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Morgan Stanley Writedown is Disappointing

By The Prince ⋅ December 19, 2007 ⋅  Email This Post ⋅  Print This Post ⋅ Post a comment

Morgan Stanley released 4Q earnings before the open this morning.  Despite the terrible deterioration in the companies mortgage trade and its mortgage portfolio the stock is up today.  Morgan Stanley swung to a fourth-quarter loss as the company took $9.4 billion in mortgage-related write-downs.  The second-largest brokerage firm reported a net loss for the quarter ended Nov. 30 of $3.59 billion, or $3.61 a share, compared with a year-earlier net income of $1.54 billion, or $1.44 a share.  The $9.4 billion in write-downs compare with the $3.7 billion the company announced last month. At that time, Morgan Stanley said the write-downs could increase if the market continued to worsen. The total includes $7.8 billion in subprime-related write-downs.  The mean per-share loss estimate of analysts polled by Thomson Financial was 39 cents on positive revenue of $4.23 billion.  "The writedown Morgan Stanley took this quarter is deeply disappointing — to me, to our colleagues, to our board and to our shareholders," said Chairman and Chief Executive John Mack.  Mr. Mack said the he will forgo his 2007 bonus, saying accountability rests with him.

After listening to the conference call it is clear that outside of the mortgage trading group Morgan Stanley did deliver strong results.  The banking group ranked 1st in global completed M&A but still trails Goldman Sachs in announced M&A worldwide and in the U.S.  Primebrokerage and equity sales had great quarters probably related to increased client activity given increased equity volatility.  The results in Asset Management and especially the Global Wealth Division were outstanding.

I found a few things interesting on the call.  The firm did cut its CMBS exposure in half, which is a trade that Goldman Sachs has been championing in the marketplace.  I also found it interesting that John Mack blamed one trading desk at Morgan Stanley.  When he said that he takes full responsibility for the firms results, it didn’t seem genuine since he kept blaming that one team.  He kept saying one desk had a lapse in judgement.  Obviously, reorganizing the risk management unit to report to the CFO and not the head of institutional securities is an admission that there was a serious failure of risk management.  Mack also said, "We are in a risk business and we will put risk capital into our trading and prop positions," which means that the firm will not be pulling back in its risk taking.  They also think that IBD revenues will be higher next year which is surprising because the sponsor business is slowed down.  The sponsors are far and away the largest fee payers to Morgan Stanley and wall street.  It was also interesting that John Mack hinted that someone new will be coming in to work on non-comp expense.

The announcement that Morgan Stanley is getting a cash infusion from the sovereign wealth fund of China, China Investment Corporation, was welcomed by the market.  Obviously, CIC has enormous incentive to provide liquidity to the financial sector in the U.S. to try and prevent the federal reserve from continuing to cut rates and drive down the yield on China’s holdings of U.S. government debt.  This allows Morgan Stanley to get better terms on the cash infusion.  Morgan Stanley only had to over a yield 20% over that available to common equity shareholders.  The investment may make it easier for Morgan Stanley to operate and expand in China.  Morgan Stanley had been talking with the Chinese investment company about a long-term investment since the summer, and the 9.9% stake has been cleared with U.S. regulators and government authorities. Much of the negotiating was conducted by Mr. Mack.  The Chinese company won’t have a management role or a seat on the board.

There hasn’t been much clarity in the press around how Morgan Stanley still lost money while it was shorting subprime CDOs.  A proprietary trading desk trading CDOs and mortgages shorted the lowest tranch of CDOs, i.e. the equity tranche, for about $2bn but they financed the trade with $18Bn of long exposure to the mezzanine tranche of CDOs.  All these trades were executed with derivatives and on the ABX index.  The loss on the mezzanine tranche was much larger than gain on the short of the lowest CDO tranches.  The Goldman Sachs analyst that called in to the call asked a real aggressive question, basically saying how can one desk lose so much money given position limits.  Morgan Stanley basically said that they got hit by long tail risk and its risk management team did know the trade was on but didn’t accurately forecast the size of the loss.  

Despite the enormous writedowns because of poor trading. John Mack’s job looks completely secure.  While this may seem surprising since Morgan Stanley’s write down is larger than Merrill’s and Citigroup’s given the size Morgan Stanley, John Mack’s popularity and management style within Morgan Stanley make him indispensable.  Mr. Kelleher, Morgan Stanley’s CFO, said he and the firm have "total conviction" that the trading loss doesn’t put Mr. Mack’s job in jeopardy, adding that he is "absolutely the right person to lead this firm out of this hiccup."  It is interesting to ponder who will take over from John Mack given that Cruz is gone and no clear successor is visible.  I would assume that a successor would come from within the firm given the Morgan Stanley culture.  Walid Chammah, has been rising through the management ranks quickly, but maybe a Morgan Stanley vetern like Vikram Pandit or John Havens may come back from Citigroup.  Only time will tell.  

“The results we announced today are embarrassing to me and the firm, and they’re the result of an errant judgement on one desk in our fixed income area and a failure to manage that,” he says. “The rest of the firm delivered outstanding results for the quarter and for the year. Global wealth management more than doubled pretax profit…our core business remains strong and moving quickly and decisively to build on that momentum.” - John Mack

For play by play of the conference call check out MarketBeat’s post.

Disclosure: Long Morgan Stanley