Morgan Stanley Is Next Target Of CDO Fraud Probe

The WSJ reports that "Federal prosecutors are investigating whether Morgan Stanley misled investors about mortgage-derivatives deals it helped design and sometimes bet against, people familiar with the matter say, in a step that intensifies Washington's scrutiny of Wall Street in the wake of the financial crisis." In essence, Abacus comes to Times Square. And the latest soundbite for today's media feeding frenzy: the "Dead Presidents." So going down the list: Goldman - check, Morgan Stanley -check, Merrill, Deutsche and UBS - to come, especially once Khuzami finds a replacement to fill his recused status when investigating the German bank.

Among the deals that have been scrutinized are two named after U.S. Presidents James Buchanan and Andrew Jackson, a person familiar with the matter says. Morgan Stanley helped design the deals and bet against them, but didn't market them to clients. Traders called them the "Dead Presidents" deals.

However, even here, and not unlike Goldman which was flawless in trading last quarter, while MS lost money on a whopping 4 days, the impact to MS was much less from this "hedging" activity, after the firm ended up losing $9 billion in 2007 on mortgage related deals.

Morgan Stanley wasn't among the biggest players in the CDO market. Although the firm made money on the Dead President deals, any profit was far overshadowed by the $9 billion the firm lost on bullish mortgage bets in 2007, a person familiar with the matter said.

As we discussed it previously, the Morgan Stanley CDO loss was among the biggest ever in prop trading history. But don't worry - banks now are prudent when using zero cost of capital discount window money direct from US taxpayers. After all what hedge fund has ever blown up when using free money. Which is why Chris Dodd had nothing to say about it - it must be under control.

We can't wait to see how far down the food chain the fraud investigation goes. Surely, with every firm in the US having done precisely what GS and MS are accused of doing, some heads will have to roll or else not only the SEC but all the various DA offices will look completely toothless when dealing with the Wall Street based masters of the universe.

More from 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.

Morgan Stanley traders took the more profitable, bearish side of these transactions, according to traders. These positions weren't disclosed in some deals. It couldn't be determined how much money Morgan Stanley made with these wagers.

The SEC's industry-wide civil investigation into Wall Street activities in selling CDOs began in 2009. Beginning earlier this year, prosecutors from the Manhattan U.S. attorney's office began showing up to meetings arranged by SEC investigators who were questioning individuals about their firms' practices, people familiar with the matter say.

There have been several rounds of SEC subpoenas issued in the probe, a person familiar with the matter says. Last summer, the SEC asked Wall Street firms about any of their clients that were betting against CDOs, the person says. In the fall, Morgan Stanley provided offering documents to the SEC about CDOs, including its Dead Presidents deals. Morgan Stanley, among other firms, received a subpoena in December 2009 asking about its sale and marketing of CDOs, people familiar with the matter say.

In the past six weeks, a fresh round of SEC subpoenas have asked a smaller number of Wall Street firms for a broad range of information on CDO deals, including prospectuses, offering documents and other data that would include disclosure statements.

On an April 21, 2010, conference call with investors and analysts, Morgan Stanley Chief Financial Officer Ruth Porat responded to an analyst question, saying "we have not received a Wells notice in connection with our CDO business." Wells notices inform firms or individuals that the SEC's enforcement staff plans to recommend that the agency bring charges.