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.
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