Morgan Stanley (NYSE:MS)
Fixed Income Investor Conference Call
February 14, 2013 9:00 a.m. ET
Celeste Brown - IR
Ruth Porat - EVP and CFO
David Russo - Treasurer
Thomas Wipf - Head of Bank Resource Management
James Strecker - Wells Fargo
Robert Smalley - UBS
Ron [Paroto] - Goldman Sachs
Good morning. At this time I would like to welcome everyone to the fixed income conference call. [Operator instructions.] Thank you. I will now turn the conference over to Ms. Celeste Brown, head if investor relations at Morgan Stanley. Please go ahead ma’am.
Good morning, this is Celeste Brown, head of investor relations at Morgan Stanley. Welcome to today’s fixed income investor conference call. Our presentation may include forward looking statements , which reflect management's current estimates or beliefs and are subject to risks and uncertainties that may cause actual results to differ materially.
The presentation may also include certain non-GAAP financial measures. Please see our SEC filings at morganstanley.com for a reconciliation of such non-GAAP measures to the comparable GAAP figures and for a discussion of additional risks and uncertainties that may affect the future results of Morgan Stanley.
This presentation is copyrighted by Morgan Stanley and may not be duplicated or reproduced without our consent, and is not an offer to buy or sell any security or instrument. If you have not already done so, please refer to the presentation that accompanies this call on the investor relations section of our website. At the end of the presentation, we will take your questions.
I will now turn the call over to Executive Vice President and Chief Financial Officer Ruth Porat.
Good morning, and thank you for joining us. Today we will focus on three areas. First, we will take you through our strategic focus and the benefits that accrue to our credit profile. Second, we will provide additional details regarding our funding framework and liquidity management. And finally, we will touch on certain regulatory topics as they relate to funding.
With me are David Russo, our treasurer, who will review our funding framework and liquidity management, and Tom Wipf, our head of bank resource management, who will address secured funding.
Beginning on slide four, as you know, because of the many strategic steps we have taken, we have a far more balanced business mix today versus several years ago. Our strategic moves have also enhanced the efficiency of our funding. We remain focused on a cohesive set of products across our institutional businesses. We continue to have leading positions in banking and equities, and in fixed income we continue to focus on market share gains and efficient capital use.
With regard to wealth management, we benefit from revenue stability and the deposit base associated with that business. More specifically, with respect to Morgan Stanley’s credit, there are five key items of note.
First, turning to slide five, capital efficiency in our institutional securities business. We are one year ahead of production targets for risk-weighted assets, which we laid out in our earnings call during the summer. Since the financial crisis, we have reduced RWAs and capital in our fixed income business. At their peak, these RWAs were close to $500 billion, which we reduced to $390 billion in Q3 ’11.
This past summer, we laid out a series of RWA targets including $280 billion at the end of 2013 and $255 billion at the end of 2014. As of the end of 2012, we reached our 2013 targets, exiting the year at $280 billion. We also established lower targets through 2016, which we believe will reflect end-state capital and RWA levels in the business. The end state, which also builds in reinvestment in areas that are important to our clients, will be less than $200 billion of RWAs and $18 billion or less of capital.
Second, we have been driving ongoing growth in the wealth management business. We had previously laid out a mid-teen margin goal by the middle of 2013 for our wealth management business. We reached and exceeded that goal in the fourth quarter of 2012. Although the first quarter margin is seasonally lower, we believe that we can drive margins to the high teens and above over time, even with only modest revenue growth in a low interest rate environment.
Third, we have been very disciplined with our CCAR request, and subject to regulatory approvals, we will own 100% of the wealth management business. As we have discussed in the past, there are a number of benefits associated with owning 100%, including pro forma year-one incremental earnings comparable to the capital required to buy the remaining 35%, driven by the elimination of NCI, contractual revenue upside, and some expense savings from the elimination of the joint venture structure. We also increase our stable deposit funding.
Fourth, we are executing on several areas of growth that are unique to Morgan Stanley and benefit from our strategic moves. Most notably, we are on a path to having approximately $140 billion in deposits, which support growth in lending in both our retail and institutional businesses.
Within our wealth management business, our lending product penetration is 500 basis points below peers, suggesting that we have upside just by closing this gap. However, there is also upside for institutional securities, beyond lower funding costs for lending, derivatives, and other bank-appropriate products. We remain focused on opportunities to expand in commercial lending, consistent with our existing skill set and risk management capabilities.
