Though the market responded very positively to Citigroup (C) and Bank of America's (BAC) reserve release-driven earnings "beats," last week's Morgan Stanley (MS) earnings report illustrated what happens when a bank doesn't have billions of reserves to release back into earnings.
Estimates called for the following:
- $.43 per share in earnings
- $.29 per share in earnings ex-DVA (debt value adjustment)
- $7.7 billion in revenue
GAAP results (including the DVA) came in at $.28 per share, while ex-DVA earnings were $.16.
Revenue was a particular disappointment, coming in at $6.95 billion.
Several issues with MS' core business were brought to light with this earnings release.
Goldman Sachs (GS) Is Eating Morgan Stanley's Lunch
I'm not an advocate of investing in Goldman Sachs' black-box revenue model either, but at they've regained their stance as the top trader on the street. GS's fixed income trading revenue was up 40%. Morgan Stanley on the other hand, saw a 48% decline in overall trading revenue for Q2, and an obscene 59% plunge in fixed income trading. While a portion of that decline had to with collateral requirements that the firm had to post in response to credit downgrades, the remaining weakness was a result of a severe decline in counterparty confidence.
With Morgan Stanley's credit rating only three notches above junk level, clients are finding few reasons to accept MS' counterparty trading risk. I expect this trend to continue; counterparty confidence and brand names take a long time to build up, but can fall apart awfully quickly. With client activity already in rapid decline, further weakness is self-reinforcing.
Ongoing Credit Risk
As the global economy deteriorates further, and Morgan Stanley's core businesses weaken further, Morgan Stanley will be downgraded once again. Though CEO James Gorman was somehow able to persuade Moody's from downgrading the firm three notches in the last review, Moody's is unlikely to be so kind (or wrong) the next time.
MS could have been called for $9.5 billion in additional collateral had it been downgraded just one more notch.
As overall revenues decline as a result of weakened client activity, further credit downgrades will ensue, progressing the move away from Morgan Stanley's businesses, resulting in a dangerous feedback loop.
While global markets have steadied a bit, the next leg of the crisis could exacerbate Morgan Stanley's weakness and draw eyes to its $52 trillion notional derivative exposure. Additionally, with only a small portion of this derivative exposure held in the bank's federally insured bank subsidiaries, Morgan Stanley is the only big bank hanging in the wind in terms of being on the hook for massive losses.
Citigroup analyst Keith Horowitz noted that 52% of revenues, or $3.63 billion, went to compensation expenses, up from 50% last year.
This is particularly worrisome. Morgan Stanley is currently unable to meaningfully to invest in new businesses due to their current compensation structure. In the event that Morgan Stanley attempts to reduce compensation, I think you could see a "run" on the bank in the sense that traders and investment bankers will jump ship.
Don't forget: cash bonuses are being capped at $125,000 this year, and with declining revenues, that should continue into next year.
The investment bankers at MS are the best in the business; they rank #1 in global equity underwriting. There is no way Morgan Stanley is going to be able to retain these guys without guarantees of better pay
Morgan's latest report, the highlight of which being the collapse in Morgan Stanley's core businesses, should be examined thoroughly by existing and prospective stockholders.
Although MS trades at a forward multiple of 6.35, the business is weakening considerably, and the forward credit risk is a double-edged sword in that it deters clients from trading with the firm and billions in collateral will have to be posted. Morgan Stanley is losing in every major segment except underwriting, but that will likely change soon.
The compensation issue is arguably the most important. MS' one bright spot right now is their equity underwriting business. Investment bankers who are ranked #1 in the business demand to be paid like they're #1. Over time, the firm's top bankers will leave due to pay, and traders will leave if they're having a tough time doing business.
The derivative exposure, for which MS is nearly completely on the hook for, is the nail in the coffin regarding a prospective investment decision in MS.
While I'm not short Morgan Stanley yet, the aforementioned reasons are plenty to get me interested. Perhaps longer-dated put options are the way to play this.
On a shorter-term basis, I expect MS to test its 52 week lows of $11.58. With Europe flaring up again, hedge funds will increase short exposure and sell their long holdings due to the prevailing thought that MS will be the "first to go" in a real crisis. Have you noticed MS vastly underperforming the major financials when EU worries heat up? That's why.
Morgan Stanley is an interesting short play: rapidly deteriorating core businesses, limited compensation flexibility, huge derivative exposures that are not limited to bank subsidiaries, and credit risks that will further harm client activity and require collateral postings.