Using Veritas to Construct the "Per…

29-04-2017 Hits:82091 BoomBustBlog Reggie Middleton

Using Veritas to Construct the "Perfect" Digital Investment Portfolio" & How to Value "Hard to Value" tokens, Pt 1

The golden grail of investing is to find that investable asset that provides the greatest reward with the least risk. Alas, despite how commonsensical that precept seems to be, many...

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The Veritas 2017 Token Offering Summary …

15-04-2017 Hits:77728 BoomBustBlog Reggie Middleton

The Veritas 2017 Token Offering Summary Available For Download and Sharing

The Veritas Offering Summary is now available for download, which packs all the information about Veritas in a single page. A step by step guide to purchasing Veritas can be downloaded here.

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What Happens When the Fund Fee Fight Hit…

10-04-2017 Hits:77298 BoomBustBlog Reggie Middleton

What Happens When the Fund Fee Fight Hits the Blockchain

A hedge fund recently made news by securitizing its LP units as Ethereum-based tokens and selling them as tradeable (thereby liquid) assets. This brings technology to the VC industry that...

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Veritaseum: The ICO That's Ushering in t…

07-04-2017 Hits:82044 BoomBustBlog Reggie Middleton

Veritaseum: The ICO That's Ushering in the Era of P2P Capital Markets

Veritaseum is in the process of building peer-to-peer capital markets that enable financial and value market participants to deal directly with each other on a counterparty risk-free basis in lieu...

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This Is Ground Zero for the 2017 Veritas…

03-04-2017 Hits:78636 BoomBustBlog Reggie Middleton

This Is Ground Zero for the 2017 Veritas Offering. Are You Ready to Get Your Key to the P2P Capital Markets?

This is the link to the Veritas Crowdsale landing page. Here is where you will be able to buy the Veritas ICO when it is launched in mid-April. Below, please...

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What is the Value Proposition For Verita…

01-04-2017 Hits:80930 BoomBustBlog Reggie Middleton

What is the Value Proposition For Veritas, Veritaseum's Software Token?

 A YouTube commenter asked a very good question that we will like to take some time to answer. The question was, verbatim: I've watched your video and gone through the slides. The exchange...

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This Real Estate Bubble, Like Some Relat…

28-03-2017 Hits:47813 BoomBustBlog Reggie Middleton

This Real Estate Bubble, Like Some Relationships, Is Complicated...

CNBC reports US home prices rise 5.9 percent to 31-month high in January according to S&P CoreLogic Case-Shiller. This puts the 20 city index close to an all time high, including...

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Bloomberg Chimes In With My Warnings As …

28-03-2017 Hits:79638 BoomBustBlog Reggie Middleton

Bloomberg Chimes In With My Warnings As Landlords Offer First Time Ever Concessions to Retail Renters

Over the last quarter I've been warning about the significant weakness in retailers and the retail real estate that most occupy (links supplied below). Now, Bloomberg reports: Manhattan Landlords Are Offering...

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Our Apple Analysis This Week - This Comp…

27-03-2017 Hits:79162 BoomBustBlog Reggie Middleton

Our Apple Analysis This Week - This Company Is Not What Most Think It IS

We will releasing our Apple forensic analysis and valuation this week for subscribers (click here to subscribe - lowest tier is the same as a Netflix subscription). As can be...

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The Country's First Newly Elected Lame D…

27-03-2017 Hits:79711 BoomBustBlog Reggie Middleton

The Country's First Newly Elected Lame Duck President Will Cause Massive Reversal Of Speculative Gains

Note: Subscribers should reference  the paywall material here for stocks that should give a good risk/reward scenario for bearish trades. The Trump administration's legislative outlook is effectively a political desert, with...

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Sears Finally Throws In The Towel Exactl…

22-03-2017 Hits:84682 BoomBustBlog Reggie Middleton

Sears Finally Throws In The Towel Exactly When I Predicted "has ‘substantial doubt’ about its future"

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The Transformation of Television in Amer…

21-03-2017 Hits:81635 BoomBustBlog Reggie Middleton

The Transformation of Television in America and Worldwide

TV has changed more in the past 10 years than it has since it's inception nearly 100 years ago This change is profound, and the primary benefactors look and act...

