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The Brokerage's Sloppy Looking Swaps

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March 02, 2007 – Comments (2)

A Bloomberg article reported last night that traders within the large investment banks are trading debt instruments at levels that suggest that there could be trouble ahead for the banks. Prices for credit default swaps (CDS) for the debt of some of the major firms like Morgan Stanley (NYSE: MS), Merrill Lynch (NYSE: MER), and Bear Stearns (NYSE: BSC) have been steadily rising so far this year, suggesting that risk is rearing its ugly head.

A credit default swap is an instrument that transfers the risk of a default on a loan obligation from one party to another. Much like any other type of insurance, the party seeking protection pays a fee to the counterparty. The fee reduces the returns on the loan, but it can significantly reduce the risk profile.

According to Credit Market Analysis (CMA), a third-party provider of credit data, credit swaps for Morgan Stanley have risen from $10,000 per $10 million in bonds to $32,775, while the swaps at other banks have moved similarly. Despite the fact that the banks still sport high ratings on their senior debt, these swap prices equate to debt ratings that are just a couple steps above junk. Much of the concern is over the mortgage exposure that many of the banks took on during the housing boom and whether they face the kinds of loan portfolio writedowns that we've heard about from places like HSBC (NYSE: HBC).

Part of this maybe a question of hubris. Risk management is at the heart of the increased principal risk that is allowing the investment banks to make some of the great returns as of late. Investors may be concerned that risk wasn't adequately managed with regards to the mortgage loans they took on. Unfortunately, the banks tend to be very opaque when it comes to principal investments, so it's really tough to tell where downside risk lies until they post numbers.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can visit Matt's CAPS page here. The Fool’s disclosure policy always has adequate risk control in place.

2 Comments – Post Your Own

#1) On March 02, 2007 at 3:35 PM, CycleFreak7 (< 20) wrote:

Personally, I believe the fallout from excessive debt is just beginning to rear its ugly head.

From the Federal debt (and continued deficit spending) to corporate debt to mortgage debt to personal debt in the form of credit cards and auto loans ... it's all going to come crashing down.

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#2) On March 03, 2007 at 11:39 AM, TMFKopp (97.83) wrote:

As far as the mortgage exposure that the banks have, it's all about risk management. Well, that is unless all the debt true-ups cause the market to falter and economic activity to slow. Then the banks are in real trouble. That's definitely not an unrealistic scenario.

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