More subprime writedowns at Morgan Stanley

Morgan Stanley has taken a total of $9.4 billion in mortgage-related writedowns in the fourth quarter, causing it to lose $3.6 billion, it announced today.

Said chairman and chief executive of Morgan Stanley, John Mack: "The results are embarrassing, for me and for the company." The losses were the result of "an error of judgement on one desk in the fixed-income division, and a failure to manage the risk properly," he added.

The desk made a large illiquid trade in the mortgage market, and then decided to hold the position rather than unwind it and take losses. "But the hedges did not perform well in late October and early November, given the illiquidity of the position," Mack said.

Chief financial officer Colm Kelleher said that the the mortgage desk had decided to short the subprime market by taking a $2 billion short position in low-rated subprime mortgage-backed securities (MBS). In order to meet the cost of the negative carry of the short position, the desk also went long $14 billion of AAA-rated super-senior [tranches] of BBB subprime securities, which we refer to as mezzanine," he said. The investment in the top tranches of collateralised debt obligations (CDOs) of MBS was assumed to be safe enough to provide a reliable source of funding to meet the cost of the short position, even if the underlying market declined.

But, he added, losses on US subprime mortgages had been severe enough to eat into the value of even these AAA-rated CDO tranches. "The losses were non-linear in relation to the ABX because of the long-short structure," he added.

Morgan Stanley had earlier reported mortgage-related writedowns of $3.7 billion in October, but added another $5.7 billion - including $4.1 billion related to US subprime residential mortgages - in November. The quarter ended on November 30.

The bulk of the $9.4 billion represents mark-to-market losses on residential mortgage exposure. However, it also includes $400 million lost on commercial mortgage-backed securities (CMBS) in November, which, Mack said, was a "realised loss".

In a note issued today, Credit Suisse warned CMBS writedowns could "generate substantial losses". Lehman Brothers, Credit Suisse and Wachovia have all announced losses on CMBS exposure, and the rising CMBX index "suggests further writedowns could be coming from other large banks", wrote analyst Daniel Davies. Morgan Stanley was the largest issuer of CMBS in the first half of the year, issuing $26.8 billion-worth. Based on this, Davies argued, its exposure was likely to be "roughly proportionate". Other large issuers were Wachovia ($20.6 billion), JP Morgan Chase ($18.8 billion), Credit Suisse ($17 billion) and Deutsche Bank ($13.9 billion).

Morgan Stanley also announced an agreement with China Investment Corporation, under which CIC would take a 9.9% stake in the bank in the form of convertible instruments. The instruments will yield a 9% annual payment until their conversion in August 2010, and will provide Morgan Stanley with a 20% premium.

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