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From CNBC: Moody's Cuts MBIA, Ambac Top Insurance Ratings

Moody's stripped the insurance arms of Ambac Financial Group and MBIA of their AAA ratings, citing their impaired ability to raise capital and write new business... Demand for their insurance wraps has also effectively dried up on concerns over losses the companies will take from insuring risky residential mortgage-backed debt.

Standard & Poor's stripped both insurance arms of their top ratings on June 5.

Moody's cut Ambac Assurance three notches to "Aa3," the fourth highest investment grade, and downgraded Ambac Financial three notches to "A3," the seventh highest investment grade, from "Aa3."

MBIA Insurance was cut five notches to "A2," the sixth highest investment grade, and MBIA Inc was cut five notches to "Baa1," three steps above junk, from "Aa2."...

MBIA said Moody's action will give some holders of guaranteed investment contracts the right to terminate the contracts or to require that additional collateral be posted. The company said it has "more than sufficient" liquid assets to meet those requirements.  Yeah, okay. Everything that has come out of Management's mount in the last year has been false - practically every defensive public statement. They can't even spell credibility at this point.

 

This is a Turning Point Ladies and Gentlemen! 

IMO, MBIA's management is the lack of wisdom in action. I know it is easy to kick someone whent they are down, and that is something that I definitely do not aim to do. Yet, I have questioned management's competency for some time, way before it was popular to do so.

This is the dilemma. Everybody and their grandaunt's cousin knew the monoline wraps weren''t worth the toilet tissue their were contracted on, but they all played along with the triple ratings agency game. Realistically, in terms of perception of risk, we are in the same place we were in two months ago.

 And to think, there is no clearing house, no guarantee of settlement, no standardized credit or counterparty rating. Who knows who the hell will pay up and who will not! I have already bet my money that the monolines wouldn't be able to pay up, and I made a penny or two on that wager. The game is now afoot.

The growth in CDS market in the last few years has outstripped that of the US equity and bond markets

The credit derivatives market has grown at a remarkable pace as reflected from the tremendous increase in total notional amount outstanding over the last few years. The total notional amount of credit derivatives as of June 2007 increased to US$42.6 trillion, an increase of 109% over the US$20.4 trillion reported in June 2006. This has been driven by both the rise in single name CDS and the multi name CDS instruments. The significant rise in the multi name CDS (traded indices) has notably surpassed the growth in single name CDS. Single name CDS’ total notional amount outstanding has increased from US$7.31 trillion in June 2005 to US$24.2 trillion in June 2007 while the multi name CDS has grown from US$2.9 trillion in June 2005 to US$18.3 trillion in June 2007.

 

image002.jpg 

Source: Thomson Research

 

From an accounting perspective, we should see big things happening though. Now, some real transparency should be coming to light. Banks and other entities will have to start marking things down significantly, contracts that will get called will bankrupt the monolines, who will either refuse or be unable to pay. Level 3 asset concentrations and counterparty risk will be the poisons du jour. Who is the most toxitic? The CDS market will show the cracks that I have been predicting for some time as the dominoes go horizontal at a hastened pace. Even the speculators, re: Ackman, et. al. may have problems. Not everyone is going to get paid on their CDS exposure, because many guys on the other side (this is read as the counterparty risk that I have been crowing about for one year) just won't have the money to pay up. Trust me. If you haven't unwound already, God Bless the side pocket clause!

... for my next prediction, a lot of people may benefit from revisiting my "I know who's holding the bag" and "The Next Shoe to Drop: The CDS market, beware what lies beneath " articles... We will be testing the Fed's ability to rescue these banks, for although they have bandaged the liquidity wound, what's killing the banks is the insolvency disease - something the Fed is powerless to mitigate. This is why Paulson was on TV yesterday pushing to hasten the Fed's regulatory power increase. 

