A few weeks ago Ken Moelis, former Drexel, DLJ, UBS rainmaking banker, was interviewed on Bloomberg about the leveraged loan market and the changes he expects to see at investment banks.  Few people are as well placed as Ken Moelis to make such forecasts and his commentary is fascinating.  He also answers questions about his new boutique, Moelis & Company, and its phenomenal recent performance.  He also throws some criticism at UBS, his former employer.  He criticizes the financial conglomerate model because lines of authority and decision making are difficult to discern.  The Prince knows that this news is slightly outdated but he does not think many people saw this interview.

Here is a link to the video that aired on April 9, 2008

On investment banking in general:

"Investment banking is an incredible business.  A very unique business in which you empower some very smart people to take unusual risks.  Almost no other business in the world allows you to empower people on a day-to-day basis to take risks."

On the leveraged loan market in response to John Mack’s rosy picture:

"To give John Mack his due, maybe we are in the 9th inning, but that means they shut the game down.  What you are really asking is when does the next game start and I think we may be in the 9th inning of the last game and we might have to wait a year before baseball season actually starts again.  Because there is no more backlog being created and there are no more commitments out there and so yeah we may be ending the crisis point in leverage credit but the floodgates will not open again for a long-time.  I think it takes a long time for these cycles to reappear; people learn lessons, boards of directors, risk managers.  It will happen again but it will probably be five to six year before we get anything like what we at 9 months ago."  

On private equity’s edge in the boom:

"There was a real arbitrage, I believe, going on between the public equity market, which was being pretty irrational, and the private finance market.  What really happened was the security that was being under priced was leverage.  It was being given away in too large size at too low rates.  And what a lot of the private equity firms were really doing, I’m not sure they thought about it this way, but they were using the arbitrage of cheap credit which allowed them to actually pay 25-30-40% more than public equity markets.  Because what we are finding out is the debt was giving them that ability by pricing themselves too low or too aggressively." 

On Moelis and Company’s edge and the M&A market without LBOs:

"First of all, let me defend us [Moelis and Company], because you said we don’t have a balance sheet and I was joking.  I think we now have the strongest balance sheet on Wall Street given what is going on.  I‘m not sure that anyone has what you would call a balance sheet anymore from the old definition.  The interesting part is that M&A, I think is going to be down but nothing like what were feeling like in New York because of the finanacial panic that we are seeing here.  The rest of the country is really not experiencing quite the same pressure that the financial are and I think you are seeing strategic deals come back.  We just put a company up for sale this week and we did get 20 bids from financial sponsors.  So I think if you have good product people will find a way to finance it and purchase these companies."

On the investment banking business:

"We are going down, we will be down 30 to maybe even 50 percent in the short run and I think the street got staffed up to support what was a slight bubble in M&A.  I do think that people will have to downsize but it will be a healthy market.  Remember, if we went back just to 2005, we sort of had a very big spike in volumes in 06 and 07.  So if you go back to 05, we may have to go back to staffing levels of 05.  It’s not the end of the world…Look, I think across the board you are going to see these firms have to reduce by anywhere from 30 to 35 percent of headcount.  A lot of the financial products are going to go down more than M&A, some of the actual leverage lending itself and mortgage products and I do think you are going to see a significant retrenchment on Wall Street."

On relationship investment banking:

"What we are really doing out there, that is leading to our success, is that we’re going back to relationship investment banking.  I think that there was a lot of distraction here put on leverage and how much you could lend people and at what rates and I really think the CEOs and these companies want long-term relationships.  People who are willing to say no to them when you should say no and will know that they will still be involved with that company 3, 4, 5 years from now when they might do a transaction.  And I think that Wall Street really has to get back to that and we hope we are leading the charge in that direction."

Sounds like a page out of the Accidental Investment Banker or Goldman Sachs: Culture of Success.

