Morgan Stanley, Italy, Swaps And Misplaced Outrage

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.