We very well soon see where I got the moniker, "The Riskiest Bank on the Street" from. See icon Morgan Stanley_final_040408 (1.38 MB). I received some notoriety after successfuly calling the Bear Stearns collapse (Is this the Breaking of the Bear?). Many who don't follow me closely may not realize how similar I consider Bear Stearns and Morgan Stanley. Morgan Stanley's net credit, counterparty, and level 3 exposure was the reason why I did the deep dive on it instead of Lehman, despite the fact that Lehman had more CRE exposure in proportion to its equity. Methinks the street may be looking at the wrong bank to fail. I may be wrong, we shall see. I made a decent profit off of Lehman anyway since those who follow the blog realized that we discovered Lehman's foibles way before most took notice. I wrote the following in April, right after the Bear debacle:

Morgan Stanley’s significant level 3 exposure and high leverage remain a cause for extreme concern

Large write-downs likely due to level 3 assets exposure: Morgan Stanley’s level 3 asset exposure, which stood at 261% of its equity as of February 29, 2008, is likely to cause a significant drag on its valuation in the near future. These assets, for which the bank uses proprietary models to gauge their value, will witness the largest write-downs of all asset categories amid the current credit market turmoil. When compared with other leading investment banks, Morgan Stanley clearly stands out to be the most vulnerable to falling values in these hard-to-value assets. It is worthwhile to mention that Bear Stearns, which last month witnessed significant erosion in its market capitalization, had level 3 assets equal to 239% of its equity, next only to Morgan Stanley. Although the Fed has mitigated liquidity concerns of investment banks in significant part, the balance sheet solvency is a far more difficult problem to address – and one in which Morgan Stanley leads the pack. 
 

Just so no one thinks I am following the crowd, I wrote this  the 2nd week of February:

 Failure of bond insurers increases counterparty credit risk

Bond insurers have guaranteed a monstrous $2.4 trillion of outstanding debt besides providing insurance coverage to troubled structured finance products such as CDOs. Banks active in the ABS RMBS and CMBS real estate markets have more than one reason to worry having bought protection through credit-default swaps (CDS) from bond insurance companies. Since the CDS market is not regulated, it is difficult to assess the amount of exposure banks have to bond insurer counterparty risk. ACA Capital Holdings is facing difficulties in paying claims due to its exposure in the CDO sector and subprime market. This prompted Merrill Lynch to write down its exposure to ACA by $1.9 billion. Sell side analysts such as Meredith Whitney of Oppenheimer, estimate that banks may have to write off securities (worth $10.1 billion) insured with ACA. Morgan Stanley’s exposure to net counterparty credit aggregates $51 billion. Nearly 27% of this was rated BBB and lower as of 30 November 2007. This reflects the $10 billion increase since August 31, 2007.

Morgan Stanley Issued Securities with Exposure to Ambac and MBIA

Morgan Stanley has exposure to bond insurers through bonds insured by them and their status as counterparties to derivative contracts. The inability of bond insurers to pay claims has become a serious concern for parties exposed to such firms.

The significant concentration in subprime home equity lines, who are subject to playing 2nd fiddle to the primary lender in first position in terms of claim on the what is increasingly highly encumbered property, leaves MS open to unprecedented losses - losses that can extend significantly past the next two quarters.

Deal Type

Min Rating

Sum of Par Amount

Sum of Potential Losses

CDO

A

$37,800,000

$0

 


AA

$15,000,000

$0

 


BB

$4,000,000

$0

 


BBB

$8,000,000

$0

CDO Total

 


$64,800,000

$0

CMBS

A

$238,297,455

$0

 


AA

$166,048,000

$0

 


AAA

$700,924,635

$0

 


B

$21,323,450

$0

 


BB

$79,302,500

$0

 


BBB

$629,817,177

$0

CMBS Total

 


$1,835,713,216

$0

Home Equity

A

$3,734,303,697

$1,679,091,758

 


AA

$3,045,402,787

$779,963,597

 


AAA

$398,260,933

$0

 


BB

$5,144,130

$5,144,130

 


