Question

How Morgan Stanley in 2007 lost $9B on subprime mortgage bets. What were the major assumptions in the fixed income models that went awry?

Answer 1

Morgan Stanely(MS) lost $9B in subprime mortgage bets due the sale of credit dafult swaps. Banks were selling mortgage based securities against the subprime loans and to cover the risk they started buying credit default swaps (CDS). In case of Morgan Stanely, they bought the CDS for B rated bonds, but to pay the premiums for these CDS they sold CDS against A rated bonds. Assumption was simply that A rated bond will have lesser probability of fall thus the bank will never have to pay those whom they sold those CDS. Also as B rated bonds were riskier MS had to pay more premium on the CDS while earned less by selling safer CDS on A rated bond. Hence to match the cashflows they (MS) sold a much higher volume of CDS against A rated securities.

But in the 2007-8 crisis when the subprime mortages failed, it resulted in freefall of housing prices, leading even the A rated loans to default. Thus if MS had bought 1 CDS against B rated securities they had sole 10 CDS against A rated ones. And as A rated bonds failed at the same pace of that of B rated ones. The outflow on the CDS sold was approx 10 time of input on CDS bought. Thus the event that triggered the removal of credibility difference amongst different ratings and reduction of prices in housing market, which was the asset secured led to such situation.

Reduction in value of asset under securities is the thing that went against the assumption of fixed models