I usually rely on public information, but I’ve had two not-so-public (well, one is public but second-hand) data points converge, and they are consistent with the MSM information on the matter at hand, namely, how Morgan Stanley came to post a $9.4 billion loss on the actions of one trading desk, which in turn led to a first time quarterly loss of $3.85 billion.
The reports in the press are not terribly specific but consistent. For instance, from the Guardian:
The outcome is particularly galling for Morgan Stanley because it spotted early signs of the looming sub-prime mortgage crisis and took steps to hedge its trading positions to protect itself against financial damage.
But poor execution allowed these hedges to fall away – a failure which prompted internal soul-searching and the recent departure of the bank’s co-president, Zoe Cruz.
The Wall Street Journal, in a page one story “Loss Pressures Morgan Stanley CEO,” offers a mere sentence;
Mr. Mack said on the call that the losses resulted from “an error of judgment that occurred on one desk, in our fixed-income area, and a failure to manage that risk appropriately.”
So by all accounts, the losses took place in one trading unit. Reader Steve provided more detail from the conference call:
During the conference call, Mack said the losses were attributable to just one prop desk (and none of the analysts said, `Oh, just like Amaranth, right?’). The position was described as long $14B super senior, short $2B mezz. Wow, nice desk limit (was that you, Ms. Cruz?). And Kelleher actually said they went long the $14B `to cover the cost of negative carry’ on the short position! Priceless.
It will be curious to learn whether anyone can reconcile that disclosure with what I heard tonight from a Morgan Stanley employee. Unfortunately, circumstances were such that I couldn’t grill him further, but he said the losses were in proprietary trading group and resulted from error, pure and simple. Someone made a mistake and put a BBB hedge on an AAA subprime position. Not only did no one notice that the hedge was incorrect, but Kelleher’s comment suggests the long position might have been increased. The FT’s Lex comments are consistent:
A dozen or so traders laid on a position to offset the cost of shorting subprime. Had things worked out, the short could have netted the bank at most about $2bn. Instead, it cost the bank more than $7bn, as the traders’ correct hunch was overwhelmed by a deteriorating long position in top-rated collateralised debt obligation securities.
Mind you, I only got the sketchiest of outlines of what transpired, but the part that was very clear was “mistake” and specifically that someone, somehow misread BBB for AAA (or vice versa). The fact that short mezzanine was described as a hedge for long AAA whas been confirmed in the press. I’m sure real traders who have access to real data can interpolate better.
Then we get to the more interesting question of what sort of managerial failure this represents. It could have originated with bad management information systems, ones that didn’t closely or clearly show how long positions and supposed hedges relate to each other. Per Steve’s comments, it also suggests overly large desk limits, at least relative to how risks were reviewed, This may in turn suggest over-indulgence of big swinging dick proprietary traders. And it also indicates failings in firm-wide risk management processes Even if the trade was put on incorrectly, how in God’s name was it allowed to keep going south until the losses reached $9.4 billion? The cardinal rule of trading is “cut your losses, let your gains run.”
The other question is why did Mack sell a stake to the Chinese? Morgan Stanley will still show a profit for the year, unlike Merrill Lynch, which has given up a whole year of earnings to its writeoffs. If this were a one-off due to an embarrassing screw-up, it doesn’t merit running to get foreign capital. Is this merely storing up reserves for what may be a long, dry period, or is other bad news in the offing?