The FT describes how Morgan Stanley placed a bet last year that the values of mortgage securities would decline, but were outsmarted by the market (and by Goldman Sachs?) when the declines were much greater than anticipated. We excerpt a description of some of the details to illustrate just how complex some of these transactions are:

Morgan Stanley…placed a big bet on a fall in those prices. To do so, they bought insurance against problems with the mortgage-backed securities in the form of credit default swaps. The value of these would rise if the outlook for the securities deteriorated. To help fund this bet, the traders also bought $13bn of exposure to the “super senior” tranches of collateralised debt obligations. These are instruments composed of mortgage-backed securities divided into slices with varying yields and risks. The top AAA-rated tranches were seen as being very safe, because any likely losses on the underlying securities would be absorbed by investors in the lower tranches. Nevertheless, the senior tranches offered a good yield which helped offset the cost of the bet.

In the first half of this year, the bet paid off handsomely, as the market woke up to the rising delinquencies among subprime mortgages. In the first two quarters, Morgan Stanley apparently booked profits from the trade, but these have not been quantified. Then things started going wrong. The value of mortgage-backed securities fell so far it ate into the cushion under the super senior tranches and they started to fall. At one point in the summer, the impact on the CDO tranches started to outweigh the rise in the CDS positions. “It went from a structurally short position to a structurally long position,” said Colm Kelleher, Morgan Stan­ley’s chief financial officer.

The trade made losses in the third quarter, which Morgan Stanley reported among $1bn of “losses in structured credit trading”. In recent weeks the market has deteriorated further and with some analysts forecasting that the company was facing losses of up to $6bn, it decided to reveal its estimate of the damage to the end of October. The fall in the super senior tranches has been so extreme that “no stress model in the world would ever have had it”, said Mr Ke­ll­eher. It implies defaults in the range of 40 to 50 per cent on mortgages written in 2005 and 2006, levels never seen before.

But even in this looking-glass world, money does not completely disappear. Someone was on the other side of the trades. With arch-rival Goldman Sachs said to have done an unrivalled job hedging its way through the crisis, how much more painful it would be for Morgan Stanley if, as some suggest, the counterparty on its misguided subprime bet proves to have been Goldman.

The FT described a transaction that was not only perfectly legal but also, in its way, completely transparent. Yet the counterparty, for example, remains completely unknown. Our point is this: in the labyrinth of complex financial transactions and in the opaque world of international hedge funds, would it not be possible to conceal bear raids on equity and debt securities of a target if manipulation of the value of those securities were the objective?

This entry was posted on Saturday, November 10th, 2007 at 12:54 pm and is filed under General, business. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.