Finally, we continue to have leading capital ratios under Basel I and Basel III. Our tier one common ratio under Basel I is 14.7% and our tier one capital ratio is 17.9%. Our pro forma tier one common ratio under Basel III was 9.5% at December 31, based on our best assessment of the rules. Our capital ratios reiterate our commitment to a strong foundation that enables us to deliver for clients and counterparties.
I will now turn it over to David.
On slide 10, I’ll briefly review our asset liability funding model. As we have said before, our funding governance requires that we align more-liquid assets with shorter-term liabilities and less-liquid assets with longer-term liabilities.
Our bank asset portfolio, including our suite of lending products available for sale of securities, and other bank-appropriate products, is funded with deposits and equity. Our liquidity reserve is primarily funded through unsecured debts, equity, and deposits. More-liquid assets are predominantly funded in the secured channel, although haircuts are funded with unsecured debt and equity.
Other, less liquid assets such as below investment grade corporate debt, or non-index equities, are funded with a mix of unsecured debt and equity consistent with the less-liquid nature or longer-term holding period assumed for these assets.
Slide 11 illustrates our debt maturity profile. As a reminder, we have decreased our overall debt outstanding by $23 billion since 2010, and we have enhanced our flexibility in terms of issuance. It’s important to note that, given our strategic steps and funding flexibility, we may not match maturities with issuance. Please turn to slide 12.
As we’ve said before, we remain focused on maintaining a prudent liquidity reserve, which was $182 billion at the end of the fourth quarter. So far, in the first quarter, our liquidity reserve has been averaging $190 billion. We believe the safety and stability that comes with this incremental liquidity ensures we can consistently deliver for stakeholders and clients.
The charts on the right indicate the composition of our liquidity reserve by type of investment and asset line on the balance sheet. As a reminder, we consider four building blocks over a 12-month horizon when sizing our liquidity reserves.
First, we fully reserve liquidity against our rolling 12-month maturities. Second, contingent funding requirements are driven by our balance sheet size and composition. Consistent with our strategy to focus on flow product, our balance sheet is more liquid than in the past. Third, we’ve reserved other contingent outflows, including collateral requirements.
We’ve also reserved for potential decreases in secured funding availability. As discussed previously, the spare capacity built into our secured funding book has an additional layer of protection before requiring access to the liquidity reserve.
Fourth, and finally, is an additional reserve which provides a buffer based on management’s assessment of the operating environment as well as any potential business requirements and uses of liquidity.
Of increasing importance is not only the aggregate size of our liquidity reserve, but also liquidity by legal entity. We size and build our liquidity reserve from bottom up. First, we perform strengths tests at the legal entity level to ensure each entity has sufficient liquidity. We then perform the same stress tests on a consolidated basis to ensure the enterprise also has sufficient liquidity.
Our conservative stress test assumptions are consistent at the legal entity and enterprise levels. Contingent cash outflows are measured independently from the potential benefits of cash inflows, resulting from mitigating actions.
And the parent stress test model does not take into account the diversification benefits across legal entities. Our stress tests assume our subsidiaries will initially use their own liquidity before drawing from the parent. These assumptions overlay parent support where appropriate, based on local regulation. Our approach at the enterprise level assumes the parent company does not have access to subsidiaries’ excess reserve.
Moving to slide 14, we have access to a number of funding channels across geographies. The components of funding include plain vanilla debt with issuance globally and through a number of channels. In addition to our U.S. dollar plain vanilla debt, we benefit from our global footprint in non-U.S. dollar plain vanilla, Uridashi issuance in Japan, with our strategic partner MUFG, and finally, we complement these channels with structured note issuance. Our broad distribution capability provides for consistent access to this market.
In the last year, across all of our channels, we issued in over 20 markets and currencies. In addition to issuing long term debt, our near term debt funding needs are also met by our deposit base, consistent and particular, with a growing suite of retail and institutional lending products in our bank; our more-liquid inventory, which supports our flow-based business strategy and decreases long term debt requirements; the potential use of excess liquidity; and our secured funding strategy.
And on that note, I will now turn it over to Tom.
