Keep an eye on Morgan Stanley

Bloomberg has a story today about Morgan Stanley and the surge in the price of Credit Default Swap (CDS) contracts. A CDS is essentially an insurance contract to offload the risk of owning debt. Company “A” issues debt – buyer “B” buys the debt because of the attractive rate but does not want risk of non-payment. Company “C” comes along and sells the CDS saying that if company “A” defaults, they’ll essentially buy the bond at the amount owed by the bond and absorb the loss.

The issuer of a CDS has an interest in making sure the rate they are charging accurately reflects the real risk. It also gives them an economic incentive to do things to make sure company “A” doesn’t default. Unlike Moody’s or S&P, they have their money on the line. The “implied risk” of a Morgan Stanley failure is showing far more risk than the credit rating agencies, which suggests that S&P and Moody’s are unaware of some large risk about MS. That is what happened in 2008 when they completely missed the fraudulent mortgage portfolios. The CDS market was showing the problem long before people (like AIG) realized what was happening.

The pricing of CDS on Morgan Stanley is higher than that of Bank of America. Morgan Stanley has a very large exposure to European banks, mostly in France.

Germany has voted to put its weight behind bailing out Greece again, but their deal requires other smaller EU countries to also agree to support the plan and assume part of the risk – something that is not assured.

In unrelated news, inflation in Europe “unexpectedly” has surged upward.

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