Morgan Stanley Curbs Enthusiasm

The investment bank suffered large write-downs and losses in quantitative trading strategies, and is unsure about the market outlook

Morgan Stanley's (MS) weaker-than-expected earnings report on Sept. 19 dashed some hopes for contained losses from the subprime mortgage meltdown. A day before, Lehman Brothers (BusinessWeek, 9/18/07) released results that beat analysts' forecast and said the "worst of this credit crisis is behind us."

Morgan Stanley's news was not so sanguine. The investment bank said its third-quarter profit dropped 17% to $1.54 billion, or $1.44 a share, from $1.85 billion, or $1.75 a share, a year ago. It gave up 33 cents a share on a $940 million writedown for the lower market value of its loan portfolio.

Excluding the results of its credit-card business, Discover Financial Services, which was spun off on June 30, the company’s net income from continuing operations fell 7% to $1.47 billion, or $1.38 a share, from $1.59 billion, or $1.50 a share, in the third quarter of 2006.

The results fell short of analysts' expectations for EPS of $1.54.

Morgan Stanley shares fell 2.2% to $67.03 on the New York Stock Exchange on Sept. 19, while the market kept rallying after the Federal Reserve's hefty 50-basis point cut in interest rates.

At the end of August, Morgan Stanley had $31 billion in commitments related to leveraged acquisition financings, including bank loans and bridge financings mostly to non-investment grade companies that had been accepted but had not yet closed.

The good news, says Deutsche Bank Securities in a Sept. 19 note, is that Morgan Stanley enjoyed records in prime brokerage results and revenue flows to asset management, while its underwriting of investment-grade debt continues to be strong. But Deutsche Bank expressed concern about how aggressive Morgan Stanley was in writing down the value of leveraged loans made to companies to fund acquisitions. (Deutsche Bank does and seeks to do investment banking with companies covered in its research reports.)

The gross writedown of $1.2 billion, which includes fees, works out to nearly 4% of the $31 billion the bank has in commitments, or just below the 4% to 5% writedown that Lehman Brothers (LEH) said it took on its leveraged loans.

While the third-quarter wasn't a great one for the bank, it managed to increase its book value 4% and deliver a return-on-equity of 17%, close to its record of 17.5%, Deutsche Bank said.

During a conference call to discuss the results, Colm Kelleher, who's slated to succeed David Sidwell as chief financial officer at the end of this year, said he believes it will take at least one or two quarters for more normal levels of credit and liquidity to return to the market.

With investors staying on the sidelines waiting for more certainty on the pricing of risk, he suggested it might take some time to find buyers for the $31 billion in loans the bank is currently committed to. Until it does, the bank remains exposed to the market conditions that could require further asset writedowns, he said.

What portion of that $31 billion the bank is able to get off its balance sheet will depend on when the market recovers. "We have seen evidence out of Europe that there are buyers coming back into leveraged loan market," Kelleher said.

Meredith Whitney, an analyst at CIBC World Markets, said she is more alarmed by the $480 million in trading losses Morgan Stanley took on its quantitative, or computer modeled, equities funds than the loss on its leveraged loan commitments.

"That mark down [of the value of those equity portfolios] was unique to Morgan Stanley" in the financial industry, she said. "I don’t know of any other broker who has that kind of quant strategy within their proprietary trading desk."

And unlike Lehman Brothers, which said it thought the worst of the credit market disruption was over on its earnings call on Sept. 18, Morgan Stanley sounded less certain about the direction of the market, as if it was telling investors to stay tuned for further information, Whitney said.

"No one on Wall Street likes to be told that. They like to be told what to think," she said. She thinks that Goldman Sachs is likely to be more clear about the credit market situation when it holds its earnings conference call on Sept. 20.

With valuations on mortgage-backed securities so cheap now, those who are willing to be aggressive, like Lehman, rather than pulling in their horns like Morgan Stanley, are going to make money, she added.

And by saying it would make efforts to control expenses, Morgan Stanley also gave cause for worries. "That never sounds good to bulls," Whitney said.

In a Sept. 19 note, UBS Investment Research said that although the 17% return-on-equity that Morgan Stanley reported for the third quarter was pretty good, "it's not in line with Morgan's premium valuation, so the stock could take a breather." (UBS AG, or its affiliates, does investment banking with Morgan Stanley, makes a market in its securities, and has acted as a manager or co-manager in underwriting or placing its securities within the past 12 months.)

Credit Suisse reaffirmed its outperform opinion on Morgan Stanley shares, saying in a Sept. 19 note that its recommendation has been based on the outlook for improving profits, which it still expects to see in the fourth quarter.

Based on the latest results, however, Credit Suisse cut its forecast for 2007 earnings to $7.50 from $7.70 a share and to $7.95 from $8.00 a share for 2008, while keeping its target price between $80 and $85. (Credit Suisse does investment banking with the company and has managed a public offering of its securities within the past 12 months.)

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