Please turn to slide 15. As we’ve discussed before, a core component of our centralized liability management structure is secured funding. In this area, we have implemented a robust process with strong governance and discipline limit monitoring. The central objective of our secured funding governance is to drive durability through weighted average maturity, investor diversifications, maturity limit structure, and spare capacity.
Our approach to secured funding is consistent with our approach to long term debt. We follow an asset-based model to obtain the appropriate term consistent with the fundability of the underlying assets in the secured market. Daily, all of our assets are categorized by fundability. Maturity targets and limits are set for each tier.
We look at assets down to a QSIP level, in four categories of fundability: super green, green, amber, and red. Those categories indicate the availability of secured funding for that asset class. Each category is based on defined eligibility criteria through our governance structure.
Super green assets are highly fundable assets such as U.S. Treasuries and agencies. These assets are central bank eligible for standard open market operations, and are acceptable collateral by a central clearing counterparty.
Green assets, which make up approximately 42% of the secured funding book, include highly rated bonds, supernationals, primary index equities, and some sovereigns. At the other end of the spectrum, and the smaller portion of the book, are amber and red assets, which represent approximately 11% of the secured funding book.
A key risk mitigant in this plan is that in advance of an asset purchase, our rules-based governance approach requires that we have sourced the appropriate term, consistent with the asset fundability. This is most relevant in the amber and red categories. In the event 180 days of secured funding is not available prior to the asset purchase, the asset would be funded with cash.
Our assets are reviewed daily, based on the fundability criteria and are recategorized based on their liquidity characteristics in the current market environment. The fully loaded cost of this funding is allocated to the businesses at a QSIP and desk level.
Turning to slide 16, as a reminder, we have, most importantly, extended the weighted average maturity, or WAM, of our secured funding liabilities. In aggregate, the WAM of the entire secured funding book, excluding super green assets, well exceeded 120 days in 2012. This accomplishes two key goals. First, it increases the durability of funding, and second, it reduces the liquidity reserve requirements needed as a contingency for loss of secured funding.
Enhancing the durability of our secured funding has been a multiyear process. In 2010, the primarily focus was to increase WAM. In 2011, we further enhanced the durability. First, we increased diversification by investor, building a secured funding book to roughly 400 investors.
Second, we increased diversification by maturity rolldown. We have rolldown limits in any given maturity period, adding to the depth and quality of our funding. And in 2012, we took advantage of cost efficiency opportunities to further extend our WAM while also adhering to our strict governance framework.
Turning to slide 17, we have added additional color in terms of how we manage diversification by investor and by maturity rolldown. We have a granular limit framework to ensure execution across these two dimensions. In any given period, we limit how much secured funding is due to mature, and we limit how much is due to mature from any single investor.
On this slide you can see the designed outcomes of our governance limits, as we just discussed. We have a smooth maturity profile within our secured funding book, and have investor diversification across maturities. Both of these reduce the refinancing lift of our secured funding.
Turning to slide 18, another tool to ensure durability of funding beyond WAM and diversification is what we call spare capacity. Spare capacity represents total secured funding liabilities in excess of inventory.
In other words, spare capacity has created excess contractual term funding which serves as an additional risk mitigant to accommodate all market environments. This is an effectively valuable insurance, which protects against potential stress in the secured funding markets. We size our spare capacity using a number of conservative assumptions about what theoretically could occur in a stressed secured funding environment.
These assumptions are not Morgan Stanley specific, and are more adverse than market conditions during recent stress periods would suggest. The assumptions include a 0% rollover of maturing liabilities over a 30-day timeframe and a 40% rollover of maturing liabilities over a three-month period. We use the liabilities that create spare capacity to fund super green assets, but we can contractually substitute less-liquid assets, green, amber, or red, in the event we ever need to.
Although we continuously review our secured funding for any indication of stress, we have this mechanism in place to manage across sudden shocks without disruptions, ensuring we can consistently deliver for stakeholders and clients.
We have seen our disciplined governance model for secured funding validated through a number of market stress events. Our risk management tools, including spare capacity, have served to build a durable secured funding structure. It is important to highlight that all of the risk mitigants in the secured funding book are designed to provide valuable insurance as a first line of defense during periods of stress, prior to drawing on our global liquidity reserve.
