Our first candidate is Morgan Stanley or MS as in MS-13.
Morgan Stanley is a large investment bank with assets of $895.4b as of 31 Dec 19. The thing that sets Morgan Stanley apart from other banks such as JP Morgan or Citigroup is that MS has a much smaller consumer loans footprint. Its main clients are large companies, hedge funds, money professionals and rich people. Perhaps the most important set of clients are money people, who manage retirement funds for good blue collar Americans like Teachers. I think this will be an important point to keep in mind. Wall Street has always been a treacherous place and retirement plans promising a return above the Government bond yield usually blow up spectacularly but don’t expect Wall Street to shoulder the loss.
So to understand Morgan Stanley, we have to understand two parts of their business: the Institutional Securities business, or IS as in Islamic State, and the Wealth Management business or WM. We also have to be able to differentiate from what is called the Banking Book and the Trading Book. I know it hurts, but I’ll try to make it very simple.
The Banking Book can be understood as the loans the bank intends to keep. The bank makes money by earning a higher interest on the banking book than what it pays to obtain the funds to “support” those loans. So the right first question to ask is, what kind of loans are on MS banking book. As of Dec 19, MS had about $130.7b of loans on its banking book. The main components are Corporate Loans – $59.3b, Consumer, mostly security margin loans of $31.7b, Residential Real Estate loans of $30.2b, and Commercial Real Estate loans of $9.9b.
So far, so good.
The interesting thing that lawmakers and readers may get confused is even though MS loans are at $130.7b, there is another figure called Credit Exposures of $262.0b, a number approximately double the loans number. So what this really means in an oversimplified way is that, in theory, if all MS customers were to draw on all their facilities at the same time, and MS did nothing to stop it, then MS loan number will balloon to $262.0b. So quite logically, the difference of $120.1b is actually called the undrawn or “commitment” part. (Small note: if you add $130.7b to $120.1b you will be slightly short of $262.0b. The difference of $11.3b refers to loans on the trading book, which we will come to shortly). This concept will be extremely important when we discuss JP Morgan.
With the United States facing the equivalent of the Great Depression, Members of Congress will ask, will the banks come begging for cash after their billion dollar bonuses and thumbing their noses to Main Street?
Many may still remember how Morgan Stanley came desperately close to failing at the last financial crisis and only a $10B lifeline from Mitsubishi UFJ saved the bank from becoming the next Lehman Brothers. So did Morgan Stanley learn anything?
The answer actually is ‘Yes’. Of all the muppets/banks we profile, MS actually earns the Kermit the Frog rating. To say, it gets the best.
The things to note about MS is that the bank is ultra well capitalized. It had a total capital of $82.8b, of which Common Equity Tier 1 ($64.7b). Capital is like a shock absorber and Common Equity Tier 1 or CET1 is the best shock absorber around. (Of course, MS just made a rather ill-timed decision to buy E*Trade recently for $15b, but its still ultra strong)
The second thing to note is that MS is a “serial hedger”, which is a good thing. MS bought $236b of Credit Default Swaps to protect its portfolio. Its not about having some insight into the Coronavirus, MS actually has being doing for a long time, as they were probably scarred by the financial crisis.
Ok, that leads to this whole thing about what a Credit Default Swap is. The Member of Congress explanation: its insurance. So rightfully, people will think won’t all this insurance cost MS some serious cash? The answer is yeah, from recording an asset of $1.3b at the end of Dec 18 when markets were going mad with fear, MS had to record a liability of $2.3b at the end of Dec 19 when the markets were going mad with greed. So this difference of $3.7b was the cost MS had to “pay” to keep itself ultra protected.
Of course, the question still remains, which muppets were on the other side of this insurance deal? Who were the guys happy to take the $3.7b and then end up on the hook for the $236b.
The answer is we don’t know right now, but they will sure come knocking on Congress door really soon.
So that is the skinny of the MS story for Members of Congress. MS is almost immune to the financial crisis because the Fed will bailout whoever sold them all the insurance. That is perhaps why MS could confidently state that on its DFAST stress test, which was mandated by the Dodd Franks Act, MS will only lose $2.2b on its loans most of it due to its insurance.
Now a couple of things to note here. The first question is this entire “insurance cost” of $3.7b. One question would be why did it “cost” MS $3.7b for 2019 when the markets ended really good? Logically, shouldn’t insurance get cheaper when everybody is promising sunny skies and get more expensive when we are facing the end of the world, again.
That is a right question to ask and it is important for Members of Congress to have a little understanding of how these CDS or Credit Insurance work, because this will be a big part of this year’s edition of the Great Financial Meltdown. To put it simply, Credit Insurance is a game between two parties (or muppets) that gets reset periodically, let’s call it a year for argument’s sake. So for argument sake let’s say that MS entered into these contracts at the end of 2017 to insure $260b of its loans and to make things concrete, let’s say that the “credit spread”, or really the cost of the insurance was 100 basis points or 1%. So what this means is that MS agrees to sort of pay the other muppet 1% of $260b or $2.6b for its insurance, but in reality that does not happen and we will explain why shortly when we understand this concept called ‘mark to market‘.
