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Researcher Criticizes Rivals On MBS Structures

A researcher at J.P. Morgan Securities has taken the unusual step of singling out and criticizing other dealers for selling structures with embedded risks that are not properly disclosed, while rival dealers fire back that the analyst's motivations are not beyond reproach.

A researcher at J.P. Morgan Securities has taken the unusual step of singling out and criticizing other dealers for selling structures with embedded risks that are not properly disclosed, while rival dealers fire back that the analyst's motivations are not beyond reproach. David Montano, head of mortgage-backed securities research at JPM in New York, wrote in a recent research report that certain collateralized mortgage obligations structured by dealers including Bear Stearns, Deutsche Bank, Lehman Brothers and UBS are taking advantage of sophisticated investors. Bankers and research officials at the firms either declined comment or did not return calls.

Montano implied that the firms are not adequately disclosing the characteristics of the structures in prospectuses, which is causing the bonds to extend shortly after they are sold. "Some of these bonds, only one month after creation, extend by more than 10 years (compared to the average lives disclosed in the prospectuses). The triggers in many of these structures are set up such that they are almost always hit in the first couple of months," Montano wrote. The contention surrounds so-called non-sticky jumps, a type of CMO structure.

"I've never seen a dealer knock another dealer in a research report," said one veteran structured products salesman. He added it is even more surprising given heightened compliance concerns.

Rivals say Montano's criticism amounts to nothing more than sour grapes. One said the report is motivated by the fact JPMorgan is not as strong in CMOs as those it singled out. "I don't know what [JPMorgan's] challenges [in CMOs] are, but historically that's been the motivation [for one dealer to criticize another]--the firm doesn't have the distribution or the capability to get deals done," retorted one MBS professional. "I question whether it was motivated from the milk of human kindness," added a head of MBS research at another firm, referring to the report. He speculated it was put out to dent the business of other dealers who are active in the market. "They are pretty much a non-player in this, which is why it's easier for them to bring up these issues," he said, referring to JPMorgan.

The issue underscores the fact that fixed-income research, despite regulatory intervention on the equity research side and The Bond Market Association's recent release of recommendations for fixed-income research, continues to be seen by investors and the sell-side as a tool to drum up, or in this case down, interest in certain securities. It remains that way, even though equity research has been radically transformed in recent years, because of the institutional nature. "We're not talking with mom and pop investors here. No one wants to waste time. Fixed-income investors are not of the mindset to do anything about something like this, they are more likely to just ignore it," said one analyst.

In light of some of the opaqueness of these structures, Freddie Mac is incorporating new requirements and is going so far as to require dealers to provide investors with a "letter of awareness" on the products they sell. It is also raising minimum denominations to $1 million from $100,000, said Mike Dawson, v.p. of multi-class issuance. "We've been in discussions with a number of dealers about how to differentiate some of these structures. It was somewhat of a coincidence that the article came out." Dawson said the awareness letter, the final shape of which is still being worked out, and the higher minimum denomination are signs of "complexity differentiation."

Although dealers have been selling these CMO structures for some time, Montano wrote the growth of these structures over the last year has come to the point where there is a critical mass; furthermore, CMOs are occupying an increasing part of the overall mortgage-backed securities market. He declined comment beyond the report.

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