Morgan Stanley Below Tangible Book Value Is Worth The Risk

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 |  About: Morgan Stanley (MS)
by: Colin Lokey

It's been quite a while since I've recommended a financial stock. In the aftermath of the financial crisis, the Dodd-Frank Act and Basel III have made it difficult for financial institutions to determine with any certainty just what the regulatory regime will look like going forward.

On December 13, Morgan Stanley (NYSE:MS) took a proactive step regarding Basel III by reaching a settlement with monoline insurer MBIA. According to MS, "the comprehensive settlement terminates outstanding credit default swap protection purchased from MBIA...and resolves pending litigation between the two parties."

While the settlement will result in a charge of $1.8 billion, the deal will "significantly reduce risk-weighted assets...releasing the equivalent of...$5 billion of capital under [the]... Basel III framework." This is critical for Morgan. Some of the securities the firm carried on its books as a result of its dealings with MBIA "carried particularly high capital charges."

Getting rid of those securities could allow Morgan Stanley to "achieve a Tier 1 common ratio of 10%...by the end of next year" according to the Wall Street Journal. This is significant because, according to TheStreet, Morgan is "likely to face a smaller capital buffer than Citigroup (NYSE:C) and JP Morgan (NYSE:JPM)" which will both be required to hold a capital buffer of 9.5% by 2019.

Morgan Stanley then, would have a higher Tier 1 ratio than is required of even the most systemically important of institutions, well more than it needs to comply with Basel III. The firm's Tier 1 ratio currently stands at around 7% and could rise by 75 basis points after the MBIA settlement according to The New York Times. In its stock report of Morgan, S&P notes that the firm's Tier 1 capital ratio received a 290 basis point boost earlier in the year when Mitsubishi UJF Financial Group converted its preferred shares to common shares relieving Morgan of its obligation to pay Mitsubishi preferred dividends.

The Wall Street Journal notes that, as a result of the MBIA settlement, Morgan may now be able to impress stockholders by both pursuing a share buyback and exercising a call option in May which will allow the firm to increase its share of the Morgan Stanley-Smith Barney brokerage unit it runs with Citigroup from 51% to 65%. The firm plans to purchase the entirety of Citigroup's stake within the next three years.

Morgan and Citi formed the joint venture in 2009 when Morgan "exchanged 100% of its Global Wealth Management business for a 51% stake in the joint venture." The venture proved successful during the third quarter as Morgan reported that the "Global Wealth Management Group delivered net revenue of $3.3 billion, with net new assets for the quarter of $15.5 billion, a record since the inception of the Morgan Stanley-Smith Barney joint venture."

Former CEO John Mack has opined that the joint venture between Citi and Morgan was the one positive development to come out of the financial crisis as far as Morgan Stanley is concerned. According to a Fortune article from earlier this year, the wealth management business is headed in the right direction as margins "climbed to 9% for...2010 [from] a meager 6% in 2009" and "revenue per rep [and] assets per rep" also rose.

Margins have continued to climb at the Wealth Management business as Morgan reported that the unit's "pre-tax margin improved to 11%" during the third quarter of 2011. Additionally, the increase in size brought about by the partnership between Citi and Morgan has allowed the unit to reduce costs as fixed costs for smaller wealth management businesses "can be 25% to 35% of your cost base, [whereas] if you're really big, they can dip to 10% to 15%."

The aforementioned Fortune article also notes that CEO James Gorman has embarked on a campaign to rebuild the firm's fixed income department which "in the three quarters through September 2010...had averaged [just] $1.8 billion...in revenue, less than half the average of its top five competitors." Improvement has come quickly--Morgan's fixed income department reported 2011 second quarter revenue of $2.09 billion in June, outperforming rival Goldman Sachs (NYSE:GS) in both fixed income and investment banking simultaneously for the first time ever according to Bloomberg.

In October, Morgan reported $3.9 billion in third quarter fixed income and commodities trading revenue, a sharp increase from the second quarter, although $2.8 billion of that total came from a so-called debt-valuation adjustment in which banks essentially count as gains the difference in the market value they paid for securities and the prevailing market value.

S&P's outlook for the investment banking and brokerage industry is positive for 2012. Specifically, the ratings agency notes that the sluggish pace of the economic recovery is forcing companies to engineer growth through mergers and acquisitions. This bodes particularly well for Morgan Stanley given that the "firm ranked # 1 in global completed M&A and #2 in global announced M&A" during the most recent quarter according to the company's report. Specifically, the company raked in $413 billion in advisory revenues during the third quarter, an 11% increase from the third quarter of 2010.

Shares of Morgan Stanley have been hit especially hard in the past few months as investors fret over its exposure to toxic European sovereign debt. Shares of Morgan have fallen from around $24 just before S&P downgraded the U.S. in August, to $15.24 most recently. In fact, in early October, Morgan's shares hit levels not seen since 2008 amid fears the firm had more exposure to Europe than most other large U.S. financial institutions.

As investors' angst peaked, "the bid price for five year credit default swaps, which hedge against the bank defaulting on its obligations, climbed to $540,000 for every $10 million worth of debt" representing a one-day increase of nearly 14% from Friday, September 30 to Monday, October 3. That number has come down considerably since October and most recently stood at $415,000, although it still costs more to insure Morgan's debt against default than most other large U.S. financial institutions according to The Wall Street Journal.

It is, of course, nearly impossible to know just how much European exposure Morgan, or any other large financial institution for that matter, has on its books. This is partly because of the lack of transparency regarding banks' positions. As Fitch noted in early November, "many of the bigger positions in European sovereigns held by U.S. banks are hedged...[but] the undisclosed nature of such protection...could prove problematic." Fitch's report put Morgan's net exposure to distressed European sovereign debt at around 3.4 billion at the end of September, far less than Bank of America (NYSE:BAC), Citigroup, and JP Morgan, according to Forbes.

Investors who are willing to take a chance on Morgan Stanley trading at 50% of its book value need not lose too much sleep over its exposure to Europe. All major U.S. financial institutions will be in the same hot water should Europe experience a financial meltdown. Morgan seems to be on track to exceed Basel III requirements perhaps by the end of 2012 thanks to its settlement with MBIA and Mitsubishi's conversion of its preferred equity to common shares in the second quarter. CEO James Gorman has the firm's fixed income unit showing definite signs of life as it bested rival Goldman Sachs in the second and third quarters this year.

One thing is for sure, Morgan is cheap--the shares trade for just 7.3 times analysts' consensus estimate of $2.13 per share in 2012 and at under $16, the stock trades well below the company's tangible book value. It remains to be seen whether Mr. Gorman can continue to boost the firm's capital, squeeze higher margins out of the wealth management business, and boost revenue in the fixed income department, but at current levels, the upside in Morgan's shares seems to be well worth the risk. S&P has a 12-month price target of $22 on the shares but some analysts see it going as high as $28.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in MS over the next 72 hours.