So now, lets roll forward 1 year to the end of 2018 when the markets had gone crazy because Jerome Powell had not rolled over to their liking and the entire US China Trade War thingy. The cost now has shot up to 2%, but MS had entered into a contract paying 1%. So MS sort of gained 1% or 100 basis points in value and the other muppet had to “sort of pay” the 1%. That is why at the end of 2018, MS recorded an economic gain, or an asset of $1.4b.
Now roll forward 1 year to the end of 2019 when the trade war was over, America won, Jerome Powell and the Fed had rolled over, the Dow was reaching new highs and crazy people actually believed that WeWork was worth more than $0. The cost of insurance has plummeted, and it only costs 50 basis points or 0.5% for the same insurance. MS now lost the spread of 1.5%, being the difference of the cost of 2% at the end of 2018 and the current cost of 0.5%. So MS records a liability, or an economic loss, of $2.3b. So from an economic gain of $1.4b, MS now has an economic loss of $2.3b, a reversal of $3.7b. That is sufficient for today’s exposure on CDS, we will develop on this as we feature other muppets. But the key point to note is that MS always bought insurance, they did not try to time things, they probably never wanted to suffer the same fate they suffered in 2008.
So for 1,400 words we have covered $130b of MS portfolios, which surprisingly 14.5% of its portfolio. So try to get more economical on the remainder of the $764.7b of its assets, which we will cover in 800 words.
So to do that, we need to look at the trading book for MS, which was $355.9b or 39.7% of its assets as of Dec 19. A good question is what is a trading book and how is it different from the banking book and should this bother Members of Congress.
To understand that we need to understand two things: VAR and the Bank’s VAR Police.
VAR or Value At Risk means quite simply, how much the minimum the bank could lose each day on a really bad day, or to be more exact the worst 5 days out of a 100. The number changes depends on what kind of risk the bank takes and how crazy things are out there. For MS, the VAR ranged from $33M to $55M for 2019. The model that measures a bank’s VAR needs to be approved by the Federal Reserve.
Let’s get a bit more detailed over her. So there were approximately 222 trading days and did MS actually lose $33M on any single day? The answer is no and that is because the whole idea of having a VAR is not to breach it – in fact if MS states that if its VAR gets breached more than 21x a year, they would throw out the model. And the task of ensuring that the “cowboy traders” do not try to take on excessive risk falls on the bank’s VAR police, or its Market Risk Managers.
This is an important point to understand.
A financial institution’s trading book cannot be effectively supervised by the Federal Reserve because it could change day by day or even within the day. A bank could start the day having a certain position and end the day taking complete opposite positions – that is the essence of trading. The task of the Federal Reserve is to ensure that the bank’s VAR models have some sort of validity and that the Management of the bank ensure that the VAR police supervise the cowboy traders and not the other way around. VAR police must be given the authority to pull over a speeding trader, give him a caution or kick him out of the office if he misbehaves again.
However, too often in some financial institution, the cowboy traders determine how much compensation the VAR police which renders the entire control meaningless. These things usually ends up in the Treasury Secretary taking the knee in front of the Speaker of the House Representatives begging for more taxpayer money to bailout these muppets.
So to wrap things up, lets see what kind of risk MS had on its trading book at the end of 31 Dec 19.
So on its $355.9b trading book on 31 Dec 19, we think of it in terms of VAR Risk.
MS had about $26M of Interest rate and credit spread risk, $11M of Equity Price risk, $10M of Foreign Exchange Risk and $10M of commodity price risk, for a total of VAR $57M. MS claimed that things don’t move altogether at the same time so claimed a $27M VAR credit and stated that its trading book VAR was $30M. So it means, for 5 days in 100, MS could lose at the minimum $30M, but these occurrences are so rare that it can only happen at most 22 times in a year before it throws out the model. To put in perspective, MS claims that the minimum it could lose on the 5 worst days out of a 100 was at least $30M on a portfolio of $355.4b, or less than 0.08%. Sounds crazy, but in 2019, it did not even register a single day when that $30M limit was exceeded.
So if you have come all the way here and are disappointed that you have yet to find that smoking gun to hammer the bank CEOs, fret not. Morgan Stanley run a good shop, but there will be other muppets who ran a loose amoral house and we will equip Members of Congress with the right information to give those CEOs a good ol’ grilling.
But for extra credit, we can reveal some more salacious parts of MS portfolio. However, don’t get your hopes up because MS has hedged its entire credit portfolio, they ran a tight shop, or that what it seems on the DFAST and their 10K.
- MS Commercial Real Estate exposure (aka offices, malls and factories) as of end 2019 was $12.0b, comprising $9.8b on its banking book and $2.0b. Commercial Real Estate will feature heavily in this year’s financial crisis due to that monstrosity called WeWork.
- MS “sponsored” Special Purpose Vehicles of $189.1b, where its total exposure was $29.0 billion. This includes $11b of exposures to CDOs , remember that stuff.
- MS warehouse lending facilities was $29.7b. This refers to financing MS provides to other Real Estate Investment Trusts which are the epicentre of this year’s disaster.
- Get familiar with these names: MTOB or Municipal Tender Option Bonds. We will cover this in another segment, but MS exposure to unconsolidated / outsourced MTOBs was $4.7b in derivative assets.
This is the first in a series about large US Financial Institutions so as to give the required understanding to exercise their oversight for the benefit of the American people*
Sorry I lied. I want to educate Members of Congress so that give those bank CEOs a good ol’ kicking for the common man out there.