BBB

$11,919,038,778

$9,239,733,896

 


CCC

$704,192

$225,201

Home Equity Total

 


$19,102,854,518

$11,704,158,582

RMBS

A

$251,756,751

$106,291,080

 


AA

$487,871,361

$98,398,644

 


AAA

$886,227,100

$0

 


BB

$6,442,461

$0

 


BBB

$254,936,389

$79,764,450

RMBS Total

 


$1,887,234,062

$284,454,174

(Other)

A

$20,000,000

$0

 


AA

$45,500,000

$0

(Other) Total

 


$65,500,000

$0

Grand Total

 


$22,956,101,796

$11,988,612,756

 

 

Counterparty credit exposure (in $ million)

 

image005.png

Source: Company data

 

 

 


So, where is all of this exposure and risk hidden?

 

Unconsolidated VIEs could aggravate woes

VIEs have tormented most Wall Street financial majors—several of them have had to consolidate their VIEs to increase liquidity and limit losses. These innovative, structured entities were introduced to boost earnings without transferring actual risk into the balance sheets of banks.

Morgan Stanley has significant exposure to VIEs, with the maximum loss ratio averaging roughly 50% in recent years. The large exposure ($37.7 billion in 4Q 07), high loss ratio and adverse market conditions could force the company out of business if its maximum loss assumptions become reality. Morgan Stanley’s unconsolidated VIEs comprise the most troublesome asset categories – MBS & ABS portfolios (worth $6.3 billion), credit & real estate portfolios ($26.6 billion) and some structured finance products ($8.6 billion). Loss exposure in the credit & real estate portfolio is not expected to be lower than 70% considering the slump in housing demand, falling home prices and rising foreclosures. The growing housing inventory across the U.S. has also raised concerns about the disposal of these assets. Home prices across the U.S. declined 7% (on average), while foreclosures increased 20% during the past year alone. This scenario reflects the bleak prospects of the housing industry and the securities linked to it.

 

Unconsolidated VIEs, Exposure to loss (in $ mn) and loss ratio (in %)

 

image004.png

Source: Company data

 

Unconsolidated VIE's

FY 2007

 


$ mn

Unconsolidated VIE assets

Maximum exposure to loss

Loss ratio %

MBS & ABS

7,234

280

3.9%

Credit & real estate

20,265

13,255

65.4%

Structured transactions

10,218

2,441

23.9%

Total

37,717

15,976

42.4%

 

To forecast these loss ratios, we have used the maximum exposure to loss as the worst case scenario. For the base case, we expect the loss ratio to be lower than the maximum exposure to loss.

 

 


Base Case

Optimistic Case

Worst Case

Mortgage and asset-backed securitizations

2%

1%

4%

Credit and real estate

50%

30%

65%

Structured transactions

15%

10%

24%

 

 


Base Case

Optimistic Case

Worst Case

Mortgage and asset-backed securitizations

109

54

217

Credit and real estate

6,080

3,648

7,953

Structured transactions

613

409

976

Total Losses in $ million

6,801

4,111

9,146

 


 

This is the "Riskiest Bank on the Street", as updated in April right after I liquidated the largest position in my proprietary portfolio, Bear Stearns puts from the year before:

Morgan Stanley’s significant level 3 exposure and high leverage remain a cause for extreme concern

Large write-downs likely due to level 3 assets exposure: Morgan Stanley’s level 3 asset exposure, which stood at 261% of its equity as of February 29, 2008, is likely to cause a significant drag on its valuation in the near future. These assets, for which the bank uses proprietary models to gauge their value, will witness the largest write-downs of all asset categories amid the current credit market turmoil. When compared with other leading investment banks, Morgan Stanley clearly stands out to be the most vulnerable to falling values in these hard-to-value assets. It is worthwhile to mention that Bear Stearns, which last month witnessed significant erosion in its market capitalization, had level 3 assets equal to 239% of its equity, next only to Morgan Stanley. Although the Fed has mitigated liquidity concerns of investment banks in significant part, the balance sheet solvency is a far more difficult problem to address – and one in which Morgan Stanley leads the pack. 
 
