FT Alphaville " Morgan Stanley's most mysterious footnote - Part 1 (7) On December 22, 2011, the Company executed certain derivative restructuring amendments which settled on January 3, 2012. ... This mysterious little footnote announced to the world that in the fourth quarter, Morgan Stanley managed to arrange a deal that reduced the bank's net exposure to Italy from $4.9bn to $1.5bn. As the deal settled on January 3, the figures in Morgan's Q4 balance sheet didn't reflect its impact; hence the footnote. It does, however, mean that by the start of 2012 Morgan Stanley's overall peripheral country exposure has dropped from $6.4bn to $3.1bn. Not a bad way to begin the year. In addition to that, the bank recorded a $600m boost to net revenue from the deal in the fourth quarter - when the deal was agreed but hadn't yet settled. What is Morgan Stanley up to? All the other banks (and FT Alphaville) certainly want to know... Unfortunately the bank isn't talking. No matter, FT Alphaville has a few ideas and so does IFR's Chris Whittall, who has been up to his usual expert sleuthing. More on that in a moment. First, a quick explainer Let's begin with Morgan Stanley's country risk exposures as declared for Q3 and Q4, which we've spliced together in the graphic below. The Q3 numbers are on top, Q4 underneath, the footnote at the very bottom with the numbers it gives scribbled into the relevant line items. Click to expand: Ignore the footnote for a moment. If you follow the orange and purple arrows from Q3 to Q4, you'll see that without the restructuring deal, Morgan Stanley would have greeted the new year with enlarged peripheral exposures - with the total increasing from $2.1bn in the third quarter to $6.4bn in the fourth quarter. The exposure to Italy would have climbed from roughly $1.8bn to $4.9bn. Hence it looks like it was with a certain sense of urgency that this "restructuring" was done. But again, because it only settled on January 3rd, it wasn't arranged in time to bring down the quarter-end net exposure numbers. Yet the fourth quarter results did get that pre-emptive revenue boost from the deal in terms of revenues. From the press release accompanying the results: Fixed Income and Commodities sales and trading net losses of $257 million included the loss related to MBIA. Net revenues for the quarter also reflected strong results in interest rate and currency products, approximately $600 million related to the release of credit valuation adjustments upon the restructuring of certain derivative transactions representing exposure to the European Peripherals and the positive impact of $239 million related to DVA.2, 8 To put that in context, "Institutional Securities" - which includes the $600m net revenue from the restructuring deal - only had total net revenue of $2bn in Q4: Hence 29% of the revenue was due to what is presumably a one-off restructuring in what was by all accounts an abysmal quarter compared to the previous one. So, what was this restructuring? But before we even go there, what were these trades? The Ultimate Tesoro Trader As FT Alphaville has mentioned before, Italy (the sovereign nation, not its banks) has a lot of interest rate swaps with dealers. As rates have fallen, the dealers have found themselves in-the-money. In the normal course of business, the counterparty with the positive mark would receive collateral from the counterparty with the negative mark in order to guarantee performance. However, sovereigns don't typically post collateral. Consider it a hang up from the days of being considered the risk-free. Portugal and Ireland are notable exceptions and do post collateral, which might be why the net exposure to these two countries is as low as it is - note that Morgan Stanley defines "Net Counterparty Exposure" as "taking into consideration legally enforceable master netting agreements and collateral." Back to Italian exposure though. As the sovereign's credit spread has widened out... ... dealers have had to wipe out some of the positive mark (on interest rate swaps, for example) with "valuation adjustments." As mentioned above, Morgan Stanley managed to reverse $600m of that with their mysterious restructuring. Chris Whittall outlines the situation like so: Many dealers have tried to persuade Italy to post collateral or restructure the trades, thereby reducing their credit and funding costs. The problem is Italy has a positive incentive not to post collateral or unwind these positions. Doing so would require Italy stumping up a large amount of cash, and that in turn would likely mean issuing more debt. Instead, the Italian Treasury may believe it is better off digging in its heels in and waiting for the swaps to roll off their books. We have talked to Italy and there is no happy ending to this story. Italy has a significant derivatives portfolio, and collateralising it would have a material impact on the public accounting. Italy has difficulty raising €5bn in a bond auction, and this funding would be more than that," said the global head of rates at a major dealer. Morgan Stanley refuses to talk about the spell it cast on Italy to get its Treasury to play ball, and frankly we're not surprised. Unless this is a technicality that the bank cleverly built into its swaps, all the other banks will want some too, and it's unlikely to be favourable to Italy to do whatever it did en masse (otherwise they already would have done it, right?). More on how FT Alphaville and Mr Whittall thinks they did it in Part 2, coming shortly. Massive H/T to Tracy Alloway for spotting the footnote, her coverage on Morgan Stanley's results here. Related links: Dealers look to reduce Italy's swaps portfolio - IFR M Stanley bucks trend with trading increase - FT Morgan Stanley Restructures Derivatives Deal to Cut GIIPS Risk - Bloomberg Businessweek This entry was posted by Lisa Pollack on Wednesday, February 1st, 2012 at 17:27 and is filed under Capital markets. Tagged with Banks, credit derivatives, CVA, earnings, interest rate swaps, morgan stanley.