Morgan Stanley, Italy, Swaps And Misplaced Outrage

Tyler Durden's picture

From Peter Tchir of TF Market Advisors

Morgan Stanley, Italy, Swaps And Misplaced Outrage

One of the big stories of the week was that Morgan Stanley “reduced” its exposures to Italy by $3.4 billion mostly by unwinding some swaps they had on with Italy.  Morgan Stanley booked profit of $600 million on the unwind.  The timing couldn’t have been worse coming on the heels of the “Darth Vader” resignation at Goldman Sachs, attracting more attention to profits on derivatives trades was the last thing the investment banks need.  Much of the outrage seems misplaced though.  In this case, don’t blame Morgan Stanley, blame Italy, and be very afraid of what else Italy has done.

From what I can tell, Italy entered into some interest rate swap or swaption contracts with Morgan Stanley, a long time ago in a galaxy far away.  Since the purpose of the trades were to “reduce” the interest expense that Italy was paying, I assume the contracts were more likely swaptions than straight interest rate swaps – selling volatility would reduce your payments up front, but would be costly if you were wrong on direction.  So over the course of time the mark to market value of these trades grew to $3.4 billion.  That mark to market valuation would show up on the reports of Morgan Stanley (buried too deep for anyone to find easily, but there nonetheless).  The mark to market loss would not appear anywhere in the Italian government budgets.  That should be a big concern for investors – the derivative trades that the country enters into aren’t marked to market by them for their accounting purposes.  Maybe that is why they have such an affinity for swaps and swaptions – they can hide problems. 

But anyways, back to Morgan Stanley.  At some point during the course of the year, it looks like MS took a “credit reserve” of approximately $600 million because of concerns that Italy wouldn’t be able to pay.  That is what credit hedging desks and risk management are supposed to do.  Simplistically, let’s say they assigned a 25% default probability to Italy  with an expected “recovery” of 30%  (in line with where CDS was trading).  They $3.4 billion * 25% (default probability) * 70% (loss in event of default) = $595 million.  So MS would have take a charge of that amount against that position.  It was dripped in over time as Italian CDS spreads blew out.  All reasonable, but they would never tell Italy that they are carrying the “risk” there.  When Italy unwound the swap and fully paid what was owed, MS was able to release that reserve as profit. 

Whatever money MS made on the Italian trade, it was all likely booked at the time of the trade.  Since then MS has been managing the risk, including the counterparty risk.  This $600 million was taken as losses due to potential for counterparties not to pay, that did in fact pay.  Morgan Stanley did nothing wrong here and from what I can tell, has been prudent in their exposure management.

Italy on the other hand has done a lot wrong.  Letting a counterparty have documentation that cancels allows termination based on ratings is horrible practice.  The termination almost always comes at the worst time (AIG’s problems weren’t actual defaults, it was that their own rating downgrade forced them to collateralize all their bad trades). 

What was Italy doing with these swaps in the first place?  If they were pure and simple interest rate swaps, why didn’t they just issue floating rate bonds in the first place?  That is an easier way for them to manage that exposure.  More likely the trades were funky and either involved some games with maturities or optionality, that gave them short term benefits but with increased longer term risk.  This should be fully disclosed, and more importantly, the mark to market changes should hit the budget in the year the mark to market changes occur.  Everyone seems to be acting surprised by the size of the Italian’s derivative book and the fact that it is massively underwater – why?  The book is big because they can do trades that hide losses from the annual budget.  Investors should demand to know all the derivative trades sovereigns have on and how they are accounted for.

Will investors demand that?  Probably not, the market is frothy right now, and just like investors don’t seem to care how many guarantees a sovereign nation has issued – whether to banks, the ECB, EFSF, ESM, the EIB, or to municipalities, they don’t seem to care about the derivative exposure.  They will only care if it is too late, like in Greece, but it will make the losses far bigger than anyone really expected because the derivative losses and guarantees are real.

Why couldn’t these trades be done on an exchange?  Why does Italy really need to face each dealer?  Why should Italy be able to enter into deals with collateral provisions that are unique to each counterparty rather than through a standardized central clearing system?  And if you don’t think it matters, then ask yourself what MS was doing with their exposure?

