maybe it is rated single A – I haven’t checked to see exactly what it is rated.
Morgan’d like to sell it if they could. And in fact there are people who think that, if they could buy it on the cheap it might be a good investment. The problem is, these particular institutional investors are prohibited from buying things not rated AAA.

So Morgan is going to re-shuffle and re-market the reduced cash flows that the original CDO is still receiving into a NEW CDO structure. The “top” of this new capital structure will, itself, merit a AAA rating. This despite the fact that the cash flows originate from an instrument rated single A. Things are already bad …. Hopefully at or near a bottom. Things will have to get much worse before the top of the new structure is impacted. And the rating agencies don’t think they’ll get that bad. Hence, the AAA rating on the top of the structure.

This will allow the AAA pieces to be sold to investors whose rules only permit them to buy AAA. Of course the bottom of the structure is Bbb, but it is priced like it is Bbb. And there is usually someone around who’ll take a flyer on something like that if it is attractively priced.

Keep in mind that being rated AAA does not mean a security is bulletproof. Just the same way as stainless steel is not stain”proof” steel

[On the Road]

10. So Are You Saying That They Restructure

just the Single-A tranche so that there is a portion that is first in line for payments? It wouldn't seem that the difference between the top and bottom of that tranche would be sufficient to raise it to a Triple-A rating. But maybe so.

Or are you saying that they have to restructure all the tranches? In that case, what would happen to current holders of securities based on the Triple-A tranche?

Just trying to clarify. Appreciate the explanation.

[econoclast]

11. they are the holder not the issuer

They are reshuffling only the tranches they own. Not sure how much/many that is. Maybe they own the all of them, maybe only one. But that is the idea. They'll take a security ( or group of them) that is rated say single A and reshulffle the cash flows to create a less-risky-than-the-original slice that can have a higher rating than the original and a riskier-than-the-original slice that will be rated lower than the original.

[On the Road]

12. I See

Would not have expected that. Thanks for the clarification.

It still means they'll have to find buyers for the lower-rated slices. But maybe some of the risk-taking money has come back.

[notesdev]

7. the key to the fraud

"There is a fixed and constant amount of risk in each deal."

Maybe so, but the chances are pretty good that risk is being misrepresented completely. A lot of these AAA senior tranches are worth 40 cents on the dollar or even less, even with all the cannon fodder of junior tranches sucking up the losses.

[econoclast]

9. not misrepresented

No, not misrepresented risks. MISPRICED risks. 40cents on the dollar is a misprice of the AAA assets. They are UNDERPRICED. Lots of the AAA “toxic” assets are still making all their scheduled principal and interest payments. They are money good.

But the thing with CMOs CDOs etc is that each one ….. even each tranche within a CDO CMO is a separate animal. A one-off. Buying 2 lots of CDOs is not like buying 2 lots of Treasury bills. You have to be very careful about just what you are buying. And the market is in no mood for studious analysis.

The market has basically thrown up its hands and declared “a pox on all your houses” about the entire CDO market. Good and bad alike. So there are no bidders. Even for things that are still paying. And most of the AAA slices are still paying. By and large the banks own the top of the CDO CMO capital structure.

That’s why the banks won’t sell them. Given the levels to where they have been marked down on their books, these things are the most profitable items on the balance sheet. Return to marked value of 18%+ That’s why the programs designed to purge the banks of their “toxic” assets haven’t flown. Those “toxic” assets are still making payments and the banks won’t part with the high returns.

The AAA slices shouldn’t be priced as low as they are. Good old fashioned security analysis says that the market price of a security should be equal to the discounted present value of the future cash flows. And the cash is still flowing and there is still a couple’a points of default protection on lots of the AAA pieces.

[notesdev]

13. The ratings are the misrepresentation

If something has any risk of dropping to 40 cents on the dollar, then an AAA rating - which implies next to zero chance of default - is a gross misrepresentation.

[notesdev]

6. I drank too much coffee this morning

I think I'll grab a newspaper and make some AAA deposits.

[Wednesdays]

14. K&R

:kick: