Morgan Stanley (NYSE:MS) is both one of the world's most critical financial institutions and one of the world's few survivors of a near-death experience in the financial crisis. The firm's challenges during the crisis and an analysis of daily credit crisis borrowings were chronicled by Kamakura Corporation. In addition to the daily funding provided by the Federal Reserve, Morgan Stanley received a $10 billion capital injection from the United States government as described in this October 5, 2009 report from the Special Inspector General of the Troubled Asset Relief Program. Morgan Stanley was also the beneficiary of the Temporary Liquidity Guarantee Program that supported financings of FDIC-insured institutions. Guarantees under this program were extended twice and expired December 31, 2012. Transactions by Morgan Stanley and others under this program are listed in this FDIC document.
In this note, we turn to the U.S. dollar bonds issued Morgan Stanley and compare its current default probabilities with those we first reported on July 8, 2013. We seek to bring a bond market perspective to the outlook for Morgan Stanley as a complement to analysis based on a common stock holder's perspective. Today's note incorporates Morgan Stanley bond price data as of October 11, 2013. We note that Morgan Stanley was a frequent issuer of zero coupon notes and regret that data errors related to those issues prevent them from being included in today's analysis. A total of 735 trades were reported on 131 fixed-rate non-call bond issues of Morgan Stanley with October 11 trading volume of $204.5 million. After eliminating the data errors mentioned above, we used data on 63 bond issues amounting to 475 trades with underlying principal value of $ 142.0 million. Although Morgan Stanley is one of the most heavily traded names in the U.S. bond market, one of the central messages of this note is that astute execution of bond trades in this reference name is essential to achieving good value.
Institutional investors around the world are required to prove to their audit committees, senior management, and regulators that their investments are in fact "investment grade." For many investors, "investment grade" is an internal definition; for many banks and insurance companies "investment grade" is also defined by regulators. We consider whether or not a reasonable U.S. bank investor would judge Morgan Stanley (which converted to a U.S. bank holding company in September 2008) to be "investment grade" under the June 13, 2012 rules mandated by the Dodd-Frank Act of 2010, which requires that credit rating references be eliminated from U.S. government regulations. Section 939A states the following:
"SEC. 939A. REVIEW OF RELIANCE ON RATINGS.
(NYSE:A) AGENCY REVIEW.-Not later than 1 year after the date of the enactment of this subtitle, each Federal agency shall, to the extent applicable, review-
(1) any regulation issued by such agency that requires the use of an assessment of the credit-worthiness of a security or money market instrument; and
(2) any references to or requirements in such regulations regarding credit ratings.
(NYSE:B) MODIFICATIONS REQUIRED.-Each such agency shall modify any such regulations identified by the review conducted under subsection to remove any reference to or requirement of reliance on credit ratings and to substitute in such regulations such standard of credit-worthiness as each respective agency shall determine as appropriate for such regulations. In making such determination, such agencies shall seek to establish, to the extent feasible, uniform standards of credit-worthiness for use by each such agency, taking into account the entities regulated by each such agency and the purposes for which such entities would rely on such standards of credit-worthiness.
(NYSE:C) REPORT.-Upon conclusion of the review required under subsection , each Federal agency shall transmit a report to Congress containing a description of any modification of any regulation such agency made pursuant to subsection .
The new rules issued by the Office of the Comptroller of the Currency in accordance with Dodd-Frank are described here. The summary provided by the OCC reads as follows:
"In this rulemaking, the OCC has amended the regulatory definition of 'investment grade' in 12 CFR 1 and 160 by removing references to credit ratings. Under the revised regulations, to determine whether a security is 'investment grade,' banks must determine that the probability of default by the obligor is low and the full and timely repayment of principal and interest is expected. To comply with the new standard, banks may not rely exclusively on external credit ratings, but they may continue to use such ratings as part of their determinations. Consistent with existing rules and guidance, an institution should supplement any consideration of external ratings with due diligence processes and additional analyses that are appropriate for the institution's risk profile and for the size and complexity of the instrument. In other words, a security rated in the top four rating categories by a nationally recognized statistical rating organization is not automatically deemed to satisfy the revised 'investment grade' standard."
Assuming the recovery rate in the event of default would be the same on all bond issues, a sophisticated investor who has moved beyond legacy ratings seeks to maximize revenue per basis point of default risk from each incremental investment, subject to risk limits on macro-factor exposure on a fully default-adjusted basis. In this note, we also analyze the maturities where the credit spread/default probability ratio is highest for Morgan Stanley.
