Is Morgan Stanley's Biggest Asset Their Debt?
Via Peter Tchir of TF Market Advisors
Stocks added to their rally today when Gasparino leaked news that MS was going to have a "solid" quarter and they were going to beat GS.
Morgan Stanley has $187 billion of public debt according to Bloomberg. Just eyeballing it, the average maturity looks close to 4 years, but let's be conservative and assume it is 3 years. I found a nice looking benchmark bond. The MS 4.2% of 11/20/14. It is a $2 billion issue. The only round lot TRACE print on Sept 30th, was a dealer buy of $5 million or more at a price of 96.156. That was a yield of 5.6%. On June 30th, the bond TRACED a couple times at 103.6 to yield 3.08%. A November 2014 treasury, yielded 0.47% on September 30th, giving a spread of 5.1%. Back on June 30th that same treasury yielded 1% so the spread on this bond was just over 2% at the end of last quarter.
So MS 3 year bonds widened by over 300 bps during the quarter. 3 year MS CDS widened by 380 bps (from 113 to 493), so the move in bonds actually outperformed the move in CDS. I do not understand exactly how banks account for spread widening in their P&L. I don't think all of their bonds are in the "mark to market" book. Maybe they can only write down the discount from par, rather than the full move, but these bonds alone, if they were mark to market, might generate 4% on $2 billion. That would be $80 million.
Is MS planning on taking a massive gain on marking their own bonds? There were stories of MS buying back their own bonds - a great move if they though they were cheap, but a critical move if they were planning on taking a gain and didn't want to have to give it back in the future if their credit spreads tightened.
Goldman has slightly less debt at $178 billion, but the spread widened far less. In the quarter GS 3 year CDS only widened by 224 bps (from 94 to 318). I found a nice 3 year GS benchmark bond. The 5.5% of 11/15/14 with an issue size of $1.3 billion. On the 30th of Sept, 250k of these bonds traded at a price of 105.65 to yield 3.55%. On July 1 and June 29th, these bonds traded at 108.6 on just over 250k to yield 2.8%. It looks like the spread went from 180 bps to 308 bps. Not great but a far cry from what we saw on MS. The bonds were still above par, and with my limited knowledge of accounting, I would guess you cannot take a write down on bonds above par, unless you took a loss.
Is this why the MS CEO is so confident they will have a good quarter and beat GS? I honestly hope not. If the CEO of MS is playing accounting games (totally legal, but stupid) on their own spreads and thinks the markets will respect that, than I am very nervous about what is going on there. The market is in turmoil, there are concerns out there, valid or not, and the CEO should not be worried about "beating the quarter" by taking accounting gains on their own debt. Sadly, so far the facts fit.
The ability to book profits on your own debt widening makes sense in a very very limited way. If you are running a match funded book with all your assets mark to market, then it makes sense to offset those losses against your funding. Well, at least a little sense. The problem is, that at the extreme, if you default you would have one amazing quarter when you got to right all your debt down, but it still means you are in default. Actually I vaguely remember that in default you cannot book a profit on your debt widening, in fact you have to write it all back up to par. One strange rule.
Again, I am just throwing this out there, but the facts fit as well as anything - Morgan Stanley has reduced risk, so how exactly are they going to blow the cover off the ball this quarter? Volumes are down in most products, so it would be very impressive if they made it acting as agent. In the end, I think they may be planning to take a big healthy gain on their own spread widening. That fixes nothing, and I don't think many analysts will look through it, if that is their plan.
CDS spread performance of the TBTFs for Q3 - why MS beats GS?
and below stock performance for Q3...
ZeroHedge Update: For those curious to learn more about this phenomenon, here is our first take on this paradox from April 2009!
ZeroHedge 4/22/09 - The Law Of Unintended "Fair Value Option" Consequences
Financial company stock prices have been on a tear these days, undoubtedly based on glowing, solid results. After all didn't Wells just have a blow out quarter? What is that you say, $5 billion in "earnings" were based on FAS 157-4 reversal and accounting gimmicks? Why should that matter to investors who are happy to buy N/M forward PE stocks any time Cramer top ticks the market, or the Power Lunch brigade glowers in the self proclaimed next American Golden Age.
Well, the financial ripfest, while benefiting bank prop desks (or at least the one that is left) may end up having some unfortunate side effects for none other than the banks themselves, and especially their accounting voodoo: the basis for the recently announced stellar financial results.
The issue at hand is the "Fair Value Option", which under US GAAP essentially allows the booking of a pre-tax profit when a bank's debt trades lower in the open market. This benefits banks that opt-in for FVO instead of other accounting approaches such as amortized cost, or historic cost.
And so readers can get a perspective of just how large an accounting "benefit" the FV Option is to financials, observe the table below which compares 2008 bank Net Income with the Pre-Tax Gain from Fair-Valuing of Own Debt.
For a somewhat rough proxy of how the five selected banks' debt securities have traded in recent times, please see the chart below.
Of the 2015 bonds, recent appreciation has been seen in Goldman Sachs and Credit Suisse bonds, while the remainder have remained relatively flat or have even declined. Of course, these are merely proxies and many more securities are calculated for FVO per GAAP.
Regardless, if the equity run up persists, its is inevitable that bond spreads will tighten (see this post for comparisons for credit and equity levels in financials), thereby eroding the FVO pre-tax accounting benefit for companies with appreciating securities, and in fact will result in a negative pre-tax treatment. How much of a negative contributor to EPS it is will ultimately depend on i) how high equity security prices go and ii) how much of a catch up role comparable credit securities play in their price. It is likely that the respective CFOs are too aware of this phenomenon, and could be one explanation for the divergence between equity values and bond prices. If bonds had experienced the same run up as stock prices, the recently announced EPS for the major banks would have been much more adversely impacted.
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