Morgan’s hedge howler
The story of Morgan Stanley’s $7.8bn is gripping.
The leading Wall Street firm correctly predicted that sub-prime related securities would fall in value over the past year.
And its clever-clogs traders shorted the equity and mezzanine tranches of those blessed CDOs.
That was a brilliant bet. Because as US homeowners with poor credit histories started to cease making payments on their sub-prime loans, the value of the mezz and the equity collapsed – which yielded big bucks for Morgan.
But those traders also took out a hedge, just in case sub-prime recovered a bit.
It took a long position in super-senior AAA bonds.
Although these are – in theory – top investment quality, they are created in a magical way (using credit default swaps) out of the lower grade BBB tranche of CDOs.
Anyway the investment worked for months.
As the price of the mezz and the equity tumbled, that of the super-senior AAA held up.
But then disaster struck.
Delinquency rates for subprime borrowers – those beleaguered US homeowners – started to deteriorate way beyond what any precedent had suggested was possible.
And that led to a sharp fall in the value of the super-senior AAA stuff.
Now the important point to understand is that subprime CDOs of the 2005-7 vintages were priced with the 2000 subprime pool as the reference point.
And when delinquency rates started to exceed by a mind-boggling margin the delinquencies relating to the 2000 loans, the value of the super-senior AAA bonds imploded.
Here’s the terrifying statistic.
Morgan Stanley has now valued the super-senior AAA securities at between 30 and 35 cents in the dollar.
That’s a two thirds write-down for an investment which was supposed to be investment grade.
No wonder John Mack, Morgan Stanley’s chairman, thought it would be inappropriate to accept the modest bonus he was offered by the bank’s remuneration committee.
And a big hello to China’s sovereign wealth fund, which has exploited Morgan’s big boo boo to acquire a strategically important 9.9 per cent stake in what remains a world class institution.
UPDATE: By the way, the Morgan Stanley super-senior writedowns are significantly greater as a percentage of principal than those announced by Barclays and RBS – so in theory the Stanley losses could presage further losses for those British banks on their subprime positions.
However, not all super-senior AAA securities are the same quality. So it’s theoretically possible that the Barclays and RBS charges are sufficiently conservative. We’ll see.
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Robert
The news continues to tumble out of our global financial institutions.
I really fear that no one really knows the full extent of unwinding their CDO, SIV and other derivative positions supported by such weak assets for at least another 6-9 months.
Central Banks certainly don't know. They have not forseen this in their regulations, so, to avert financial meltdown (liquidity led), they have issued shed loads of new money. Global money supply stats would make an interesting read, especially for our Asean friends with their large stocks of US Bonds and Currency reserves. What price value?
This feels like a Harry Potter seven episode story that will take years to tell. Thing is we all can take an educated guess at this ending, based on the Potter ending, and be about right in our thoughts. One or two surprises, but the outcome somewhat predicatable. In reality, markets will adjust and readjust. In this case, the scale is different to previous adjustments, but the outcome, will, eventually be the same. We will all suffer financial pain in the coming 18-24 months, personal and business.
Triple-A rated debt collapsing in value, eh, who'd have thought it?
Not the wriggling Northern Rock shareholders on here who talk about its "Good mortgage book", which will collapse in the same way.
Just to drag things back to your favourite topic :)
Hi Robert - thankyou for at last moving on from the Northern Rock sideshow and start stepping into the root cause and its size.
Can you do a bit more to help us all understand?
I've heard that as much as $500bn of write offs of capital is estimated - and this is just sub prime in America. This could easily double to $1 trillion if it moves onto other groups of customers and other jurisdictions as falling house prices reveal default.
$1 trillion in capital under Basel II rules would reduce lending capacity by $25 trillion. Add back the unknown quantities of off balance sheet funding (can you find out?) and there is a potentially massive deflationary effect here.
And last but not least the sums indicate the fragility of the bank capital - they're having trouble now just to put off balance sheet assets back...what will happen when the defaults happen next year?
The sums being discussed as repairing balance sheets thus far seem trivial compared to the problem. Are they?
Super senior AAA rated?
Fitch and S&P?
Perhaps they should be hauled in and spoken to by the SEC and take a nice seat on a select commitee review.
Then we can all get the investment banks to grade them??
Just a thought..........and no mention of NR (oops!!)
Just how smart are these Masters of the Universe who bought these AAA instruments that morphed into junk
so fast!
Similarly, I have long suspected that the "quality" NR mortgage book is unlikely to be that healthy because NR grew it's market share so fast. Problem is when the cracks appear and the mass defaults start , we the tax-payers will be picking up the tab.
