Morgan Stanley’s Pre-2008 Mortgage-Backed Securities Strategy

Morgan Stanley trader Howard (Howie) Hubler reportedly lost the firm about $9 billion, the largest trading loss in financial history, after net-long positions on mortgage-backed securities (MBS) soured in 2007. Were the transactions underlying Hubler’s position on Morgan Stanley’s nostro (proprietary) account or were they principal transactions, simply part of the bank’s securitization of MBS?

Hubler was named Managing Director of the Global Proprietary Credit Group (GPCG) in early 2006. Financial News reported in April 2006 that the creation of GPCG was meant to reorganize Morgan Stanley in such a way as to “separate buyside client business from principal activities.” GPCG was placed under the principal group umbrella, as opposed to the client-facing group, along with Global Commercial Real Estate Lending and Warehousing, and the Residential Principal Group. Hubler reported to Tony Tufariello, Global Head of the Securitized Products Group, who said that the reorganization would “enhance our client-oriented sales and trading businesses and take advantage of proprietary trading and investment opportunities.”[1]

GPCG’s activities were also chronicled in The Big Short. Before GPCG was formed, Hubler was squarely in the client-facing securitization business and Morgan Stanley developed MBS credit default swaps (CDS) to offset the risk from their ‘warehouse’ of mortgages. By 2004, Hubler’s desk had entered into around $2 billion of CDS on BBB- asset-backed securities (ABS). Eventually, Morgan Stanley created GPCG as a proprietary trading group and moved Hubler’s desk eight floors above his old bond desk to separate the prop trading from the customer business, as reported in the Financial News. According to The Big Short, GPCG went on to sell about $16 billion of CDS on AAA MBS to pay the premiums on the lower quality CDS they had bought. These transactions were completed with Hubler’s contemporaries at firms like Deutsch Bank, Bear Stearns, and Merrill Lynch.[2]

More information of this organizational structure is available in public filings from legal action brought against Morgan Stanley and Hubler. In the Matter of Morgan Stanley and Co. LLC, et al., Administrative Procedure File No. 3-15982, Morgan Stanley settled cease-and-desist proceedings with the SEC, paying $275 million in disgorgement, interest, and penalties for making misleading public disclosures regarding the number of delinquent loans in two subprime MBS that GPCG and MSAC (more below) sponsored, issued, and underwrote.[3] The settlement dealt with two particular securitizations that “were created by a team within Morgan Stanley’s [GPCG] (the ‘Finance Group’). The Finance Group provided the Collateral Analysis Group (‘Collateral Analysis’) . . . with specific criteria for selecting a loan pool to securitize from Morgan Stanley’s inventory of mortgage loans. . . . The selection of the loan pool was an iterative process as certain categories of loans were switched in and out at the direction of the Finance Group.”[4] If investors asked for information about delinquency history, the “Finance Group forwarded [charts] to sales personnel.”[5]

Moreover, a complaint filed by the Federal Housing Finance Agency reveals that Hubler, in addition to heading GPCG, “also served as a Director” at Morgan Stanley ABS Capital I, Inc. (MSAC).[6] “MSAC was the depositor” for many Morgan Stanley securitizations and, as depositor, “MSAC was responsible for preparing and filing reports required under the Securities Exchange Act of 1934.”[7] MSAC would purchase mortgage loans from affiliated Morgan Stanley entities “pursuant to the applicable Assignment and Recognition Agreement or a Mortgage Loan Purchase Agreement,” and then “sold, transferred, or otherwise conveyed the mortgage loans to be securitized.”[8] Hubler “participated in the operation and management of [MSAC], and conducted and participated, directly and indirectly, in the conduct of [MSAC’s] business affairs.”[9]

The preceding story suggests that Hubler’s MBS position transitioned from principal to proprietary risk in 2006. The Financial News article and The Big Short make it sound like the principal activities groups, including GPCG, were separated, organizationally and physically, from client-facing activities for the purpose of allowing them to engage in prop trading. GPCG undoubtedly arranged at least two securitizations, as set out in the SEC documents, and likely participated in more since MSAC was the depositor for many more securitizations, although the Residential Principal Group was probably also responsible for securitizing loans. However, GPCG’s participation seems like it was assistance with arranging the underlying loan portfolio, which would then be transferred to client-facing teams separated by information walls. GPCG would then remain free to enter the MBS market through whatever transactions it deemed appropriate, irrespective of who bought the MBS it helped construct, because it was not connected with the marketing and sale of those MBS.

