Morgan Stanley's decision to take a short position in HBOS, whose £4bn rights issue it had underwritten, was cleared by City regulators yesterday.
The Financial Services Authority is satisfied that the decision to take the short position was made by the investment bank's trading desk entirely separately from the underwriting department, which had inside information about the performance of the issue. Morgan Stanley is said to have kept the watchdog informed of its intentions throughout the process.
The investment bank surprised the market on Monday by declaring a 2.35 per cent short position in HBOS taken out on Friday, the day the rights issue closed.
HBOS's shares had traded below the 275p rights price all morning but they jumped soon after the offer closed at 11am as short sellers started covering their positions. Better-than-expected results from Citigroup in the US added to demand for the shares as long investors sought exposure to the banking sector. The shares continued to rise, closing up 5 per cent at 282p.
Morgan Stanley's trading desk decided to sell shares it did not own to satisfy the demand, which might have evaporated by Monday if there had been bad news on the financial sector. The bank's trading desk also knew that Morgan Stanley was going to be on the hook for a large chunk of the £2.6bn of unsold HBOS stock.
The episode would not have come to light if the FSA had not introduced new rules forcing holders of short positions of more than 0.25 per cent in companies conducting rights issues to disclose their bets.
It was widely believed in the market that the issue had received a low take-up because HBOS shares had traded below the rights price in the crucial few days before the closing date. Barclays had revealed earlier on Friday that its offer of £4bn to existing shareholders had received a take-up of only 19 per cent.
The bank had not shorted HBOS's shares at any time during the rights issue process, despite being allowed to do so, though it shorted other banks as proxies to hedge its exposure.
Dresdner Kleinwort, the other underwriter of HBOS's rights issue, has not declared a short position in the bank
HBOS shares fell 1.3 per cent yesterday, in line with the sector, to close at 261p.