Pulling it all together, there are four key pillars that limit refinancing risk in the secured funding book. First, WAM provides appropriate time based on asset fundability. Second, rolldown limits limit total liabilities maturing in any given period, and give us a smoother maturity profile. Third, concentration limits reduce our reliance on any single investor. And finally, we have built up spare capacity as an additional risk mitigant against sudden shocks in the market that would reduce rollover rates.
These steps have not only enhanced the durability of our secured funding, but also set us up well to efficiently meet increased demand from our clients. I’ll turn it back over to David.
Ending with two items that are on the regulatory horizon. First, the LCR on slide 19. Our liquidity stress test scenarios incorporate and build upon those in Basel proposals. As you are aware, the objective of the liquidity coverage ratio, or LCR, is to ensure that banks have sufficient liquid assets to cover outflows in the 30-day stress period.
Our internal stress scenarios consider periods of continued stress well beyond the 30-day horizon. Under our interpretation of the latest draft rules issued in early January, our pro forma LCR is in excess of 125%. The key driver of our LCR include extension of weighted average maturity of the secured book, the size of our liquidity reserve, virtually no reliance on commercial paper or other short term funding and short duration commercial deposits, and finally, the size and composition of our unfunded lending portfolio.
Now turning to the second item, orderly liquidation authority. There has been much discussion about OLA and its potential impact on financial institutions and creditors in particular. Although the rules are still in flux, there has been a range of proposals intended to quantify a minimum required amount of unsecured debt. These requirements may be in the form of specific debt instruments and based on parent-level issuance.
Whether the rule is calibrated toward total assets or risk-weighted assets, we believe we are well-positioned given our unsecured debt is primarily issued from the parent.
Thank you for listening. We will now take your questions.
[Operator instructions.] The first question will come from James Strecker with Wells Fargo.
James Strecker - Wells Fargo
This is probably for David. Going back to your comment about how issuance may not match maturities again in 2013, I was wondering if you could provide a little color. Obviously there’s some offsets. You’ve got a huge excess liquidity pool. You’ve got incremental deposit inflows. But on the other side, you’ve got the [last slug] of the JV to take down, and about $25 billion maturing this year. So can you give a little more color, and maybe size it versus the $6 billion that you did in plain vanilla debt last year?
So, as we’ve said before, we’ll continue to issue across multiple channels. Our dollar/non-dollar structured notes and Uridashi, quarter-to-date we’ve issued a bit over $1.5 billion. Primarily that’s been overseas. And our funding needs will continue to benefit, and have benefitted, from the change in our business mix, having really moved toward more flow-based businesses.
We also see benefits coming from our increased deposit taking, and this is very consistent with our investment in Morgan Stanley Wealth Management. All of this, when you put it together, is reflected in the liquidity reserve, as you point out, which is up from $170 billion at the end of the third quarter to $182 billion at the end of the fourth quarter, and has been averaging $190 billion so far in the first quarter of this year.
So, part of the way we build our liquidity reserve, the way we think about it, is looking at our forward 12-month maturities, and also future expected business needs. So we’ll continue to issue across all these channels opportunistically, but with liquidity running in that $190 billion range, we think it gives us a lot of flexibility.
James Strecker - Wells Fargo
That’s fair. And this one might be more oriented towards Ruth. To the extent you can comment, have you all been having direct involved conversations with any of the regulators on OLA and a minimum debt threshold requirement? There seems to be some varying opinions in the issuers that I talk to about how deep those conversations are running right now. And I was just wondering what color you could provide on that.
I think it’s fair to say that it’s really far too early to call which direction it’s going to go, because there seem to be a number of different proposals out there, whether looking at debt as a percentage of assets, or looking at it as a percentage of risk-weighted assets, looking at parent debt in general, or focusing on sub-debt. So I appreciate the question. There are a number of proposals, and it’s too early to call. I think the main point that David highlighted is given how we fund the firm, primarily from the parent, we believe we’re in a good position.
The next question will come from Robert Smalley with UBS.
Robert Smalley - UBS
A couple of questions. First, on the liquidity reserve, going back to your second quarter presentation, you put in a slide dimensioning what the four uses of the reserve were, the additional reserve, contingent outflows, balance sheets, [unintelligible] composition, and maturities. As I’m looking at maturities going down, and balance sheet going down, I’m wondering, could you compare your current reserve to a quarter or two ago? And where did the change from $182 billion to $190 billion as the average, in which one of the four buckets are you putting that reserve in now, the excess?
