I very much enjoyed this Morgan Stanley electric shenanigans case that settled yesterday. According to the complaint, this happened:

  • KeySpan, an electric generator, realized that prices for electric generation would be going down as more capacity came online.
  • It decided to keep up prices by cutting back its own generation.
  • But that’s dumb, because then it wouldn’t be able to sell much electricity at the high prices, which would mainly benefit its competitors.
  • So it decided to buy its main competitor, cut back generation, but still sell plenty of electricity at high prices.
  • But it “concluded that its acquisition of its largest competitor would raise serious market power issues” and so would raise problems with antitrust and electric grid regulators.
  • So it said “aha, a swap!”
  • And it synthetically acquired the capacity of its largest competitor (Astoria Generating) by entering into a swap with Morgan Stanley where it effectively bought that capacity at $7.57 a kilowatt-month.
  • And Morgan Stanley hedged that trade by entering into a swap where it effectively bought the capacity from Astoria at $7.07 a kilowatt-month.
  • Attentive readers will note that that’s a $0.50 difference, so Morgan Stanley made $0.50 per kW-month for about three years, for total revenue of around $21.6mm.*

So what do you make of it? The complaint sounds terrible, but then it would, and Morgan Stanley isn’t talking (and not admitting or denying etc. etc.), so we’ve only got one side of the story and maybe it’s exaggerated. But if you believe the complaint then everyone at KeySpan and Morgan Stanley knew that they were structuring this deal to get around antitrust requirements that they knew would make it impossible for KeySpan to buy Astoria directly. That’s certainly one possibility – everyone was as criminal as criminal can be – and, yeah, sure, probably, though the relatively low-dollar-value settlement might suggest otherwise.

But I like imagining the other possibilities in which someone was taking advantage of someone else’s naïveté. I think there are two of these. In one, Morgan Stanley is taking advantage of KeySpan’s ignorance of how swaps work: Morgan Stanley offers to sell KeySpan synthetic electricity at $7.57, without discussing where it’s getting its synthetic electricity from. KeySpan is willing to pay, and never thinks to ask about Morgan Stanley’s ability to generate synthetic electricity. Morgan Stanley, meanwhile, sources its synthetic electrons elsewhere much more cheaply, without bothering KeySpan with that information, and clips like $22mm on a $490mm notional contract, which is a lot.**

This scenario seems to be untrue – the complaint has lots of specific allegations about how the swap started with KeySpan’s idea of actually buying Astoria’s physical generating assets, everyone knew there were back-to-back contracts with Astoria, etc. But it’s interesting to me, first of all, because it seems to be true everywhere else in swap anger-land. We’ve talked about swap fury in Oakland and Strats and Abacus, and the anger there was generated in large part by swap customers not fully internalizing that their dealer counterparties had offsetting swaps.*** And it could apply here: “Sure, I was buying electricity synthetically from Morgan Stanley, but I had no idea they were buying synthetic electricity elsewhere to give to me. I assumed they had a synthetic electricity generator.”

And if it was true, would it be illegal? It so happens that here KeySpan effectively acquired its largest competitor synthetically, but what if Morgan Stanley had just made a naked bet on electricity prices and written KeySpan this swap without hedging it? The result would have been the same – KeySpan would have no incentive to bid its capacity aggressively and so electricity prices would have stayed high – but the antitrust case seems weaker. (Does it?****) And if that would be okay, what if Morgan Stanley was actually hedging by, say, buying synthetic electricity in some other market with correlated prices? Or, even, by buying synthetic electricity from Astoria without KeySpan knowing about it?

I dunno. The other naïveté scenario is one in which KeySpan took advantage of Morgan Stanley. This one sounds even sillier but I think it’s probably true. If you go to your investment banker and say “hey, we’d like to acquire our largest competitor,” they pull out their M&A checklist and their checklist has things like “talk to antitrust lawyer and get antitrust approvals.” If you go to them and say “hey, we’d like to do a swap,” they pull out their swaps guy, and the swaps guy has his own checklist, and that checklist doesn’t usually have antitrust lawyers. And perhaps, if you are a conniving executive looking to get the benefits of an illegal merger, you know that: and so you don’t go to M&A bankers, you go to swaps bankers.

Of course, after this case, the swaps checklist will include a “consult antitrust lawyers” item. Maybe. Lots of people have complained about this settlement that it’s pretty wrist-slappy, given that it’s only 22% of the amount that Morgan Stanley made on the swap. If Morgan Stanley had consulted antitrust lawyers they might have suggested not doing this trade – but it turns out that doing this trade and getting caught was better for Morgan Stanley than not doing this trade. And now they know it. If I were selling derivatives, after this, I might start looking around for other desirable-but-illegal mergers, and trying to replicate them synthetically.

Federal Judge Grudgingly Approves Morgan Stanley Price-Fixing Case [DealBook]
U.S. v. Morgan Stanley [SDNY]

* You can math you some math but it won’t work. The contracted swap capacity was 1800 MW and it ran for 3 years, $0.50 x 1,000 [kW in a MW] x 1,800 [MWs in the contract] x 36 [months in the contract] = $32.4mm, whatever.