To make itself more popular HMG has been giving our money away like a man with no hands - most recently to the pensioners of the earlier failed schemes.
Where will it end?
Investment banks made large amounts of money collatorising debts of various sorts and then distributing the resultant CDOs to their customers. Then recognising the shortcomings of the products they had created, rather than seeking to support their customers, certain banks sought to make more money by using their first hand knowledge to bet on the eventual collapse of these investments. There is a question of trust involved here. What trust can any customer can have in any future products originated by these banks?
So these clever-clogs traders turned out to be - as we say in Scotland - a bunch of "numpties".
And you reckon this will impact further on RBS? Excellent.. I absolutely detest that company. £10bn in profit.. Amount invested in Scottish start-ups precisely zero..
What's the point of having huge alledgedly successful financial institutions if it won't invest in it's own community.
Robert you might care to dig a bit deeper into the asset side of the Northern Rock balance sheet and find out how much their subprime debts are really worth. If Morgan Stanley are writing down "AAA"-rated CDO tranches to 30-35% of par it would be interesting to apply similar valuation methods. Then we could quite easily work out how much of the government's loans to the bank are effectively lost. Brown dodged a question on this at today's press conference.
Okay, which bit of this am i missing? The banks took on this debit from Sub prime borrowers. These banks repackaged and sold on this debit to various financial institutions. Why are these banks now suffering such big losses? Surely it should be the buyers of these products we should be hearing from. Are the banks losses just the cash in the system before repackaging and selling on? Are we looking at huge losses from pension funds insurance companies (the major buyers of these products??) in the near future?
How much of NR's loan book is in Northern Ireland?
Robert,
Correct me if I'm wrong, but the net effect of parcelling up tranches of sub-prime and other debt and selling them on to investment banks and other investors was to inflate the value of that debt well above their issued par value. What we are seeing now is the reversal of that as sub-prime delinquencies prove way ahead of expectations and the market for these and other debt securities has dried up. It is probable that the current wave of write-downs has reduced the carrying value, wherever it sits, to well below par value. In essence these write-downs are just book-keeping entries which may or may not reflect the true value of these loans and the value that a market that barely exists currently puts on them. I for one would not be at all surprised if the American banks in particular are kitchen-sinking their provisions and we could see significant reversals over the next few years. I would certainly not project their book-keeping policies onto Barclays or RBS who seem to have taken a sensibly prudent approach without over-egging it.
It would help if some reasonable analysis of written down values were done, just to put it all into context. Whilst it may be prudent to hold sub-prime debt at a significant discount, there must be a significant amount of perfectly good corporate debt that is being tarred with the same brush.
In an acknowledgment of the most-difficult period in Bear Stearns Cos.' 84-year history, Chief Executive Officer James Cayne and other senior executives are expected to forgo bonuses for this year, people familiar with their plans say.
The expectation comes as Bear prepares to announce tomorrow its first quarterly loss ever, an outcome certain to curb pay for the firm's 15,500 employees. This is a turnabout for Bear, which over the years has used its generous, merit-driven compensation system to recruit job candidates it calls PSDs: those who are poor, smart, and have a deep desire to be rich.
John No 2
Northern Rock "Good mortgage book", which will collapse in the same way.
Sir, would you care to bet next months salary on that?
Get a clue, you idiot.
#6 - give me a good derivative by which I can short Northern Rock's mortgage book at the default rate currently being claimed for it and I will bet this *year's* salary on it, and borrow next year's to pile in to boot!
Harry E wrote:
"thankyou for at last moving on from the Northern Rock sideshow and start stepping into the root cause and its size."
Unfortunately the US mortgage issues are in fact simply a symptom of an even larger problem.
Central banks have used the cover of globalisation, which has masked an inflationary environment by keeping consumer price gains low, to justify keeping interest rates far lower than they should have been. This in turn has ignited an unjustified turbo charged expansion of asset values both on stock markets and in bricks and mortar.
All the while they have marveled at how our modern western economies can withstand higher and higher input energy costs [ the true base currency of modern life ] when realy the low interest rates kept us temporarily in an illusion of fiscal health.
Like all illusions reality is the real master and now we are retuening to that reality in the worst possible shape to deal with it.
The truth is we are reaching the climax of the current fossil fuel production curve and we have no viable replacement, there can be no fiscal growth were the base fuel production rates cease to expand and that is exactly what is occuring.
