Another man's junk is another man's treasure. Morgan Stanley is taking this saying and trying to profit from it: Morgan Stanley Plans to Turn Downgraded Loan CDO into AAA Bonds. Morgan Stanley is trying to turn junk into gold.

Morgan Stanley plans to repackage a downgraded collateralized debt obligation backed by leveraged loans into new securities with AAA ratings in the first transaction of its kind, said two people familiar with the sale.

Morgan Stanley is selling $87.1 million of securities that it expects to receive top AAA ratings and $42.9 million of notes graded Baa2, the second-lowest investment grade by Moody’s Investors Service, according to marketing documents obtained by Bloomberg News. The bonds were created from Greywolf CLO I Ltd., a CDO arranged in January 2007 by Goldman Sachs Group Inc. and managed by Greywolf Capital Management LP, an investment firm based in Purchase, New York.

CLO stands for collateralized loan obligation. A collateralized loan obligation is a form of securitization. An issuer, in this case Morgan Stanley, pools a portfolio of loans which serves as the "collateral". Next, the issuer will then issue securities typically in the form of bonds (or debt instruments) that have a claim on the proceeds from the loan pool. The issued securities are structured into "senioritized credit tranches" or tranches for short. These tranches are the key part of a CLO. Each tranche may have a different level of seniority and credit risk. The most senior tranches typically carry the highest rating (AAA).

The interesting thing about what Morgan Stanley is doing is that they turning junk to AAA or at least trying.

Moody’s reduced the $365 million top-ranked portion of Greywolf in June by six levels to A3 from Aaa as the default rate on the loans in the CDO rose to 7 percent.

Why is Morgan Stanley doing this? Simple, because there is a huge market for it. But why does anything a rating agencies says mean anything at this point?

A lot of banks and insurers “cannot buy anything but AAA,” said Sylvain Raynes, a principal at R&R Consulting in New York and co-author of “Elements of Structured Finance,” which is due to be published in November by Oxford University Press. “You’re manufacturing AAA out of not AAA, therefore allowing those people who have AAA written on their forehead to buy.”

Morgan Stanley is doing this by either adding an additional layer of debt, offering questionable additional collateral or possible using Credit Default Swaps. Like we need more leverage in the system.

Morgan Stanley is copying a financing structure known as Re-REMICs that bundle mortgage securities into new bonds that often offer investors an additional layer of protection, or collateral, from downgrades.

But Morgan Stanley is not alone. Banks and insurers are doing to right now.

Banks are using re-REMICs to protect against losses on residential-mortgage securities during the worst housing slump since the Great Depression.

About $27 billion of home-loan bond Re-REMICs have been issued this year, up from $17 billion for all 2008, according to a June 12 report by Bank of America Merrill Lynch. Re-REMIC stands for “resecuritizations of real estate mortgage investment conduits,” the formal name of mortgage bonds......

Banks have issued about $2 billion of the debt in the last three weeks, according to Barclays Capital. That compares with $5.8 billion of similar offerings in all of 2008, Credit Suisse Group data show.

“Somebody does something and it seems to make magic, and the other guy says ‘Hey, let’s do that, too,’” Raynes said.

So, here we are trying to rebuild the "House of Cards". Amazing how nothing changes. The questions is are there any Credit Default Swaps (CDS) that are backing these CLOs and who is writing those CDS?