** That is surely a dumb way to measure “notional.” $7.57 x (all the other numbers above). $13.6mm of “monthly notional”? I dunno. The point is, MS made 6.6% on this thing, which is high for a risk-free thing.

*** “What do you mean John Paulson was betting against these mortgages you were [synthetically] selling me?” “What do you mean you can’t tear up our Libor swap at below market value?” “What do you mean my collared swapped-to-floating bank trust preferred unwinds at below par?”

**** DOES IT? Everything I know about antitrust law could fit in this footnote. Here is the statute that Morgan Stanley neither admits nor denies violating.

Comments (36)

  1. Posted by Guest | August 8, 2012 at 5:23 PM

    You don't understand capacity markets in electricity. This is a credit sleeve. No market manipulation. Go back to studying for the CFA.

  2. Posted by Super Swaps Banker | August 8, 2012 at 5:24 PM

    Matt, if asked what super power you would most want to have, would your answer have something to do with an ability to get around pesky federal laws via derivative instruments?

  3. Posted by Guest | August 8, 2012 at 5:28 PM

    WaWaWeWa

    Very Nize Matt!

  4. Posted by Sleeveless Steve | August 8, 2012 at 5:28 PM

    Wizard Sleeve > Credit Sleeve?

  5. Posted by Guest | August 8, 2012 at 5:30 PM

    "You can math you some math but it won’t work"

    Suck on that math geeks. Degree in liberal arts > degree in math.

  6. Posted by Texashedge | August 8, 2012 at 5:42 PM

    This is not a credit sleeve, son.

    A credit sleeve is when you want to put debt on a power plant or SPV holding multiple power plants–and therefore need fixed capacity payments to service the fixed interest and amortization schedule–but the creditor doesn't trust the power buyer to come through on all of said payments over x number of years, which makes sense because power buyers generally have shit credit.

    So the creditor demands that a more credit worthy counterparty like Morgan Stanley (haha!) takes on the power capacity and then sells it down to the buyer, taking a spread roughly equal to the PV of the credit risk of the counterparty spread evenly over x number of years. The point being that MS is obligated to pay the generator, which waterfalls down to the creditor (sometimes the sleeve and creditor are the same entity)

    BUT, the reason why this isn't a credit sleeve is that here KeySpan, a generator, is buying capacity from another generator. There is almost no scenario under which they'd need a sleeve for this. In fact, it's kind of a Texas hedge (hey!) for Key Span since they own a power asset and are now separately long power. Said non-hedges are not generally conducive to raising debt or the concomitant sleeves debt would require.

    And if it's Astoria demanding the sleeve from Key Span, then it's a blatant anti-trust violation.

  7. Posted by zombUBS_MD | August 8, 2012 at 5:43 PM

    "aha, a swap!"…and in the same electricity charged instant:

    "I am alive! And ready to eat brains on a comedically limited budget."

    - Guest who's seen earlier threads this week and knew there was an orgin story waiting in the wings somewhere…

  8. Posted by matt's intern | August 8, 2012 at 5:45 PM

    the probability of getting caught and what the fines and legal fees are likely to be are included in the analysis of whether to undertake the project / do the trade. does not suprise me that msco fared better by doing the trade and getting caught than not doing the trade at all. they likely expected to get caught. feds don't understand incentives, you know what i mean? like why doesn't msco have to divorce themselves of the profits altogether? if it's illegal, that is, heck, maybe it isn't, maybe it was just a government shakedown. maybe it was only synthetically illegal. and 449 bps on the notional is not a bad haul at all, as you pointed out (350 bps by my calculations post-settlement, although that's pre-tax and i don't think you can write off legal fines as an expense, but i'm pretty sure you can write of legal fees – so by the end of the day, we can maybe ballpark this deal at 200 bps – worst case – for pretty much doing absolutely nothing and maybe striking synthetic trading gold).

  9. Posted by Guest | August 8, 2012 at 5:54 PM

    I realize that selling electrical generating capacity is subject to transmission limitations in some areas, but $160 million per year of electricity purchases seems like a small amount of capacity to be able to corner a market.

  10. Posted by Guest | August 8, 2012 at 5:55 PM

    I see Matt hasn't finished the capitalization training session yet

  11. Posted by _guest | August 8, 2012 at 6:14 PM

    "And it synthetically acquired the capacity of its largest competitor (Astoria Generating) by entering into a swap with Morgan Stanley where it effectively bought that capacity at $7.57 a kilowatt-month."

    I'm assuming that KeySpan reviewed its operations and financial structure and was satisfied it did all the could do before pursuing this option, because that would be what a company would normally do in the face of market changes…

  12. Posted by URBS Energy MD | August 8, 2012 at 6:14 PM

    No idea what this means, but between making it through a Matt post, and then this whole comment, I am absolutely knackered.

    -Guy whose bad jokes needed to merge with his uninventive handle in order to survive.

