Morgan Stanley may have suffered a $91m loss on Wednesday, on slowing momentum in its trading business, but a significant chunk of its underperformance was also down to the firm’s so-called debt valuation adjustments (DVAs) — rather than trading itself.
In this case DVAs reflected tightening spreads in the company’s own debt (and others), and via that, a mark-to-market loss in the credit default swaps purchased to protect against defaults in that debt.
Of course, while other banks will also have seen an impact here, the interesting thing about Morgan Stanley’s case is the degree to which DVAs sliced revenues this quarter.
Morningstar’s Michael Wong runs through the issue in a recent post. As he notes:
At first glance, the company’s revenues and earnings appear to have drastically underperformed peers, but it was more due to accounting rules than severe operational issues. We anticipate maintaining our fair value estimate for the company.
Just as we pointed out about second-quarter earnings, adjusting Morgan Stanley’s trading revenues for debt valuation adjustments, or DVA, paints an almost completely different picture than what the reported numbers show. The reported numbers show an over 50% decline in the company’s institutional securities fixed income and equity sales and trading revenues.
If you were to strip out the positive $731 million of DVA in the second quarter and the negative $660 million DVA in the third quarter, then the sequential decline is a much more reasonable 20%. In fact, if you were to back out the entire $750 million of DVA in the second quarter and $731 million of DVA in the third quarter, overall company net revenue actually grew 4% sequentially.
So why does Morgan Stanley feel the need to carry such sizeable positions in its own debt insurance (and others)?
Well, John Kemp of Reuters raises does raise one issue that’s uniquely relevant to Morgan Stanley — average daily Value-at-Risk (VaR).
According to the columnist, when it comes to trading, the bank is becoming oh that little bit more risky than its other main peers on Wall Street. As he explains:
In contrast to rivals [Goldman] Sachs <GS.N> and JP Morgan <JPM.N>, which have both been reducing the amount of risk they hold in their trading book, including for commodities, Morgan Stanley has kept trading risk at a high level in a bid to catch up after falling behind in 2008-2009.
Value-at-risk (VaR) allocated to commodity trading averaged $32 million in Q3, up from $29 million in Q2 and $27 million in Q1. Commodity VaR was the highest since the three months ending August 2008. Morgan Stanley has been pursuing the opposite strategy to its arch-commodity rival in recent years. Morgan Stanley cut commodity VaR sharply in 2009 and early 2010, when Goldman was boosting its own risk allocations.
Now that Goldman has begun to trim commodity VaR, Morgan Stanley has raised its own risk profile. The decision to expand commodity VaR reflects a broader increase in risk appetite across the bank’s trading book. Firmwide VaR net of diversification effects rose to $142 million in Q3, up from $139 million in Q2, and $143 million in Q1. Firmwide VaR is up 20 percent compared with the same quarter a year ago. In contrast Goldman has cut VaR by 40 percent.
And here’s a nifty graphic that puts the bank’s recent risk acceleration in context:
But as Kemp also points out, all that extra risk-taking is yet to translate into higher profits.
Related links:
BAC gains on Merrill’s deterioration in Q1 – FT Alphaville
Profiting from your own crummy creditworthiness, redux - FT Alphaville
Banking credit catch-22 in action? – FT Alphaville
CVAs or ‘the magic of your own credit profits” - Holding to account