On how Wall Street firms will survive a private equity fee diet:

"Well I think the good ones are going to manage back to remember who their client relationships were.  I think they are going to have to go back out, remember that their client is a relationship not a counterparty, and I think they are going to have to remember that about their own people too.  I think some of these firms have gotten used to moving paper around in size and forgot that the people within their own organizations are the true assets.  We used to say that the assets went up and down in the elevators at these investment banks but now the assets are piled up in CDOs and warehouse facilities and that’s the problem.  So I think you are going to see the firms go back to relationships with their own employees, the ones who do it right, I’m not sure that everyone will get there as quick as they should, and we might actually see some deconglomeration of these financial institutions." 

Given the first quarter M&A numbers all of what Moelis describes lays out sounds correct.  In the first quarter M&A activity by volume was down 22% to $861 billion globally versus Q12007.  U.S. activity was down 28%, to $318 billion, reflecting lack of credit for acquisitions and the related hiatus of financial sponsors.  Also consider that Yahoo-Microsoft at $45bn and Phillip Morris’ divesture by Altria at $111bn make up 50% of U.S. M&A thus far.  M&A fees are also down 28% globally in Q12008 versus Q12007. 

The recent wave of layoffs have predominately been in departments that are close to the credit crisis, i.e. structured product groups and leveraged finance product groups.  While some layoffs have occurred within investment banking division with deal volumes dropping more layoffs will be coming.  Certainly product groups like leveraged finance have already been cut and will continue to be cut but even coverage groups will be trimmed.  Many banks are even beginning to reexamine their M&A groups, normally considered the safest and most prestigious groups within most investment bank.  The investment banking divisions at major banks are going to be facing significant headwinds over this year and possibly even through 2009.  While these headwinds will certainly lead to some restructuring of the divisions, The Prince agrees with Moelis, that some downsizing will take place. 

However, those predicting cuts similar to those that occurred in 2002 in the wake of slow M&A from 2001 to 2004 will probably be wrong.  Moelis is right on point when he says we are going back to 2005 staffing levels.  Much of the headcount that was focused on financial sponsor transactions will be directed towards the middle market, deals with foreign buyers, and hostile transactions.  This makes sense considering that DB, GS, and MS all have their global M&A group heads based out of Europe now. 

If you are curious about what Moelis and Company is up to check out this great article from Dealmaker (free subscription required).

The prince doubts that Goldman does risk management better than other firms or they have a secret edge.  Yes, they were right last spring and summer when others were wrong but that may be nothing more than a great call not an active choice to reign in risk.  Yet, nothing about a large short various tranches of the ABX trade necessarily screams that they have a risk management edge over other firms. Maybe the prince is way off base but he would love to hear from anyone who can answer his questions with anything more than pointing to Goldman’s recent performance.   Other firms may have had risk management processes just as good or even better than Goldman but were on the wrong side of this one.  Also, the prince is operating under the assumption that risk managers move from firm to firm.  How would Goldman be able to maintain an edge in risk management with its people moving to its competitors continuously.  The revolving door at top wall street firms for talented and/or lucky individuals makes it difficult to keep any advantage a secret for long.

Anecdotally, if you really want a glimpse into Goldman’s risk management or the culture of risk management they eschew ask Gary Cohn, current GS President and COO, about his famous aluminum trade. That position made his name at the firm when he made millions for the bank right around the time of the IPO.  I think you will hear a story that doesn’t display Goldman’s risk management in a positive light.  A highly concentrated position that was trying to corner the world aluminum market in London was deeply in the red.  Cohn refused to listen to his superiors and risk officers who told him to close the position.  After avoiding disaster by bluffing his way out of proposed higher rental rates on aluminum storage by his landlord in London, the aluminum market began to respond to a lack of supply and his position skyrocketed.  He was rewarded, his legend grew, and he advanced up the firm. 

Sounds like the risk management team at Goldman really reigned him in. Hmmm.  Goldman got to show strong profits right around the time of the IPO which were materially increased by the out-performance of Cohn’s proprietary position that the risk managers and senior firm leaders had insisted he close because it was large, deeply in the red, and had it went public would have portrayed Goldman in a negative light right as it became a publicly traded company.  Albeit this is just an antidote and things have become more sophisticated in risk management since that time.  However, it is a good example of where the risk management process was wrong and disregarded, the eventual outcome looked great, and no one focused on why the risk managers had been wrong.  Had the trade been a huge failure then the risk management process would have drawn critics amongst the first investors in Goldman Sachs at their first earnings meetings after becoming a public company.

Goldman and all the other banks still have balance sheet problems and their earnings power has been greatly diminished, as the Prince has pointed out in recent posts.  If we want to continue to judge Goldman’s risk management by the performance of the firm then the press may be crying foul if Goldman struggles comparatively in the year ahead as a result of not delevering like its competitors in this volatile environment.  Maybe the press a year from now will be touting some other firms risk management practices based on outcome based evidence only.  The Prince thinks it is highly likely.

Also, stay tuned this week as the prince deconstructs fortunes special on how to fix wall street. Not only does the piece convey a naïve understanding of the crisis and Wall Street in general but in Fortune’s rush to dumb down the crisis for the average Joe they get a number of facts and practices just flat wrong. The Prince can’t wait to tackle the Fortune coverage and talk about Nassem "The Dream" this week.  I will also lay off Goldman for awhile a lay some grief on some other firms, but Goldman has been taking such a different course than its competitors lately that it demands the Prince’s comment.

Now these demands, which are directed at investment banks for less leverage and more liquidity (more capital cushion), are very similar to the demands that regulators made on commercial banks following the stock market crash/great depression.  However, very little attention has been focused on how this is going to affect the organization of the investment banking industry or how it will affect profitability in the industry.  Bill Gross, famed bond investor and CIO of PIMCO, wrote on his company’s website in his April investment outlook that regulators will force investment banks to set aside more capital, "resulting in reduced profitability."  A report by analysts at Morgan Stanley and consulting firm Oliver Wyman predicts "longer term ROEs to fall as banks seek to de-lever and regulators ask banks to hold more cushion.”  Others have privately speculated that profitability will go down as measured by ROE but how this change in profitability induced by further regulation will effect the competitive positions of the various firms has not been directly addressed.

Allow the Prince to take a look at this.  In this article this morning from Bloomberg David Viniar, Goldman Sachs’ chief financial officer, was asked if he thought the crisis would have “permanent implications” for Wall Street’s appetite for leverage. His answer: “No, I don’t.”  He made this statement less than 48 hours after a government-backed deal rescued Bear Stearns.  The Prince disagrees, and in fact, the regulation that will come about to limit leverage and the liquidity of assets will impact Goldman more than its peers.  Despite Mssr. Viniar’s strong comments The Prince must believe that privately Goldman management is seriously worried about how their firms comparative advantage in proprietary trading may be taken away by regulators wanted to reign in risk at investment banks.  Like The Prince wrote in his earlier post, if Goldman’s edge over JP Morgan is removed by more regulation then the JP Morgan business model will reign supreme on Wall Street and firms that used to have big trading books like GS will be permanently handicapped.

Llyod Blankfein, CEO Goldman Sachs Group, Smug Contrarian or Arrogant Fool?

Before we pursue this commentary further the Prince needs to make clear to his readers how liquidity and leverage are inextricably linked when an investment bank tries to finance its balance sheet.  Keep in mind that most firms, except Goldman Sachs which increased its leverage, are reducing historically high leverage levels right now because of market volatility and uncertainty.  Now the Prince thinks Goldman Sachs increasing its leverage reeks of arrogance and will probably end poorly for them given the lack of confidence and volatility in the market place.  They do have more freedom to increase their leverage compared to their competitors, since Goldman can still borrow at 10 year duration at 2.41% over 10 year treasuries versus 3.02% over treasuries for Lehman.  Yet, just because they have the freedom to do it does not mean it is a good choice.  In fact the Prince thinks they will regret it but he has to grant that recently their contrarian stances have paid off.   On this move, however, their luck may run out.

