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Funny Money?



September 26, 2007 – Comments (2)

In reading through some of the investment banks' earnings call transcripts, I have noticed some eerily similar statements regarding the ways in which they were able to offset the massive writedowns in fixed income instruments with so-called "structured notes".  See below for some examples, and tell me this doesn't look a little sketchy:

Morgan Stanley:   

The credit environment impact on our lending and credit sales and trading was partially offset by an approximately $390 million gain from the spread widening in Morgan Stanley's credit on some of our own structured notes. Of this amount, approximately $290 million was reported in fixed income sales and trading and $100 million in equity sales and trading.

Anything that we mark-to-market will reflect the mark in the period that we are in, so if you think about our structured notes, where we fair value those notes, obviously given what happened to credit spreads broadly and to Morgan Stanley specifically where our credit spreads widened during the quarter, the liability which is represented by those structured notes, given the widening in our credit spread, we take a gain on that. To some degree, that represents that if you wanted to buy back that piece of paper, presumably you would pay less to buy it back because of the counterparties view of your credit worthiness. So obviously to the extent next quarter credit spreads change, that mark will change. So to the extent credit spreads tighten, you would expect to see a gain; to the extent they widen further, you would expect to see a loss if credit spreads tighten from where we are and if they widen, incremental gains.


Exactly. Though I would point out, Jim, on that there is an awful a lot of attention being given to this structured notes issue. If you can indulge me for a minute. The way we look at this structured notes business, we are issuing securities to investors. These are essentially marketable securities that get mark-to-market by them and us. They are trading instruments. They do get traded. Generally the way customers exit those trades is by selling them back to us. The fact is that we had a policy of not hedging the credit exposures imbedded in that portfolio given the fact we have been issuing these over the last several years at what were then very tight credit spreads for not only us but for the industry. That posture may change going forward, but we think that the gains that are recognized there while it is an accounting change, the accounting change was, I believe, granted to allow dealers like us to reflect the true economics of this business.


Understood. In your text, you said these losses were partially offset by large valuation gains on economic hedges -- that I get -- and then other liabilities. What are the gains that you get on other liabilities that act as an offset to the valuation reductions?

Well, all of the instruments that are mark-to-market in the books, so it will be the hedging instruments whether the derivatives or short positions that are in inventory, or in a case where we have designated some portion of our structured notes that we have issued will be mark-to-market as well. All of those items will on the liability side will generate gains in a credit spread widening environment.


How none of the analysts questioned these instruments, who the "investors" are, or how they are being marked to market is beyond me...

2 Comments – Post Your Own

#1) On September 26, 2007 at 8:40 PM, StockSpreadsheet (74.73) wrote:

I think of bigger concern for the major investment banks is their Level 3 holdings.

On their most recent financials, Lehman showed that Level 3 holdings increased and a good chunk of their profit, (or I should say, a reduction in their losses), came from the value they placed on these Level 3 investments.  Since there is no market for Leve 3 investments, they can claim they are worth anything they want them to be worth to make their losses look smaller.  At some point though, the fact that a lot of these Level 3 holdings are worthless will come through, as I believe that a lot of them will become evidently worthless before Lehman can offload them to an unsuspecting investor, (which is what they are hoping they can do, so they don't take the loss themselves).  Once these losses start rolling in, I think that they will look back on the size of their current losses as "the good old days".  Just my opinion though.


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#2) On September 26, 2007 at 8:59 PM, retailsails (92.19) wrote:

Agreed - there was also a lot of funny stuff going on with movements between Level 2 & Level 3 - especially a lot of mortgage residuals, which these guys hold billions of (also brough up on the calls, albeit very briefly) - those are extremely illiquid but there will be massive losses...just a question of when they take them...

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