Morgan Stanley Derivative DilemmaAnnemarie McAvoy in Forbes, May 12, 2010
Carl Gutierrez, 05.12.10, 5:50 PM ET
Morgan Stanley slid on news that it was under investigation for its role in a pair of mortgage-related securities. The brokerage house may seek a settlement in order to make the bad press go away, regardless of whether the investigation will ultimately lead anywhere.
"It's not a surprise they're under investigation," said Annemarie McAvoy, adjunct professor of Fordham Law School and former federal prosecutor. "Any firm involved in collateralized-debt obligations are likely being looked at, whether these investigations will be taken public is another issue."
On Wednesday reports said federal prosecutors are investigating whether the firm misled investors about its role in a pair of $200 million derivatives. According to the report, Morgan Stanley sometimes bet against the success of the derivatives, which were underwritten and marketed to investors by Citigroup and UBS.
The report, published by the Wall Street Journal, sparked worries that Morgan Stanley could ultimately face some charges, and shares of the bank slid 2%, or 58 cents, to close at $27.80.
McAvoy, who as also a former in-house counsel for Morgan Stanley, noted the difficulty required to bring in these kind of charges. "These cases are hard for the U.S. attorney’s office to bring because they are so technical that even people within the field have problems understanding these transactions," McAvoy said. "They aren’t like a murder case which people can easily understand, nonetheless, they still operate under the same standard which is beyond a reasonable doubt."
Even so, the longer they stay in the news, the worse it makes the company look, regardless if it did anything wrong. "They're in a difficult situation because these firms can't defend themselves until they get into a courtroom, so all they can do now is put out a press release," McAvoy said, "all the while the investigation may go nowhere."
Which is why they may choose to settle. "They just want it out of the press and the media and make their clients not have to think about it," McAvoy said.
The negativity was contained to Morgan Stanley, though, as shares of Citigroup ticked up one cent to $4.18, while UBS gained 1.5%, 22 cents, to $14.98, in New York. The broader sector, as measured by the Financial Select Sector SPDR exchange-traded fund, rose 1.1%, or 18 cents, to $16.05.
The SEC refused to comment on the report. Morgan Stanley said it has not been contacted by the Justice Department about the transactions mentioned in the WSJ report and that it has no knowledge of an investigation.
Wednesday's development harkens back to the recent government suit leveled against Goldman Sachs regarding mortgage-related securities. (See "Goldman Punched In The Gut.") In April the SEC filed a civil complaint against the firm and one of its employees, alleging they failed to disclose vital information to investors regarding the collateralized debt obligation that one of its clients helped create and then shorted.
Like the Goldman case, the news about Morgan Stanley comes as Washington enters what will surely be a difficult financial reform effort. (See "The U.S. Needs Real Financial Reform.") Derivatives and other esoteric financial products played a significant role in the financial crisis as many were tied to the performance of subprime mortgages and the broader housing market. As the housing market collapsed, the value of these securities plummeted, leading to the loss of billions of dollars.