Yet, back to the strong link between liquidity and leverage when financing an investment bank’s balance sheet.  Clearly regulators and to some extent ratings agencies will put pressure on banks to lower their leverage.  There are multiple ways for an investment bank to finance and most use a combination of long-term debt, short-term commercial paper, and repurchase agreements to finance their liabilities and lever up on the equity they have.  The better the bank is as a credit risk the more opportunity they will have to get longer term capital by issuing long-term bonds (like 10 years) or issuing short-term commercial paper.  The third kind of financing, repurchase agreements or repos (also remember the opposite reverse repos), is where Bear Stearns got crushed. 

In the case where no one will buy new issuance of commercial paper or more new issuance of long-term debt or the yield demanded just makes such paper too expensive for a bank to make the interest payments a bank must rely more and more on repos to finance their liabilities and leverage.  Goldman tends to borrow more short-term CP and long-term debt and not rely as heavily on overnight or short-term repos.  "Goldman is still AA rated and has a good image in the marketplace as shrewd risk takers, so the spreads they’re paying for 10-year money are a lot less than everybody else’s,” said CreditSights’ Hendler.  Goldman only finances 14.8% of its balance sheet with repos while Lehman finances about 27.2% of its balance sheet with repos.  For comparison, Bear Stearns used repos for 26.2% of its borrowing at the end of 2007.  The problem with the repo market is that you must rely on other broker dealers or other counterparties to trade with you.  When Bear could not tap the commercial paper or long-term debt markets, could not get an equity infusion, and its counterparties stopped doing repos with them they were inches from becoming insolvent.  Combine that with all the prime brokers saying at once they would not disintermediate trades done with Bear Stearns for derivative contracts like CDS. 

Now how much money you can borrow against your cash bond collateral in the repo market is directly proportional to the quality of the bond collateral you hold.  So in Bear Stearns case the CDO and MBS collateral they were trying to borrow against would not fetch as much money on loan as if they held government treasurys.  So banks that have AAA rated non-mortgage debt of long and short term maturities can actually get more leverage cheaper in the repo market using such debt as collateral in the repurchase agreement.  So in this case the better your assets they more you can lever up and the more liquid your collateral/financing. 

Now in Bear Stearn’s base they were holding illiquid mortgage securities that were falling in value or had no bid in the marketplace.  They were trying to borrow against this collateral but some banks would not take that mortgage debt as collateral to lend money in the repo market.  When no one would do repo with Bear with any kind of collateral the game was really up.  So in this case the banks that are left standing now will have as much liquidity and freedom of action to lever their balance sheets as the strength of the bonds they hold can provide serving as collateral in the repo market for cash on loan.  Yet, like the Prince said before, freedom of action with respect to leverage is not a reason in and of itself to actually put on more leverage given market conditions.

To summarize the Prince’s predications.  ROE will fall across Wall Street as regulators force banks to deliver.  Goldman Sachs will suffer more losses than peers in this volatile environment because of their contrarian move to increase leverage.  In the long term Goldman Sachs will be stripped of its proprietary trading advantage which is the central component of its business model by regulators wanting to lower risk in the investment banking world.  JP Morgan and other big balance sheet banks with small trading books will replace Goldman Sachs as the top investment banks.  Disagree with the Prince’s analysis or predication?  He grants an audience to any subjects that wish to question his commentary.  What him to tone down the negative comments on Goldman Sachs?  Tough.

Disclosure: The Prince currently owns SKF but has no other positions in broker dealers or other positions linked to broker dealers.

However, just the fact that they have chosen to tape the public equity markets for $3bn speaks to the weakness of their position. If anything this move may exacerbate fears that the bank has an extremely troubled balance sheet.  This fear may persists even with a $3bn fundraising.  It seems like the smarter move would have been to lineup a large investor or two to take convertible preferreds or put private equity into the company like many of Lehman’s competitors have done.  Those who have pursued this path have not been punished by investors and are investors are not speculating about their viability.  The fact that Lehman is going into the public equity markets is another sign that makes them look weak since it raises speculation that sovereign wealth firms took a look at the books and said no thanks. 

