Managing clients’ interest rate risk was the over-riding challenge for investment banks in 1999, as liquidity all but dried up. Morgan Stanley Dean Witter rose to that challenge, and for that reason wins not only our Interest Rates Derivatives House of the Year award, but also our overall award for OTC derivatives providers: Derivatives House of the Year

In a year that saw rapid changes across the capital markets, the fixed-income derivatives business was particularly challenging. At the start of 1999, the markets were still shell shocked by the crises of the previous year. But they bounced back, riding on a record wave of European mergers and an equally breathtaking boom in US technology investment. Such activity needed to be financed, and the debt markets – especially in the new-born euro-denominated bond markets – surged in response.

But here’s the paradox. Many well-known fixed-income derivatives powerhouses turned in a less-than-salutary performance in 1999. Several of the major investment banks appeared to have run out of ideas. Others had dismissed some of their best staff in an over-reaction to the 1998 crisis.

However, the main problem for the fixed-income derivatives community was its failure to understand the real implications of that dramatic year. The amount of liquidity provided by fixed-income arbitrage activity has declined dramatically over the past 18 months – by around 90%, according to the estimates of some market participants. Firms such as Goldman Sachs and Salomon Smith Barney, which once used their arbitrage capability to provide aggressive pricing for customers, spent this year closing their internal hedge funds down, or spinning them off into investor-funded entities.

The result? The interbank market in swaps and options has become an increasingly treacherous place to do business. Liquidity, taken for granted by traditional pricing models, vanishes without warning. Many firms discovered this the hard way when they tried to hedge in the sterling market during the summer. Some hope that John Meriwether’s new Relative Value Opportunity fund will bring back the old days, but they are probably misguided – the smart money is now chasing the credit market, which plays according to different rules.

Traditionally, derivatives dealers and brokers focus on price, and Risk’s interbank rankings, which are compiled every September from a poll of dealers, recognise this. Recent winners in swaps such as Deutsche Bank compete in many markets purely on a price basis. Others, such as Chase Manhattan have built up strength over the years largely by concentrating on shorter maturity, lower-risk business.

Excellence in fixed-income derivatives demands something more – an ability to handle risk with confidence. If offloading risk to arbitrage traders is no longer a possibility, then risk must be treated more as a commodity. And as any dealer in the precious metals market will tell you, building up large stocks of a commodity can be dangerous. The trick is to keep your books (fairly) flat while giving the customers what they want.

Morgan Stanley Dean Witter (MSDW) is the firm that has most clearly demonstrated this capability. Not only has MSDW demonstrably kept clear of many of the risk pitfalls that have snared its competitors, but it is also a popular firm among a variety of end-users, many of which attest to its creativity.

One example is Virginia-based US mortgage agency Freddie Mac, which issued more than $100 billion of mortgage-backed bonds in 1999. The agency is a large user of interest rate swaps and swaptions, and has recently engaged MSDW to hedge its $53 billion reference note debt programme. According to Louise Herrle, managing director of trading and hedging at Freddie Mac: “Morgan Stanley has done a great job. We often trade multiple-billion notional swaps over a period of weeks, and are very execution sensitive. Morgan Stanley is proactive; they have a well co-ordinated team and are very good at articulating hedging strategies.”

Another satisfied customer is New York-based Moore Capital Management, a macro-style fixed-income hedge fund with more than $6 billion under management, which trades at a high volume in the shorter-dated swaps market. According to the fund’s head of trading, Chris Pia: “During 1999, Morgan Stanley went from being our seventh-largest dealer to third. While they don’t compete so much on price, they’re very good at customer relations. They also have a savvy credit facility that recognises our liquidity and doesn’t penalise us with haircuts.”

The global head of MSDW’s derivatives product group, George James, says: “We try to have a strategic dialogue with all our customers. We try to keep them appraised of how we see the market developing, and try and get feedback from them in terms of what their problems are. The firm then tries to provide integrated solutions, whether cash sales, cash purchases, derivatives sales, or whatever. The dialogue allows us to spot changes in the market and help customers capitalise on that.”

