Morgan Stanley Won't Be the Last Wall Street Bank Caught in CDO Snare

Last Updated May 12, 2010 2:34 PM EDT

Bad news for Morgan Stanley (MS): Goldman Sachs (GS) wants to settle SEC charges that it defrauded investors in complex securities known as "collateralized debt obligations."

Wait a sec -- that came out last week. What about new reports that Morgan is under federal investigation over similar allegations? Thing is, that was bound to happen. As Goldman execs recently acknowledged to lawmakers, its CDO practices were standard operating procedure on Wall Street.

The real surprise would've been if Morgan hadn't eventually drawn fire. And since the investment bank is a relatively small player in the CDO business, I'd be even more shocked if more probes weren't announced in the weeks to come. Citigroup (C), Deutsche Bank (DB) and Merrill Lynch (now owned by Bank of America (BAC)), along with numerous hedge funds, all trade in synthetic CDOs.

Although details are thin, the Morgan investigation appears to center on the same issue that got Goldman into trouble -- whether Morgan misrepresented mortgage-backed derivative deals it sold to investors. Reports the WSJ:

Morgan Stanley arranged and marketed to investors pools of bond-related investments called collateralized-debt obligations, or CDOs, and its trading desk at times placed bets that their value would fall, traders said. Investigators are examining, among other things, whether Morgan Stanley made proper representations about its roles.
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 said. Morgan Stanley helped design the deals and bet against them but didn't market them to clients. Traders called them the "Dead Presidents" deals.
Morgan itself couldn't have been taken by surprise. The company received a federal subpoena regarding its CDO deals in December 2009. Today, CEO James Gorman parsed his words carefully in saying that the company has "not been contacted by the Justice Department about any transactions that were raised in The Wall Street Journal article and we have no knowledge whatsoever of a Justice Department investigation."

In other words, Morgan may have been contacted by the feds about suspicious transactions, only not by DOJ and not in connection with any of the deals laid out in the WSJ. Morgan CFO Ruth Porat gave a similarly hedged response during a April 21 earnings call in telling an analyst only that the SEC hadn't formally notified the banking firm that it's under investigation.

Meanwhile, the SEC, Congress and other snoops have been sniffing around CDOs since last year. Certainly, the market doesn't seem caught off guard. Morgan shares dipped a modest 3 percent in early trade after news of the investigation surfaced. By contrast, Goldman's stock price dove more than 13 percent when the SEC disclosed its lawsuit.

In short, Morgan had to know this was coming. At this stage, it's difficult to say what U.S. prosecutors might find at the company. But Morgan will certainly keep close watch on Goldman's negotiations with the SEC. The danger for Morgan is that it finds itself legally hemmed in by any Goldman settlement, since it would be risky for Morgan to fight charges that a rival has already copped to.

Regulators face their own challenges. Assuming that these investigations into CDOs aren't merely a political sideshow intended to boost support for financial reform, such cases are hard to prosecute. They hog resources and are tough to prove. I wouldn't be surprised if, rather than trying to knock down one bank at a time, government officials eventually push for some sort of consolidated settlement targeting CDOs.

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    Alain Sherter covers business and economic affairs for