Various excuses have been put forward for the tight energy markets ranging from refinery bottlenecks, yeah right, to lack of investment in E&P since the last great oils shock. These without exception fail to hold water. Take the refinery bottleneck idea... If that were the case why are the recently released EIA data sets available from the link: showing a patern of finished products largely in the average range for the past five years wereas the commercial crude oil stocks are falling off a cliff... Sounds like the refineries
are doing just fine but the crude is falling behind. This is also reflected in the crude oil price movement, how can anyone be duped into thinking that a bottleneck at the refineries could cause these crude price rises. If the refineries were the bottleneck then finished products would be in short supply but LESS crude would be sucked into the refineries thus relieving crude demand, would this cause crude prices to rise...?
Regards
Jon
Is it just me or do the names of these devices remind you of eBay? "Super senior AAA". Any more "A"s and it could be an English educational qualification.
This shows cristal clear that the emperor of wall street (or the city by extension) wears no clothes.
This supusedly financial "experts" are no more than just glorified gamblers. The good thing for them is that they use other peoples money for their bets...
A lot of people bang on about a crisis of confidence and the run on Northern Rock. However I do not think banks "deserve" the confidence placed on them. Only a couple of bank have written down the value of their CDO positions in line with the ABX (the "market" price).
I wonder how much the traders who took this smart bet were paid and how much they have earned in bonuses over the last 5 years? In theory, they were worth every penny because of the monster profits MS made on their activity but what happens now? Do they hand their bonuses back? Don't think so. So the numpties are the banks that employed them. As Ricky Gervais put it - anyone who thinks they are a genius is an idiot.....
The really gripping story out in financial lala land is not the banks losses to date, but the losses to come when the "monoline" insurers hit the buffers.
The banks "insured" the CDO mess with a number of insurers who all relied on their AAA ratings to write insurance against default, but those insurers are now shown to be built from bricks of straw.
ACA insured $65bn of CDO liabilities on less than $700m of capital with which to pay claims, and their A financial rating has just been reduced to CCC or junk status.
MBIA is covering $550bn in insured liability with $2.5bn in capital to pay claims.
Canadian Imperial Bank of Commerce has just announced that it had $3.5bn insurance with ACA and is making provision in its accounts for the sum because it no longer thinks ACA can pay its claims.
Many of the bank CDO valuations are based on the fact that their debt is "insured", but if the insurance company cannot pay its claims, then the true debt falls back on the bank balance sheets.
As most of the CDO market now has a market valuation of 30% max of face value, it means the insurers are bust and $1 TRILLION of CDO losses are on their way back to the banks.
The old saying "if you owe your bank £1m you are lost, if you owe your bank £1bn, the bank is lost" seems more apt by the hour.
At last, that which has been discussed on internet forums for the last 5 years is finally being picked up by the mass media.
This financial mess is a rabbit warren that runs mighty deep. I find it staggering that anyone who sees the full picture is criticised as being a doom-monger or nay-sayer, a 'negative' kind of person.
This indicates just how powerful the banks propoganda has become in our daily lives (aided and abetted by a willing govt), just how entrenched their ethos of 'buy now, pay later' is.
But it's all about to come to an end. And people really aren't going to like what it develops into. It's no wonder there are those that are unwilling to believe it.
A friend of mine who works in the city advised me last week to 'diversify' into canned goods. I wasn't convinced he was joking.
Let's be clear about some things: There are different ways of marking a portfolio; it's not quite accounting but similar.
1. Mark to market: If instruments are traded in an open market and prices are observable, financial instruments can be 'marked'/priced. Even this is problematic if the bid-ask spread widens ridiculously.
2. Mark to theoretical: You have an exotic derivatives that is custom tailored and there is no open market for it. You value the exotic option based on a pricing model using inputs preferably calibrated to observable parameters like the price of bonds/options that form some of the building blocks of the exotic. There will always be additional risk factors due to the structure itself; model risk, unobserved forward risk and counterparty risk factor in quite a bit in this environment.
In the current climate, there may be no bids at all for some instruments. Imagine trying to mark an instrument that has bids 20cents to the dollar. The point is that the valuation of the portfolio leading to the writedown is a worst case scenario - I doubt that real monetary losses have been realized. Let me give you an example: Suppose you live in a house on a street of identical houses. If you neighbour has decided to sell and the for-sale sign has been up for >6mths, and a couple of silly bids came in for 60% of the asking price, you are lucky you do not have to report to your mother-in-law that you have taken down the valuation of your portfolio by 20%.
All prices are a reflection of market expectations (well... theoretically). A lot of other factors dirty the price like counterparty risk and model risk. Unless the defaults happen in the future at the rate the prices imply, the losses are book losses. Look out for massive 'profits' once the US government work out a deal for the subprime mortgagers.
