Jeremy Warner's Outlook: Morgan Stanley in hot water over HBOS short

An outstanding trade, or just too clever by half? Morgan Stanley made a small killing when it shorted 2.25 per cent of HBOS last Friday. What's raised eyebrows is that it was also one of two lead underwriters to the HBOS rights issue that had closed that very morning. It therefore knew it would be able to close out its short positions at a substantial profit with the shares it was about to be left with as a result of being a prime underwriter.

Morgan Stanley insists it did nothing wrong, and, indeed, that the Financial Services Authority was kept informed throughout. Unlike underwriters to the Royal Bank of Scotland rights issue, it took out no direct short position while the rights issue was in progress, though it did engage actively in other hedging strategies. However, in terms of directly undermining an issue which it was underwriting, its hands were clean. The same could not be said of underwriters to RBS.

With HBOS, it was only after the rights issue closed that the direct short position was taken. By that stage, it was widely assumed in the stock market the rights issue had flopped, though only Morgan Stanley's client relationship team would have known quite how badly. Even if the traders responsible for the short position had been able to take a peep over the Chinese wall to see the full damage – the issue was only 8.3 per cent subscribed – it would have made no difference to their actions. As it is, Morgan Stanley insists there was no such snooping.

Overnight relief at trading news from Citi had that morning boosted the whole banking sector, so the HBOS share price briefly broke back through the rights issue price. In order to satisfy market demand for the stock, most of it from hedge funds looking to close out their own short positions, Morgan Stanley itself shorted the shares knowing full well the positions would be covered by the underwriters' stick.

The laughable part of this everyday story of City money-making jiggery-pokery is that, were it not for new FSA rules requiring the disclosure of short positions, no one would ever have known that the trade had taken place and it would by now already have been lost in the mists of time.

Morgan Stanley did nothing wrong, but the episode has nonetheless added to the general air of suspicion that now surrounds everything the City does. Having helped create the credit crisis in the first place, the investment bankers are profiting from the misery of dealing with its consequences. And you wonder why the bankers manage to maintain their mansions in Hampstead and yachts in the south of France, while the archetypal small HBOS shareholder still lives in a hovel in Halifax.

The quid pro quo for the repeated bailouts the banking system is receiving from the taxpayer right now is meant to be a greater degree of oversight and accountability, on practice as well as bonuses. Bankers must at least show contrition if they are to avoid regulatory over-reaction. The trouble with the Morgan Stanley short is not that it was against the rules, but the way it looks.

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