Do you think MS was taking the write-downs and just hoping things would get better, or were they out there buying CDS on Italy?  In the ever circular world of OTC derivatives, MS was likely buying CDS on Italy in an effort to contain potential losses.  That of course was driving the CDS on Italy wider.  MS, being prudent, was then probably buying CDS on the banks that had sold them CDS on Italy to hedge that exposure.  What a vicious cycle.  Of course that became a virtuous circle once Italy terminated the deal and paid them.  Then MS could sell the CDS they bought on Italy.  Then MS would sell the CDS on the banks that they had bought protection on to hedge their Italian hedge.  So Italian CDS and bank CDS could all go tighter.  This high degree of correlation and opaqueness should be ended.  There is no reason it can’t be done on a central clearing system.  Would collateral requirements be higher?  YES, but so what, this isn’t about what banks want, it is about what the financial system needs.  If the collateral requirements mean a trade isn’t worth doing, then it probably wasn’t worth doing in the first place.  Rarely do collateral requirements trump conviction.  If a trade is important, and the belief is strong, a few percentage points difference in collateral won’t stop it from getting done.  Then MS wouldn’t be managing their counterparty exposure, because they wouldn’t have any.  Neither would the other banks that all seem to be sitting on similar trades.   It is time to make the derivatives market less dangerous to the system.  To get the counterparty risk down to a minimum, and all controlled in one place.  It is far more standardized than many believe, and the risks of not having it centralized means it becomes systematic and self-fulfilling each and every time we get a hiccup in the global markets.

The systematic risk of derivatives and the counterparty risk needs to be addressed.  It creates too much unnecessary volatility.  With capital requirements for “mark to market” positions less stringent than for accrual accounting positions, and so many credit hedge funds, and so much leverage in the credit space (including LTRO) that volatility feeds on itself.

In any case, the outrage shouldn’t be focused on MS, it should be focused on the governments that do the trades, and the regulators who let this system continue to exist in all its opaque glory.

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Heroic Couplet's picture

But between MS and "the government" there's another factor: how many lobbyists and influence peddlers is MS sending to the seat of government, in Italy, in the US, and in any other country?

If there ARE MS lobbyists infecting and influencing "the government." then Morgan Stanely IS responsible, not "the government."

eddiebe's picture

oh yeah, I can just hear the wailing and gnashing of teeth of the derivative sellers that we need less regulation not more, because that's how free markets are supposed to work. That would be socialism and anathema to capitalism. Just look at how much money is being made and how well the markets are doing because the markets are so free. Yeah right. About as free of corruption and flim flammery as fecal matter is free of stench.

DoChenRollingBearing's picture

There is lots and lots and lots of blame to go around when looking at CDSs, Italy (Greece, etc.), 2008 crash, deficits & debt, sleazier behavior seen almost everywhere now, etc.

Each of us is to blame to one degree or other as well.

sIewie the pi-rat's picture

From what I can tell, Italy entered into some interest rate swap or swaption contracts with Morgan Stanley, a long time ago in a galaxy far away.

Morgan Stanley did nothing wrong here and from what I can tell, has been prudent in their exposure management. Italy on the other hand has done a lot wrong.

In any case, the outrage shouldn’t be focused on MS

One thing is for sure MS would never, I mean never employ the ancient bunga bunga sales techinque to close a deal on the otherhand the author's giving a pass to MS strikes me as a bit whorely



Harlequin001's picture

'trikes me as a bit whorely' - That's one way of putting it,. The smple solution is to just not bail out the couinterparties. You'd be stunned at just how quickly these markets would sort themselves out, one way or another.

Buying CDS on a bank that sold you CDS is merely leveraging your 'insurance', and now most probably at tax payers expense....

It shoulod be illlegal for government to give public money to ANY private institution under ANY circumstances. That would end the bailouts.

DeadFred's picture

I think you're being overly critical of fecal matter

Ghordius's picture

As long as no congress or parliament has a supermajority of members capable to write a comprehensive book on those post-60s deregulation-is-always-better-woodo-economics-WMD-derivatives: BAN THEM.

PontifexMaximus's picture

Exactly, that's the point, funny, that Intesa, Unicredit or Mediobanca or any other EU bank was not able to arrange this deal. Either because of mazzette changing hands or, because whenever one of those strange operations is taking place, you have JPM, GS or MS in the game. They are always smarter, because they know the name of the game, even under the table, if necessairy. And it always is!

