Morgan Stanley has lost $3.7bn on subprime mortgage-linked investments in the past two months after a big market bet went disastrously wrong, the bank revealed Wednesday night.
…
Mr Kelleher said Morgan Stanley’s losses were not related to such client-linked business but were the result of a big bet at the end of last year that subprime securities prices would fall.
For some months this looked highly profitable but as subprime prices fell far further than the traders expected, the investment became heavily loss-making, due to a phenomenon known as negative convexity [emphasis mine].
Wighton, David. “M Stanley loses $3.7bn on one subprime bet.” The Financial Times 8 November 2007.
The bet that prices of subprime mortgage-linked securities were going to fall turned into a big loss because they fell too much? Bizarre. I should look into this further.
Update 2007-11-09 9:05AM: Aha!
Morgan Stanley lost its money on a badly engineered bet. It is particularly galling because its traders were right that subprime mortgages would get hit. The problem was, they had built up long super-senior mortgage exposure (which was meant to be safe) to help defray the cost of their expensive short positions. The subprime wipe-out ended up so extreme that those “safe” securities were hammered and ended up overwhelming the short positions.
“LEX COLUMN: Morgan Stanley’s hit.” The Financial Times 9 November 2007.
Rather than betting on subprime prices falling, Morgan Stanley was actually speculating that the spread between subprime and super-senior positions would widen. Unfortunately for them, they were wrong.
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