Term Structure of Default Probabilities
Maximizing the ratio of credit spread to matched-maturity default probabilities requires that default probabilities be available at a wide range of maturities. The graph below shows the current default probabilities for Morgan Stanley (green line) ranging from one month to 10 years on an annualized basis. They are plotted versus the default probabilities for Morgan Stanley that we reported earlier for July 8, 2013 (orange line). Default probabilities have moved down substantially over the last 3 months. For maturities longer than ten years, we assume that the ten year default probability is a good estimate of default risk. The current Morgan Stanley default probabilities range from 0.15% at one month to 0.06% at 1 year and 0.17% at ten years.
We also explain the source and methodology for the default probabilities below.
Summary of Recent Bond Trading Activity
The National Association of Securities Dealers launched the TRACE (Trade Reporting and Compliance Engine) in July 2002 in order to increase price transparency in the U.S. corporate debt market. The system captures information on secondary market transactions in publicly traded securities (investment grade, high yield and convertible corporate debt) representing all over-the-counter market activity in these bonds. We used the bond issues mentioned above in this analysis.
The graph below shows 5 different yield curves that are relevant to a risk and return analysis of Morgan Stanley bonds. These curves reflect the noise in the TRACE data, as some of the trades are small odd-lot trades. The lowest curve, in dark blue, is the yield to maturity on U.S. Treasury bonds (NYSEARCA:TLT) (NYSEARCA:TBT), interpolated from the Federal Reserve H15 statistical release for that day, which matches the maturity of the traded bonds of the Morgan Stanley. The 1 month U.S. Treasury rate is still being dramatically affected due to the impasse over the U.S. government debt ceiling that is on-going as this note was written. The next curve, in the lighter blue, shows the yields that would prevail if investors shared the default probability views outlined above, assumed that recovery in the event of default would be zero, and demanded no liquidity premium above and beyond the default-adjusted risk-free yield. The orange line graphs the lowest yield reported by TRACE on that day on Morgan Stanley bonds. The green line displays the value-weighted average yield reported by TRACE on the same day. The red line is the maximum yield in each Morgan Stanley bond issue recorded by TRACE.
The graph shows an increasing "liquidity premium" as maturity lengthens for the bonds of Morgan Stanley, although the volatility of the data is perhaps the highest of any firm yet analyzed in this series of bond notes. This increasing liquidity premium is a pattern seen usually with firms of good credit quality. We explore this premium in detail below.
The high, low and average credit spreads at each maturity are graphed below for Morgan Stanley. We have done nothing to smooth the data reported by TRACE (other than eliminating erroneous data as explained above), which includes both large lot and small lot bond trades. For the reader's convenience, we fitted a cubic polynomial that explains the average spread as a function of years to maturity. The polynomial explains 29.94% of the variation in credit spreads over the maturity spectrum. This is the lowest level of explanatory power that we have seen yet in this series of notes.
Using default probabilities in addition to credit spreads, we can analyze the number of basis points of credit spread per basis point of default risk at each maturity. For Morgan Stanley, the credit spread to default probability ratio ranges from 4 to 20 times at maturities under 2 years to a range from 8 to 21 times at longer maturities. The ratios of spread to default probability for all traded bond issues are shown here:
The credit spread to default probability ratios are shown in graphic form below for Morgan Stanley. The fitted polynomial explains 28.94% of the variation in the reward to risk ratios by maturity for the firm.
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. For the week ended October 4, 2013 (the most recent week for which data is available), the credit default swap trading volume on Morgan Stanley was 153 trades for $1,190.2 million. The number of credit default swap contracts traded on Morgan Stanley in the 155 weeks ended June 28, 2013 is summarized in the following chart. Morgan Stanley CDS volume ranked 14th among all reference names traded world-wide during this period.
The weekly trading volume for the 155 weeks ended June 28, 2013 is graphed here:
On a cumulative basis, the current default probabilities (in green) for Morgan Stanley range from 0.06% at 1 year to 1.74% at 10 years. This is down substantially from the July 8, 2013 cumulative default probabilities graphed in orange.
Over the last decade, the 1 year and 5 year annualized default probabilities for Morgan Stanley spiked during the credit crisis as documented in the Kamakura Corporation study on Fed borrowings by Morgan Stanley given in the link above. The 1 year default probability peaked at slightly over 8% in 2008-2009. The 5 year default probability peaked at slightly over 2% on an annualized basis at the same time.