847328_3527's picture

I blame global warming. It's behind all the diabolical events and actions, right?

Mario55's picture

No "the governement" is not meant to be naive enough to be manipulated by lobbyists. Let'us stop accusing the banks and forgive these victimized ingenuine governements. For your information, the head of MS in Italy is a former finance minister, probably not the one who dealt the swaption.

By the way, it is extraordinary how little publicity this news has had in the italian newspapers. A few months ago, such a piece of news would have triggered an endless list of enraged questions on front pages of the main newspapers. Today, the point that still today nobody knows what the deal was. Maybe a simple swaption corridor?..


Sophist Economicus's picture

'Wall Street' has always been a place where insiders try to scalp 'investors'. If any idiot buys a product from them, or 'trades' in their casinos without their eyes WIDE OPEN, they get what they deserve

Greed on the part of ALL the participants will always make it so.

GeneMarchbanks's picture

'In any case, the outrage shouldn’t be focused on MS, it should be focused on the governments that do the trades, and the regulators who let this system continue to exist in all its opaque glory.'

An attempt at channeling Taleb from four years ago, huh Pete?

So anyways... you've concluded that no matter if this was one of those Greece/Goldman deals or not, the blame should fall squarely on the shoulders of the Italian government. Nice. Thinking ahead, how... how... very banksterish of you.

Now that even you smell the Shitstorm approaching I grow concerned.


Sophist Economicus's picture

So, in this meeting between MS and the government of Italy, in your mind do you see it as:

1. A couple of guys with big mustaches, dressed like they just came off the vineyard truck, with sweat on their brow sitting in a posh room across the table from two Armani draped sharpies with HBS MBA/law degrees


2. A room full of guys and gals, dripping in Armani, all with HBS degrees, each thinking the other side was dumb for taking the other side of the deal

I've been in those kinds of meetings. I vote for number 2

oogs66's picture

Number 2 except the one side is hoping if they do the deal they get job offers from other side in future

slaughterer's picture

Only low-level mobsters wear Armani.  The real kingpin thugs wear Brioni. 

SilverDosed's picture

I vote 3


A room full of guys and gals, dripping in Armani, all with HBS degrees, figuring how to borrow money from the future to pay for the present all while ensuring the highest commisions, fees, and bonuses on one side, and re-election on the other. Working together to rob the future and the people, its a perfect relationship between a banker and a politician.

Andrew G's picture

Well it's kind of like drug dealers - even if you're a decent libertarian and would allow weed/ecstasy/coke to be legally sold, there are some kind of drugs (e.g. meth) that just seem far too harmful to be allowed... To me, these kind of derivatives smell more like meth than weed.

dick cheneys ghost's picture

You know why they call it "opaque glory"........


Cause Fuck was already taken

Bam_Man's picture

Corrupt, bankrupt governments engaged in shadowy financial dealings with their pathologically greedy Wall Street enablers. What a wonderful world we live in. And people continue to say "gold is in a bubble".

qqqqtrader's picture

Just about everything is in a bubble, until it aint!

DJIA, another bubble?

cm44888's picture

At last, an intelligent article on deriv (non-) collateralisation

On balance, asymmetry between collateralised and non-collateralised trades almost never suits the banks. It is too hard to model and adds a lot of credit & liquidity risk to trades that would otherwise be easy to hedge.

Some public sector counterparties think it a slight that collateral should be demanded from them. Time to break the taboo and admit that no counterparties - not banks, and certainly not public sector - are too big or too creditworthy to fail. Merely having full collateralisation of OTC deals (with cash - not junk government bonds) would be a big improvement.

GeneMarchbanks's picture

'On balance, asymmetry between collateralised and non-collateralised trades almost never suits the banks. It is too hard to model and adds a lot of credit & liquidity risk to trades that would otherwise be easy to hedge.'

You are aware that there are intermediaries that deal with especially this kind of 'need'?

Intelligent? In a kind of, don't-blame-the-banks-or-my-life-is-a-lie type way, certainly. Pure evasion of responsibility if you ask me.

