Morgan Stanley and 'Dottor StranaMonti'

Morgan Stanley’s most mysterious footnote — Part 1 & 2

Posted by Lisa Pollack on Feb 01 17:27.http://ftalphaville.ft.com/blog/2012/02/01/861291/morgan-stanleys-most-mysterious-footnote-part-1/

(7) On December 22, 2011, the Company executed certain derivative restructuring amendments which settled on January 3, 2012. …

This mysterious little footnote announced to the world that in the fourth quarter, Morgan Stanley managed to arrange a deal that reduced the bank’s net exposure to Italy from $4.9bn to $1.5bn.

As the deal settled on January 3, the figures in Morgan’s Q4 balance sheet didn’t reflect its impact; hence the footnote. It does, however, mean that by the start of 2012 Morgan Stanley’s overall peripheral country exposure has dropped from $6.4bn to $3.1bn. Not a bad way to begin the year.

In addition to that, the bank recorded a $600m boost to net revenue from the dealin the fourth quarter – when the deal was agreed but hadn’t yet settled.

What is Morgan Stanley up to? All the other banks (and FT Alphaville) certainly want to know…

Unfortunately the bank isn’t talking. No matter, FT Alphaville has a few ideas and so does IFR’s Chris Whittall, who has been up to his usual expert sleuthing. More on that in a moment.

First, a quick explainer

Let’s begin with Morgan Stanley’s country risk exposures as declared for Q3 and Q4, which we’ve spliced together in the graphic below. The Q3 numbers are on top, Q4 underneath, the footnote at the very bottom with the numbers it gives scribbled into the relevant line items. Click to expand:

Ignore the footnote for a moment.

If you follow the orange and purple arrows from Q3 to Q4, you’ll see that without the restructuring deal, Morgan Stanley would have greeted the new year with enlarged peripheral exposures – with the total increasing from $2.1bn in the third quarter to $6.4bn in the fourth quarter. The exposure to Italy would have climbed from roughly $1.8bn to $4.9bn.

Hence it looks like it was with a certain sense of urgency that this “restructuring” was done. But again, because it only settled on January 3rd, it wasn’t arranged in time to bring down the quarter-end net exposure numbers.

Yet the fourth quarter results did get that pre-emptive revenue boost from the deal in terms of revenues. From the press release accompanying the results:

Fixed Income and Commodities sales and trading net losses of $257 million included the loss related to MBIA. Net revenues for the quarter also reflected strong results in interest rate and currency products,approximately $600 million related to the release of credit valuation adjustments upon the restructuring of certain derivative transactions representing exposure to the European Peripherals and the positive impact of $239 million related to DVA.2, 8

To put that in context, “Institutional Securities” — which includes the $600m net revenue from the restructuring deal — only had total net revenue of $2bn in Q4:

Hence 29% of the revenue was due to what is presumably a one-off restructuring in what was by all accounts an abysmal quarter compared to the previous one.

So, what was this restructuring? But before we even go there, what were these trades?

The Ultimate Tesoro Trader

As FT Alphaville has mentioned before, Italy (the sovereign nation, not its banks) has a lot of interest rate swaps with dealers. As rates have fallen, the dealers have found themselves in-the-money. In the normal course of business, the counterparty with the positive mark would receive collateral from the counterparty with the negative mark in order to guarantee performance.

However, sovereigns don’t typically post collateral. Consider it a hang up from the days of being considered the risk-free.

(Portugal and Ireland are notable exceptions and do post collateral, which might be why the net exposure to these two countries is as low as it is — note that Morgan Stanley defines “Net Counterparty Exposure” as “taking into consideration legally enforceable master netting agreements and collateral.”)

Back to Italian exposure though. As the sovereign’s credit spread has widened out…

… dealers have had to wipe out some of the positive mark (on interest rate swaps, for example) with “valuation adjustments”. As mentioned above, Morgan Stanley managed to reverse $600m of that with their mysterious restructuring.

Chris Whittall outlines the situation like so:

Many dealers have tried to persuade Italy to post collateral or restructure the trades, thereby reducing their credit and funding costs.The problem is Italy has a positive incentive not to post collateral or unwind these positions. Doing so would require Italy stumping up a large amount of cash, and that in turn would likely mean issuing more debt. Instead, the Italian Treasury may believe it is better off digging in its heels in and waiting for the swaps to roll off their books.

“We have talked to Italy and there is no happy ending to this story. Italy has a significant derivatives portfolio, and collateralising it would have a material impact on the public accounting. Italy has difficulty raising €5bn in a bond auction, and this funding would be more than that,” said the global head of rates at a major dealer.

Morgan Stanley refuses to talk about the spell it cast on Italy to get its Treasury to play ball, and frankly we’re not surprised. Unless this is a technicality that the bank cleverly built into its swaps, all the other banks will want some too, and it’s unlikely to be favourable to Italy to do whatever it did en masse (otherwise they already would have done it, right?).

More on how FT Alphaville and Mr Whittall thinks they did it in Part 2, below.

Morgan Stanley’s most mysterious footnote — Part 2

Posted by Lisa Pollack on Feb 01 18:50.

In Part 1, we looked in and around Morgan Stanley’s mysterious little footnote about how the bank had reduced net exposure to Italy from $4.9bn to $1.5bn with a restructuring that settled in the early days of 2012.

