For the latest gimmick to mask PIIGS sovereign debt exposure (where we already know that the traditional fallback of "gross being irrelevant and only net being important" crashed and burned today after Jefferies offloaded precisely half of its gross exposure, while raising net, thereby confirming that gross exposure is indeed a risk), we turn yet again to Morgan Stanley. As a reminder, despite our note that the company's gross exposure (which is now a major risk factor, thank you Rich Handler for proving our "bilateral netting is flawed" thesis) to French banks alone is $39 billion, Morgan Stanley downplayed this by saying that only $2.1 billion is the actual net funded exposure to Peripherals Eurozone countries. We'll see if Jack Gorman will have to revisit his defense after today's Jefferies action. Well as it turns out, we now have gimmick number two, one which will surely delight the bearish investors out there looking to find a bank doing all it can to mask not only its gross but net exposure (and wondering why it has to resort to such shenanigans). Presenting the Level 1 to Level 2 switcheroo, courtesy of, who else, Morgan Stanley.
From the just released 10-Q:
"Financial instruments owned—Other sovereign government obligations. During the quarter ended September 30, 2011, the Company reclassified approximately $1.8 billion of other sovereign government obligations assets and approximately $2.1 billion of other sovereign government obligations liabilities from Level 1 to Level 2. These reclassifications primarily related to European peripheral government bonds as transactions in these securities did not occur with sufficient frequency and volume to constitute an active."
Uhm, are you serious? Transactions in all PIIGS securities were sufficiently active in both frequency and volume. We are delighted to present Morgan Stanley with a CUSIP list of all PIIGS bonds together with price and volume data if they so desire to confirm to them that their excuse is about to get tested substantially by the market as one not of prudent accounting (we jest: Level 2 assets are merely a legal way to get par marks for a security that is realistically trading at 35 cents on the dollar in the case of Greece and 87 in the case of Italy), but one of yet another attempt at blatant obfuscation.
And to confirm that this reasoning behind this reclassification in a quarter in which there was massive volatility in all PIIGS securities, is pure lunacy, we ask: did Morgan Stanley reclassify any PIIGS bonds from Level 1 to Level 2 in Q1 or Q2, when vol was indeed less and when one could make the argument that there is a basis for a Level 1 to Level 2 transition?
Here is the language for the 9 months ended, not just Q3:
Financial instruments owned—Other sovereign government obligations. During the nine months ended September 30, 2011, the Company reclassified approximately $1.8 billion of other sovereign government obligations assets and approximately $2.1 billion of other sovereign government obligations liabilities from Level 1 to Level 2. These reclassifications primarily related to European peripheral government bonds as transactions in these securities did not occur with sufficient frequency and volume to constitute an active market.
So... the only time Morgan Stanley did the Level 1 to Level 2 shift was in Q3, when everything was trading, was volatile trades occurred in both "frequency" and "volume" yet when Morgan Stanley's back office couldn't find enough marks to justify keeping PIIGS bonds at Level 1? And let's not forget the fact that the Level 1 to Level 2 amount was $2.1 billion or... precisely the amount of the firm's self-professed net funded exposure!
SERIOUSLY, MORGAN STANLEY!?
Just like the DVA fudge, should we now expect every single bank to report a transfer in PIIGS exposure from Level 1 to Level 2 (only for Q3 mind you)? And if so, just how ugly is it about to get for US bank stocks with PIIGS exposure.
As for Morgan Stanley, please keep coming up with more and creative ways to mask the fact that your publicly disclosed net exposure to Europe is totally fabricated and meaningless. The market is just going to love picking off your Sovereign flow book at 1.5% gross losses (just like with Jefferies) as you scramble to offload your gross exposure next to prove, yet again, just how unexposed to Europe you "truly" are.