ItsDanger's picture

But regulation is bad isnt it?  Thats what they always say on FOX News.  LOL

Catullus's picture

There are these "regulations" that say governments can't do a lot of things. But they still do them. Turns out the "regulators" are employed by the government and they don't like telling their employer that they cant massage a balance sheet to hide their debt exposure.

But make continue to believe that "regulations" matter. They've been selling that snake oil to liberals for decades.

Piranhanoia's picture

Is there a fair chance that both MS and Italy were trying to screw one another?

Kali's picture

No doubt, but who really got screwed in this mess?  That $600million really came from where?  The people of ITaly are the ones who got screwed.

PontifexMaximus's picture

Did Monti doublecheck it?

SubjectivObject's picture

Happy accident. 

Any cut on a bankster is a good one.  For all the ostensibly undeseved ones, how many deserved ones are there we don't know about.

And corrupt governments, any cut on them too.

I am Jobe's picture

Only Iceland had balls to tell the banksters go go Fuck with themselves. USSA has no balls just a bunch of texting, ssexting crap. Nice. BTW, Thai's have more balls than US folks. Nothing like sheeples led to believe in the AAPL crap;

oogs66's picture

Iceland should be the model. Greece should have wiped out bond holders and been able to move on

boskowski's picture

According to Italian newspapers, these contracts were signed when Mario Draghi was head of the Italian treasury.

onebir's picture

"What was Italy doing with these swaps in the first place?"

Reducing its deficit so it could get into EMU? (I thought this had already come out...)

slaughterer's picture

Once again, a Goldman alum directs capital from a struggling state to a crafty, cunning IB.  Just wait to see what Draghi does with the ECB.  Forget "Muppetgate": having Draghi in charge of the ECB is Goldman's grand coup.   

atomaniac's picture

yeah, it was done in the 90ies, he headed italian treasury from 1991 to 2001:


In 1991, he became director general of the Italian Treasury, and held this office until 2001. 


And now Super Mario Junior is an interest rate trader at Morgan Stanley.

oleander garch's picture

Those pesky new-fangled swaptions!  Who could have foreseen that extremely complex derivative instruments would be inappropriate for use in public finance?

Well, yes, their main purpose is to conceal and to make complex that which a functioning market would prefer to have transparent and simple.  A government, long-term, fixed rate bond is transparent and simple which makes it a relatively straightforward and attractive investment for many. many people and institutions.  Cannot have that!  Make it complex and give it some juice as an up front enticement and we can make these public entities sing like castrati and they'll never understand why.

For the domestic variety of this delightful financial vintage, one need look no further than Pennsylvania where the state's auditor general has been finding these fruity concotions at the Delaware River Port Authority, over 150 school districts, the Pennsylvania Turnpike, the Philadelphia Sewer Authority, etc., etc.    The Wall Street houses have been busy in the Keystone State.  Will it be the one to bring down the arch of American democracy?

atomaniac's picture

The author forgot to mention some pretty interesting things:


1. the transaction was done in the 90ies. at that time italian treasury was headed by no other than Super Mario Draghi.


2. Currently Super Mario Junior works  as an interest rate trader at (surprise, surprise) Morgan Stanley.


As for the purpose of the transaction something tells me it was to massage the books before EU entry.

Tao 4 the Show's picture

Super Mario Junior? I didn't catch the "Junior" first time through. Assume you mean his son works at Morgan Stanley.

If true, that just might ruffle some Italian feathers. Full Monti is proposing another VAT hike and the natives are restless. They are just beginning to see that his "Technocrat as savior" cover is a fake. Even the average person sees that the current 21% VAT (also a Full Monti creation) is strangling businesses and consumers alike. And now we find that half of it is going to pay MS for Draghi's debacle.

Will the Italians catch on that their fate is being determined by Draghi 1 who enriched Draghi 2 while propelling himself to ECB head, with enforced payments by Full Monti?

It's the new "Axis of Weasels".

atomaniac's picture

It is true 100% 

Yet, Draghi's son has been an interest trader at Morgan Stanley since 2003.

I wonder what was his total bonus since that time? :)


I also share the view that some serious stuff might hit the fan in Italy soon in regards to this news.  

Tao 4 the Show's picture

Thanks. Interesting watching the camel's back.

q99x2's picture

Down with MS. May the whistleblowers play a symphony on their behalf.