As the bank doesn’t want to give any additional detail on what the restructuring, the below outlines some of the possibilities and the implications thereof. We emphasise that we don’t know which is the case and, again, we did ask Morgan Stanley for comment.

1) Pixie dust, in the contract?

As sleuthed by IFR’s Chris Whittall:

Two senior traders at separate banks believed Morgan Stanley exercised a provision in its collateral agreement with Italy that allowed it to unwind a trade if its mark-to-market breached a certain level.

Traders said it most likely related to a legacy interest rate swap, which Italy had used to lock-in rates for 30 years at about 4-5% on around €3-4bn of debt. Thirty-year rates being now more like 2.5%, Italy would be significantly underwater on the trade, and would therefore have to pay up as much as €2bn to unwind it, the traders estimated. A major unwind or restructuring would also explain volatility at the long-end of the euro swaps curve late last year, they added.

Such break clauses are not very common, though. Hence we don’t expect that many will get to exit via this route, even if it turns out that Morgan Stanley was actually able to. Note again that the traders in the above quote are just speculating.

2) Pixie dust, by re-couponing?

Whittall again:

If there wasn’t a break clause, Morgan Stanley may have been able to persuade Italy to re-coupon the trade in a way that would reduce its exposure — an avenue other dealers are most likely investigating too.

This could be achieved without Italy having to make an upfront cash payment by shortening the tenor of the swap. However, it is debatable whether Italy would agree voluntarily to this, because doing so would bring forward its debt payments.

To this FT Alphaville would like to suggest a few additional possibilities.

3) Novation, aka give the trades to someone else

Our first thought when we saw the press release was that the Italy trades were novated, i.e. another party was found to take Morgan Stanley’s side of the trade in exchange for a fee.

Prime candidates would be Italian banks, as for them it’s similar to selling CDS protection on themselves, i.e. it’s very circular but what do they have to lose? If the sovereign finds itself on the verge of default, chances are the banks will have already gone down or would be nearing that point anyway.

The trick to that would be finding a novation where the price was right. Given the capital relief and face-saving from dumping the trades, we imagine the House of Stanley could eat a discount on the positive mark.

4) Get collateral

Another possibility is that the bank managed to convince the Italian Treasury to post collateral.

But what collateral would Morgan Stanley want?

Posting Italian treasuries would surely be comical, but hell, if it gets the capital requirement and net exposure down, why not? Ideally though, it’d be cold, hard, non-euro cash. And we guess the Italian Treasury would have to be hella desperate to do that, and somehow we doubt the Morgan Stanley relationship is a big enough deal to go to such lengths to save.

Between Italian treasuries and non-euro collateral, there are surely additional possibilities.

But here’s one option that we really doubt played a role.

Buying even more CDS (from non-peripheral banks)

Morgan Stanley may have done this between quarters, but it doesn’t look like it played a part in the restructuring that settled in January.

Solely for the purpose of explaining the results in the table sourced from the same disclosures as in Part 1, “Hedges” are defined as the “Fair value of hedges on net counterparty exposure and funded lending.” But note that there’s a “CDS Adjustment” that “represents the fair value of credit protection purchased from European peripheral banks on European peripheral sovereign and financial institution risk, or French banks on French sovereign and financial institution risk.”

In short, buying CDS protection on Italy from JP Morgan counts, whereas buying it from Unicredit doesn’t.

Between the third and fourth quarters, the fair value of Morgan Stanley’s Italy hedges (both non-sovereign and sovereign) actually went down, from $2.8bn to $1.4bn. This could be a function of the mark on the trades as well as the composition of the trades changing.

Concerning the restructuring here’s the impact that it had to the items to the left and right of the hedging column:

From the above it’s pretty clear that additional CDS hedging didn’t play a significant role in the restructuring.

What happens in Rome, stays in Rome

FT Alphaville is pretty sure that Morgan Stanley doesn’t want what they did to be anywhere near the light of day, what with all the stonewalling. Is that a good or a bad thing?

For investors, they should presumably be pretty happy with the bank for decreasing net exposure against Italy.

They should, however, be ready to question how they did it. There’s a world of difference between tearing up trades and sitting on dubious collateral.

From a regulatory perspective, does it matter whether there are increasing amounts of CDS protection sold being held by Italian banks?

From a policy perspective, is it not interesting to know whether the contracts did have break clauses that required a large payout by the Italian Tesoro? And if so how many more have them?

Answers on the back of a postcard. We’ll be watching out to see if any other banks pull off something similar.

(Massive H/T to Tracy Alloway for spotting the footnote, her coverage on Morgan Stanley’s results here.)

Related links:Dealers look to reduce Italy’s swaps portfolio – IFR
M Stanley bucks trend with trading increase – FT
Morgan Stanley Restructures Derivatives Deal to Cut GIIPS Risk – Bloomberg Businessweek
Morgan Stanley’s most mysterious footnote — Part 1 – FT Alphaville

This entry was posted by Lisa Pollack on Wednesday, February 1st, 2012 at 18:50 and is filed under Capital markets. Tagged with Banks, credit derivatives, CVA,earnings, interest rate swaps, morgan stanley.