Some news came down the pipe yesterday that Morgan Stanley is planning to repackage some ugly leveraged loans into AAA-rated collateralized debt obligation securities, also known as CDOs. You might remember CDOs as being one of the major types of securities that got banks into a big mess and led to the credit crunch. As a result, many are surprised and cynical about Morgan's decision to step back into the CDO market. I'm not, because securitization is still, and always should be, a viable option.
Let me start with a truly bizarre quote by Simons:
You cannot make assumptions about how a security is going to perform and rate according to your own assumptions.
Huh? Of course you can. Any rated debt security ever sold, secured or unsecured does that. If I buy a Microsoft unsecured corporate bond, then it has a rating based on some assumptions about how Microsoft is expected to perform in paying back that debt. The idea that you can't evaluate debt based on assumptions is ridiculous.
What he should have done is put the word "bad" before "assumptions." Because that's absolutely true; and that's the mistake the rating agencies made. They made bad -- very bad -- assumptions about the mortgage market.
That raises a question: what if the rating agency and/or Morgan Stanley made better assumptions? Then should the security achieve a AAA-rating? Absolutely.
Now I have no clue what assumptions Morgan Stanley is making, and whether those assumptions are good. But I can provide an example explaining what I mean.
Let's say that those leveraged loans are truly heinous. Imagine they only turn out to be worth 20 cents on the dollar. How in the world could that security get a AAA-rating? Easy. Just include 80 cents on the dollar in a cash reserve to cover losses. That way, any losses from those leveraged loans will be covered by the cash reserve to protect investors' principal.
It's important for people to realize that the credit crunch was not caused by securitization -- it was caused by very poor assumptions used to rate securitizations. In a different world, with smarter rating agencies and investors who did due diligence, things might have turned out better. The future of finance should not exclude securitization. It should continue to be utilized, just with better assumptions.