 
Bank Level 1 Assets Level 2 Assets Level 3 Assets Shareholder Equity Total Assets Level 1 Assets-to-Total Assets Level 2 Assets-to-Equity Level 3 Assets-to-Equity Leverage (X)
Citigroup $223 $934 $133 $114 $2,183 10.2% 822% 117% 19.21
Merrill Lynch $122 $768 $41 $32 $1,020 12.0% 2405% 130% 31.94
Lehman Brothers $73 $177 $39 $26 $786 9.2% 687% 152% 30.59
Goldman Sachs $122 $277 $72 $47 $1,120 10.9% 586% 153% 23.71
Morgan Stanley $115 $226 $74 $31 $1,045 11.0% 723% 236% 33.43
Bear Stearns $29 227 $28 $12 $96 30.7% 1926% 239% 8.15
 
Based on latest quarterly filings and transcripts 
 
Also, the growing proportion of level 3 assets in Morgan Stanley’s total asset exposure is raising investors’ concerns over expected write downs in the coming quarters. The bank’s level 3 assets have increased partly due to re-classification of assets from level 2 to level 3 on account of unobservable inputs for the fair value measurement. During 4Q2007, Morgan Stanley re-classified $7.0 bn of funded assets and $279 mn of net derivative contracts from level 2 to level 3. Morgan Stanley’s level 2 assets-to-total assets ratio declined to 5.2% in 4Q2007 from 8.9% in 1Q2007 while its level 3 assets-to-total assets increased to 7.0% in 4Q2007 from 4.3% in 1Q2007 indicating growing uncertainty associated with valuation of assets not readily marketable. The trend can be expected to continue in the coming quarters as uncertainty associated with realizing values from illiquid assets continues to grow.  
image0121x.gif
image014x.gif
 
High leveraging could hinder capital raising abilities: While expected asset write-downs could continue eroding Morgan Stanley’s equity at least for the next few quarters, the company’s higher-than-peers leverage levels could prove to be an impediment in raising additional capital to maintain its statutory capital levels. Morgan Stanley’s leverage (computed as total tangible assets over tangible shareholders’ equity) stood at 37.3X as of February 29, 2008, while the bank’s balance sheet size had been reduced to $1,091 bn as of that date from $1,182 bn on November 30, 2007. The bank’s leverage is the highest among its peers which could be a cause of concern amid falling income levels and tight liquidity conditions in the financial markets.
image0121.gif
 * Adjusted assets / adjusted shareholder's equity 
 
Morgan Stanley taking initiatives to “de-risk” its balance sheet: In the wake of issues underpinning the current crisis in the markets, Morgan Stanley is making continued efforts to “de-risk” its balance sheet by reducing its exposure to risky credit positions. Morgan Stanley’s total non-investment grade loans decreased to $26 bn in 1Q2008 from $30.9 bn in 4Q2007. In addition Morgan Stanley reduced its gross exposure towards CMBS and RMBS securities to $23.5 bn and $14.5 bn, respectively, in 1Q2008 from $31.5 bn and $16.5 bn, respectively, in 4Q2007. 

5

 

Significant counter-party risks from monoline downgrades to result in further write-downs

While hedging does function as an effective tool in minimizing loses from write-downs of dubious assets, hedging in the form of protection from monolines/bond insurers carries associated counterparty credit risks which cannot be ignored in the current environment of continued weakening of monolines. An increasing probability of counterparty risks materializing for investment banks from the deteriorating financial position of the monolines could contribute to further asset write-downs by the banks. It is estimated that the top five US investment-banks have a combined $23 bn in uncollateralized exposures to triple-A rated counterparties part of which is with the monocline bond insurers including AMBAC, MBIA (may face downgrade from Fitch, same with Ambac), and FGIC (is now rated as junk), which have been a subject of downgrades in the last few months. Merrill Lynch’s total uncollateralized exposure to triple-A counterparties stood at $7.1 bn as of August 31, 2007, while that of Morgan Stanley was $7 bn as of that date. The corresponding figures for GS, Lehman and Bear Sterns were $4.7 bn, $4 bn and $330 mn, respectively. Merrill Lynch has reported that around 50% of its total hedging is in the form of monoline insurance, giving a fair indication of the possible write-downs resulting from downgrades of monolines. Merrill Lynch also reported a $3.1 bn asset write-down in 4QFY07 in response to a downgrade of ACA Capital (to which it had an exposure) to junk status.
 
