Morgan Stanley and Merrill Lynch reveal billions more subprime damage

The subprime crisis continues to deepen as Morgan Stanley and Merrill Lynch, two of the worst-affected US banks, reveal further damage - and an SEC investigation into Merrill Lynch.

Morgan Stanley announced late yesterday that it lost $3.7 billion on exposure to collateralised debt obligations of asset-backed securities (CDO of ABS) based on US subprime mortgages, and on the mortgages themselves, in September and October alone. With a month to go until the end of its financial year, it has $2.7 billion net losses on subprime exposure.

The bank's chief financial officer, Colm Kelleher, told a conference call that the fall in the ABX index of ABS since the end of August had caused the bank to cut the fair value of its holdings. "The impact on the fourth quarter will depend on future market developments," he added, warning "it may take several quarters to return to normal operating levels".

Kelleher also predicted a pullback from the complex structured credit products at the root of the losses. "We will see a return to traditional credit analysis," he said.

Morgan Stanley had prepared for a slight downturn, but had underestimated the severity of the crisis, he explained. "We were on the wrong side of a negative convexity trade. We went short, expecting a certain range of losses, but that range was burned through by market action so we ended up being long."

Meanwhile, Merrill Lynch announced, in its quarterly report issued yesterday, that its exposure to subprime markets was higher than it had previously admitted. It had a further $5.7 billion exposure through two subsidiaries, Merrill Lynch Bank USA and Merrill Lynch Bank & Trust, which was not announced earlier in the year.

"Our stress tests and other risk measures significantly underestimated the magnitude of actual loss from the unprecedented credit market environment during the third quarter of 2007, in particular the extreme dislocation that affected US subprime residential mortgage-related and ABS CDO positions," the bank said in the report.

The US Securities and Exchange Commission has begun investigating Merrill Lynch's subprime portfolio, the bank revealed. No details were available on the investigation, which started on October 24. The bank also challenged press reports that it had tried to conceal writedowns earlier this year. "We have no reason to believe that any such inappropriate transactions occurred. Such transactions would clearly violate Merrill Lynch policy," it said.

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