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Morgan Stanley and the “Reps and Warranties” of the Fed’s Stress Test

April 13, 2012

In our piece last year The Fed’s New Stress Test (, we had questioned the need for the regulator to do a stress test.  Far better and far more credible, we averred, would have been if the Fed had forced greater disclosure from the big banks and left it to the markets to conduct their own stress tests under scenarios which they deemed to be likely.   The king sized credit derivatives exposures of the London whale of JP Morgan Chase, of which the regulators had no clue about, clearly points to the folly of relying on regulators to police the market properly.  It is a must that regulators acknowledge their intellectual and resource inadequacies and outsource to the market a chunk of the task of regulation (of course basic requirements such as minimum level of Core Tier 1 have to be set by the regulators).  The markets can perform this task well only if the quality of disclosures of the banks is of acceptable quality.  Current bank disclosure level, across all countries, is just too poor for the markets to properly allocate capital by shifting money away from institutions that are run as casino operations to those that are run prudently.   That by itself will ensure capital would be shifted from the big banks to the regional banks, forcing them to shrink and be less of a threat to global financial stability.

Morgan Stanley is one of the many institutions whose sobering reality bears no resemblance to the portrait painted by the Fed’s stress test.  Even without performing a detailed analysis (at some point we will publish a detailed credit analysis of Morgan Stanley), one can state, with a fairly high degree of confidence, Morgan Stanley will be shown to be grossly undercapitalized within the next two years.

The biggest risk facing Morgan Stanley is the “Reps and Warranties” risk which was not adequately captured by the Fed’s stress test.  The Fed’s stress test projected a bank’s net income and regulatory capital under conditions of high unemployment, big fall in GDP and stock market levels, fall in house prices etc.  It did not deal with loans and mortgages which were sold/securitized by banks (such as Morgan Stanley) through misrepresentation of loan asset quality, a practice that was rampant in the glory days before 2008.  If the loans were not to the quality advertised, the purchaser of the loan (could be an insurance company or a pension fund) or a guarantor (such as Fannie Mae or a monoline bond insurer such as Ambac) had the right to put those loans back to the institution which mis- sold the loan.    In addition, institutions such as Morgan Stanley agreed to be responsible for the reps and warranties of 3rd parties (such as mortgage originator New Century) which are now bankrupt.  As on 31st December 2011, in the area of residential mortgage-backed securities (RMBS), Morgan Stanley had unpaid principal balances of such “reps and warranties” of $ 23.5 billion and these have so far resulted in cumulative losses of $10.5 billion.  The unpaid principal balance of commercial mortgage-backed securities (CMBS) subject to reps and warranties was $48.5 billion (of which $35 billion are in the US).  Now not all these loans subject to “reps and warranties” are going to end in the dog house, but a meaningful fraction will (we cannot exactly estimate the likely losses with the level of Morgan Stanley disclosures).  To get an idea of the scale of the impending disaster, as on 31st December 2011, Morgan Stanley’s common equity amounted to $60.5 billion. 

And we have not yet considered the company’s sizeable retained interests in securitization transactions, its Level 3 assets which Morgan Stanley’s management values pretty much as it likes (yeah sure they have a Fair Value Control Process to value those assets, but members of that team know which way their bread is buttered), its quanta of deferred tax assets, the quality of its lending and trading portfolio, the implications of Basel III and the Dodd-Frank Act etc.       

The earnings profile of Morgan Stanley, already weak from fall in trading volumes, is going to weaken further.  A thinly capitalized entity with weak earnings prospects is the last thing the global financial system needs.  But the Fed is strangely untroubled (or so it claims in its stress test results).  Faith, as the Bible says, is the substance of things hoped for, the evidence of things not seen.


From → Credit Analysis

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