As of February 29, 2008, Morgan Stanley had $4.7 bn aggregate exposure towards monolines with a $1.3 bn exposure in ABS bonds, $2.6 bn in municipal bond securities and $0.8 bn in net counter party exposure. The deterioration of credit market coupled with significant losses suffered by monolines had caused downgrades of monolines. Any further downgrades of monolines could result in additional write-downs by financial institutions and adversely affect the financial markets. Morgan Stanley recorded approximately $600 mn write-down in 1Q2008 on account of its exposure from monolines. S&P estimates that the total hedges to CDO exposures by bond insurers are currently around $125 bn, though the location of these hedges is not entirely known. A separate report by Oppenheimer & Co estimates that the total write-down by the financial institutions resulting from potential rating downgrades of monolines could range between $40 bn to as high as $70 bn, with Citigroup, ML, and UBS being the most vulnerable as they together hold a large chunk of the credit market risk associated with bond insurers. The coming quarters could thus witness more significant assets write-downs if monolines are downgraded.
 
The possible relief comes from the recent developments whereby monolines have been successful in raising capital to maintain their AAA ratings.  Earlier, in March 2008, both S&P and Moody’s affirmed AAA and Aaa ratings, respectively, to AMBAC after it raised $1.5 bn through sale of common stock and convertible units.  Another factor which may reinforce the banks’ counter party risks on monocline exposure are the recent developments which indicate that the monolines may be looking for means to terminate their guarantee contracts with the banks to evade their liabilities. A case in point is the legal battle initiated between Merrill Lynch and Security Capital Assurance (SCA) wherein Merrill Lynch sued SCA’s XL Capital Assurance unit on the ground that the latter refused to honor the commitments arising on the bank’s CDS worth $3.1 bn. SCA has in turn alleged that Merrill Lynch had not honored the contractual terms by transferring the control rights on the CDOs to a third party. More such legal battles could follow creating increased uncertainty on the true extent of hedging exercisable on monocline exposure. 

5

 

Hidden losses from unconsolidated VIE’s a cause of concern for Morgan Stanley

image016t.gif
Morgan Stanley has a significant exposure to MBS, ABS, credit and real estate assets and other structured transactions through VIEs. As at November 30, 2007 Morgan Stanley consolidated $22.4 bn of assets from VIEs, with a maximum loss exposure of $17.6 bn. In addition, the bank also has $37.7 bn in exposure through unconsolidated VIEs with a maximum loss exposure of $15.9 bn, yielding a maximum loss-to-total exposure at 42.4%. Morgan Stanley’s total exposure towards unconsolidated VIEs is in some of the riskiest asset class categories, including a $7.2 bn exposure towards MBS and ABS securities (maximum loss-to-exposure of 3.9%), $20.3 bn towards credit and real estate (maximum loss-to-exposure of 65.4%) and $10.2 bn towards structured transactions (maximum loss-to-exposure of 23.9%).   
 
Consolidated VIE's  ($ mn) 30-Nov-07
US$ mn VIE assets consolidated  Maximum exposure to loss
     
 Mortgage and asset-backed securitizations 5,916 1,750
 Municipal bond trusts 828 828
 Credit and real estate 5,130 5,835
 Commodities financing 1,170 328
 Structured transactions 9,403 8,877
 Total 22,447 17,618
     
    78.49%
     
Unconsolidated VIE's ($ mn) 30-Nov-07
US$ mn VIE assets not consolidated Maximum exposure to loss
 Mortgage and asset-backed securitizations 7,234 280
 Credit and real estate 20,265 13,255
 Structured transactions 10,218 2,441
 Total 37,717 15,976
     
