Friday, November 9, 2007

"Negative Convexity" at Morgan Stanley

Morgan Stanley reported a $3.7b write down on subprime related exposures. Make no mistake though, Morgan Stanley didn't bet on the wrong side of the market. It started the year with a short position in subprime, a position that earned good profit for the first nine months of 2007. Here is Colm Kelleher, Morgan Stanley CFO's explanation of what happened in the last two months:

We began with a short position in the subprime asset class, which went right through to the first quarter; as the structure of this book had big negative convexity and the markets continued to decline, our risk exposure swung from short to flat to long.

In essence, you can think of Morgan Stanley's trade as a short position in the junior tranche of ABS CDO, with an offsetting long position in the super senior tranche of the same structure.

Initially, as the delinquency ratio in subprime market on the rise, the junior tranche suffers the first loss and declines more in value than the super senior tranche. The overall trade represents a short subprime position.

In the last two months, as the subprime problem continued to worsen, the junior tranche has lost most of its value with losses now bites into the super senior tranche. Since the value of the junior tranche is floored at zero, it now declines in a much slower pace than the value of super senior tranche. As a result, the trade now becomes a long position in subprime, hence the $3.7b paper losses.