  13. Posted by Winston | August 8, 2012 at 6:24 PM

    When someone asks if you're a god, you say YES

  14. Posted by Jim Cramer | August 8, 2012 at 6:44 PM

    Hey guys! Jim Cramer here again, at the old hedge fund we used to run into this issue where the pesky equity research team wouldn't agree with our options traders… so one day I got so annoyed at the ER people that I walked up to them and with uncontrollable rage proclaimed, B-B-B-B-B-B-B-B-B-B-B-B-B-B-B-B-B-B….BOOOOOOOOYAAAAAAAAAAAAAAA SKEEEEEEEEEEEEE DADDYYYYYYYYYYYYY and they shut up after that

  15. Posted by D.O.U.G. | August 8, 2012 at 6:46 PM

    According to the complaint, in January 2006, KeySpan and Morgan executed a financial derivative for New York City capacity while Morgan simultaneously entered into an off-setting derivative with Astoria Generating Company, KeySpan’s largest competitor in the capacity market. The agreements effectively transferred to KeySpan a financial interest in Astoria’s capacity, thereby ensuring that KeySpan would withhold substantial output from the capacity market and increase prices.

    For its part, Morgan earned revenues by retaining the spread between the fixed prices of the two derivative agreements. The anticompetitive effects of the Morgan / KeySpan agreement lasted until March 2008, when regulatory conditions eliminated KeySpan’s ability to affect the market price of electricity capacity.

    New York City’s electricity generating capacity market was created to ensure that sufficient generation capacity exists to meet expected electricity needs. Electricity retailers serving consumers in the city are required to purchase capacity from generators in amounts related to their expected peak energy demand. Electricity generators offer to sell their capacity to electricity retailers in regularly held auctions.

    This is not a credit sleeve.

    The lack of steel in Zone J is the main issue. Unless Morgan was planning to build or upgrade transmission before the commencement of the swap, they had basically a zero chance of backing this trade. Since this trade has concluded, additional ATC has been built (Neptune and GE's VFT among others). The only REASONABLE place to get the steel and the electrons was clearly Astoria and that meant that too much control (based on NYISO standards) would be in the hands of one generator. Since the NYISO backbone can not bring down enough power from upstate, this created market power issues.

    The real issue is controlled capacity during an N+1 at peak event versus available capacity including imports. FirstEnergy just did roughly the same thing this year as well.

    In regards to the difference in cash flows of the swaps, one possibility is that the Astoria contract was UC and the other deal was Firm LD. That mismatch may have left Morgan short if Astoria tripped.

    I enjoy reading your articles Matt. Keep them coming.

    –D.O.U.G.

  16. Posted by Texas Aggie Gas Pro | August 8, 2012 at 8:03 PM

    Jesus! Just buy the electricity and fucking store it! What is wrong with these electricity trading dumbasses?

  17. Posted by Texashedge | August 8, 2012 at 8:40 PM

    Exactly

  18. Posted by JT Marlin Trader | August 8, 2012 at 9:15 PM

    It's not just electricity, it's all these fucking derivative trading assholes who probably can't get a damn hard on without an 85 slide power point to explain it. just Buy. The. Fucking. Dip.

  19. Posted by Tseug | August 8, 2012 at 9:38 PM

    I keep coming back here looking for G.O.T.'s insight . . .

  20. Posted by G.O.T. Fan | August 8, 2012 at 9:49 PM

    Indeed, his wisdom is missed. In the present situation I highly doubt a man of such wealth and taste would resort to this pussy footing around with swaps and whatnot. More likely a plan involving Atoria's CEO, a strip club, a half gallon of bourbon, some power tools and the Aggie intern taking a long drive in the woods with a shovel

  21. Posted by D.O.U.G | August 9, 2012 at 6:57 AM

    Well done sir. That pumped storage in State Island should get more work

    D.O.U.G.

  22. Posted by Die already | August 9, 2012 at 7:09 AM

    Might be time to retire the weak Jim Cramer jokes…

  23. Posted by Guest | August 9, 2012 at 9:11 AM

    i liked it, cheers Matt

  24. Posted by Mancrush | August 9, 2012 at 9:14 AM

    Matt! Matt! Matt! The "lamestream" financial press…it is no good. They are…a…like…a…the sheep.

  25. Posted by Thurgood Jenkins | August 9, 2012 at 9:39 AM

    this is the first time that i've read a matt post and was more confused by the comments than the post

    - guy not sure if matt is becoming clearer and more coherent or if i am still high

  26. Posted by Balls Mahoney | August 9, 2012 at 9:45 AM

    I read through this entire post twice and still see no mention of Wizard Sleeve.

  27. Posted by Matt | August 9, 2012 at 11:25 AM

    No. Soviet Russia!

  28. Posted by Guest | August 9, 2012 at 12:11 PM

    No means yes, yes means…

  29. Posted by L Filerman | August 9, 2012 at 12:20 PM

    Yep – agreed.

    - Guy who sidled in and wished he understood

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