Morgan Stanley recently unwound credit hedges on monoline insurer MBIA at a potentially significant loss. This could hit first quarter results for Morgan Stanley’s troubled fixed income division and compound its reputation as disaster-prone, at least when it comes to credit trading.
The episode underscores the way hedging decisions by individual firms can undermine performance at other members of the club of banks that are too inter-connected to fail. And hints at a regulatory slap for Morgan Stanley from the Federal Reserve for its credit hedging policy highlight the extent to which supervisory decisions taken behind closed doors continue to affect the prospects for major banks.
Hedges of structured finance deals with monoline insurance firms have caused huge losses and enduring headaches for a wide array of banks since the onset of the credit crisis.
Morgan Stanley’s current woes stem from its decision to purchase enormous amounts of credit default swap protection on MBIA. When the highly leveraged specialist insurance firm appeared likely to fail in 2008, 2009 and much of 2010 these trades by Morgan Stanley probably looked like a sensible bet. Old structured finance deals by the bank that were insured by MBIA would be covered and there was a potential trading profit from the default swaps in the event of a bankruptcy filing.
Unfortunately much of the protection owned by Morgan Stanley was bought at levels that implied a near guarantee that MBIA would indeed default on its obligations.
When the monoline cheated death and staggered through 2010, its credit spreads began to fall from levels that reflected a market assumption about its likely demise. Morgan Stanley racked up losses on monoline credit counterparty exposure last year of $865 million and recent market trades indicate that it may have crystallized a further loss by unwinding hedges as MBIA spreads came under renewed downward pressure. Spreads for three and five year default swaps fell from levels around the equivalent of 3,000bp in mid January to roughly 1,800bp by late February, pointing to a significant hit for Morgan Stanley, which was the protection holder on much of the outstanding derivatives exposure in the market.
Some bank stock analysts estimated that Morgan Stanley might take a hit of around $300 million on its MBIA exposure for the first quarter, but derivatives dealers think the total could be much higher.
A number of factors have pushed MBIA spreads lower this year. Twists in ongoing legal battles between MBIA and its bank counterparties remain a central issue. Morgan Stanley, UBS and Bank of America are in court trying to overturn the 2009 restructuring of the monoline. If the suit is successful, it would greatly enhance Morgan Stanley’s position.
However, MBIA has also made a surprising amount of progress in commuting obligations to cover CDO and ABS deals on its books, cutting $23.3 billion of gross exposure between the start of 2010 and March 2011. These two issues can be linked. When Barclays dropped out of a suit by a group of banks against MBIA at the end of December it led to speculation that the two firms had reached an accommodation on disputed trades.
This seemed to be confirmed with a note in Barclays annual accounts on February 15 stating that wrapped assets with a fair value of $4.8 billion with a single monoline insurer had been commuted in a deal struck in January this year. It also announced a $824 million impairment of its loan to Protium, the fund where it has parked its troubled structured finance assets.
The widespread belief that Barclays carried out this commutation with MBIA, and at a beneficial level for the insurer, led dealers to reassess the credit prospects for the firm.
The decision by Barclays to cut its losses on MBIA exposure appears to have led directly to a significant drop in the value of credit protection on the insurer held by Morgan Stanley.
Selling of default swap protection on MBIA by Morgan Stanley – trades that effectively unwound existing hedges – indicated that the bank may have been pushed towards unwinds by concern that other dealers would follow Barclays into ripping up old contracts with the insurer, in turn improving its long term credit prospects.
But Morgan Stanley may also have felt that it was under regulatory pressure to unwind its default swap hedges.
On January 25 Patrick Parkinson, director of banking supervision and regulation at the Federal Reserve, released an unusual letter expressing reservations about the use of high cost credit protection trades by banks.
The letter could have been directed at Morgan Stanley, which owned so much high premium protection on MBIA at the end of 2010 that it felt obliged to note in its full-year accounts that the value of its hedges exceeded its gross exposure of $4.2 billion by $1.1 billion.
Parkinson said that some high cost credit protection trades are designed to obtain beneficial risk capital treatment and defer recognition of losses, and warned banks not to make any assumptions about capital recognition.
He concluded that misuse of credit protection trades could impact a bank’s supervisory rating, including its ability to pay dividends, buy back stock or make acquisitions.
A warning that might have looked like an arcane point of order from a regulator took on potentially greater significance in late March, when questions arose over whether Morgan Stanley had been given permission to resume group dividend payments.
The Federal Reserve has been reluctant to disclose its views on the relative soundness of individual banks. It did not release much information about its most recent round of stress tests and pressed banks to keep their own results private.
But announcements about dividend plans by a number of banks have allowed investors to make assumptions about the likely regulatory scorecard.
JPMorgan received approval from the Federal Reserve to make boosted dividend payments this year, and even battered Citi will be allowed to make a nominal payment to investors.
Bank of America Merrill Lynch took a knock when it revealed that it had not been given permission to resume dividend payments, while Morgan Stanley was ambivalent about its interaction with regulators.
The bank has a perfectly good business reason not to make payouts to investors, as it has announced that it intends to accelerate the full integration of retail brokerage Smith Barney.
Uncertainty over the supervisory view on the bank persists, however. A write-down for the cost of unwinding MBIA hedges in the first quarter would not of itself single Morgan Stanley out for a badge of shame. Its main competitors are still working through their own legacy losses on structured finance deals from the credit boom, after all. But both regulators and investors will recall that Morgan Stanley racked up the single biggest individual trading loss in financial market history in 2007, with a supposedly hedged credit position that ended up driving a loss of roughly $9 billion. Another credit trading mishap could cast doubt over the progress that has been made in risk management at the firm. It would also provide a reminder to investors about the continuing dangers from management of troubled legacy credit positions at other dealers. The widespread assumption that marked down legacy positions are a source of potential future upside for banks could be misplaced in some cases.
