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Net Net: Promoting innovation and managing change

In Defense of Morgan Stanley's 'Nuclear Holocaust'

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Jesse Eisinger paints a pretty awful picture of banker misbehavior in his latest Pro Publica column.

On March 16, 2007, Morgan Stanley employees working on one of the toxic assets that helped blow up the world economy discussed what to name it. Among the team members' suggestions: "Subprime Meltdown," "Hitman," "Nuclear Holocaust," "Mike Tyson's Punchout," and the simple-yet-direct: "Shitbag."

These facts have come to light thanks to a lawsuit brought against Morgan Stanley by a Taiwanese bank that invested in a $500 million collateralized debt obligation. According to Eisinger, $415 million of the assets backing the CDO, which was actually called Stack 2006-1, wound up being worthless.

Most of those suggested names came from a lawyer at Morgan Stanley named Phillip Blumberg. His emails were released to the public as part of the lawsuit. It's just incredible that this sort of thing still gets sent around in emails just a few years after Wall Street's equity analysts found themselves under fire for, among other things, sending internal emails dissing the stocks their firm's were selling to the public. They'll never learn, I guess.

Eisinger's Morgan Stanley bankers, however, were not selling equities to ordinary retail investors. They were putting together structured financial products that were sold to sophisticated financial institutions. There's a big difference between selling a product to a retail investor and a bank, even a Taiwanese bank.

Or, at least, I think there should be. I get the feeling that Eisinger is not so sure their should be a difference at all. He seems to want to impose the kind of financial paternalism that we require for retail investors on the institutional end of the market. Actually, he wants to go even further than that. His argument is that investment banks shouldn't sell products if they have taken a position against those products.

"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," Eisinger writes.

Eisinger is, of course, correct that people "across the bank" understood the housing market was in trouble. But he implies that this was some kind of secret knowledge, something Morgan Stanley kept hidden from outsiders, which just isn't the case. In fact, at the time Morgan Stanley was openly one of the most bearish shops on Wall Street when it came to housing.

In October 2006, for example, Morgan Stanley issued a note asking "Is The Housing Recession Over?" Noting that there were glimmers of hope in the market, Morgan Stanley analyst Richard Berner wrote "Call me stubborn, but I still think the housing recession has a long way to go." What's more, Berner issued a warning about mortgages and mortgage lending in particular: "the deterioration in mortgage credit quality is just beginning. We think that lenders are more at risk than are borrowers…"

A few months earlier, in August 2006, Morgan Stanley chief economist Stephen Roach wrote a note entitled "Another Post Bubble Shakeout" that described the effects of the bursting of the housing bubble in dire terms."

"Today, America's housing bubble is finally bursting. Is the die cast for another bubble-induced downturn in the US and global economy?" Roach asked. He went on the answer his question in the positive.

These were not secret memos that only Morgan Stanley's bankers saw. They were available on Morgan Stanley's website and emailed out to clients. So while it is true that people "across the bank" had information that America's housing market was in trouble, it's not true that this was some secret.

Should Morgan Stanley have foregone selling credit products linked to the mortgage market because of this view? The Taiwanese lawsuit and Eisinger's article are based on the premise that this is the case.

But that's not how Wall Street operates. Investment banks have typically allowed clients to take the opposite sides of trades, even when they regard one side of the trade as misguided. This is still common practice.

Take, for example, Goldman Sachs. Last quarter, Goldman made $2.95 billion in fees for underwriting bonds for corporate clients. Goldman's CEO is on record saying it is telling all of its corporate clients to borrow as much as they can now, while rates are at record lows.

But Goldman's CEO has also warned that bond investors are too complacent about low rates.

"Someone is buying that debt," Blankfein said at a New York Times' Dealbook conference in December. "What's going to happen when growth picks up and interest rates rise? There's going to be a reversal and people will have losses."

I have no doubt that Goldman is trying to position itself so that it will make money when interest rates rise. At that point it will be in exactly the same position as Morgan Stanley in 2007: having positioned itself to make money from the fall in value of bonds it sold to investors.

To put it in Eisinger's terms, people across Goldman Sachs understand that the American bond market is in trouble. They are taking advantage of that knowledge to create and then bet against securities and then also to unload garbage investments on unsuspecting buyers.

Hopefully they're all smart enough not to call the latest bond deal the a nuclear holocaust.

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