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Morgan’s hedge howler

• Robert Peston
• 19 Dec 07, 05:00 PM

The story of Morgan Stanley’s $7.8bn is gripping.

The leading Wall Street firm correctly predicted that sub-prime related securities would fall in value over the past year.

And its clever-clogs traders shorted the equity and mezzanine tranches of those blessed CDOs.

That was a brilliant bet. Because as US homeowners with poor credit histories started to cease making payments on their sub-prime loans, the value of the mezz and the equity collapsed – which yielded big bucks for Morgan.

But those traders also took out a hedge, just in case sub-prime recovered a bit.

It took a long position in super-senior AAA bonds.

Although these are – in theory – top investment quality, they are created in a magical way (using credit default swaps) out of the lower grade BBB tranche of CDOs.

Anyway the investment worked for months.

As the price of the mezz and the equity tumbled, that of the super-senior AAA held up.

But then disaster struck.

Delinquency rates for subprime borrowers – those beleaguered US homeowners – started to deteriorate way beyond what any precedent had suggested was possible.

And that led to a sharp fall in the value of the super-senior AAA stuff.

Now the important point to understand is that subprime CDOs of the 2005-7 vintages were priced with the 2000 subprime pool as the reference point.

And when delinquency rates started to exceed by a mind-boggling margin the delinquencies relating to the 2000 loans, the value of the super-senior AAA bonds imploded.

Here’s the terrifying statistic.

Morgan Stanley has now valued the super-senior AAA securities at between 30 and 35 cents in the dollar.

That’s a two thirds write-down for an investment which was supposed to be investment grade.

No wonder John Mack, Morgan Stanley’s chairman, thought it would be inappropriate to accept the modest bonus he was offered by the bank’s remuneration committee.

And a big hello to China’s sovereign wealth fund, which has exploited Morgan’s big boo boo to acquire a strategically important 9.9 per cent stake in what remains a world class institution.

UPDATE: By the way, the Morgan Stanley super-senior writedowns are significantly greater as a percentage of principal than those announced by Barclays and RBS – so in theory the Stanley losses could presage further losses for those British banks on their subprime positions.

However, not all super-senior AAA securities are the same quality. So it’s theoretically possible that the Barclays and RBS charges are sufficiently conservative. We’ll see.

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