I should probably add “criminal enterprise” as a category. Although so far only Morgan Stanley has appeared twice.
Getting caught up on my reading for the past couple of weeks, I came across this gem from Willem Buiter.
A fascinating contribution by Gillian Tett in today’s Financial Times on the role of CDS in the default of the largest Kazakh bank, BTA, raises a number of wider issues. Last week, BTA went into partial default when Morgan Stanley and another bank demanded repayment of loans they had made to BTA and BTA was unable to comply. Tett also discovered that, just after calling in its loan to BTA, Morgan Stanley asked the International Swaps and Derivatives Association (ISDA) to start formal proceedings to settle credit default swaps contracts written on BTA.
Imagine if someone else bought fire insurance on your house and then burned your house down. What would you call that person? (If you answered, “Morgan Stanley”, congratulations; you win!)
A Credit Default Swap is essentially an insurance contract on a bond; you pay regular premia, and if the bond defaults, the insurer pays you. Except you do not actually have to own the bond. So imagine if it were possible for other people — like hedge funds and massive banks — to buy fire insurance on your house. And all of the houses in your neighborhood…
So, yes, Morgan Stanley bought insurance against BTA’s default and then caused that default. If you are wondering how this could possibly be legal, then good.
But you aren’t, because the stock market is rallying and obviously everything is fine, just fine. Buy stocks now or be priced out forever.
…
Funny, and yet not funny: The Onion absolutely nails this one.
Update
OK, OK, Morgan Stanley had an insurable interest. So I guess this is more like buying an insurance policy on your own house — where you can insure the full value of the house multiple times via multiple policies — and then burning it down yourself.
The answer, at least in part, has to be the counter party on the CDS. I’m not familiar with the details of the standard contract, but insurance contracts always exclude “intentional acts” — although it doesn’t always work.
In this example, they did have an insurable interest. They held a loan.
I would ask if the CDS exactly hedged the loan exposure or was materially larger or smaller. Unless it was materially larger, then they are in the same financial position (or slightly worse) than if the loan were performing.
I am no fan of CDS’s. Just saying.
My biggest beef is the situation where the brain dead rating agencies use a firm’s stock price as a rating factor. You then get in a situation that if a stock price “can” force a lower rating, it WILL cause a lower rating. The CDS’s facilitate an attack on a stock price by providing a widely available, highly leveraged way to pressure the stock.
Maybe whoever sold the CDS’s on this firm hedged them by shorting the stock.
I don’t like them. Not convinced by your example, though.
It’s interesting that this case is drawing so much attention. I thought the “non-evil” way to use CDS was to hedge against a risk that you held in your underlying portfolio.
Morgan is just so big that it seems like they have few options in situations like this. To me, this seems like an argument against massive financial institutions rather than an argument against CDS contracts, since it was not the contract itself that drove the situation but the massiveness of Morgan’s involvement.
Well, the FT piece by Gillian Tett makes the same accusation, albeit without proof…
…but based on the fact that MS called the loan for no apparent reason. I think the case would be a lot weaker had their own actions not caused the default.
Of course, we will never know for sure. Which, quite frankly, is itself part of the problem.