Financial Alchemy at Morgan Stanley: Greywolf A3 CDOs now Aaa bonds
The Online Merriam-Webster Dictionary describes alchemy as “a power or process of transforming something common into something special” or “aiming to achieve the transmutation of the base metals into gold.” Well, it seems Morgan Stanley is engaging in some financial alchemy because it is about to trade near-junk rated paper for Aaa gold-standard bonds (hat tip Max Keiser and Stacy Herbert).
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.
Here’s the problem. In June, Moody’s downgraded the Aaa tranche of this CDO six notches to A3 because the default rate for loans in the tranche soared to 7 percent. So, now, Morgan Stanley has been able to re-package this paper, and…voila this debt is Aaa again. Everybody’s doing this repackaging. Goldman plans to sell over $200 million of repackaged Commercial mortgage-backed paper very soon.
So, when earnings start coming in this quarter and you are wondering how these banks aren’t writing down huge losses due to events like this and this, you now have one more reason why. Here are two more reasons here and here. The question is whether investors will be fooled.
ps. – I am sure Morgan Stanley added credit enhancement, collateral, reduced the poorly performing assets, etc, etc. But, nevertheless, you have to wonder how this stuff gets a Aaa rating when substantially the same loan pool was just downgraded six notches.
Source
Morgan Stanley Plans to Turn Downgraded Loan CDO Into AAA Bonds – Bloomberg
Ed,
It would seem to me that this isn’t all that unreasonable. Asset values have declined, the downside is probably much less than it was originally and there isn’t any reason you can’t take a CDO or any other securitization and retranche it. You could even argue that now might be the time to pick up something like this if the return is respectable.
I would take some issue with your comment that it’s substantially the same loan pool. It seems to me it’s a loan pool that’s been totally reworked.
One other observation. Investors should know by now what the risks are in these deals. If they don’t do their own due dilligence at this point in time, they really deserve no sympathy if this goes poorly.
Usually the way these things work is that they write down the principal in order to boost the rating. People would rather have $87 million notional of a AAA-rated tranche than, say, $150 million notional of a A-rated tranche. No changes to the underlying loan pool are required. The logic is actually fairly simple and transparent because you’re more likely to get back $87 million than $150 million. That improvement in odds gives you your better rating. There’s nothing really underhanded or mysterious about it.
I never implied it was underhanded to begin with. Morgan Stanley is just looking to make money out of securitized assets. It is the rating agencies who must decide if those assets qualify as Aaa. It seems highly suspect that th asset pool gets downgraded, yet assets from that same pool now qualify as Aaa.
Who is buying the schlocky assets left over that got this CDO pool downgraded to begin with? What is it rated? Is MS forced to hold onto it? This re-packaging raises a lot of questions of that nature.
Edward,
Your analysis is pretty good. The whole point of the transaction is that there is some portion of the underlying collateral which the ratings agencies will label as money-good, even if the collateral is rated single-A. It might be miniscule, but it still allows you to create some portion of AAA from single-A collateral. The tradeoff is that there is no secondary market for resecuritized CDOs. MS could care less as they are making arbitrage profits but you better be aware that if buy this stuff you are holding on to it forever.