Morgan Stanley shrinking correlation unit added $50 bn

Morgan Stanley was shrinking its derivatives business to cut risk under new banking rules when three deals came along that it couldn't resist.

The bank bought credit-correlation positions with a notional value of more than $50 billion over the past three years, including a portfolio sold by Credit Suisse Group AG in 2012, four people with knowledge of the transactions said. The trades helped boost Morgan Stanley's fixed-income revenue, the lowest among the biggest Wall Street firms, at the same time they swelled the balance sheet with risky assets. Such large acquisitions have since been halted, two other people said.

Global banks are shrinking or shutting correlation units, which make bets on the degree to which companies will default at the same time, as new regulations force them to hold more equity against the positions.

Morgan Stanley's moves highlight the challenges confronting CEO James Gorman, 54, as he seeks to meet long-term strategic goals while satisfying demands to show short-term revenue gains.

"They recognise that this credit-trading part of the business is going to be uneconomic" under new capital rules, said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York and a former Morgan Stanley treasurer. "So you work these positions off and, unfortunately, it brings your revenue down."

Credit-correlation positions, primarily derivatives linked to corporate debt, indexes of companies and tranches of those indexes, produced billions of dollars of losses in the financial crisis. They included complex products such as collateralised debt obligations, or CDOs, that comprised pieces of other CDOs. JPMorgan (JPM) Chase & Co.'s more than $6.2 billion trading loss last year came from a unit that held credit-correlation positions.

Cutting Assets
Gorman has said his New York-based bank is exiting structured businesses including securitisation units to focus on trading for clients and set a goal of cutting risk-weighted assets, or RWAs, under new Basel III rules by 60 percent from a peak of almost $500 billion during the financial crisis. Reducing RWAs, a regulatory measure of assets that determines how much equity capital must be held against each position, allows a firm to improve its capital ratios and potentially reward shareholders through dividends and stock buybacks.

That left Colm Kelleher, 56, head of Morgan Stanley's investment-banking and trading division, and Ken deRegt, 57, who stepped down last week as leader of the fixed-income business, with a dual mandate from Gorman: Shrink the capital the unit uses while increasing market share.

While the purchases helped the bank with the latter goal, halting them suggests Morgan Stanley is more focused on capital than revenue.

Natixis, RBS
In addition to the Credit Suisse portfolio, Morgan Stanley bought a book with a notional value of more than $35 billion from Paris-based Natixis SA in 2010 and positions from Royal Bank of Scotland Group Plc the next year, said three people familiar with the trades. Credit Suisse reduced its RWAs by $20 billion, according to two other people.

While the portfolios probably produced gains for Morgan Stanley, they're hard to sell because of a lack of buyers and consume large amounts of capital until they expire, the people said. That means the short-term revenue benefits may come at a cost of slower reduction of RWAs and lower returns on equity.

The people didn't say what Morgan Stanley paid for the positions or the gains the bank realized. Mark Lake, a Morgan Stanley spokesman in New York, declined to comment.

Purchasing the portfolios helped Morgan Stanley meet the goal of increasing revenue share among the largest fixed-income traders to 8 percent from the 6 percent it achieved in 2010. Its market share among the nine largest global investment banks rose to more than 8 percent in the 12 months through March 2012, according to data compiled by Bloomberg.

Market Share
As the bank stepped back from the credit-correlation business over the past 12 months, it accelerated reductions in RWAs while losing market share. The figure dropped to less than 6 percent by the end of March, excluding accounting charges, the data show.

The company has said the decline was caused in part by clients halting some trading amid a Moody's Investors Service review of Morgan Stanley's credit rating last year. Chief Financial Officer Ruth Porat said last month that the 8 percent target was still in effect.

Morgan Stanley's $24 billion of RWAs tied to credit correlation as of March 31 was the second-highest figure among the biggest U.S. banks, topping Goldman Sachs Group Inc.'s $22.7 billion and Citigroup Inc. (C)'s $14.2 billion, according to company filings. JPMorgan was first, with $55.3 billion of RWAs.

Revenue Decline
Morgan Stanley posted a 42 percent drop in fixed-income trading revenue in the first quarter, the largest decline among the five biggest Wall Street firms. The bank also said its fixed-income RWAs dropped 10 percent in the quarter as the correlation book shrank.

"We've consistently said that our focus is going to be on the flow, high-velocity, lighter-risk-weighted-asset businesses," Gorman told investors in July. "The dial has been turned up on that."

Morgan Stanley began winding down its credit-correlation book in 2008 after losing more than $9 billion on structured fixed-income bets a year earlier and as regulators debated new capital rules. It sold Cournot Financial Products LLC, a credit-derivatives company created by its investment bank in 2007 to sell credit-default swaps.

