When Morgan Stanley's Merger Bankers Say No, Its Derivatives Bankers Say Yes

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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.

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You can read the Jamie Dimon "Don't gloat about how bad Goldman is. Did you hear me? Don't gloat about how BAD GOLDMAN IS. The fact that GOLDMAN is BAD is of no interest to our clients. Or the press. Don't leak this to the press!" memo two ways. One is, y'know, what it sounds like: Dimon gets to score some easy/meta points by spreading it around that his business practices are so superior that he doesn't even need to spread it around that his business practices are superior. The other is that making money off of clients isn't something invented at Goldman Sachs and anyone at JPMorgan who throws stones is likely to be clonked on the forehead by a ricochet. (Or possibly by a deranged fictional whistleblower!*) The latter interpretation is probably right for James Gorman's more full-throated defense of Goldman because whoops: