Morgan Stanley Capital Boost Wins No Respect From Moody’s
Regulators and investors have touted higher capital ratios as the path for banks to restore confidence. Morgan Stanley (MS), the best-capitalized Wall Street firm, is proving that’s not enough.
Morgan Stanley has the highest Tier 1 common ratio among the five largest U.S. investment banks, topping JPMorgan Chase & Co. (JPM), Bank of America Corp. (BAC), Citigroup Inc. (C) and Goldman Sachs Group Inc. (GS) Still, it faces the largest potential downgrade from Moody’s Investors Service, has the highest-priced credit-default swaps and trades at the biggest discount to liquidation value.
The firm’s underperformance highlights Chief Executive Officer James Gorman’s difficulty convincing investors that his is a different company than the one that borrowed more than $100 billion from the Federal Reserve to survive in 2008. Morgan Stanley also faces doubts after JPMorgan, the only U.S. bank with more credit-default swaps on its balance sheet, announced a $2 billion loss from derivatives trading.
“With the recent surprise with what happened at JPMorgan, we are all very skeptical of what’s on those balance sheets that we as outsiders can’t figure out,” said Charles Peabody, an analyst with Portales Partners LLC in New York, who has a neutral rating on the stock. “Morgan Stanley has not proven in recent history to be good risk managers.”
Gorman, 53, who has weathered a 53 percent stock-price plunge since taking over at the start of 2010, has sold businesses, added liquidity and vowed to increase the bank’s reliance on steadier wealth management, trying to assuage concerns that his firm is riskier than rivals. He’s also trying to convince Moody’s that Morgan Stanley doesn’t deserve the three-level cut the ratings company said it may make this month.
The maximum downgrade, which would be the largest among U.S. banks and place the firm’s rating two levels above junk, may raise borrowing costs and force Morgan Stanley to post more collateral on trades. It would also threaten a fixed-income trading turnaround as some counterparties wouldn’t be able to do derivatives deals with such a low-rated firm.
Morgan Stanley, owner of the world’s largest brokerage, had a ratio of Tier 1 common equity to risk-weighted assets of 13.3 percent as of March 31, using Basel 1 standards, the highest of the five banks. It also may have the highest ratio under not- yet-implemented Basel 3 rules. Chief Financial Officer Ruth Porat said in April the ratio would have been between 8 percent and 9 percent, depending on how the Fed assigns some risk weightings in rules it is writing.
That may put the bank above JPMorgan’s 8.2 percent Tier 1 common ratio and Goldman Sachs’s 8 percent. Bank of America and Citigroup have Basel 3 ratios below 7.5 percent.
Moody’s said in its downgrade of German banks this week that it also considers the ratio of equity to total assets in addition to risk-weighted regulatory measures. Morgan Stanley’s ratio was 8 percent at the end of the first quarter, double the 4 percent for German banks that Moody’s criticized as “thin.”
Morgan Stanley fell on June 4 to $12.36, the lowest closing price since Dec. 2, 2008. It’s trading at 51 percent of tangible book value, a measure of equity that excludes intangible assets such as goodwill, below Citigroup’s 53 percent and Bank of America’s 59 percent. That means investors value the New York- based bank at about half of what the company estimates would remain if it sold all assets and retired debt.
Gorman said last month that the share price was “inexplicable.” The stock climbed yesterday to $13.94, the biggest advance since Nov. 30.
“Capital doesn’t seem to be solving all the problems,” said Shannon Stemm, an analyst at Edward Jones & Co. in St. Louis. “Compared with the European banks, a lot of the U.S. banks look really well-capitalized, yet that’s still not helping them. They’re still trading at half of book value, just like the European banks.”
Treasury Secretary Timothy F. Geithner and former Federal Deposit Insurance Corp. Chairman Sheila Bair are among regulators who have called for higher capital ratios to help restore confidence in large banks.
Morgan Stanley will deploy some of its capital to increase its investment in a brokerage joint venture. The firm, which has the option to buy Citigroup’s remaining 49 percent stake in Morgan Stanley Smith Barney over the next two years, announced it would buy an additional 14 percent this year.
Morgan Stanley and its competitors have faced declining trading volumes and low merger activity as investors and companies remain wary about the European debt crisis and the U.S. economy. David Trone, an analyst at JMP Securities LLC in New York, downgraded all five banks to market underperform on May 21, declaring them “un-investible” because of macroeconomic threats.
Still, Morgan Stanley’s 7.9 percent share-price decline this year is more than JPMorgan’s 0.5 percent drop, while Bank of America, Citigroup and Goldman Sachs have climbed. The shares fell even though Morgan Stanley had the largest trading-revenue increase in the first quarter, leading Konrad to say it had the best quarter of the five banks.
“It becomes very difficult at small fractions of book value to make any kind of a fundamental call, because the stock is trading as if the firm’s under severe duress, and the reality is it’s not,” said Roger Freeman, an analyst at Barclays Plc (BARC)’s investment bank in New York. “Part of it is just institutional memory. They were viewed as in a relatively weak position then, and I think they’re viewed that way now and don’t get credit for all the changes they’ve made.”
Those changes may not preclude a bigger cut from Moody’s than Bear Stearns Cos. received the week before it collapsed and was sold to JPMorgan in March 2008. That would bring its rating to Baa2, five levels below where it was at the end of 2007, when its leverage was more than double its current level.
Moody’s said in February that current ratings don’t capture challenges facing investment banks, including a more difficult operating environment, fragile funding conditions and greater regulation. Abbas Qasim, a Moody’s spokesman in New York, declined to comment beyond the firm’s reports.
Morgan Stanley has cited its capital ratios in trying to convince Moody’s that it doesn’t deserve a three-level cut, according to a person briefed on the discussions. Gorman and Porat are among bank executives who have attended about half a dozen meetings with the ratings company since the review was announced, said the person, who asked not to be identified because the meetings were private.
“We’re saying to them we’re actually in much, much better shape than perhaps was understood by the marketplace and the ratings agencies,” Gorman said in a CNBC interview last week. “The kind of company we are now from a few years ago is very, very different, and part of the discovery process with Moody’s is to share that information.”
Mary Claire Delaney, a spokeswoman for Morgan Stanley, declined to make Gorman available for comment.
The maximum cut would place Morgan Stanley at its lowest rating ever and at least two levels below Goldman Sachs, its closest U.S. competitor. Goldman Sachs generated 75 percent of its revenue last year from capital-markets businesses, the “inherent vulnerabilities” of which Moody’s said in February prompted the industrywide review. That’s higher than Morgan Stanley’s 53 percent.
Morgan Stanley’s risk management “did not perform as well during the crisis as Moody’s had anticipated,” said the ratings firm, which cited Goldman Sachs’s “strong track record.”
In the fourth quarter of 2007, Morgan Stanley posted $9 billion of writedowns, largely tied to proprietary trading in mortgage-related products. In 2008, it faced a liquidity crunch as clients pulled funds from its prime brokerage and had to rely on Fed borrowing to survive. At the peak, on Sept. 29, the firm owed the central bank $107.3 billion, an amount greater than its total liquidity of $99.8 billion.
Since then, Morgan Stanley has taken writedowns as it exited investments in hedge fund FrontPoint Partners LLC, mortgage-servicing firm Saxon Capital Inc. and Atlantic City, New Jersey-based casino operator Revel Entertainment Group LLC, as well as posting a $1.7 billion loss in the fourth quarter to close out contracts with bond insurer MBIA Inc. (MBI)
Gorman has vowed to make no “new mistakes.” The bank has increased the size of its risk-management operation to about 500 people, from about 300 at the start of 2009. It also has added a risk committee to the board of directors, headed by former U.K. Financial Services Authority Chairman Howard Davies, and developed a new internal stress-testing model.
Moody’s said in a Feb. 17 credit opinion that Morgan Stanley faces the challenge of sustaining improvements it has made in risk management in the face of demands for higher returns. The bank posted a 4 percent return on equity last year, below Gorman’s goal of 15 percent. Investors also need further proof that firm’s new leadership won’t repeat the mistakes of the 2008 crisis, said Stemm of Edward Jones.
“They need a couple quarters of consistently demonstrating they can operate and be profitable in a difficult environment,” Stemm said. “Last year, they didn’t quite build that track record because they were dealing with so many legacy issues. So I don’t think investors feel they have that consistency yet.”
Moody’s gave guidance in February on how many levels it could cut each of the banks, something it didn’t do when it placed Bank of America, Citigroup and Wells Fargo & Co. (WFC) on review last year. It ended up cutting Bank of America two grades, Wells Fargo one level and affirming Citigroup’s rating.
The ratings firm also delayed its decision, saying it will complete the review, previously scheduled for mid-May, by the end of June. The uncertainty has hurt banks’ spreads and stock prices, said Douglas Ciocca, CEO of Kavar Capital Partners LLC in Leawood, Kansas.
The cost to protect Morgan Stanley debt for five years has jumped 28 percent to 414 basis points since Moody’s announced its review Feb. 15, leaving the firm’s protection more than 100 basis points costlier than any of the other investment banks. Goldman Sachs’s credit-default swaps trade at 312 basis points, while JPMorgan’s cost 160 basis points. A basis point is 0.01 percentage point.
“Left to their own devices, the markets tend to over- account for things,” said Ciocca, whose firm manages about $225 million in assets, including bank debt and equity. “It’s like my mom used to send me and my brother to our room when we did something wrong and wait for our dad to get home. The longer it took for him to arrive, the more certain we became of how severe the punishment was going to be.”
John Guarnera, an analyst at Societe Generale SA in New York, said there’s a 60 percent chance Moody’s will downgrade Morgan Stanley three levels and a 40 percent probability of a two-grade cut. Donald Jones, a credit analyst at Sterne Agee & Leach Inc., estimated last month that the chance of a two-grade cut is 75 percent.
Moody’s decision to provide specific guidance about potential downgrades of 17 of the world’s biggest banks was the result of investor demands for more transparency amid a volatile European crisis, which helped prompt the delay, said David Hendler, an analyst at CreditSights Inc. in New York.
“Now investors and the companies rated are saying, ‘Get it over with already,’” Hendler said. Some investors are upset with ratings agencies because they rated banks too highly during the crisis, and “then, after they rebuilt their balance sheets two-to three-times stronger in capital and liquidity, now you want to ding them,” he said.
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