As the total drawdowns on banking capital are likely to exceed or equal what they actually have the issue is certainly bank solvency.
To prevent a total implosion of the global economy one supposes wide scale Nationalization or Government winking at insolvent banks. To prevent hyperinflation (price of bullion going through roof) one can expect deposit withdrawal restraint. Nothing is safe!
However the capacity to lend is lost and the great 70 year long rising tide of debt/production ratio will reverse on a supercycle (+/-70 year scale) or grand super cycle (Western civilization/industrial revolution scale.)
There will be rallies but we face a massively less prosperous future than we had planned for ourselves. The frauds we are now seeing revealed were the balloon pricking event of the great ponzi scheme financing our sham democracies.
Reply to Jamie number 9,
The answer to your question is yes, the banks do/did sell pieces of the CDO's to other financial institutions, pensions funds etc. However, the bank issuing the CDO would own the Equity Piece in the deal (or in otherwords the first loss piece) along with any other tranches they failed to offload in the market. The issuing bank owns the Equity Piece for 2 reasons 1.) owning the first loss piece provides confidence to potential investors of the other tranches and 2.) The Equity Piece is used to scrape out any excess interest generated from the deals at each interest payment date. So in short, the on balance sheet exposure to this market increases each time the bank closes a CDO, the more CDO's you close the greater your exposure becomes.
It'll be interesting to see the long term influence of the sovereign funds. With no efforts being made to cut the US federal debt levels, the sovereign funds will continue to buy stakes in companies.
And buying stakes avoids the political conflicts which stopped the CNOOC/Unocal and Dubai Ports bids.
I wonder if the issue will come up in the US Presidential elections ?
Good point by post 9. Insurance and pension funds have been big buyers of these assets and we have not heard of significant write-downs in these markets. While interest rates have been low pension fund managers have been buying up these AAA rated bonds yielding the extra 1% or so and this is were once again the ordinary man in the street will be paying price while incompetent fund manager's have been getting fantastic bonus's for the last 5 years. Your average hard working Joe who has paid his pension all his working life will probably get zero. it beggars belief that these people would invest in products that they have no idea how to value so rely completely on counterparty valuations. During the recent Florida investment fund problems it came out that assets backed by subprime CDO's were being purchased during October, did the manager not read newspapers this Credit crunch has been happening for over a year now with the New Century filing for Chapter 11 in March. There can be no excuse. And this is not just going to be a problem for the US but will turn up in funds all over the world and don’t think your money is safe invested in cash funds these guys have been buying Assets backed by Subprime CDO’s as well.
AAA Plumber gets first listing in the small ads
no guarantee he wont take a leak in your cistern
but thats as far as some will look
AAA Good investment anyone?
"However I do not think banks "deserve" the confidence placed on them."
I'm sorry, you placed confidence in banks? Don't you understand how banking works?
Banking is basically a legalised Ponzi scheme. While it expands exponentially, all is well, you're in the boom. Money is being created with abandon, prices are inflating here, there, everywhere! Woohoo! However, there must be a bust, eventually the debt interest must be paid, because all our money comes from debt, there's always less money than there are debts and the people at the bottom of the pyramid are separated from their property, just as with any Ponzi system.
Look up "Fractional Reserve Banking".
You're a mark if you have confidence in bankers and banking.
TW, post 21: If a CDO originally priced at 100p, that pays out say 5% p/a, is now trading at 30p, doesn't that infer that the market expects that the CDO will default after 6 years? Perhaps irrationality is now at work and these things are being underpriced ... on the other hand, if that were the case, there would be hedge funds piling in and buying them up, so the price wouldn't be that low. Unless, of course, the hedgies don't really know what they're doing either. Get my broker on the phone!
Scamp, RBS is a leading global financial institution, not a charity that has some obligation to invest capital in high risk start-ups in Scotland. The losses associated with the "sub prime crisis" are measured on the balance of risk and reward. You cannot get it right everytime and to be fair the RBS business model is so strong it can withstand even these substantial and growing losses. The general rule is that that start-up companies require equity capital not debt as the business risks are too high. You only lend money when you are satisfied that there is sufficient forcasted cash flow to pay it back in the first instance and appropriate security in the second instance.
The impending phenonema that Jon Bowes wrote about in entry 15 is basically 'Peak Oil'. Peak Oil is largely ignored by politicians becuase there isn't anything they can do about it and true to breed, if they can't control something they ignore it.
Peak Oil will have a far bigger impact on the global economy and far quicker than global warming. In fact, it will actually help sort global warming out by making oil and therefore oil-based or oil-reliant items so expensive that consumption, even of gas and electricity, will fall sharply.
