So Italy now has a new government, and all is well, right? Not so fast. Europe continues to teeter, and some of our banks are beginning to worry, and investors would be wise to pay heed. Morgan Stanley announced its exposure to Euro zone debt, and its shares lost 9% last week.
With the demise of MF Global Holdings Ltd., investors want to know not only the extent of exposure to risky European debt, but also the nature of exposure through hedges. Before the market meltdown, investors assumed that hedges, implemented through credit default swaps, were a protection. As the old saying goes, "once burned, twice shy", and now they are savvier. Why? Because the companies on the other side of the hedge, known as counter parties, could be vulnerable, and the somewhat limited level of disclosure outside our country compounds the problem.
Even so, if Morgan Stanley is an example, investors are right to be wary. Morgan Stanley currently includes $1.9 billion of potential losses if the credit defaults fail in its $7.2 billion in gross exposure. Its share price reflects investor concern: down 26% since July 31, versus -11% for the S&P. It suggests that those hurt by the credit disaster 3 years ago have learned a valuable lesson.