Lehman will offer 3 million convertible preferred shares.  Demand for the shares was already three times greater than the amount offered as of 6:30 p.m. in New York, according to a person familiar with the offering.

"We still maintain that we don’t need capital, but we’ve realized that perception is the dominant issue in today’s markets,” Chief Financial Officer Erin Callan said in an interview. "This is an endorsement of our balance sheet by investors.”  The Prince doesn’t disagree but her saying they don’t need capital seems implausible and almost laughable.  The CDS on Lehman has fallen so it would appear that the credit markets believe the move makes Lehman a better credit risk.  Credit-default swaps tied to Lehman’s senior unsecured bonds narrowed 15 basis points after the announcement to 285 basis points.

The fact the deal is so oversubscribed shouldn’t be surprising since it is offering such great terms.  It has a coupon payment of 7 percent to 7.5 percent.  The conversion premium is said to be 30 to 35 percent above the current stock price.  Yet, like the Prince said earlier, the move will certainly improve their balance sheet but restoring confidence in their firm will not be helped by the weakness this offering displays. 

Disclosure: The Prince has a short position in Lehman Brothers and a net long a basket of broker dealers.

This morning in the New York Times, Andrew Ross Sorkin draws attention to the the fact that the Fed was calling the shots behind the Bear Stearns "bailout."  This point was obvious last week.  Just because the price moved from $2 to $10 and there is speculation about whether or not the Fed set the offer prices does not make this any more or less of a "bailout."  It was pretty obvious the Fed was pulling the strings from the beginning.  Just take a look at the original $30bn backstop (now $29bn with JP Morgan on the hook for first losses of $1bn on risk derived from illiquid BS assets).  By meddling in the Bear Stearns mess again the Fed has entered a quagmire of competing interests.  The parties it must politically handle are Bear Stearns’ shareholders, J.P. Morgan, Wall Street, neo-liberal economists who want the Fed to stay out of this mess, those that want to give relief to homeowners, and congressman trying to figure this out.  To wit, the consequences of Bear going bankrupt would have been catastrophic for economies and markets around the world.  However, The Prince doubts chapter 11 was ever an option for a Bear Stearns, which was careening towards insolvency (he is not alone and BS could only seek Chapter 7 with the trustee being SPIC).  Were the actions the Fed took in the "national economic interest" of the U.S.?  It does not matter much to The Prince—what is done is done, and its implications are enormous.  

After reading Mssr. Sorkin’s column, The Prince is convinced that by focusing on the intrigues of how the Fed called the shots on the offer, he is missing the long term implications of the Federal Reserve’s actions in the Bear Stearns debacle.  It is interesting that the Fed did not inform Bear of its plans to open the discount window the night it signed JP Morgan’s bid.  These actions clearly favor the argument that the Fed preferred the first bid, as Mssr. Sorkin points out.  The Prince couldn’t agree more with Sorkin when he states the fact that, "The Fed is officially in the deal-making business."  But why is this problematic? 

Most of the stories about this mess have spoken vaguely about "moral hazard" and setting a precedent which will increase risk taking in the future etc.  Very few columnists, journalists, or bloggers have looked at what the actions of the Fed forebode for Investment Bank regulation going forward.  The Prince does not care what happens with the Bear Stearns takeover because the long-term implications of the actions taken by the Fed in this debacle are far more ominous and important.  Please allow The Prince to illustrate some of the most problematic implications.

First, the Fed has now become the lender of last resort to the entire financial system, not just the bank holding companies that it normally regulates.  This is a landmark event in American monetary and economic policy.  The Fed as a lending last resort has fundamentally altered the on-the-ground reality of counterparty risk, and this will forever change the environment in which investment banks operate.  The Prince does not know when the current credit crisis will end or when the Bear Stearns will be put down, but one thing is beyond clear.  At the end of this mess the regulatory environment governing the financial sector will be dramatically different from what we have now.  While many on Wall Street may like the safety that the Fed provides as a lender of last resort, many on Wall Street will not like the changes that are coming.

