Negative Convexity at Morgan Stanley

Morgan Stanley was short subprime. Subprime went down. Morgan Stanley lost

$3.7 billion on the trade. How is that possible? Morgan Stanley’s CFO, Colm

Kelleher, explained

it thusly:

“We began with a short position in the subprime asset class, which

went right through to the first quarter; as the structure of this book had

big negative convexity and the markets continued to decline, our risk exposure

swung from short to flat to long.”

So, what is this "negative convexity" of which Kelleher speaks?

Eric Jardine says

that it means that "we started out perfectly hedged but have since gotten

long as markets have deteriorated," but that’s not entirely right: as Kelleher

says, the bank started out short, they were then briefly perfectly hedged, and

then they ended up long. I have a feeling that in fact Morgan Stanley was putting

on a trade which was much more complicated than the simple long-senior short-junior

play that Jardine hypothesizes.

Part of the problem is that "convexity", as a concept is not very

easy to understand. It’s basically about the relationship between price and

yield: as a bond’s price goes up, its yield goes down, and vice versa. But if

you draw a graph with price on one axis and yield on the other, you don’t get

a straight line, you get a curve. Convexity is basically a measure of the shape

of that curve.

With most bonds, there’s something called positive convexity, which is great

for investors. If you buy a Treasury bond at par, say, then your profit in the

event of a 50bp drop in yields is greater than your loss in the event of a 50bp

rise in yields. For any given move in interest rates, your upside is bigger

than your downside. Nice!

But of course in the world of ultra-sophisticated financial engineering, you

can create instruments which have so much negative convexity that the price

might start off moving in one direction as yields start moving, and then eventually

start moving in the other direction.

I have no idea what kind of trade Morgan Stanley got involved in. But essentially

they went short at a point on the price-yield curve which was so very, well,

curvy that their profits from falling prices soon turned into losses

from falling prices.

The people responsible for this trade have, we’re assured, been taken

out and shot. I guess now they understand how convexity can bit

you in the ass.

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