When we reported on some peculiar action in MBIA CDS back in February, we said that one of the reasons for the massive tightening in MBIA CDS which ripped from 55 pts up to 37 pts in the span of two weeks was possibly on CDS commutation speculation (this in addition to ongoing aggressive litigation by MBIA against mortgage originators who may be commutating CDS in a quid-pro-quo fashion to achieve prompt settlement). But whatever the reason for the move, one thing was certain: one bank more than anyone, will be hurt materially by the move - Morgan Stanley. As we said "According to a source, Morgan Stanley was short risk the monoline after it had obtained protection on a static pool of CMBS via an MBIA-related entity called LaCrosse Financial. And as LaCrosse wrote protection against the static pool that was non-transferrable by Morgan Stanley, the bank hedged its counterparty risk by purchasing protection on MBIA itself. So while CDS was blowing out, MS was profiting. Then over the past two weeks, the bank has seen hundreds of millions in paper P&L evaporate through the window. The only question is when will Morgan Stanley close its now underwater protection (which continues to bleed a substantial amount of theta), especially since the actual credit event may have just been pushed back indefinitely. In other words, those who are short the MBIA CDS may wish to wait just a little longer, and see just what the breaking point on Morgan Stanley's collateral call is." Well, per another source, and per Euro Money magazine, that breaking point has been reached and MS has now been forced to close its exposure, at a loss that some speculate could be in the billions.
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.
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.
Just how big is the total hit?
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.
We completely agree. Per our source, the complete unwind of the MS position occurred in mid-February, meaning the bank was forced to eat the full 18 pts tightening difference.
As can be seen on the CDS chart below, if MS had a carried loss of nearly $1 billion on its books on monoline exposure (most of its MBIA), when MBIA was trading roughly 3,000 bps, the hit to the bottom line upon taking the loss when it traded at 2,000 must have been vicious, and likely ended up costing the firm over $1 billion.
Look for the market to reprice MS substantially lower as this news is gradually appreciated. And once that is done, the market will move on to Citi, which at last check had over $4 billion in notional exposure (per direct exposure to monolines) and as Lehman has taught us so well, notional becomes realized very quickly when there is a diametric shift in recovery expectations. In fact, this variable may be one of the main reasons why Citi has been limited to a $0.01 dividend.