Two parts. The discretionary reserves to which you refer, I think, was the block on the top, right? And that is really set by management’s assessment of the operating environment as well as potential outflows. The increase in reserve from $182 billion to the $190 billions has occurred predominantly in our non-bank area.
Robert Smalley - UBS
Second question, in terms of subordinated debt, you did a subordinated debt issue a little while ago. It came around 100 basis points wide to the outstanding senior debt. Now, on a [G spread] basis, it’s creating about half of that. Can you give us an idea of how you look at subordinated debt pricing, and what you think the proper senior sub spread ought to be? We’re all struggling here with a very unclear picture on OLA, certainly, together, but as a result, we also can’t really work back from recoveries. So if you could, just paint us a picture of how you think about subordinated debt and what you think the right price should be, senior to subordinated debt for an institution like yours.
We certainly did issue $2 billion of subordinated debt last year, 10-year, and we’ll continue to evaluate needs going forward. We think of it as valuable tier two capital, and so, again, we’ll continue to think about needs going forward. In terms of the spread, though, I think I’m going to have to leave that to you and the market, and let them price it as they see fit.
Robert Smalley - UBS
Okay. Last one, on the subdebt. And thank you for outlining all your ways that you can fund the company, in various markets, but in your assessment, have you come to the conclusion that the U.S. market is really the broadest and deepest for subordinated debt, whereas the other markets are better for senior debt, probably five years and in? Or is there any light you can shed on that?
I think we find value in all the distribution channels, and at times past, our historical issuance has been mixed 50-50 between dollar and non-dollar. That could change over time. We’ll just remain opportunistic as we see those channels open to us.
Robert Smalley - UBS
But by asset class, do you see any other kind of differentiation there in any of the markets?
I don’t think so.
[Operator instructions.] And the next question will come from Ron [Paroto] with Goldman Sachs.
Ron [Paroto] - Goldman Sachs
First, touching back on the funding, you guys obviously have made a lot of progress and going to make more on reducing the fixed income RWAs. Any color you can give on how much unsecured funding is associated with those RWAs? Presumably, those are the less-liquid securities that have relied more on that funding? So we can get a thought on trajectory of the long term debt balance over that time period?
You know, there’s a link between assets that require more capital and the funding requirements for those assets, but we do have to point out, it’s an imperfect link between RWAs and the absolute funding requirement. So, look, all else being equal, bringing down RWAs will be linked to a decrease in our funding needs to an extent.
Ron [Paroto] - Goldman Sachs
And any update on the movement of derivatives to the bank? I know that’s one of the things that you pointed out as far as being a benefit for the institutional business, but is that something that is ongoing, or it’s just largely for new transactions, or we kind of have to wait a little longer until the full JV is brought into the group?
Well, we have been writing new foreign exchange derivatives in the banks, I think you know. It was up about 26% last quarter. And we are moving all foreign exchange derivatives into the bank. We do plan to write new interest rate derivatives in the bank. But I do think it’s important to note that derivatives are part of an overall product suite for the bank, and we do expect that they’ll be a relatively small percentage of assets in the context of everything else we’re doing in the bank, specifically with retail lending institutional lending and moving other bank-appropriate products associated with the institutional securities business into the bank.
Ron [Paroto] - Goldman Sachs
And just one last one. Obviously, it’s a lot smaller than [tiers], but there are some trust-preferred, I believe, that are still in tier one capital. Any thoughts on those, and whether the thought would be over time those would be replaced with other additional tier one capital?
We’ll continue to evaluate the outstanding [trups] and see where we head with them.
I have a question emailed to me for Tom, and I believe the question is, how are you prepared if there’s an issue with U.S. Treasuries, i.e. if there’s a missed payment?
Certainly internally we’ve taken the appropriate steps to manage for those contingencies. We’ve seen a reasonable framework laid out by the Treasury Market Practices Group and SIFMA around some of those contingencies. We’ve taken the steps to operate in that scenario, but we certainly hope we don’t see that day.
With that, we don’t have any additional questions, either on the phone or by email. So we appreciate you joining us. We apologize for any challenges getting on the call today, and look forward to speaking to all of you soon.
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