Morgan Stanley was short subprime. Subprime went down. Morgan Stanley lost
$3.7 billion on the trade. How is that possible? Morgan Stanley’s CFO, Colm
Kelleher, explained
it thusly:
“We began with a short position in the subprime asset class, which
went right through to the first quarter; as the structure of this book had
big negative convexity and the markets continued to decline, our risk exposure
swung from short to flat to long.”
So, what is this "negative convexity" of which Kelleher speaks?
Eric Jardine says
that it means that "we started out perfectly hedged but have since gotten
long as markets have deteriorated," but that’s not entirely right: as Kelleher
says, the bank started out short, they were then briefly perfectly hedged, and
then they ended up long. I have a feeling that in fact Morgan Stanley was putting
on a trade which was much more complicated than the simple long-senior short-junior
play that Jardine hypothesizes.
Part of the problem is that "convexity", as a concept is not very
easy to understand. It’s basically about the relationship between price and
yield: as a bond’s price goes up, its yield goes down, and vice versa. But if
you draw a graph with price on one axis and yield on the other, you don’t get
a straight line, you get a curve. Convexity is basically a measure of the shape
of that curve.
With most bonds, there’s something called positive convexity, which is great
for investors. If you buy a Treasury bond at par, say, then your profit in the
event of a 50bp drop in yields is greater than your loss in the event of a 50bp
rise in yields. For any given move in interest rates, your upside is bigger
than your downside. Nice!
But of course in the world of ultra-sophisticated financial engineering, you
can create instruments which have so much negative convexity that the price
might start off moving in one direction as yields start moving, and then eventually
start moving in the other direction.
I have no idea what kind of trade Morgan Stanley got involved in. But essentially
they went short at a point on the price-yield curve which was so very, well,
curvy that their profits from falling prices soon turned into losses
from falling prices.
The people responsible for this trade have, we’re assured, been taken
out and shot. I guess now they understand how convexity can bit
you in the ass.