Thursday, December 20, 2007

More on Morgan Stanley’s shocker

(FT Lex) John Mack wants investors to know he feels their pain. But forget the bonus Mr Mack will forgo. The Morgan Stanley boss is lucky to hang on to his job after the bank disclosed a total writedown of $9.4bn for the quarter and its first ever loss. Yes, Morgan Stanley can point to other bits of the bank that are humming, such as wealth management. But so could Merrill Lynch, whose own mortgage writedown led to Stan O’Neal’s departure.

As for the writedown, it is jaw-dropping, even by subprime standards. A dozen or so traders laid on a position to offset the cost of shorting subprime. Had things worked out, the short could have netted the bank at most about $2bn. Instead, it cost the bank more than $7bn, as the traders’ correct hunch was overwhelmed by a deteriorating long position in top-rated collateralised debt obligation securities. How could that have happened?

There are two failings of risk management. The first is in the stress tests. Taking historical losses, even record ones, and magnifying them does not capture the once-in-a-lifetime crisis. Of course, Morgan Stanley was in good company. The reason it took such a big long position (about $14bn) to defray the costs of shorting was precisely the market’s view that such securities were so low-risk.

For investors, the main issue is the second failing – in the safety nets that can catch disastrous risk-taking in rare moments when models are irrelevant. This is not just about systems and processes. It is about culture and psychology; about when, for instance, you force traders to close out positions and take hits, even though they – and maybe most others – believe the trade will work out with just a bit more time.

And from FT Alphaville:

Until October/November super-senior CDO exposure (a curio of the synthetic CDO world) was weathered, but holding firm. Mezz CDO paper was the stuff being downgraded by the rating agencies. Mezz CDO paper was - and is - the truly risky stuff, with high subprime exposure. Whereas super senior swaps - in academic terms at least - came with the unofficial tag of being safer than safe; AAA++; untouchable; gilt-like. Why hedge against them? And, more importantly perhaps, how?

But onto the real issue with this “desk of shame” malarkey: it’s unfair to imply that holding super-senior swaps was a short term “trading” decision at all. Referring to it as a single “bet” is slightly disingenious. For a start, why make such a huge, singular bet on such a dull, low-yielding product?

In the past, it was the monoline bond insurers who wrote super senior swaps (more on this issue, in light of Wednesdays downgrades, shortly). Banks weren’t interested because the yields were so low. Banks only became interested when they invented a way of sexing them up. They created leveraged super-seniors - whereby super-senior swaps on synthetic CDOs were collected together into special purpose conduits and geared using commercial paper. (For the curious, details in a thorough post here by Felix Salmon.)

All of a sudden, banks found yet another way they could profit from the origination and sponsoring of CDOs. In general it’s a pretty familiar story. What Merv King -and probably a million other people - call, “the search for yield”. Bank takes low yield boring product, spivs it up, applies leverage, makes money. Yada yada.

What we’re trying to get at here is the fact that Morgan Stanley’s super senior exposure goes way beyond being the responsibility of “one desk”: it’s a pretty accurate reflection of banks’ way of conducting business in general.

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