Did Merrill, Morgan Stanley Overpay?

From WSJ $

Some of Wall Street's biggest players bet heavily on the subprime mortgage sector last year just as it started to head south. Now, investors are questioning whether the firms overpaid to get into a sector that has become less profitable.

Last year, Merrill Lynch & Co. and Morgan Stanley bought subprime mortgage lenders, with Merrill paying $1.3 billion for First Franklin and Morgan Stanley acquiring Saxon Capital Inc. for $706 million.

Matthew Howlett, a mortgage-sector analyst at Fox-Pitt, Kelton, estimates that the pace of subprime lending and the volume of securities backed by such loans may fall by nearly half this year. As a result, Mr. Howlett believes Merrill may have overpaid for First Franklin by $600 million. He doesn't believe Morgan Stanley overpaid as much for Saxon because that business includes a mortgage-servicing platform, which he believes has held more of its value.

Umm, no kidding. We said it at the time that this was a borderline insane decision (buying before the market collapse)

Let me explain how my guess is that this works:

1. You are an MD at ML

2. Your bonus depends on this year's securitization volume

3. Securitization volume starts falling

4. You convince your boss that to use ML's balance sheet (whose capital cost is probably not charged against your bonus calculation) to buy a subprime lender to maintain your flow

This misalignment of incentives is the generous description of what happened...

Posted on May 20, 2007 and filed under Finance.