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| Jon Macaskill is one of the leading capital markets and derivatives journalists, with over 20 years’ experience covering financial markets from London and New York. Most recently he worked at one of the biggest global investment banks |
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The run on Morgan Stanley’s stock and default swaps over the past few days had alarming similarities to the collapse in confidence in the bank during 2008. Morgan Stanley’s share price plunge and a drive in its five-year default swap spread towards 500bp came exactly three years after its credit crisis borrowing from the Federal Reserve peaked at $107.3 billion – the most secured by any bank, including troubled firms with far bigger balance sheets, such as Citigroup.
Morgan Stanley’s need for emergency government aid in 2008 was driven in large part by the sudden withdrawal of balances by its prime brokerage clients, with hedge funds pulling around $130 billion in the weeks following the failure of Lehman.
The most recent crisis of confidence in Morgan Stanley was accompanied by talk of another flight by funds, with the same risk that market speculation could spark a negative feedback loop and prompt clients to cut exposure to the bank on a precautionary basis.
Morgan Stanley was propped up during the 2008 crisis in two main ways, neither of which was fully disclosed at the time. The first was by direct government financial backing. Like its peers, Morgan Stanley was heavily reliant on Federal Reserve financing lines during the market panic of 2008. The extent of its dependence on state funding was not known until this year, when the Federal Reserve finally lost a rearguard legal action attempt to keep the details of crisis era loans to individual banks secret.
Morgan Stanley also received crucial help in defending market share from the Federal Reserve in the form of moral suasion, as the regulator intervened to persuade healthier banks to stop poaching prime brokerage clients.
Bill Dudley, markets head at the time and now president of the Federal Reserve Bank of New York, contacted senior executives at rival banks to ask for a cease-fire in the interest of market stability. Bankers heeded Dudley’s call, as they were unwilling to cross the regulator while they were themselves tapping Federal Reserve financing lines.
This regulatory intervention helped Morgan Stanley to stem the desertion of hedge fund clients by making it more difficult to shift their accounts to other banks. The firm then did a good job of rebuilding its prime brokerage franchise when markets recovered, which will have made the current revival of speculation about hedge fund defections all the more disheartening for Morgan Stanley executives.
Prime brokerage revenues for global investment banks had been expected to comfortably exceed $10 billion during 2011, until market turbulence took a toll on funds in the third quarter.
And Morgan Stanley was back in its old position at the top of the prime broking pole, ranking second to Goldman Sachs in terms of fund balances. The two firms no longer enjoy an unchallenged duopoly at the head of prime broking, as Credit Suisse, Deutsche Bank and JPMorgan now round out a tightly bunched top five. Morgan Stanley’s return to a prime broking leadership position had nevertheless appeared to signal a broader recovery in its sales and trading fortunes, until the recent renewed crisis in confidence.
The sense of déjà vu surrounding Morgan Stanley’s prime brokerage is mirrored by a fear that the firm may once again have mistimed an attempt to win market share in fixed income trading.
Morgan Stanley surpassed Goldman in fixed income, currency and commodities revenues in the second quarter, which was a psychological boost, and it appeared to be making progress in CEO James Gorman’s goal of winning two percentage points of fixed income market share.
This was accompanied by an increase in average value-at-risk from $121 million to $145 million over the quarter and signs of an increasingly buccaneering trading style, however.
The sharp deterioration in market conditions in the third quarter is leading to concern that Gorman is repeating some of the mistakes of his predecessor, John Mack.
Morgan Stanley’s near-death experience in 2008 can be placed firmly at Mack’s door. He mandated an increase in risk taking in an attempt to close the sales and trading gap with Goldman Sachs, which led to the biggest single trading loss ever seen, in the form of a $9 billion hit on a supposedly hedged credit position.
That loss was incurred just before the 2008 crisis set in and left Morgan Stanley in a weakened position when market confidence collapsed at the end of the third quarter of that year.
Gorman clearly does not share Mack’s infatuation with swashbuckling traders of the old Wall Street school. Gorman has publicly criticized the culture that allows desk heads to place outsized bets with little regard for the overall health of a bank and made his personal distaste for former employees like one-time fixed income head Jack DiMaio fairly obvious.
But any drive to win fixed income market share can only be accomplished by an increase in trading volume. Fixed income clients value liquidity provision more than any other differentiating factor, including trade idea generation and customer service.
In the modern fixed income markets this involves an increase in derivatives volume, first with clients, then with other dealers as client trades are offset.
This in turn can lead to upward pressure on the default swap spreads of any firm that is increasing its trading activity, as other dealers buy protection to hedge their counterparty exposure.
Hedging by fellow derivatives dealers is thought to have been the main contributor to the sharp rise in Morgan Stanley’s default swaps in late September, though hedge funds are also increasingly proactive in managing their exposure to dealers.
The market for single name default swaps is much less liquid than is often realized. Volumes are down at least 50% from their pre-crisis peak and a recent Federal Reserve study found that even widely quoted reference credits like Morgan Stanley see an average of only around 10 trades a day.
This causes gapping in prices when there is sustained protection buying, and arguably overstates the deterioration in the creditworthiness of individual references in times of market stress. Default swaps are nevertheless still more liquid than individual corporate bonds and are the best credit indicators available. So a sudden swap spread widening like the one suffered by Morgan Stanley at the end of September inevitably heightens concern among clients.
Most investment banks have been steering investors to expect poor third quarter results. New financing was virtually non-existent and markets slumped on increased volatility, so earnings expectations are certainly low. But recent price moves indicate that any unexpected trading losses for Morgan Stanley pointing to risk control weaknesses could cue a reaction comparable to the full-blown panic seen in 2008.
