Morgan Stanley’s risk taking

By Felix Salmon
July 22, 2009

The NYT’s Graham Bowley comes out and says it in his report on Morgan Stanley’s weak earnings today:

The results were in sharp contrast to rivals Goldman Sachs and JPMorgan Chase, which both reported strong second-quarter profits last week. Those two banks in particular have rebounded more quickly, mostly by taking on more risk in trading for themselves and their customers. But Morgan Stanley, which was burned more severely by the crisis, has moved to reduce its risk taking and try to build a stable, less volatile firm.

While analysts say the approach may pay off in the long run, for now Morgan’s losses are raising questions about the strategy being pursued by its chief executive, John J. Mack.

This seems clear: Goldman Sachs is making money because it’s “taking on more risk”; Morgan Stanley is losing money because it “has moved to reduce its risk taking”. What’s more, anonymous analysts seem to think that the take-less-risk approach is a good idea.

But:

graph.jpg

Clearly there are limits to reducing risk-taking. And if you use the purest indicator of risk-taking that Morgan Stanley reports quarterly, it’s going up, quite fast, not down. (From $105 million to $154 million in five quarters is a 36% annualized growth rate.)

So how come Morgan Stanley is so weak while Goldman Sachs is so strong? It’s very unclear to me.

10 comments

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Isn’t Stanley Morgan still a bank? It’s hard to keep up with these categorizations of convenience.

Posted by Blurtman | Report as abusive

Felix, it’s possible because reported VaR is utterly meaningless, and I don’t mean in the Taleb sense.

VaR is not calculated continuously; it’s at a certain time of day, usually the tail end (it can be done overnight in time for execs to see it the following morning). So what this might mean is that MS is taking on “more risk” with whatever positions it holds overnight. But it gives us no sense of what banks are doing during the day.

Posted by DaveS | Report as abusive

“So how come Morgan Stanley is so weak while Goldman Sachs is so strong? It’s very unclear to me.”

Fortunately for your readers, that’ll be no reason for you to stop slandering Goldman.

Posted by Eagle | Report as abusive

If vol goes up by a factor of two and you reduce your assets to equity by 25%, your VaR is up 50%. True tail risk as a multiple of the volatility measured in these calculations has surely gone down — even if the real tail risk is comparable to, or a bit higher than, it was last year, it hasn’t gone up as much as these measures have — so a theoretical, Platonic measure of risk would probably give a decrease so long as VaR hasn’t gone up too quickly.

The worst thing a company can to is to OVERREACT and has its strategy swings around like a pendulum. That’s what happened to Morgan Stanley, they overreacted and went the other extreme. I have friends in both GS and JPM, and they’re telling me that you don’t have to take too much risk to make a lot of money these days. They are actually taking less risk to make more money. VaR can be misleading, so I was told.

Posted by 20yrinvestor | Report as abusive

Along the same lines as dWj, the math behind VaR also depends on the correlation between asset classes. Even without knowing their exact models, I think it is a fair guess that as correlations in general have converged in the last year, the correlations used to calculate VaR for these firms are significantly closer to 1 then in previous years. So a firm could own a smaller basket of assets but have a higher VaR. I would also guess that it is more difficult to find creditable counterparties for derivatives that might lower your VaR. Finally, the greatly widened spreads in the credit markets, while a positive for the dealers profits, will increase the volatility calculation for those assets and thus raise VaR. While I do not dismiss VaR as measure of the risk a company is taking, I do not think it should be the only measure.

Felix

I think you need to take a primer on what VaR is and how it’s calculated. Not that I know that much, but as far as I recall:

a) VaR is measured by putting current positions (I defer to DaveS and others on when they’re booked) vs historical data – so the more volatile the markets were in the underlying set of historical data, the higher VaR will be. So, given how volatile the last two years have been, it’s entirely possible that current capital deployed has dropped even as value at risk has increased.

b) VaR is a statement of how much money can be lost. It doesn’t measure the potential positive return on the capital being put at risk.

In other words, VaR is pretty much useless for the analysis you’re trying to do.

Posted by Murray | Report as abusive

Morgan Stanley didn’t actually lose money though.

From the NY Times article:

“It also reported $2.3 billion in losses tied to the way banks must account for their debts. Banks record losses as their credit spreads improve, because they are deemed more likely to pay off all their debt. As executives at Morgan Stanley and other banks point out, this is actually a sign that the financial industry is returning to health. But Morgan Stanley executives said their bank was suffering most from this accounting rule because the bank’s spreads were among those that ballooned most during the crisis.”

That “loss” accounts for more than their total net loss; however, it isn’t a real loss because it does not in any way imply that Morgan Stanley now owes its debtors any more money than before. It still strikes me as odd to claim profits/losses from the changing value of one’s own debt as the only way such profits/losses could ever be realized is if the company were to default. Apparently, they are all required to do this under current rules.

There’s an Excel spreadsheet to calculate Value at Risk at http://optimizeyourportfolio.blogspot.co m/2011/06/calculating-value-at-risk-in-e xcel.html together with a discussion of this techniques limitations.

Posted by FredDinnage | Report as abusive

Perhaps the modified value at risk would be a better way of measuring risk. See http://investexcel.net/223/modified-valu e-at-risk/

Posted by RajeshPandai | Report as abusive