The Dexia Domino & The Run On Morgan Stanley

Positions: We are currently short Citigroup (Ticker: C) in the Virtual Portfolio.

 

In times like these, we obviously want to be careful that we are not fear mongering, but we also want to accurately flag critical risk signals, even if portending worse news.  This morning two important events are occurring in the global banking system.  First, credit default swaps on the major U.S. brokerages are blowing out big time.  In particular, Morgan Stanley credit default swaps are now at 800/875 basis points per Zerohedge.  Second, Dexia, a Belgian bank that is two times the size of Washington Mutual appears to be on the precipice of some form of a government bailout.

Last night after the close, Morgan Stanley President and CEO James Gorman sent a memo to his firm suggesting that the rumors around the company's solvency were overdone. In the memo he wrote:

"To help you wade through the maze of numbers and information, it might be worth reading two analyst reports that were published this morning. One is from Howard Chen at Credit Suisse that examines Capital, Funding and Liquidity at Morgan Stanley and Goldman Sachs and, in some detail, highlights the dramatic improvement to our financial strength over the last three years.”

Unfortunately, this is the same Howard Chen who upgraded Morgan Stanley at north of $30 per share in early January 2010.  The point is not to denigrate Chen, as we are sure he is a great analyst, but rather to highlight that the Morgan Stanley memo reeks of desperation, which is exactly what the market is telling us this morning.

Currently, the stock price of Morgan Stanley is below $12, which, as we outline in the chart below, the lowest price for the stock since December 2008.  Even more disconcerting are the credit default swap markets on Morgan Stanley debt, which are now trading beyond 800 basis points on the one-year tenor (per Zerohedge).  As the second chart below highlights, this is well above the close of yesterday at 529 basis points on the five-year tenor. Simply, Morgan Stanley CDS at this level are not sustainable. 

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Meanwhile the rest of the brokerage sector in the U.S. is showing similar stress.  Goldman 1yr CDS are now just shy of 400 basis points, Bank of America 1yr CDS are just over 500 basis points, and Citigroup’s 1yr CDS are just below 400 basis points.  Certainly the rest of the brokerage sector does not appear to be under the duress of Morgan Stanley, but swaps being prices back at levels reminiscent of 2008 are noteworthy.

As it relates to Dexia, our Financials team wrote a note this morning, which we’ve excerpted below:

"It's been a tense week at Dexia.  On Monday it was reported that the board was conducting emergency meetings.  This morning the company is facing criticism over their sovereign debt accounting, which doesn't mark Greek debt to market.  Anonymous sources told Bloomberg and other news outlets that a breakup of the company could be imminent.  Dexia could sell the healthy business units, which include asset management and a Turkish unit, in order to offset the capital hit from the sovereign debt portfolio.  

Throughout the crisis, European lenders have insisted that their capitalization levels are adequate.  Subsequent events have shown that this is transparently not the case.   

The problem with using regulatory capital ratios is a simple one.  Tier 1 Common and other regulatory ratios use as their denominator risk-weighted assets.  Under Basel II (the relevant standard for European banks), the risk-weighting for sovereign debt rated above AA-/AA3 is 0%.  That is, from a regulatory perspective, sovereign debt bears no chance of default and requires no capital.  In the current environment, looking at a capital ratio that ignores the asset class under scrutiny is quixotic.   

Thus, we revert to examining capital on the basis of tangible equity / tangible assets.  This metric removes the distortion caused by the regulatory paradigm and is less easily gamed.  We first published these charts on September 22nd in conjunction with a conference call.   

Dexia jumps out in the tables below as the least-well-capitalized of the major European lenders.  At the top of the table, for comparison, we show the US banking system in 2Q08.  European banks today look comparable to the American banks just before the crisis bore down in full force. 

These charts should be read in conjunction with the tables below showing the relative exposure to sovereign debt.  To take the Greek banks as an example, they look relatively better capitalized on a TE/TA basis.  However, their exposure to Greek and other PIIGS debt is correspondingly higher, and taking a realistic mark on the sovereign holdings would wipe out the bulk of this apparent advantage.   

On a TE/TA basis, Dexia is the weakest link.  It comes as no surprise to us to see the company wobble."

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Daryl G. Jones

Director of Research