The WSJ has an autopsy of the Morgan Stanley panic of a few weeks ago that provides some insight into the workings of Wall Street. The most active players in betting against MS turn out to be their rivals:

Trading records reviewed by The Wall Street Journal now provide a partial answer. It turns out that some of the biggest names on Wall Street — Merrill Lynch & Co., CitigroupInc., Deutsche Bank and UBS AG — were placing large bets against Morgan Stanley, the records indicate. They did so using complicated financial instruments called credit-default swaps, a form of insurance against losses on loans and bonds.

A close examination by the Journal of that trading also reveals that the swaps played a critical role in magnifying bearish sentiment about Morgan Stanley, in turn prompting traders to bet against the firm’s stock by selling it short. The interplay between swaps trading and short selling accelerated the firm’s downward spiral.

Various regulators are looking into the trading to see if there was manipulation involved, but my guess is they won’t find anything concrete. It’s possible that they find a scape goat who was spreading rumors but that is hard to prove. More likely they will find, as I have and Arnold Kling has, that this was just a function of the CDS market.

The sellers of CDS used a dynamic hedging technique that required them to short stock in ever increasing quantities as the price fell. This dynamic hedging is similar to the portfolio insurance that is widely believed to be a cause of the ’87 crash. As the price of MS stock fell, the CDS sellers had to short more stock. The falling stock price also caused MS bond holders to worry and buy CDS which further reinforced the negative feedback loop.

The real question here is whether this negative feedback loop was put into motion purposefully. Did someone try to cause MS to fail? I actually don’t think so, but the possibility is there. Even some at the SEC believe the CDS market could be manipulated:

Erik Sirri, the SEC’s director of trading and markets, contends that the swaps market is vulnerable to manipulation. “Very small trades in a relatively thin market can be used to … suggest that a credit is viewed by the market as weak,” he said in congressional testimony last month. He said the SEC was concerned that swaps trading was triggering bearish bets against stocks.

The big players in the CDS market for MS were other brokerage firms such as Merrill who had a need to hedge their counterparty risk. One wonders if they understood that the act of buying protection was contributing to the demise of MS. Even if they did understand it, what else could they do?

I don’t believe there was an intentional effort to drive MS out of business. Hedge funds who pulled funds out of MS were just trying to protect themselves. The same is true of the MS rivals with counterparty risk. The question we need to be asking is, what do we do about the CDS market? Even if it is moved to an exchange, this negative feedback loop would still exist. Most of the people who use the CDS market use it for legitimate hedging purposes. You can’t ban the speculative use of CDS because that would limit the liquidity of the market and drive up the cost to those who have a legitimate need to hedge.  The best answer I can come up with is that companies should not put themselves in a position that will attract speculators to their CDS market. In other words, MS can blame whoever they want but ultimately the villain can be found in the mirror.

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