Analysis: If M Stanley and Goldman don’t get it, who will?

By Lauren Tara LaCapra

NEW YORK (Reuters) – New revelations about a billion-dollar derivatives dispute between Goldman Sachs Group Inc and Morgan Stanley underscore just how hard it will be for Wall Street to convince investors to buy innovative new products in the near term.

That suspicion on the part of clients will make it only harder for banks to boost their trading revenues, analysts said.

To be sure, memories on Wall Street are short and investors’ wariness may not last, but for now it’s real, experts said.

A report by a Senate subcommittee is set to disclose details about a derivatives transaction that Goldman used to bet against the housing market starting in 2006, according to the Wall Street Journal. Morgan Stanley took the other side of a big part of the deal.

In 2007, as the housing market headed south, the two banks squabbled over how much collateral Morgan Stanley should put up. But Morgan Stanley also argued that Goldman Sachs had a conflict of interest because it was in charge of liquidating the credit derivatives linked to mortgages that were bundled into the derivatives transaction.

Because Goldman was betting the underlying mortgages would weaken, it had an incentive to take as long as possible to liquidate, giving the home loans even more time to deteriorate.

Morgan Stanley believed Goldman was obliged to sell immediately when triggers were hit, and considered suing the bank, the Journal reported.

Goldman realized only belatedly that it would be in a conflict position as liquidation agent when it was also short the instruments, known as Hudson Mezzanine Funding 2006-1.

Spokesmen for Morgan Stanley and Goldman Sachs declined to comment on the Journal report.

Experts said the subcommittee’s findings could reveal just how poorly Wall Street understood the instruments it foisted on investors in the run-up to the credit crunch. Morgan Stanley lost big money from making the wrong bet. But even Goldman Sachs, which made the right bet, did not seem to have considered that being a liquidation agent and being short on the same deal could be a conflict of interest, or at least a public relations mess afterward.

Investors who were already suspicious of new products from Wall Street are likely to be even more wary, analysts said. New and complicated products have long been a key source of trading profits for investment banks.

“The real issue is, if you think you’re buying something, is that really what you’re buying?” says Peter Vinella, a director at Berkeley Research Group who has spent over 25 years in the structured-credit and derivatives business.

Investors’ distrust of Wall Street is manifest in the market for asset-backed securities, where companies issued just over $100 billion of bonds last year, compared with more than $700 billion of debt both 2005 and 2006.

For collateralized debt obligations, a newer and more sophisticated product known as “CDOs,” annual issuance fell 98 percent between 2006 and 2010.

“I haven’t seen anybody and I haven’t talked to anybody that has any increasing appetite” for structured credit products, said Vinella. “On the flip side, the idea of aggressively marketing these products right now isn’t the most appetizing, either.”

Declining demand for new products may be evident in banks’ trading results. For example, in 2006 Goldman Sachs delivered $25.6 billion of revenue and $10.6 billion of pre-tax earnings from its trading business; last year, it reported $21.8 billion in revenue and $7.5 billion of pre-tax earnings from that division.

“It’ll have to become a lower margin, higher volume business,” said Kevin McPartland, a senior analyst at consulting firm TABB Group who focuses on derivatives.

But experts warned against writing off complicated products for good.

Frank Iacono, a partner at Riverside Risk Advisors who traded and structured credit derivatives deals at Morgan Stanley until 2008, strongly believes the business of structured finance will come back eventually. He notes that while investors aren’t buying into subprime residential mortgage CDOs, demand for structured equity and commodity products has risen.

“You can’t underestimate the market’s capacity to repeat the same mistakes but with a different form,” he said.

(Reporting by Lauren Tara LaCapra; editing by John Wallace)

Analysis: If M Stanley and Goldman don’t get it, who will?