I hate to pick on these guys, but I just can't help it. From Bloomberg :

Analysts Backtrack on Banking Stocks After Saying Worst Is Over

Wall
Street analysts who only weeks ago were telling investors to buy bank
stocks because the worst of the credit crisis was over are now
flip-flopping.

Goldman Sachs Group Inc. reversed a call on financial stocks, saying on June 23 that its May 5 recommendation was ``clearly wrong.'' Merrill Lynch & Co. on June 17 cut its rating on Lehman Brothers Holdings Inc.
to ``neutral,'' just a week after telling clients to buy. Barron's, the
financial newspaper, said this week that its February advice to buy American International Group Inc. was a ``mistake.''

``Analysts probably have less credibility than they did 10 years ago,'' said Charles Geisst,
the author of ``100 Years on Wall Street'' who teaches finance at
Manhattan College in New York. ``This has just eroded it a little bit
more.'

Wednesday, 25 June 2008 01:00

Mark to Misery in the cash equivalent fund biz

Written by

This is an unconfirmed, yet interesting email from a reader:

A
bond fund closed down yesterday and it brings up another interesting
dilemma that few people if anyone wants to address, including the SEC
and that is the public mutual funds that have invested in structured
mortgage debt. Many, and I do mean many fund managers are
very well aware that their holdings are incredibly overstated in value,
yet they do not challenge the pricing companies that evaluate their
holdings, unless they view the asset in question to be marked to low.

Sunday, 22 June 2008 01:00

User contributions though mini-sites

Written by

I urge all of blog members to take advantage of the personal websites available at boombustblog.com. Here is boombust member Numb's macro snapshot of Turkey via his site.

Friday, 20 June 2008 01:00

Now, they're all holding the bag!

Written by

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