An example of where MSDW appears to have foreseen US market developments correctly is in the use of dollar swaps by investment managers as a proxy for credit spreads. As James points out, credit spread volatility in the wake of the 1998 crisis forced dealers to reduce positions, yet an “investor strike” against buying corporate bonds during the summer of 1999 further reduced liquidity. “People are looking much more at the plain-vanilla interest rate swap as a means of hedging credit spread exposure,” James says.

Not only does MSDW have the ideas but, crucially, it also has breadth of expertise that makes creativity possible. More than any other big player in fixed income, it appears to have successfully integrated derivatives into its wider business activity, including investment banking. James says: “What differentiates MSDW’s approach from those of our competitors is a very centralised approach to all the uses of derivatives, as well as trading the basic products.”

One suggestion of how this works in practice comes from US restaurant giant McDonald’s. According to assistant treasurer Karen Leets: “Morgan Stanley takes the time to understand our company’s needs before proposing solutions. We have worked with them on a variety of structured financings and strategic liability management transactions. They are especially innovative and focused on integrating derivatives into financing and investment structures.”

One product that McDonald’s purchased from MSDW was the REPS (reset puttable securities), a type of synthetic puttable bond. When the US Financial Accounting Standards Board (FASB) changed the accounting rules that made such synthetic instruments attractive for hedging purposes, James’s team quickly developed a FASB-compliant version of the product.

But it is perhaps in Europe that MSDW’s creative approach has shown the most promise. While the firm is a large player in the euro debt markets, and underwrote Elf Aquitaine’s E18 billion acquisition of Total, the best example comes from the sterling market.

As Risk reported in December, MSDW showed itself to be one of the sterling swaption market’s biggest players with a bold £1.06 billion 40-year supranational medium-term note (MTN) issue privately placed in July 1999 as a guaranteed annuity hedge for its advisory client, the life company Scottish Widows. (MSDW has steadfastly refused to name this client; Risk learned about it from other sources). Given that shortly after this transaction, turmoil in the long-dated sterling swaps market led to severe losses for a number of dealers, how did MSDW escape the carnage?

A dealer at a leading German house claims that the swaption exposure embedded in these MTNs lost MSDW some $50 million. According to MSDW’s European head of fixed-income derivatives, Jonathan Chenevix-Trench: “I can categorically deny that. Less than 5% of that deal was hedged in the interbank market.” As he explains, MSDW kept out of trouble by using its securitisation desk to lay off the swaption risk in a clever way.

Chenevix-Trench cites some interesting principal finance and property securitisations transacted by MSDW as among his highlights of 1999. In May, the firm did a £1.54 billion deal for the British Land Company (which owns the property occupied by Lehman Brothers and several other investment banks), using a financing vehicle called Broadgate. The assets backing this issue were fixed-rate mortgages.

Of the various tranches involved, £680 million were issued as floating-rate notes with maturities ranging from 15 to 32 years. Behind the scenes, MSDW had transacted a swap with Broadgate, and thus received long-dated fixed rate sterling swap payments in size. These payments could be passed on to Scottish Widows as coupon payments on the MTN. Another significant long-dated sterling floating-rate note issued this year by MSDW was an £82 million pub securitisation for Alehouse Finance; a number of other transactions have not been disclosed.

While these interlocking deals are a showcase of integrated derivatives trading, debt syndication and investment banking, an equally important lesson lies in the superior risk management. By not being periodically stretchered out of the markets, like so many other derivatives houses, MSDW sends a strong message to clients.

Chenevix-Trench says: “During the turmoil surrounding Russia and Long-Term Capital Management, we were one of the few firms who could carry on making prices, especially in derivatives. That gave us an enormous amount of leverage this year when we could go back and pitch for more business – we are going to hang in there, because the firm is better managed.”

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