The bank reduced risk-weighted assets in its fixed-income-trading unit to $253 billion as of March 31 from almost $500 billion at the peak. The calculations are based on Basel III rules adopted by the Basel Committee on Banking Supervision, which coordinates banking regulation among 27 nations. About a third of the decrease came from eliminating correlation positions, according to a person familiar with the matter.

'Prudent Fashion'
Morgan Stanley's more than $24 billion of RWAs linked to credit correlation is based on Basel 2.5 rules, which seek to better capture risk in banks' trading assets than previous versions and were implemented in the U.S. earlier this year. The bank provided the figure for the first time this month.

Basel III regulations, which aren't in effect yet, require that even more capital be held against derivatives.

"The problem we have as risk managers is how do we manage that risk down and maintain talent to dynamically hedge that stuff until it rolls off," Kelleher said at a Bloomberg conference in New York in December 2011. "So you have to do this in a prudent fashion. But if you look out two to three years, you get yourself to a situation where your capital allocated to the business is significantly less."

Offsetting Positions
Risk-weightings of correlation assets are driven largely by the comprehensive-risk measure, which estimates potential losses in the positions over one year with 99.9 percent certainty. A surcharge is added to that estimate, and the resulting RWAs under Basel 2.5 are 12.5 times that figure.

Buying multiple portfolios may not carry as much risk as the notional amounts indicate because separate books could have positions that offset each other or cancel bets the bank already has, according to two people with knowledge of the market.

Brian Neer, head of European credit trading and global head of credit-derivatives products, and Tim Jennison, co-head of European credit sales, led Morgan Stanley's efforts to buy discounted books of assets out of the bank's London office, two of the people familiar with the credit-correlation purchases said. Neer reported to Michael Heaney, who was named global co-head of fixed-income sales and trading last week.

'Non-Productive'
While the halt in correlation purchases may have affected recent revenue, it could help the firm catch up with competitors in other measures. Morgan Stanley achieved its 2013 fixed-income RWA goal at the end of 2012 and accomplished all of the reduction it wanted this year in the first quarter, when it trimmed $27 billion.

"Each time we've put out a goal, we've beaten it, so we're obviously determined," Gorman said at the firm's shareholder meeting May 14. "The business is quite profitable without all this excess stuff, which is legacy and is dead money."

About a quarter of Morgan Stanley's fixed-income assets, or $46 billion, are "non-productive" in that they don't contribute to revenue, Howard Chen, a Credit Suisse analyst, estimated in a December note. Those dead-weight assets suppress returns and result in a 3.8 percent revenue yield on fixed-income assets, below the 5 percent average of competitors, Chen wrote. The yield is a measure of how much revenue the bank produces based on the fixed-income assets on its balance sheet.

Dead Weight
Analysts have questioned for years why Morgan Stanley's fixed-income business produces less revenue than its size would suggest relative to peers, something they refer to as balance-sheet velocity. Chen blamed assets left over from the financial crisis that hadn't yet matured. Gorman said earlier this month that some dead-weight assets date to the mid-1990s.

The book bought from Zurich-based Credit Suisse includes securities structured in 2006 and 2007 and tranches with durations of five, seven and 10 years, said one of the people.

Much of the first-quarter drop in RWAs came from expirations of structured-credit contracts, Porat said last month. They had no impact on the firm's profit because the risk was hedged, she said.

"The RWA reductions largely represent runoff," Gorman said in January. "We do not expect the reductions to impair revenues as we run them down."

Reducing RWAs and returning capital to shareholders are critical for Gorman's plan to double return on equity to 10 percent and return on tangible equity to 12 percent. Gorman said earlier this month that the firm can reach the goal by next year if it's allowed by regulators to return "reasonable amounts" of capital.

Gorman's Goal
Gorman has set a goal of getting below $200 billion in fixed-income RWAs by the end of 2016. That would require $18 billion of equity capital under Basel III rules, the bank said in January.

For the fixed-income unit to produce the 10 percent return on equity that Gorman is targeting for the whole bank, it would have to produce between $1.5 billion and $2.5 billion of revenue each quarter, according to a person with knowledge of the matter. Over the past 13 quarters, Morgan Stanley's fixed-income revenue averaged $1.5 billion.

While Gorman said at the shareholder meeting that he's "positive" the firm can reach the $200 billion RWA goal, he hasn't ruled out altering the target.

"If you find a compelling opportunity, you'd have to articulate to the marketplace, 'We were going to be at $200 billion, but we have this compelling opportunity and that 200 becomes 220, but look at the revenue opportunity from that,'" Gorman said. "So we're not maniacally heading down a road, but absent those opportunities presenting themselves, we are maniacally heading down the road."