Excerpted from report by Gillian Tett of The Financial Times:

As the financial crisis virus has swept around the globe in recent months, Kazakhstan's banking sector has been engulfed in turmoil. This is not just creating a headache for the Kazakh government and Western creditors, but also highlighting issues about the credit derivatives market that extend well beyond those far-flung steppes.

Take the case of Morgan Stanley's dealings with BTA, Kazakhstan's largest bank. A few years ago, BTA - like many of its Eastern brethren - was an up-and-coming darling of the capital markets world, with investment bankers furiously competing to float its bonds, provide loans, and much else.

But earlier this year, when funding dried up for Kazakh banks, BTA fell under the control of the government. Initially BTA wanted to keep servicing its loans, and its creditors, such as Morgan Stanley, appeared happy to play along.

But last week Morgan Stanley and another bank suddenly demanded repayment. BTA was unable to comply, and thus tipped into partial default. That sparked fury among some other creditors, and shocked some Kazakhs, who wondered why Morgan Stanley would have taken an action that seemed likely to create losses.

One clue to the US bank's motives, though, can be seen on the official website of the International Swaps and Derivatives Association. One page reveals that just after calling in the loan, Morgan Stanley also asked ISDA to start formal proceedings to settle credit default swaps contracts written on BTA.

For it transpires that while the US bank has a loan to BTA it also has a big CDS position on BTA, that pays out if - and only if - the Kazakh bank goes into default. Indeed, some of Morgan Stanley's rivals suspect that notwithstanding its loan, Morgan Stanley is actually net short the Kazakh bank.

As a result speculation is rife that Morgan might have deliberately provoked the default of BTA to profit on its CDS, since a default makes the US bank a net winner, not a loser as logic might suggest.

Morgan Stanley, for its part, refuses to comment on this speculation (although its officials note that the bank does not generally take active "short" positions in its clients.) And I personally have no way of knowing whether Morgan is short or long, since Morgan refuses to disclose details of its CDS holding.

What is crystal clear is that somebody has been placing big bets on whether or not the banking equivalent of Borat will blow up.

 

There is more so please read the whole report.  Also, Willem Buiter comments on some wider implications  of the "nasty case of moral hazard" created when CDSs can be written without any insurable interest and provides a bit of information on the attempts of foreign  creditors to get the Kazakh  government to guarantee their unsecured loans with oil and gas revenues.

Open questions are who is on the hook for those CDS that Morgan wants settled and whether or not BAT is free of the defaulted debt or just has a new creditor -- maybe US through AIG.  What are the foreign policy implications of that?