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                 BEST OF DOUG NOLAND

…..Morgan Stanley’s bombshell. "During the fourth quarter, the firm recognized a total of $9.4 billion in mortgage related writedowns as a result of the continued deterioration and lack of liquidity in the market for subprime and other mortgage related securities since August 2007. Of this total, $7.8 billion represents writedowns of the firm’s U.S. subprime trading positions…"

Morgan Stanley’s CFO: "As you are aware, over the past year our trading group decided to short the subprime market. The traders were short the lowest tranche of the subprime securities with a notional value of approximately $2.0bn. The traders decided to cover the cost of the negative carry in the short position. To do so they went long approximately $14bn of the super senior AAA or BBB subprime securities we refer to as mezzanine. As the Credit markets declined dramatically, the implied cumulative losses in the subprime market "ate" (unclear) into the value of the super senior AAA tranche we were notionally long. As a result, not withstanding the short position, the implied losses of the notional long generated a major net loss when the position was marked-to-market. The loss was non-linear with the decline of the relevant ABS index, given the long/short structure of this particular trade."

Analyst question: "I know everyone is dancing around it, but I guess my question would be to help us understand how this could happen – that you could take this large of a loss? I would imagine that you have position limits and risk limits, as such. It behooves me to think that you guys could have one desk that could lose $8 billion?"

CFO: "Look, let’s be clear. One, this trade was recognized and entered into our accounts. Two, it was entered into our risk management system. It is very simple – it’s simple and very painful. So I’m not being glib. When these guys stress-lossed (tested) the scenario on putting on this position, they did not envisage in their stress losses that we could have this degree of defaults, right? It is fair to say that our risk management division did not stress those losses as well. It is as simple as that. There was a big fat tail risk that caught us hard, right? That’s what happened. Now, with hindsight, can you catch these things? We are not unique being long these positions, right? What is unique is that this was a trade that was put on as a proprietary trade and we have learned a very expensive and, by the way, humbling lesson."

Morgan Stanley’s stock was up 8% for the week, despite reporting the first loss in its 72 year history. Investors were apparently comforted with the news of a $5bn equity infusion from the China Investment Corporation (controlled by the Chinese Finance Ministry).

The marketplace should be petrified with the revelation of an $8bn loss on a single trade that was not "rogue" - nor did it apparently even circumvent risk management processes. Instead, it appears to be a "simple" case of a devastating failure in the models used to structure a highly leveraged "hedged" trade. At the heart of the issue were illiquidity and a collapse in the value of a leveraged position, in a development that is very much systemic in nature. As the CFO stated, the company is "not unique being long these positions." Morgan Stanley is quite fortunate that they do retain a strong global franchise in what remains a period of extraordinary Global Credit Bubble excess. They still enjoy the capacity to plug part of the hole in their equity base…..

Morgan Stanley’s CFO stated that the company was caught hard by "big fat tail risk." I don’t believe it was a case of "tail risk" at all. Devastating illiquidity and market losses were inevitable, only the timing was unclear. Broker/Dealer assets ballooned 140% in just four and one-half years to $3.2 TN. During this same period, the asset-backed securities market (including "private-label" MBS) inflated 120% to almost $4.3 TN. Myriad sophisticated structures, financial guarantees, liquidity agreements, and leveraging strategies were implemented to perpetuate the greatest financial Bubble in history. As with all great schemes of leveraged speculation, the minute the music stops collapse ensues. Underlying Acute Fragility is exposed with the inevitable reversal of speculative and leverage-based market liquidity.

To keep the music playing required increasingly egregious excesses – ever greater quantities of increasingly risky loans, structures and leveraging. The Credit Insurers came to play a critical role in perpetuating the Bubble. They could not resist the allure of easy "profits" insuring Wall Street’s creative "structured Credit products," while at the same time aggressively expanding their traditional guarantee business at the top of a Historic Credit Cycle. The Credit insurers destroyed themselves.

We expect further significant and imminent weakness in "structured Credit products" – certainly in the illiquid markets for CDOs and Credit default swaps (CDS). Keep in mind that the economy is only now succumbing to recessionary forces, and we’ve yet to experience the failure of a major financial institution in the U.S. There will be many, and it’s worth noting that Rescap’s CDS prices surged again this week. It’s amazing to watch the massive central bank liquidity injections inflate the value of government and quasi-government backed securities, while having minimal impact on the imploding market for Wall Street-backed securities. It’s impossible to rectify the damage from the bursting Bubble, and there’s today literally trillions of increasingly impaired Wall Street securities overhanging the debt markets.

Doug Noland is a market strategist at Prudent Bear Funds. Their website is www.prudentbear.com.