    42.36%
 
 
 
Net losses Optimistic Case  Base Case Worst Case
 Mortgage and asset-backed securitizations                          28                           42                      84
 Credit and real estate                     2,187                      3,314                6,628
 Structured transactions                        564                         854                1,709
Total in US$mn                     2,779                      4,210                8,420
 
 
As can be ascertained from its high maximum loss-to-exposure ratio of 65.4%, the credit and real estate product is the most vulnerable of all the products in respect of a probability of defaults considering that most of the US housing problem is linked to loans originated with poor underwriting standards to marginal buyers at the peak of the housing bubble. Falling housing prices coupled with stringent lending standards are making it increasingly difficult for borrowers to refinance existing loans resulting in higher delinquency and foreclosures for these loans. Under our base case scenario we have estimated total losses of $4.2 bn from unconsolidated VIEs primarily off losses from the credit and real estate sectors. Also it is worth mentioning that some investment baking firms (prominently UBS and Lehman) are spinning off or considering a spinoff of their riskier assets into separate subsidiaries, CLOs and SIVs as an off-balance sheet exposure in an attempt to shrink their balance sheet through accounting shenanigans designed to deceive investors by presenting a rosy picture of their financial affairs. 


 

Worsening credit market to impact Morgan Stanley’s financial position

The current gridlock in the credit market has drastically pulled down the mark-to-market valuation of mortgage-backed structured finance products, resulting in significant asset write-downs of banks and financial institutions. It is estimated that further write-downs by investment banks could touch $75 bn in 2008 after an estimated $230 bn already written off since the start of 2007. With the situation not expected to improve in the near-to-medium term, investment banks are likely to face a sizeable erosion of their equity from large write-downs in the coming periods. Though the recent mark-down revelations by UBS and Deutsche Bank have injected some positive sentiment in the global capital markets with the hope that the credit crisis has reached an inflection point, it is overly optimistic to believe that the beginning of the end of the current turmoil is at hand before the causes of the turmoil, tumbling real asset prices and spiking credit defaults, cease to act as catalysts.
image013x.gif
* expected 
 
Morgan Stanley wrote off a significant $9.4 bn of its assets in 4Q2007. However, the write down in 1Q2008 was much lower with $1.2 bn mortgage related write-down and $1.1 bn leveraged loan write-down, partly offset by $0.80 bn gains from credit widening under FAS159 adjustments. One of the factors which the bank considers while estimating asset write-downs is the movement in the ABX index which tracks different tranches of CDS based on subprime backed securities. Nearly all tranches of ABX index have witnessed a significant decline over the last six months. While Morgan Stanley’s 4Q2007 write-down of $9.4 bn appeared in line with a considerable fall in the ABX index during the quarter, a similar nexus is not evident for 1Q2008. Morgan Stanley recorded a gross write-down of $2.3 bn in 1Q2008 though the decline in ABX indices seemed relatively severe (however not as steep as in the preceding quarter). The disparity raises a concern that Morgan Stanley might report more losses in the coming periods. 
 
image015y.jpg
 
ABX BBB indices (September 26, 2007, to  April 2, 2008) Source: Marki.comt Although the ABX indices showed a slight recovery in March 2008, this is expected to be a temporary turnaround before the indices resume their downward movement owing to expected continuing deterioration in the US housing sector and mortgage markets. The following is a detailed, yet not exhaustive, example of Morgan Stanley's "hedged" ABS portfolio - icon Morgan Stanley ABS Inventory (1.65 MB)6.
"Hedged" is a parenthetical because we believe that large scale investment bank hedges are far from perfect. We discuss this later on in the report.
 
