Morgan Stanley (NYSE:MS) had initially planned to wind down its derivatives unit to reduce the risk as required by the new Basel rules. But the bank changed its mind when three deals came along that seemed lucrative, at least at the time of purchase. Over the past three years, Morgan Stanley (NYSE:MS) purchased credit correlation positions that have a notional value of about $50 billion, people familiar with the transactions told Michael J. Moore, Mary Childs & Erik Schatzker of Bloomberg.
The positions include a portfolio that Credit Suisse Group AG (NYSE:CS) sold in 2012. The acquisition increased Morgan Stanley (NYSE:MS)’s fixed income revenues, which were the lowest among the big Wall Street banks. But they loaded the company’s balance sheet with risky assets. Morgan Stanley (NYSE:MS) has now halted such large purchases, reports Bloomberg.
Banks around the world are closing or scaling back their correlation units as new regulations have compelled banks to hold more equities against those positions. But Morgan Stanley (NYSE:MS) CEO James Gorman is facing dual challenges of meeting long-term goals and satisfying investor expectations of short-term revenue gains. This credit trading would prove uneconomic under the new regulations. So, if Morgan Stanley (NYSE:MS) tried to get rid of them, it will bring down revenues.
Credit-correlation positions caused billions of dollars of losses during the 2008 financial crisis. They included complex products like collateralized debt obligations, derivatives linked to indexes and corporate debts.
Morgan Stanley Slashes Assets
James Gorman said Morgan Stanley (NYSE:MS) is selling its structured businesses including securitization divisions so that it can focus on trading for clients. The New York-based bank has set a goal of reducing the risk-weighted assets, or RWA’s by more than 60 percent of the 2008 peak of $500 billion. Under the new Basel rules, RWA is a measure to determine how much equity capital the banks must hold against each position.
Apart from the Credit Suisse Group AG (NYSE:CS) portfolio, Morgan Stanley (NYSE:MS) also purchased a book from the French company Natixis SA that has a notional value of about $35 billion in 2010. The third trade was a position from Royal Bank of Scotland Group Plc (NYSE:RBS) (LON:RBS) taken in 2011. Sources didn’t say anything about how much Morgan Stanley (NYSE:MS) paid for these positions or the gains it realized.
Though the portfolios produced short-term gains for the company, they are extremely difficult to sell because they consume a lot of capital until they expire, plus there is a lack of buyers. So, the short-term revenue gains would slow Morgan Stanley (NYSE:MS)’s RWA’s reduction process, and result into lower returns on equity.
Morgan Stanley (NYSE:MS) reported a 42 percent decline in its first quarter fixed income trading revenues. The fixed income RWA’s also fell 10 percent during the quarter. Morgan Stanley (NYSE:MS) started cutting its credit-correlation book after it lost over $9 billion on structured fixed-income bets in 2007. It also exited Cournot Financial Products LLC that was formed by its investment banking unit in 2007. Cournot Financial was a credit derivatives business that sold credit default swaps.
As of March 31, Morgan Stanley (NYSE:MS) has reduced RWA’s in its fixed income trading business from more than $500 billion in 2008 to $253 billion. People familiar with the matter said that about 30 percent of this reduction came from elimination of correlation positions.
Morgan Stanley (NYSE:MS) shares were up 1.59 percent to $26.23 at 9:43 AM EDT.