Thinking about Morgan Stanley

Morgan Stanley needs cash and fast. Let’s hope Mitsubishi UFJ, or someone (Secretary Paulson?), is feeling generous. 

Last week, I wrote that regulators should not allow another big financial firm to declare bankruptcy because of the consequences such an event would have in the credit default swap (CDS) market. I was wrong. Bankruptcy is not the only issue. Credit ratings matter just as much.

Credit Default Swaps work like insurance in the sense that they transfer downside risk in exchange for a fee. However, unlike insurance contracts, CDS are swaps and that means they involve real time cash flow.  This is a big difference.

The financial conglomerate that insures your car doesn’t monitor, on a day-to-day basis, the speed you drive. In other words, it doesn’t monitor the changes in the risk affecting your car. Moreover, your insurer doesn’t have to show you that it has the money to pay if something goes wrong (That is why you have insurance company advertising: “you’re in good hands…”). Instead, both you and your insurer wait until something bad happens and then the policy is settled according to the damage done. It’s a system built on trust.

CDS payments are built on proof. A protection seller – the insurer – must prove to the protection buyer that it can pay.  A portion of the payout amount the protection seller would owe the buyer upon the occurrence of a credit event is posted as collateral at the onset of the contract. As the risk of a credit event increases (as the market value of the CDS contract goes up) the proportion of the total payout, the amount of collateral that must be posted, increases.

Increased risk of a credit event, however, is not the only thing that can force a protection seller to post more collateral. A protection seller’s ability to pay upon the occurrence of a credit event, what’s known as the counterparty risk, also affects how much collateral must be posted. And a protection seller’s ability to pay is determined by the seller’s credit rating.

The better the rating the less money the protection seller must have available to show the protection buyer it can meet its CDS obligations. As a seller gets downgraded, the seller must post more collateral. It wasn’t a particular credit event, such as a bankruptcy, that caused AIG’s CDS portfolio to implode. It was AIG’s credit rating downgrade on September 15th that forced it to post more cash than it had, which ultimately led the Federal Reserve to come to the rescue.

Increased risk of a credit event and increased counterparty risk affect one another. But, increased risk of a credit event only affects one CDS at a time. A credit rating downgrade for a protection seller, a change in counterparty risk, forces that seller to come up with cash for all its CDS positions. Therefore, as I understand it, a credit rating downgrade has more potential to create catastrophe in the CDS market than individual changes in the market’s perception of credit risk for a particular reference entity.

Long story short, watch for a downgrade of Morgan Stanley’s credit rating. If it happens the consequences for Morgan’s CDS portfolio will be catastrophic, regardless of whether or not it is a net protection seller. 

Posted in banking, credit default swaps |