Reading the Morgan Stanley (MS) press release, I cannot help but think that we are seeing a 2007 version of portfolio insurance. It is interesting to note that in 1987, declines in the market were exacerbated by the phenomenon of portfolio insurance, the practice of selling index futures to "hedge" against further declines. In 1987, this selling created more forced selling and ultimately the cataclysmic black Monday.
In a similar way, firms have used the ABX Credit Default Swaps to short against mortgage exposures. Just two years ago, these ABX CDS instruments did not even exist!! In a few short months, they have become the de facto hedging tool for anyone form hedge funds to investment banks. As a result, these indices are suppressing the marks of the other side of the hedge, the actual mortgages. Therefore attempts to hedge suppress values further. Just as in 1987, the product innovation of the ABX CDS can move the much larger mortgage market.
Now, how can one be sure that the MS write-down is having this effect? The conference call detailed that MS got caught in a negative convexity trade. This is a complex way of saying we started out perfectly hedged but have since gotten long as markets have deteriorated.
Let me simplify this down to a two trades. Lets say that I start 2007 by shorting $1bln of mezzanine BBB debt that I thought would trade lower as I know that borrowers are getting delinquent in payments. To offset this, I buy $10bln of the super senior AAA tranche of some CDO's. Why buy $10bln and not $1bln you ask? Well, that is what the model says is a good hedge ratio given historical market conditions. Earlier in the year, the BBB debt declined significantly while the senior debt maintained near par. The trade worked even better than expected. Eventually, I get too much of a good thing as the short position cannot go lower than 0 and the long starts to feel the pinch of rising defaults and declines in price. What was once a great idea of how to get short subprime mortgages with low risk has now turned into a long subprime mortgage trade and therefore a large write-down.
Nobody, including Morgan Stanley or any other investment house, knows if borrowers are going to be able to pull through and pay their mortgages. Fear is gripping the mortgage market and prices are coming from limited sources so the ABX index is the best available idea of a market price. Lehman (LEH) and Goldman (GS) are next on the come clean list; who knows what their hedge ratio was and how they are marking these bonds? We do know that selling can force more selling making the problem appear bigger than current reality. Of course, things could always get worse in the underlying mortgage market.
Disclosure: none
