Stephen Foley: Morgan Stanley feels the eurozone jitters


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The Independent Online

US Outlook: The investor relations department at Morgan Stanley has had to do a lot of work this week to calm its shareholders, creditors and clients, and it really shouldn't have to.

The reason for the flap is a dramatic rise in the cost of insuring against a default on the investment bank's bonds. This cost is measured by the spread on a credit default swap – effectively an insurance policy that will pay out should Morgan Stanley fail to meet its obligations to bondholders.

The CDS spread has blown out to a level that suggests Morgan Stanley is riskier than those Italian and French banks that are stuffed to the gills with about-to-default eurozone debt. That is absurd, yet not the most absurd part. The reason cited for the nervousness is Morgan Stanley's exposure to eurozone banks – but you cannot logically put a higher probability on Morgan Stanley getting into trouble than you do on the cause of the trouble.

The CDS market is implying Morgan Stanley's own debt should be rated about six notches lower that it actually is by the rating agencies. Of course, the rating agencies could be wrong, and the CDS market could be right (you hardly have to be a doctrinaire free-marketeer to side against the rating agencies on this one, given their poor record). Except that CDS spreads should absolutely not be quoted as a meaningful guide to market sentiment about Morgan Stanley's creditworthiness, or the creditworthiness of any bank, or any company, or any thing at all, actually.

A Federal Reserve study out this week showed that even the most active corporate CDS, such as those on bellwether companies like General Electric, are traded just 20 times a day on average. This is a highly illiquid market, that can be moved sharply by a single trade, unlike stock or bond prices that trade constantly and can legitimately be cited as a guide to what is going on.

So whenever you read that such-and-such a company's creditworthiness has been called into question, check whether the source for that comment is the spread on its CDS. If it is, you can discount it.

Confidence in banks is a fragile thing, and there are terrors enough in the financial system at the moment. We could do without spooking ourselves unnecessarily.