Streetwise Professor

July 22, 2009

It Gets Worse

Filed under: Derivatives,Economics,Financial crisis — The Professor @ 9:00 pm

In the wake of Goldman Sachs’s huge earnings, Morgan Stanley just reported a quarterly loss.  CEO John Mack blamed the loss on the company’s cautious attitude towards risk taking:

A week after  Goldman Sachs Group Inc. proved securities firms still can rake in record profits from taking big risks, Morgan Stanley reported a $159 million second-quarter loss from continuing operations that left Chairman and Chief Executive John Mack conceding that parts of the company got too conservative after surviving its near-death experience last fall.

. . . .

“We are not satisfied with our performance” in “key areas of fixed-income trading and in asset management,” Mr. Mack said in a statement. To turn things around, Morgan Stanley is bringing in new blood in its managerial ranks, expanding its trading with clients and “increasing capital commitments in a disciplined way,” he added.

Translation: Morgan Stanley now plans to rev up its risk taking, which it has been averse to doing since the company came close to perishing or being forced into a government-assisted takeover last fall.

“We were encouraged that they had a more aggressive tone than in past quarters” on trading, said Barclays Capital analyst Roger Freeman. “But the quarter itself doesn’t leave much to be encouraged about. They’ve let opportunity slip by.”

In bond trading, Morgan Stanley’s revenue was barely a third of that reported by Goldman, even after the impact of Morgan Stanley’s own credit spreads were excluded. Stock-trading revenue was less than half what Goldman brought in during the quarter.

Earlier this year, Morgan Stanley executives said they were reluctant to take the sorts of chances that were common before the financial crisis erupted, concluding that the returns wouldn’t be generous enough to justify the possibility of losses.

But hold on!  Felix Salmon reports that Morgan Stanley’s value-at-risk went up by about 25 percent from the fourth quarter of 2008 to the second quarter of 2009.  The WSJ article also reports that the firm increased its leverage from the end of last year.  So much for the “oh-we-lost-money-because-we-were-so-conservative excuse.”  Actually, it should be “we-lost-money-because-we-took-more-risk-and-and-made-bad-calls.”

Salmon expresses puzzlement at MS’s poor performance as compared to Goldman and J.P. Morgan.  I’m puzzled why he’s puzzled.  Goldman took on more risk, sure, and made money.  But you don’t make more money just because you take on risk.  You make money because you bet, and bet right.  And if you bet big and right, you make a lot of money.  That’s what Goldman did. MS’s performance gap isn’t due  it not betting, it’s due to its betting bigger–and wrong.  No mystery here.

And this represents more bad news, because the lesson the firm has apparently drawn from its experience, and no doubt Goldman’s, is that it needs to take on more risk:

On Wednesday, though, Morgan Stanley Chief Financial Officer Colm Kelleher said he feels more “constructive” about taking trading risks as markets stabilize. He said some traders avoided riskier trades during the second quarter, despite management’s willingness to take more risks. “Some of the trading desks didn’t see the opportunity and weren’t prepared to put capital to work,” he explained in an interview.

. . . .

“We’ve been seeing clear signs of stability,” Mr. Kelleher said, noting renewed activity in the bond and commercial-paper markets. But the firm plans to continue to tread carefully, mainly ramping up risks in well-traveled areas such as government bonds and currencies.

“It takes awhile,” he said. Late last year, “we stared into the abyss,” and some traders may still be “gun-shy.”

Why is this bad news?  To me it suggests that seeing Goldman’s performance, and concluding that it too is too big to fail, Morgan Stanley thinks that loading up on risk is the way to go.  Why be a chump and reduce risk, when Goldman has shown you can swing for the fences and rely on Uncle Sugar if the bets don’t go the right way?  

To me, this line blaming the losses on excess conservatism is just bull, and an excuse to use the losses to justify ramping up the risk taking.  Given that equity holders benefit from the Treasury put of a too big to fail institution, they will be cheering MS on.  Me, on the other hand, being one of the guys who is (involuntarily) short the put, will be groaning.

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  1. It really underscores the moral hazard of saving these folks. For starters, Goldman Sachs is nothing more than a big hedge fund just lucky enough to have had their alumni and campaign contributions get them a seat at the table. One of these days they are going to bet big and lose. They’ve managed to become the most loathed name associated with all of the excesses of Wall Street. I’m sure the Morgan Stanley lemmings will place riskier bets. Gordon Gekko even in his diminished stature lives on with these folks.

    Meanwhile regional banks are blowing up right and left.

    Comment by penny — July 22, 2009 @ 10:36 pm

  2. Another wsj blog tells us – “Morgan’s Var was $173 million in the second quarter. Goldman’s VaR was $245 million”. I check these numbers on the respective 8Ks. Not sure which one to believe. But since we don’t have so much respect for these Var numbers anyway it may not mean much. Both firms increased their risks and one of them faced losses. May be GS has spies inside MS lol – doing what I can to chime in with yet another Goldman urban legend.

    But seriously – var is easy to fudge in many ways. Also curiously I found that GS and MS have both filed an 8-K instead of the usual 10-Q. I believe both are unaudited (not that it means much :-D) but still, why this instead of the usual? Alright I found out – 8K is a preliminary report. 10Q would follow this and can contain corrections. Hmm…interesting.

    Btw, what is the precise definition of var breach? Is it an event registering a profit or loss outside the quoted Var?

    Comment by Surya — July 22, 2009 @ 11:07 pm

  3. Professor – what do you think of the Dow’s latest spurt? Handiwork of the automated trading systems at the gamblers’?

    Comment by Surya — July 23, 2009 @ 10:52 am

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