Morgan Stanley’s fourth quarter results are the most remarkable I’ve ever seen.
Last time, I talked about John Paulson’s mega profit from shorting subprime. While Paulson’s team was putting together a series of trades that gained $12 billion, their competitors at Morgan Stanley were putting together trades that have lost over $9 billion.
What’s remarkable is that Morgan Stanley’s record breaking loss came from a trading desk that took the same view of subprime as Paulson – they looked at the sector and saw a dog with fleas that was crying out to be shorted. Having seen this, they then constructed a trade that, in three months, lost them over $9 billion.
In this context, it’s easier to see the truth of Arpad Busson’s comment that the great merit of Paulson’s trade lay in its execution.
So how did Morgan Stanley’s traders manage to make record losses out of a correct prediction of subprime’s downfall?
The losses stemmed from the fact that they did not fully understand the debt market they traded.
Morgan Stanley’s team shorted subprime but hedged by going long supposedly solid AAA debt. The theory was that, if their short went against them, their long position in AAA debt would rise and cover the losses. They put approximately $2 billion into their short position and $14 billion into their long position.
The mistake the traders made – and they were not alone – was that although their long position was in supposedly AAA debt, this debt had been constructed from BBB debt using credit default swaps – known to those in the business as mezzanine.
According to Portfolio.com – who give a simple, animated explanation of how lower quality debt was transmuted into high quality AAA debt – financial professionals thought that BBB debt could be elevated to AAA through “diversity”: If borrowers were defaulting in Florida, they could still count on payments from California. But over the last year, different kinds of mortgages defaulted at the same time – leaving no money even for the supersenior AAA tranche, which was meant to be completely safe.
In fact, the AAA debt Morgan Stanley bought as a “hedge” is now worth only about 30c for each dollar they paid.
Although they’re putting a brave face on it – trying to spin it as improving their links with China – in order to remain sufficiently capitalized, Morgan Stanley has been forced to borrow $5 billion from the China Investment Corporation. The $5 billion comes at a high price – the Chinese are charging 9 percent interest. In a couple of years’ time, this debt will convert into CIC owning 10 percent of Morgan Stanley.
John Mack, Morgan’s chairman, says he is embarrassed by the results and Morgan will be reigning in its risk taking in future trading.