Morgan Stanley Reduces Risk But Still Has A Long Road Ahead

On December 17, 2008 Morgan Stanley (MS) posted another loss for their 4th quarter earnings.  The firm has been hit hard by losses from assets across the spectrum, and investors have destroyed the stock as it converts to a bank holding company.  For the 4th quarter, Morgan Stanley reported a net loss of $2.3 billion, or $2.34 a share, compared with last year’s loss of $3.59 billion, or $3.61 a share.  Although this loss is narrower than the previous year, the losses still trump the average analyst expectations of a loss of $0.34 a share, polled by Thomson Reuters. Morgan Stanley reported one day after Goldman Sachs (GS) posted a loss of $4.97 a share, mainly due to the performance of their trading and principal investments group.  A more in-depth look into Goldman’s latest earnings can be found here.  Both Morgan Stanley and Goldman Sachs’ stock prices have been slaughtered this year, down over 72% and 64%, respectively.

Although Morgan Stanley’s loss was much worse than analysts expected, their reduction of risk showed some signs of hope.  Since the start of this year, Morgan Stanley has reduced their leverage from 32.6x to 11.4x.  This is truly an accomplishment by Morgan Stanley’s management, as it is extremely important for the firm to reduce their risk.  The reduction in their leverage came from a reduction in their total assets this year by 37% to $658 billion.  They were also able to raise a significant amount of capital, which also helped to reduce their leverage significantly.  Many analysts were happy with the new balance sheet strength and expect this leverage ratio to remain pretty stable.  Goldman and Morgan Stanley were forced to reduce their risk in almost a “rat race” pace as investors punished the stocks for their excessive leverage.

Morgan Stanley was also able to increase their tier 1 capital ratio to 18.3% in the 4th quarter from 12.7% in the 3rd quarter.  Goldman also increased their tier 1 capital ratio by about 500bps compared to the 3rd quarter, but only to 15.6%.  To compare, Citigroup’s (C), J.P. Morgan’s (JPM) and Bank of America’s (BAC) tier 1 capital ratios were at 14.8%, 10.8% and 9.5%, respectively.

Morgan Stanley is also looking to target capital into better businesses that have better risk-adjusted returns such as flow trading, equity derivatives, foreign exchange, interest rates, and commodities.  They are also expecting to notice an additional $2 billion in cost savings from a reduction in headcount.

In their 4th quarter earnings statement, John Mack, the CEO stated:

“The global capital markets - and the financial services industry - have experienced unprecedented turmoil in the past few months. But the people of Morgan Stanley came together as never before to lead the Firm and our clients through this challenging environment. These exceptional market conditions profoundly impacted our performance this year, especially in the fourth quarter. However, we still achieved three quarters of profitable results and are moving aggressively to reposition the Firm for the future - continuing to re-size our business, reduce legacy assets, and further strengthen our balance sheet and capital position, which today includes an industry-leading Tier-1 capital ratio.”

Although the outlook looks much better for Morgan Stanley, they still have a long road ahead of them to return to sustained profitability.  They have done a great job so far to weather the worst crisis since the Great Depression, but there is still a lot of restructuring and rebuilding to be done.  The talent at both Goldman Sachs and Morgan Stanley are still best of breed in the industry.  When the markets finally do recover, I believe that they will once again trade with a significant premium over their bloated competitors.  I would avoid them in the short-term and wait for more news and guidance about the way they will gain banking deposits and sustain revenues.

Disclosure:  The Fund the author is associated with is long JPM and GS.

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