The US housing markets are yet to stabilize and housing prices are still above their long-term historical median levels, leaving scope for a further downside in prices. Between October 2007 and January 2008, the S&P Case Shiller index declined nearly 6.5% (with 2.3% decline in January 2008 alone). We would like to make it clear that although the CS index is an econometric marvel, it does not remotely capture the entire universe of depreciating housing assets. It purposely excludes those sectors of the housing market that are hardest hit by declines, namely: new construction (ex. home builder finished inventory), condos and co-ops, investor properties and “flips”, multi-family properties, and portable homes (ex. trailers). Investor properties and condos lead the way in defaults due to excess speculation while new construction faces the largest discounts, second only to possibly repossessed homes such as REOs. A decline in this expanded definition of housing stock’s pricing could result in increased defaults and delinquencies, significantly beyond that which is represented by the Case Shiller index, which itself portends dire consequences. As credit spreads continue to widen over the next few quarters, the assets would need to be devalued in line with risk re-pricing. Morgan Stanley and the financial sector in general, are expected to continue with their balance sheet cleansing exercise, recording further asset write-downs till stability is restored in the financial markets.  While it is believe the expected continuing fall in the security market values would indicate more write-downs in the coming quarters, a part of this could be set-off under FAS159 by implied gains from write-down of financial liabilities off an expected widening of credit spreads. Morgan Stanley is expected to record assets write-down losses of $16.5 bn and $7.6 bn in 2008 and 2009, respectively, considering the bank’s increasing proportion of level 3 assets amid falling security values. This would be partially off-set by FAS159 gains of $930.8 mn and$116.1 mn in the two years off revaluation of its financial liabilities. It is important to note the fact that FAS 159 gains are primarily accounting gains, and not economic gains and they do not truly reflect the economic condition of Morgan Stanley. Of the $18.3 bn of total liabilities for which the bank makes adjustments relating to FAS159, $14.2 bn and $3.1 bn of liabilities relate to long-term borrowings and deposits.
 
Since most of these securities are traded in the secondary market, it would be difficult for Morgan Stanley to translate these accounting gains into economic gains by purchasing them at a discount to par during a widening credit spreads scenario.  To explain in simpler terms, marketable securities can be purchased at a discount to par if credit spreads increase as MS debt is devalued. Thus, theoretically, MS can retire this debt for less than par by purchasing this debt outright in the market, and FAS 159 allows MS to take this spread between market values and par as an accounting profit, presumably to match and offset the logic in forcing companies to market assets to market via FAS 157. In reality, only marketable securities can yield such results in an economic fashion, though companies that would be stressed enough to experience such spreads probably would not be in the condition to retire debt. In Morgan Stanley’s case, these spreads represent non-marketable debt such as bank loans, negotiated borrowings and deposits. These cannot be purchased at less than par by the borrower, thus any accounting gain had through FAS 159 will lead to phantom economic gains that don’t exist in reality. For instance, a $1 billion bank loan will always be a loan for the same principle amount, regardless of MS’s credit spreads, unless the bank itself decides to forgive principal, which is highly unlikely. It should be noted that Lehman Brothers actually experienced an economic loss for the latest quarter of about $100 million, but benefitted by the accounting gain stemming from FAS 159, that led to an accounting profit of approximately $500 million. This profit, which sparked a broker rally, was purely accounting fiction. Similarly, Morgan Stanley (in economic profit, ex. “real” terms) overstated its Q1 ’08 profit by approximately 50%. This overstatement apparently induced a similarly rally for the brokers. Quite frankly, we feel the industry as a whole is in a precarious predicament due to dwindling value drivers, a cyclical industry downturn, a credit crisis and a deluge of overvalued, unmarketable and quickly depreciating assets stuck on their balance sheets. Their true economic performance is revealing such, but is masked by clever, yet allowable accounting shenanigans.
Morgan Stanley Write-down -2008 Level 1 Level 2 Level 3 Total
(In US$ mn)        
         
Financial instruments owned        
U.S. government and agency securities                -                 12                 2               14
Other sovereign government obligations                -                   9                 0                 9
Corporate and other debt                 2          2,761          2,223          4,986
Corporate equities             413               71               62             546
Derivative contracts             226          7,252          3,240        10,719
Investments                 1                 1             196             198
Physical commodities                -                 12                -                 12
Total financial instruments owned            642       10,120         5,723       16,485