As explained at the end of this note, the firm's default probabilities are estimated based on a rich combination of financial ratios, equity market inputs, and macro-economic factors. Over a long period of time, macro-economic factors drive the financial ratios and equity market inputs as well. If we link macro factors to the fitted default probabilities over time, we can derive the net impact of macro factors on the firm, including both their direct impact through the default probability formula and their indirect impact via changes in financial ratios and equity market inputs. The net impact of macro-economic factors driving the historical movements in the default probabilities of Morgan Stanley has been derived using historical data beginning in January 1990. A key assumption of such analysis, like any econometric time series study, is that the business risks of the firm being studied are relatively unchanged during this period. With that caveat, the historical analysis shows that Morgan Stanley default risk responds to changes in 7 domestic U.S. risk factors and 6 international risk factors among the macro factors used by the Federal Reserve in its 2013 Comprehensive Capital Assessment and Review stress testing program. These macro factors explain 89.2% of the variation in the default probability of Morgan Stanley. The remaining variation is the estimated idiosyncratic credit risk of the firm.
Morgan Stanley can be compared with its peers in the same industry sector, as defined by Morgan Stanley and reported by Compustat. For the USA "diversified financials" sector, Morgan Stanley has the following percentile ranking for its default probabilities among its 218 peers at these maturities:
- 1 month 84th percentile
- 1 year 74th percentile
- 3 years 61st percentile
- 5 years 32nd percentile
- 10 years 29th percentile
The short term ranking of Morgan Stanley relative to its peers is higher because business conditions are so good currently that they rank at the 90th percentile for the period from 1990 to the present. The strong corporate business conditions drive the default probabilities of all firms to low levels. Over a longer time horizon, Morgan Stanley ranks in the safest one-third of its peer group from a credit risk perspective. Taking still another view, the actual and statistically predicted Morgan Stanley credit ratings both show a rating in the "investment grade" territory. The statistically predicted rating is 2 notches below the legacy rating from firms like the Standard & Poor's affiliate of McGraw-Hill (NYSE:MHFI) and Moody's Investors Service (NYSE:MCO). The legacy ratings of the company have changed only 4 times in the last decade, in spite of the need for the U.S. government to inject $10 billion of capital into the firm.
We believe that a strong majority of analysts would rate Morgan Stanley as investment grade. We note, however, that the firm does not compare well with its peers in the short run from a default probability perspective. We also note that the history of the firm from a default probability perspective is filled with drama. Many will debate whether the home price and mortgage market disaster that triggered the credit crisis can happen again. We remind the reader that the vast majority of observers of U.S. home price data prior to mid-2006 denied that there was any possibility that home prices in the United States could decline to any substantial degree. Putting aside macro-economic conditions, Morgan Stanley is a survivor in an increasingly concentrated securities business, one of the unexpected outcomes of the credit crisis. It offers above average ratios of credit spread to default probability ratios compared to other firms analyzed so far in this series. The volatility of the credit spread data (based on actual trades) that we analyzed above shows that good execution is absolutely essential to make an investment in Morgan Stanley bonds "good value."
Background on Default Probabilities Used
The Kamakura Risk Information Services version 5.0 Jarrow-Chava reduced form default probability model makes default predictions using a sophisticated combination of financial ratios, stock price history, and macro-economic factors. The version 5.0 model was estimated over the period from 1990 to 2008, and includes the insights of the worst part of the recent credit crisis. Kamakura default probabilities are based on 1.76 million observations and more than 2000 defaults. The term structure of default is constructed by using a related series of econometric relationships estimated on this data base. An overview of the full suite of related default probability models is available here.
General Background on Reduced Form Models
For a general introduction to reduced form credit models, Hilscher, Jarrow and van Deventer (2008) is a good place to begin. Hilscher and Wilson (2013) have shown that reduced form default probabilities are more accurate than legacy credit ratings by a substantial amount. Van Deventer (2012) explains the benefits and the process for replacing legacy credit ratings with reduced form default probabilities in the credit risk management process. The theoretical basis for reduced form credit models was established by Jarrow and Turnbull (1995) and extended by Jarrow (2001). Shumway (2001) was one of the first researchers to employ logistic regression to estimate reduced form default probabilities. Chava and Jarrow (2004) applied logistic regression to a monthly database of public firms. Campbell, Hilscher and Szilagyi (2008) demonstrated that the reduced form approach to default modeling was substantially more accurate than the Merton model of risky debt. Bharath and Shumway (2008), working completely independently, reached the same conclusions. A follow-on paper by Campbell, Hilscher and Szilagyi (2011) confirmed their earlier conclusions in a paper that was awarded the Markowitz Prize for best paper in the Journal of Investment Management by a judging panel that included Prof. Robert Merton.