MS CDS – The Saga Continues

Today, the CDS market is highly efficient. It is both liquid and ringing with endorsement for Morgan Stanley. It is clear that the credit analysts, who once again are good predictors of the future, have done their homework and decided that Morgan Stanley is safe.

Without a doubt some of the concerns are being addressed. With the imminent nationalization of Dexia, the potential for counterparty losses there have been addressed. The resolve Europe seems to have mustered to prevent bank creditors from having any losses is also helpful. Asia and EMEA where MS gets about a third of its revenues have rebounded nicely. CMBS and credit products in general have rallied, also helping MS. These are all valid points.

What I find “interesting” is that earlier this week, the CDS market was full of manipulative bears who were attacking an otherwise great company, that CDS was extremely illiquid, that you couldn’t rely on the pricing, and that spread widening was forcing additional hedging. Well, the CDS market is still populated by the same people as it was earlier in the week, it is no more or no less liquid. The price discovery mechanism hasn’t changed, and as the name has gone tighter, some people have found themselves over-hedged and are now forced to sell some protection into a tightening market, forcing it even tighter.

In full disclosure, I have only traded MS a few times this week, and it has always been from the long side, when I felt the stock movement was overdone. My writing on the subject has been to try and provide some clarity and consistency and deeper look at what is driving the spreads. To the extent the mainstream media laments how analysts or traders or websites “at the fringe” can attract a following, maybe they should review their own reporting of MS CDS earlier in the week, and their reporting now. Some have done a good and fair job. Too many, in my opinion, spent half their time disparaging CDS earlier in the week, and now avoid any mention of those same issues. The nature of the market has not changed and valid issues remain valid issues and points that were just wrong, are still just wrong.

MS stock hit a low of 11.60 this week, and a high of 15.50. That is a move of 33% from the lows to the high. CDS traded in an 8% range. Using 100 strikes, the high print of 650 was a “price” of 78.4 and the tight print of 420 was a “price” of 86.2. So if you had sold protection at the tightest level, and bought it back at the widest level (the worst trade you could have done), you only lost less than 8% of notional. A horrible trade but a far smaller move than the stock had. Once again, it does make me wonder why the CDS isn’t being pushed onto exchanges where it can be transparent and cleared sooner. The collateral should be manageable, and credit moving in an 8% range when the stock (junior in the capital structure) moves in a 33% range seems about right.

Anyways, I hope Europe works on some serious solutions this weekend, but takes into account the need to protect their sovereign ratings, or the plans fall apart. If any of the 6 AAA guarantors get downgraded, EFSF will have to be re-sized smaller to retain a AAA rating, in spite of all the talk about levering it up and making it bigger. Solutions have to be realistic and be done with the understanding that there are costs from any proposed solution and you can’t just hide or bury losses without impacting someone.