Morgan Stanley's Lose-Lose Scenario

| About: Morgan Stanley (MS)

When it comes to putting depositors on the hook for potential losses on a portfolio of derivatives, Morgan Stanley (NYSE:MS) is late to the party. Way back in 2008 when Goldman Sachs (NYSE:GS) and Morgan Stanley converted to bank holding companies, they were each granted an exemption which allowed them to transfer their derivatives to their federally insured bank units. Morgan Stanley did not take advantage of the opportunity. Fast forward four years and that decision could prove to be a grave mistake.

If you're a financial institution, the advantage to holding your derivatives at your bank subsidiary lies in the favorable terms you are able to get on trades. Because the bank subsidiaries hold billions in federally insured deposits, they typically enjoy higher credit ratings than their parent firms. Because of this, Goldman Sachs, JP Morgan (NYSE:JPM), and Citi (NYSE:C) hold the vast majority of their derivatives at subsidiary bank units effectively ensuring that their derivatives businesses do not live and die by the hand of Moody's, Fitch, and S&P.

By contrast, Morgan Stanley--which only holds around 5% of its derivatives at its subsidiary--has found itself scrambling to offload its derivative exposure to Morgan Stanley Bank NA (the firm's deposit unit) amid downgrades from Moody's and S&P over the course of the last nine months. It may be too late. Thanks to JP Morgan's multi-billion dollar credit derivatives blunder, regulators are now hypersensitive to the issue of taxpayers shouldering the burden of Wall Street's derivatives bets. Unfortunately for Morgan Stanley, the opinion of regulators matters in this case as, according to the NY Times

"...transactions between an insured bank and an affiliated entity cannot exceed 10 to 20 percent of the bank's capital, unless regulators grant an exemption. That means Morgan Stanley cannot shift derivatives valued at more than $2.1 billion, which is 20 percent of the bank's $10.5 billion of capital."

Despite this rather restrictive rule, Morgan was able to move some 2.2 trillion (notional value) in derivatives to its insured bank unit during the first quarter. This is only possible because the derivatives are measured based on fair value assessments. Subtracting derivatives positions whose fair value is negative from derivatives positions whose fair value is positive, will invariably net a total that is far less than the notional value, effectively allowing Morgan Stanley to slide-in under the $2.1 billion transfer cap.

However, as the above-cited NY Times article so eloquently conveys, the fact that the 'net fair value' of the derivatives came in well below the transfer threshold was a happy coincidence considering the same derivatives whose net fair value was $6 million in the first quarter had a net fair value of $6.4 billion during the fourth quarter last year.

What the NY Times article doesn't say is that this discrepancy is likely no coincidence at all. The vast majority of the derivatives Morgan Stanley transferred to its bank subsidiary were foreign exchange contracts. Specifically, 'OTC forwards' at Morgan Stanley Bank NA jumped from $10.85 billion (notional) in the fourth quarter of 2011 to $440.7 billion (notional) in the first quarter of 2012 and 'OTC options' jumped from $70.9 billion (notional) during th fourth quarter of 2011 to $768.6 billion (notional) in the first quarter of 2012.

A look at the "assets and liabilities measured at fair value" table in Morgan Stanley's 10-Q shows that most of these foreign exchange contracts are 'Level 2' instruments. If you are unfamiliar with fair value accounting, here is a description from Morgan Stanley's 10-K of how Level 2 instruments are valued:

"[Level 2] valuations [are] based on one or more quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly."

Now compare that to how Level 1 instruments are valued:

"[Level 1] valuations [are] based on quoted prices in active markets for identical assets or liabilities that the Company has the ability to access...Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment"

Notice that prices for Level 1 instruments involve the use of active market quotes and do not rely to a significant degree on the firm's judgment. Level 2 instruments on the other hand, rely on quotes from non active markets and are often called 'mark-to-model' instruments as their value is sometimes determined by way of extrapolation. The key is that Level 2 assets can be priced based on the firm's own models as long as the inputs to those models are 'observable'. This leaves considerable leeway for firms to manipulate the value of their Level 2 instruments when it is advantageous: for example when a firm wants to make the net fair value of some foreign exchange derivatives fall from $6.4 billion to just $6 million in the space of four months in order to get them transferred to a bank subsidiary.

Unfortunately for Morgan Stanley, it still has a ways to go before Morgan Stanley Bank NA holds a percentage of the holding company's derivatives inline with its peers. As mentioned above, JP Morgan, Citigroup, Bank of America (NYSE:BAC), and Goldman Sachs hold substantially all of their derivatives at their deposit units. If Morgan Stanley wants to offload a comparable amount of derivatives-associated risk to its bank subsidiary, it will need to transfer some $50 trillion in notional value from the holding company. If it doesn't, the firm's counterparties might well stop doing business with Morgan Stanley whose debt is rated just three notches above 'junk' by Moody's.

In order to move the derivatives to the bank subsidiary, Morgan Stanley will need FDIC approval, which, if last year's similar move by Bank of America is any indication, will not come without controversy. If Congress subjects the matter to intense scrutiny it could turn into a public relations nightmare for the company once the public hears that a Wall Street firm is seeking approval to move $50 trillion in derivatives to a federally insured deposit unit.

It seems then, that the situation is a lose-lose scenario for Morgan Stanley. If it doesn't transfer its derivatives to its bank subsidiary its counterparties will abandon ship, denting earnings, and if it gets regulatory approval to move the portfolio, the negative publicity will be unrelenting. Don't expect this issue to go away anytime soon. Short Morgan Stanley or long MS puts.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.