Read all you can about Peak Oil, it will affect the lives of virtually every single one of you reading this and not nicely either.
Robert, please start communicating in clear, jargon-free English or this story - arguably the biggest in 2008 as well - is going to be lost on the average, intelligent, eager to understand listener/reader who does not have a deep City background.
The challenge for you is to make complex financial matters comprehensible to a lay audience, expecially when the implications of market turmoil affect us all quite directly.
I hardly know where to begin: What is a CDO? What is a mezzanine thingy?
I am sure what you have to say is fascinating and drawn from a deep well of knowledge, which is why I was reading. But until you rewrite, I will never know.
#13, Tricky Dicky, it wasn't my post but I'd bet a month's salary on it coming to pass.
#31 Toby. CDOs are complex to understand in detail but simple to understand at an outline level.
Take, for example, 100 bonds of $10m value each. Put them all in a pot. Now issue bonds backed by the pot.
If any of the bonds default the lowest tranche takes all the losses. When the lowest tranche is wiped out any further losses affect the next tranche up, and so on.
It's more complex than that, but now you've got a very basic outline of what a cash CDO is and how it works. A synthetic CDO is much the same but based on credit default swaps rather than actual bonds.
In theory the highest tranche, the super-senior, will take few if any losses. In practise it doesn't work that way, as myself and a few others I know who understand these things have been predicting since 2005.
Anyone who says the current meltdown could not be predicted is either lying or doesn't understand how the system works.
Harry E wrote:
"thankyou for at last moving on from the Northern Rock sideshow and start stepping into the root cause and its size."
Unfortunately the US mortgage issues are in fact simply a symptom of an even larger problem.
Central banks have used the cover of globalisation, which has masked an inflationary environment by keeping consumer price gains low, to justify keeping interest rates far lower than they should have been. This in turn has ignited an unjustified turbo charged expansion of asset values both on stock markets and in bricks and mortar.
All the while they have marveled at how our modern western economies can withstand higher and higher input energy costs [ the true base currency of modern life ] when realy the low interest rates kept us temporarily in an illusion of fiscal health.
Like all illusions reality is the real master and now we are retuening to that reality in the worst possible shape to deal with it.
The truth is we are reaching the climax of the current fossil fuel production curve and we have no viable replacement, there can be no fiscal growth were the base fuel production rates cease to expand and that is exactly what is occuring.
Various excuses have been put forward for the tight energy markets ranging from refinery bottlenecks, yeah right, to lack of investment in E&P since the last great oils shock. These without exception fail to hold water. Take the refinery bottleneck idea... If that were the case why are the recently released EIA data sets available from the link: showing a patern of finished products largely in the average range for the past five years wereas the commercial crude oil stocks are falling off a cliff... Sounds like the refineries
are doing just fine but the crude is falling behind. This is also reflected in the crude oil price movement, how can anyone be duped into thinking that a bottleneck at the refineries could cause these crude price rises. If the refineries were the bottleneck then finished products would be in short supply but LESS crude would be sucked into the refineries thus relieving crude demand, would this cause crude prices to rise...?
Regards
Jon
"30. andy williams wrote:"
"The impending phenonema that Jon Bowes wrote about in entry 15 is basically 'Peak Oil'. Peak Oil is largely ignored by politicians becuase there isn't anything they can do about it and true to breed, if they can't control something they ignore it."
And Iraq is?
Nuclear power is about the only solution (other than complete economic devastation that is) to peak oil. Roll on the batteries.
Anyone know what language the Khazaks speak?
I hardly know where to begin: What is a CDO? What is a mezzanine thingy?
Wikipedia is your friend.
CDO is a type of debt based financial product made up of other financial products, like a bunch of mortgages munged together.
It's split into 3 slices (don't you hate the word tranche?). Good, medium and "toxic waste". Mezzanine means the middle bit. (I generally find that when people resort to a register they're trying to hide something.)
The way it's designed, the risk of losing out is low[1] with the good (AAA rated) slice, medium with the medium slice and it seems, nobody has a clue with the toxic waste slice. The interest rate paid depends on the slice, the more risky, the higher the rate.
Beyond this it gets ridiculously complex.
[1] I had assumed (silly me) that the AAA rated part of a CDO was so rated because it was made up of similarly rated bonds; UK government bonds for example, but no, instead, the financial community have been busily gilding turds. The AAA rated part of a CDO is made up of the same stuff as the "toxic waste". The difference being it's insured. Ah well, that's ok then, that makes it as safe as the Bank of England[2]...
[2] The only safe bank in the UK.