“We began with a short position in the subprime asset class, which went right through to the first quarter; as the structure of this book had big negative convexity and the markets continued to decline, our risk exposure swung from short to flat to long.”
So, what is this "negative convexity" of which Kelleher speaks?
Eric Jardine says that it means that "we started out perfectly hedged but have since gotten long as markets have deteriorated," but that's not entirely right: as Kelleher says, the bank started out short, they were then briefly perfectly hedged, and then they ended up long. I have a feeling that in fact Morgan Stanley was putting on a trade which was much more complicated than the simple long-senior short-junior play that Jardine hypothesizes.
Part of the problem is that "convexity", as a concept is not very easy to understand. It's basically about the relationship between price and yield: as a bond's price goes up, its yield goes down, and vice versa. But if you draw a graph with price on one axis and yield on the other, you don't get a straight line, you get a curve. Convexity is basically a measure of the shape of that curve.
With most bonds, there's something called positive convexity, which is great for investors. If you buy a Treasury bond at par, say, then your profit in the event of a 50bp drop in yields is greater than your loss in the event of a 50bp rise in yields. For any given move in interest rates, your upside is bigger than your downside. Nice!
But of course in the world of ultra-sophisticated financial engineering, you can create instruments which have so much negative convexity that the price might start off moving in one direction as yields start moving, and then eventually start moving in the other direction.
I have no idea what kind of trade Morgan Stanley got involved in. But essentially they went short at a point on the price-yield curve which was so very, well, curvy that their profits from falling prices soon turned into losses from falling prices.
The people responsible for this trade have, we're assured, been taken out and shot. I guess now they understand how convexity can bite you in the ass.