Yet, the principal groups were an integral part of the buyside securitization process all the way through 2007, and Morgan Stanley still had loans warehoused for securitization when the market collapsed. Therefore, I think the distinction between GPCG’s proprietary trading and Morgan Stanley’s overall MBS risk exposure is slightly artificial. Hubler’s compensation might have been driven by GPCG’s proprietary profit-and-loss but the group’s contribution to Morgan Stanley’s mortgage exposure, through its warehouse securitization activities, did not disappear with the 2006 reorganization.


[1] Renée Schultes & Jonathan Sibun, Morgan Stanley creates new trading group, Financial News (Apr. 17, 2006), https://www.fnlondon.com/articles/morgan-stanley-creates-new-trading-group-20060417.
[2] Michael Lewis, The Big Short: Inside the Doomsday Machine (W. W. Norton & Company, 2010).
[3] https://www.sec.gov/divisions/enforce/claims/morgan-stanley-abs.htm
[5] Id. at 7.
[7] Id. at 6.
[8] Id. at 26.
[9] Id. at 85.

Comments

  1. ZacklenoxFebruary 22, 2018 at 2:34 PM

    To follow up: After looking back at Morgan Stanley's disclosures from 2007 and 2008, it looks like GPCG's proprietary trading activities can be blamed for about 75-80% of the bank's total mortgage-related losses during the financial crises. The remainder of their losses were from non-performing loans on their balance sheet.

    ReplyDelete

Post a Comment

Popular posts from this blog

A Plumber's View - Voting Intermediated Shares

Image
Introduction “The existing system of shareholder voting is crude, imprecise, and fragile. Gil Sparks, a leading Delaware lawyer, estimates that, in a contest that is closer than 55 to 45%, there is no verifiable answer to the question ‘who won?’” [1] That system, explicated by Kahan and Rock in 2008, is largely the same system employed today. This post updates the seminal work of Kahan and Rock, from whom the quote came, by (1) briefly reviewing how shareholder voting in the United States is crude, imprecise, and fragile, [2] (2) comparing the U.S. system to other shareholder voting systems around the world to highlight practices that are more precise and robust, (3) discussing technology that can increase the certainty and validity of shareholder votes, and (4) suggesting regulatory reforms that might alleviate some voting problems. U.S. Proxy Voting This section reviews how shareholder voting in the United States is dysfunctional. It starts by presenting background...
Read more

Planned Misery

I want to briefly address what Professor Susan Marks, of the London School of Economics, calls ‘planned misery’. [1] In her writing, planned misery “denotes misery that belongs with the logic of particular socio-economic arrangements.” [2] To me, this definition invites reflection about how global capitalism is structured such that human, labor and environmental rights abuses perpetrated in developing countries in industries like mining, textiles, and electronics seem unavoidable. There is a very positive side to globalization over the past 30 years. Namely, the combination of increased foreign investor protections and lower trade barriers have increased the flow of capital to poor countries, redistributing industrial resources from rich countries to the global poor, and increasing standards of living throughout the developing world. The quintessential contemporary model for this story is China but there are many other examples. For instance, China’s economic miracle might be put ...
Read more

Corporate Governance Overview - Current Issues

Introduction This post provides a summary report on a collection of public company corporate governance topics, including the historical development of the issues, the positions adopted by major institutional investors and proxy advisory firms, and the current state of corporate America with respect to the topics covered. Corporate governance refers to a panoply of issues, generally focused on the board of directors. A corporate board is the governing body for the company. The board sets corporate policy as well as, among other things, oversees company executives, decides executive pay, and assesses major transactions. In carrying out its role, a board must act in accordance with federal law, state law where the company is incorporated, and the corporate charter and bylaws. Additionally, board members are held to fiduciary duties like loyalty and care, which ensure that board members do not have conflicts of interest and act in an informed manner. Within these constraints, ho...
Read more