Let’s analyze the situation more closely.  The Fed has rescued an entity with almost $30bn in credit and the entity is not regulated by the Fed.  Remember BS is regulated by the SEC.  The SEC’s required capital levels are roughly a third of what the Fed requires of the commercial banks it regulates.  The Fed has taken these steps because of its concerns over counterparty risk.  That is the worry that Bear Stearns liquidating would impose enormous burdens on its counterparties and throw the financial system into a frenzy.  This is the second time The Fed has done this (the first time being LTCM where it helped to orchestrate a Wall Street bailout of the hedge fund).

We will soon learn that the Fed has learned its lesson when it comes to counterparty risk.  Such risk will have to be managed much better by banking regulators around the globe.   This will bring an end to the free-wheeling days of fixed income derivatives.  The Prince predicts that most of these derivatives are pretty much over and will be the whipping objects of many analysts of what went wrong at the investment banks.  More robust (regulated) settlement and clearing processes are coming and the Fed/Treasury will be driving these changes not the ISDA, the SEC, or the broker dealers themselves.  Fixed income derivatives are likely to go the way of other securities markets.  This means they will be non-levered hedging and speculation tools.  Leveraging through derivatives will probably end with an order from the regulators against such actions.

Second, the Fed has crossed the Rubicon in regards to the type of financing it is providing for the transaction.  The financing of $29bn is almost equity type financing.  It is a $29bn non-recourse line to finance toxic parts of the balance sheet of Bear Stearns only protected by $1bn cushion of first loss collateral from JP Morgan.  What would happen if a broker deal is going down and there is no other broker dealer to buy the company like JPM?  This BS deal better work or we are may be seeing the Fed explicitly recapping financial institutions by directly injecting equity or taking over the institution.

Third, the days are gone when an independent investment bank could have a large trading book.  The Fed will ensure that if it is required to bailout such institutions, not having regulatory of capital jurisdiction over such entities would be wholly unacceptable.  The Prince also sees no real way for the investment banks to opt out of the protection that the Fed has now extended because any investment bank is subject to counterparty risk in the financial marketplace.  Investment banks will turn into banks, through consolidation driven by non-stressed, distressed, or regulatory realities.  Under this new regulatory system Goldman Sachs, with its large trading book, is no longer the model investment banking and JP Morgan now assumes that title.  JP Morgan is the correct model to the Fed in an "everybody is too big to fail" regulatory regime.  As a result of this new regulatory regime, a big round of consolidation among financial services is coming in the U.S. and probably globally.

To conclude this argument, The Prince must say that the credit risk of any modestly sized financial institution, that is a player in the capital markets, is a good buy now that we are living in an era free of moral hazard.  If a company is big enough, there is no credit risk with the Fed waiting there with a bailout.  So go forth and sell protection on LEH, GS, and MS CDS at these levels.  Also go out and buy Agency credit risk.  It may be some of the last good money to be made before the regulators begin to burn and pillage the investment banking community.  If BS is too big to fail and the Fed has to provide $30bn in effective equity in a bailout then what large financial institution is a credit or a counterparty risk?  That is all my loyal subjects.

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

Its difficult to say if Goldman was smarter or just luckier than the rest of The Street.  Morgan Stanley under Mack has moved aggressively to take more risk.  However, it appears that the press is assessing the prudence of that risk based on the outcome only.  What if the market went Morgan’s way and not Goldman’s way.  Then GS would be hurting and the press would be saying it should take lessons from Morgan Stanley?  Both firms placed their bets but what do we infer from the outcomes met by both firms.

Mack started out in the bond business at Morgan Stanley, which has always lacked the luster of IBD and IED at Morgan.  Its ironic that the lousy quarter was the result of “isolated losses by a small trading team in one part of the firm.”  In Mack’s rush to take risk like GS, the bond business at Morgan Stanley, a business Mack grew up in, burns him.