Or, “This House believes all interesting things are in footnotes and FT Alphaville reader comments.”
Allow us to make the case in favour of the motion. Beginning with:
Exhibit A – The Morgan Stanley Footnote (January 19, 2012)
(7) On December 22, 2011, the Company executed certain derivative restructuring amendments which settled on January 3, 2012. …
Here, Morgan Stanley announced to the world that in the fourth quarter it managed to arrange a deal that reduced the bank’s net exposure to Italy from $4.9bn to $1.5bn while also recording a $600m boost to net revenue.
To back up a bit, Italy (the sovereign nation, not its banks) has a lot of interest rate swaps, and other derivatives, with dealers. It’s part of how Italy manages its huge pile of debt.
As rates have fallen, the dealers have, in general, found themselves in the money on those swaps. In the normal course of business, the way swaps work is that the counterparty with the positive mark on the derivative would receive collateral from the counterparty with the negative mark in order to guarantee performance under the swap.
However, sovereigns don’t typically post collateral. Portugal and Ireland do, but that’s a fairly recent innovation. Consider not posting collateral something of a hangover from the days of sovereigns being considered risk free.
Exhibit B – FT Alphaville post (February 1, 2012)
Focusing back on Morgan Stanley though, it’s clear that the bank was seriously in the money on some derivatives trades with Italy.
In our original post about the footnote, FT Alphaville speculated about what deal the bank might have done that would have resulted in the aforementioned decrease in exposure to Italy and positive net revenue. Of the four guesses we had, we now know this one was the closest (and we also now know that even this wasn’t quite right):
3) Novation, aka give the trades to someone else
Our first thought when we saw the press release was that the Italy trades were novated, i.e. another party was found to take Morgan Stanley’s side of the trade in exchange for a fee.
Prime candidates would be Italian banks, as for them it’s similar to selling CDS protection on themselves, i.e. it’s very circular but what do they have to lose? If the sovereign finds itself on the verge of default, chances are the banks will have already gone down or would be nearing that point anyway.
The trick to that would be finding a novation where the price was right. Given the capital relief and face-saving from dumping the trades, we imagine the House of Stanley could eat a discount on the positive mark.
To be clear, the “fee” or “price” would have been somewhere around the current mark on the swaps, minus the amount required to save face with the client.
Exhibit C – FT Alphaville reader Yogi Bear’s comment on our post (February 1, 2012)
Don’t forget that Italy has been downgraded and put in negative watch several times during the last year by a number of rating agencies. I would not be surprised if any of the swaps between Italy and MS or even the ISDA MA itself had a collateral/ early termination trigger clause that would have allowed MS to “magically” ask Italy to either kindly post collateral or terminate the agreements (or at the very least negotiate an advantageous exit or reduction once the S&P downgrade was already imminent).
Remember that at the time in which they entered into these swaps it may have looked unlikely that Italy would have downgraded so heavily and the relevant Italian bureaucrat may have thought that the clause was harmless and that it was not worth fighting against the MS rocket scientists for something that would not be triggered anyway.
To summarise Yogi Bear: he thought that maybe the swaps in question had clauses in them that would allow the early termination if Italy was downgraded below a certain threshold. The person negotiating the swap on the Italian side probably wouldn’t have thought much of it at the time.
Hmmm … intriguing idea. And then, there was this:
Exhibit D – Bloomberg article by Nick Dunbar and Elisa Martinuzzi (March 16, 2012)
When Morgan Stanley (MS) said in January it had cut its “net exposure” to Italy by $3.4 billion, it didn’t tell investors that the nation paid that entire amount to the bank to exit a bet on interest rates.
Oh, so that reduction in exposure to Italy fully corresponded to a cash payment to exit the swaps? Interesting!
The reporters also have some Bloombergian nut-graph perspective on this for us:
The cost, equal to half the amount to be raised by Italy’s sales tax increase this year …
How much is Italy’s sales tax going up by? Anyway …
The language of the article was starting to make it sound like the trade was totally terminated and gone. With a novation, the original trade is indeed torn up and mark-to-market value exchanged, but there’s a different counterparty there to step in for the remainder of the trade. So, ok, bye bye FT Alphaville novation theory.
But hurrah!, Yogi Bear’s downgrade trigger is still in the running, as the cash payment of the Bloomberg story would be consistent with it. Back to his comment then:
… it is well known that certain counterparties of some Southern European sovereigns were able to include downgrade trigger clauses that at the time looked as difficult to trigger since they were well below the then current ratings of the sovereign.
The beauty of the Early termination clauses is that they do not even require a CSA [‘credit support annex’ that does things like dictate the posting of collateral], they can just be embedded in the main part of he contract (Schedule using isda’s parlance although only reluctantly) hidden as an Additional Termination Event and the relevant sovereign could still claim to the rest of the world hat it was not obliged to post collateral under its derivative transactions. As to the termination procedure, the sovereign’s only option is to pay the negative MTM with hard cash.
Yogi is, after all, smarter than the average bear.
Join us in Part 2, as the mystery of Morgan Stanley’s footnote continues to unravel …
Why Italian sovereign CDS has left the banks behind – FT Alphaville
Peripheral exposures: mind the cash – FT Alphaville
One-way CSAs pile up funding risk for banks – Risk (2011)
Morgan Stanley Restructures Derivatives Deal to Cut GIIPS Risk – Bloomberg Businessweek
Morgan Stanley Is Still Massively Exposed To European Sovereigns – Business Insider