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Thursday, October 13, 2011

Morgan Stanley: Systemic Mistrust or Bad Financials?

Morgan Stanley by any measure is a safe and solid investment bank. Except for one: The amount of trust people have in the whole financial and political system. It's just about zero,” according to Jesse Eisinger of The New York Times in October 2011. Even as there is undoubtedly an element of hyperbole in his conclusion—for zero trust in the financial system and governments would occasion far greater problems than the world faced at the time of Eisinger’s report—his broader point that bankers would be held accountable one way or the other for not having learned their lesson on derivatives (and risk more generally) is valid. The subtext is that even though banks like Morgan Stanley were in actuality in solid financial shape, they deserved the negative repercussions from the systemic skepticism that the banks themselves brought about by virtually ignoring risk analysis in preference to a run of profits and (not coincidentally) bonuses.

Eisinger points out that, at least as of October 2011, Morgan Stanley “has almost $60 billion in common equity, compared with $36 billion before September 2008, and its ratios are stronger. Its trading book - which is volatile and where any bank can take sudden, large losses - is smaller than it was. Morgan Stanley has more long-term debt and higher deposits, both of which stabilize its finances. The bank has more cash available in case there's a crunch and a smaller amount of Level III assets, which don't have an independently verifiable value and so must be estimated by the bank. Hedge funds have parked a smaller amount of assets at Morgan Stanley. That's good because in the financial crisis, they pulled them from the bank.” But because all of this could be easily wiped out by a run on the bank occasioned or fueled by a wider mistrust of the financial sector, Eisinger brings up the topic of derivatives as a way of showing that the bankers did not in fact learn their lesson (i.e., all the improved stats may be for naught). Accordingly, the bankers deserved the systemic mistrust even at the expense of any effort having resulted in added financial strength.  

According to the reporter, Morgan Stanley had a face value of $56 trillion in derivatives in October 2011. He notes that JP Morgan Chase had more: a face value of $79 trillion. This is the GNP of some countries. Even though the bankers insisted at the time that they had adequately hedged their long positions, the hedges themselves could fail, especially if the derivatives are positively correlated, as in September 2008 when AIG was completely overwhelmed due to the housing-based derivatives caving in virtually all at once.

In other words, those of us capable of learning lessons know that we should not trust hedges in so far as systemic risk is concerned; the system itself can be overwhelmed by the sheer momentum of a really big wave. So we are back to the issue of trust in the entire financial system, which is and ought to be a drag on even stellar financials until the broader lesson is learned. Unfortunately, that lesson may not be in the immediate financial interest of particular banks due to externalities occasioned by moral hazard (e.g., the possibility of being rescued while another bank, such as Lehman, fails).

Even though governments can step in to protect the broader system (unless captured by the regulated), legislators and regulators cannot force bankers to learn their lesson. A mentality to safeguard even one’s own bank as a going concern cannot be imposed; it must be felt and valued from the inside. All too often, bankers are engaged in “managing” regulations as impediments to be minimized rather than stepping back to ask why the regulations exist in the first place. They might exist for the banks’ own good. If so, the banking lobby trying to water down the Volcker Rule might have been working at odds with those institutions that the lobby ostensibly represents. Be careful what you wish for, Wall Street bankers. You might just get it, especially if you have the gold and therefore can make the rules. It would be ironic if the protesters rather than yourselves had your back, even as you ridicule the masses marching below your towering be-windowed edifices of greed.


Jesse Eisinger, “Between the Lines, Wall St. Banks Face a Deficit of Trust,” The New York Times, October 12, 2011.