Dead Presidents in detail | FT Alphaville

Dead Presidents in detail

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Detail on Morgan Stanley’s Dead Presidents deals, the synthetic CDOs reportedly being investigated by US prosecutors, are slightly more difficult to come by than Goldman Sachs’ Abacus. Luckily ProPublica have gotten hold of the Jackson 2006 Series prospectuses — one of the deals cited in the Wall Street Journal’s report — which means we have a bit more insight on the way the subprime CDOs were structured.

According to the WSJ, Morgan Stanley is being investigated for possibly misleading investors about CDO deals it helped designed and then sometimes took short positions against. The bank has denied misleading investors and said it’s unaware of an investigation.

But there are hints in the Journal, and a 2009 New York Times article, that the CDOs had a couple of features that made them particularly ‘special’ as structured finance goes. Here’s the WSJ:

One feature of the Morgan Stanley deals was a structure that could increase the magnitude of the bullish investors’ exposures to the underlying mortgage bonds. This feature, which was disclosed in some offering documents, made it more likely that such investors could lose money if the underlying bonds performed poorly.

And the NYT:

Banks also set up ever more complex deals that favored those betting against C.D.O.’s. Morgan Stanley established a series of C.D.O.’s named after United States presidents (Buchanan and Jackson) with an unusual feature: short-sellers could lock in very cheap bets against mortgages, even beyond the life of the mortgage bonds. It was akin to allowing someone paying a low insurance premium for coverage on one automobile to pay the same on another one even if premiums over all had increased because of high accident rates.

That sounds like an Automatic Reinvestment feature. This was something that was marketed to CDO investors in the heady pre-crisis days. Many CDOs had a built-in period in which repaid principal would be reinvested. The Auto Reinvest was meant to make that process as easy and fast as possible.

The downside was that it happened despite the performance of the reference portfolio. Even as the housing market collapsed, your CDO could still be taking long positions in it. The flip-side (we think) is, as the NYT suggests, that those on the short-side could still make cheap bets against subprime.

A commenter over at Felix Salmon’s blog has a neat explanation:

Subprime mortgage bonds amortize so ABS CDOs amortize (or were supposed to). On a synthetic deal, you could structure the CDS contracts underlying the CDOs to reference a specific subprime mortgage bond but allow the notional that was referenced on the underlying bond to change over time. As the underlying bond amortizes, you simply have the amount of notional increase by the same amount. In this way, there is no amortization on the top level CDO tranches. At a certain point (usually 10-20% of original face), the notional is amortized down at 5-10 times the rate of the underlying mortgage security, thus paying off the tranche.

The rub here is that, because the underlying mezzanine subprime mortgage bonds would, in the best case, likely pay down pro rata with the rest of the structure, you are increasingly becoming exposed to the bottom 20% of the collateral pool underlying the deal. This is problematic even in a non subprime meltdown scenario because the tails of these pools, even to casual observers, were cuspy at best.

In hindsight it’s a rather unpalatable structure from a long-subprime investors’ point of view. But from a short perspective it’s a stroke of pure securitised genius. Whatever one’s position, however, it looks like all of the Jackson 2006 prospectuses mention the Reinvest feature in their risk factor summaries.

For example, from Jackson 2006-I :

The synthetic reinvestment of principal payments in the same Reference Obligation will occur automatically under the circumstances described above, even if the credit quality of the Reference Obligation has deteriorated. Accordingly, the synthetic reinvestment feature will operate to increase the exposure of Noteholders to a Reference Obligation as its principal balance is reduced. As a general matter, the RMBS Securities and CMBS Securities are likely to experience increased defaults the longer that such securities are outstanding. Accordingly, the fact that the Applicable Notional Amount of a Reference Obligation will not be reduced in conjunction with its principal amortization until the 20% threshold is reached may increase the potential magnitude of any losses resulting from the occurrence of a Credit Event with respect to any such Reference Obligation over time.

Only one of the prospectuses (V) mentions Morgan Stanley, and that’s as a counterparty to a currency swap. An absence of disclosure, according to the WSJ’s report, seems to be the prosecuters’ problem with the deals, if indeed they really are investigating them. The CDO structure, so far as we can tell, isn’t really at fault here.

But it does tell you something about the potential for huge asymmetric gains and losses in pre-crisis CDOs. Whether long and short-investors were operating on the same playing field is presumably the crux of prosecutors’ and the SEC’s new-found interest in structured finance.

On that note, the below links are worth a perusal.

Related links:
Cashing in on subprime – D Magazine
More on the CDO of ABS possible Ponzi – Deus Ex Macchiato
How Lucido helped AIG lose big on Goldman Sachs CDOs – Bloomberg
The experience of Laura Schwartz – FT Alphaville