TooRichtoCare's picture

The morons here are the Italians, and Morgan Stanley is simply doing what it does...which is taking the other side of a risk trade where the counterparty (in this case Italy) wanted to get rid of a particular risk.   If they had to do it on an exchange, then maybe they would lose their clearly it was in Italy's interest to do the trade this way.  Similarily, in the earlier trade, years ago, between the Greeks and Goldman, whereby the Greeks were able to fudge their stats and lie their way into joining the Euro, the "bad guy" in that story is the sovereign nation wanting to hide their risk, not necessarily the financial intermediaries who profit off their misfortune.  The Banks are amoral, no question about it, but without the Greek or italian desire for obfuscation and without their need to sweep their gross incompetence & profligacy under the carpet, MS and GS would have no market for their fancy schmancy swaptions etc

hooligan2009's picture

Why do I get the feeling that the Italian "government" did not understand the deal and that the actual trades were structured in such a way as that the Italians were in a "heads you win, tails I lose" situation. The Italians needed to "park" assets off the Governments balance sheet (so Italian banks could get a whole bunch of LTRO out of muppet ECB and European tapayers), but were not aware that this engineering was like ummm...paying interest to a lower rated counterparty (MS) for the privilege of the counterparty ripping them off?

slewie the pi-rat's picture

this is important stuff here, from reading PrudentBear  , imo

[Paste]: Flow of Funds and More  by Doug Noland; March 16, 2012

March 16 – Bloomberg (Nicholas Dunbar and Elisa Martinuzzi):  “When Morgan Stanley said in January it had cut its ‘net exposure’ to Italy by $3.4 billion, it didn’t tell investors that the nation paid that entire amount to the bank to exit a bet on interest rates.  Italy, the second-most indebted nation in the European Union, paid the money to unwind derivative contracts from the 1990s that had backfired… The cost, equal to half the amount to be raised by Italy’s sales tax increase this year, underscores the risk derivatives countries use to reduce borrowing costs and guard against swings in interest rates and currencies can sour and generate losses for taxpayers. Italy, with record debt of $2.5 trillion, has lost more than $31 billion on its derivatives at current market values…”

so, peterT's version is a bit more subdued and hopefully (for ITA) more accurate than the first reprts via bloomie on friday, but both reports certainly agree that italy did a lot wrong!

i've lost track of how many goobermints have "inadvertantly" handed their tax revenues to banksters who set up incomprehensible ways for them to get more from their tax revenues b/c the "bet" went against the client.  AGAIN! good thing there are never any kickbacks to the local-and-up-pols, huh?  they just got a bit hornswaggled by them tricky big-city bankster boyz, yeszendede!  and if the city, state, local, national lawyers and accountants couldn't understand the brand new contracts (derivative instruments) why did they get launched?

the simplest answer would be kickbacks, but that would be RIC0 stuff unless the recients just "forgot" it on their taxes if it was too big to thru PACS [which some of this local stuff is] 

i and a small band of minimum-wage morons with out own little PAC, sponsored by an aware local moneyed maven canvassed for 2 months to stop a nearly PUC-final-approved privatization of a new city sewage treatment plant which was pretty easy. really, b/c people will respond when they understand the media propaganda of the local pols is some deep anal foreplay

unlike partisan stuff, when we got to the last precincts, and people knew we were coming,  people would answer their doors and give us our own spiel!  we would tell them to write us a  check anyhow, dammit! 

we get sold out all day long

it is called: centralPlanningTM; "making markets"; and "governance", and BOY! is it ever expensive, eh?

mt paul's picture

making markets

for muppets..

Venerability's picture

I think Mario Monti is actually doing a good job, one of the few effective leaders in the world right now.

A real contrast to Berlusconi.

While not everyone agrees, many do, reflected in the fact that the MIB has been among the best-performing markets in the world the past five months or so - and may well continue to be.

hooligan2009's picture

I agree Monti is doing a good job, pronlem is, he has no mandate. We are (and it guts me to say it) only half way along a path of rejection of welfare democracy as a viable electoral method. By getting Ital's finances "straight as best he can, he is still unelected with no people (welfare dependent) majority. Until NO REPRESENTATION WITHOUT TAXATION is adopted globally, all democracies are welfare democracies with voters requesting larger and larger benefit packages. No win.