Morgan Stanley a good bet until Wall Street's next crisis
The China Investment Corp's purchase of a US$5 billion stake in ailing Wall Street giant Morgan Stanley is the new state-run fund's biggest overseas investment yet. And considering the lamentable performance of its stake in Blackstone Group - now 20 per cent below its purchase price - it is also the boldest.
Still, the flak CIC's managers have taken over the Blackstone deal has not put them off buying into the US financial sector. Clearly they think Morgan Stanley is a better proposition.
For one thing, they bought Blackstone at the very top of the market, before the current credit squeeze took hold. They have reason to hope they are buying Morgan Stanley at the bottom.
Between its mid-July high and Tuesday's close before the deal was announced, the investment bank's share price had fallen 34 per cent. Now, with most of the US bank's subprime mortgage exposure eliminated by its US$9.4 billion fourth quarter write-down, CIC's bosses probably think they are getting a bargain.
Even so, they have taken good care to avoid the sort of criticism they came in for over Blackstone. Rather than buy Morgan Stanley shares straight away, CIC is buying bonds that will convert into equity in August 2010 and carry a 9 per cent annual yield in the meantime.
The bonds' yield is something of an artful illusion. On conversion, CIC will have to buy Morgan Stanley stock at a 20 per cent premium to a fixed reference price. Assuming the reference price is close to Tuesday's close of US$48.07, the 20 per cent premium will effectively wipe out CIC's income from the bonds.
Nevertheless, the deal's structure ensures CIC earns a decent initial return and that it suffers no embarrassing short-term losses should more bad news emerge or should the US market slide if the economy sinks into recession next year.
Whether Morgan Stanley proves a good longer-term investment is debatable. Its chairman, John Mack, dismissed its huge fourth-quarter write-down of US$9.4 billion - more, incidentally, than Washington's foreign development budget for this year - as the result of 'isolated losses by a small trading team in one part of the firm'.
His statement exposes the ingrained hubris of investment banking's management culture, while losses of such magnitude illustrate the deep flaws in Wall Street's businesses model.
In recent years, investment banks have made much of their profit from proprietary trading; literally betting the bank in financial markets. The problem is that the statistical models they use to manage risk simply are not up to the job.
Their reliance on past data means they fail accurately to predict the chances of sudden bouts of extreme volatility, gulling traders into taking ever greater risks when markets are calm. As one risk manager puts it: 'We've had four 'once-in-a-hundred-year' events in the last 10 years.'
Even worse, the banks' reliance on similar models mean they all head for the exits simultaneously when something does go wrong, exaggerating the severity of any financial crisis.
And Wall Street's chieftains appear remarkably complacent about the dangers. If they did not reform in response to the Asian crisis, Long-Term Capital Management or the dotcom bust, there is little reason to believe they will change their ways this time. Shareholders in investment banks will face the same risks in the future.
CIC is likely to do well out of Morgan Stanley in the medium term. Its holding will gain the investment bank a privileged position in China. It is hard, for example, to imagine Chinese regulators turning down the bank's application to form a joint venture with China Fortune Securities, now that Beijing is a shareholder. Equally, state mandates are bound to flow its way, now that the state itself stands to gain. Morgan Stanley's shares will benefit, at least until the next crisis.
Jake van der Kamp is on holiday