Capitalizing on Morgan Stanley's Level 3 Assets

Our Call Spread Recommendation on Goldman Sachs (GS) last week was right on the money, as the brokers and investment bank stocks seem to have recovered from their lows and are starting to show some solid performance. What's driving it? We believe there is something VERY important going on in this sector (specifically in the big Wall Street I-Banks) that is (up until now) beneath the surface of the banks' accounting for "Level I, 2 and 3" assets.

Let’s look at some accounting background for the investment banks. Currently, assets on the banks balance sheets are classified as Levels 1, 2 or 3. Level 1 assets are the easy to price, liquid holdings on the banks balance sheets. Think US Treasuries.

Level 2 assets may be less liquid, but they are priced according to comparable marketable assets, even if they aren’t actively traded themselves.

Level 3 assets, though, are the illiquid holdings that have gotten everyone in trouble lately - the mortgage backed structured products, derivatives, all that toxic waste. These are illiquid, and have been priced according to "mark to model" theoretical pricing programs. Basically they are prices made up out of thin air. Keep with us here, because this is important - last month there was an offer to the big Wall Street investment banks to come to the discount window of the Fed (something not done for over 70 years) and use those level 3 assets for collateral for 100 cents on the dollar fully liquid, US Treasury note-based loans. Now think about that! It's truly turning lead into gold with this type of accounting alchemy.

We saw, in most banks' quarterly earnings releases, huge transfers of assets from "level 2" into "level 3", basically (we suspect) to take advantage of this total windfall of taxpayer cash to the banks. And yes, you can thank Henry Paulsen (of Goldman Sachs pedigree) for this $200 billion taxpayer funded program. Morgan Stanley (MS) has $32 billion now in Level 3 assets (it increased by 45% in Q108) and Goldman themselves added $27 billion to make their "level 3" pile $96 billion. WOW!

Setting aside the discussion of the morality/ethicality of bailing out the Wall Street banks with taxpayer money, this happened last month and we have to figure out how to make an investment return on it. The Wall Street investment banks are now in a position to swap off the worst toxic waste on their balance sheets for US Treasury note-based loans. That's exactly what they're doing, and there's nothing you or I, or Congress, or the President of the United States, can do about it. As a matter of fact, they're looking at this $200 or $300 billion program as the cost of maintaining our financial system's integrity. I guess every once in a while the roots of the tree of global finance have to be replenished with the US taxpayers' capital. (Apologies to Thomas Jefferson's great quote regarding the tree of Liberty).

So today we're picking another investment bank that is currently awash in this program of transferring toxic waste off its balance sheet, Morgan Stanley. In the first quarter, MS increased its Level 3 assets by 45%, to a total of $32 billion, (with a total current market cap of $55 billion, that is a significant number). We believe this positions them to participate in this asset swap in a meaningful manner. The stock is currently down a little, but we feel in the near term we could see a strong move upward in the stock, along with all the other investment banks due to this reliquification program launched by the Fed. Thank you, Mr. and Mrs. Taxpayer. And oh yes, enjoy your $600 tax rebate checks this month.

The chart below shows Morgan Stanley (MS) stock for the last six months. The stock bottomed in March, and has been making upward progress since then. We would expect the shares to revisit the previous Dec '07 highs in the fullness of time. Stochastic lines are positive and we think the timing is right for a call spread on this name.

Morgan Stanley's Fundamental Data:

• Current Price: $48.95
• Shares Outstanding 1.1 Billion
• Market Cap $55.5 Billion
• Forward Price / Earnings (avg. Est) 7.6x
• PEG Ratio (5 Year Expected) 0.7x
• Price / Book 1.7x

Earnings estimates for Morgan Stanley’s next quarterly earnings report (due in June 2008 for the quarter ending May ’08) are pretty widely spaced. The average of 18 estimates presently published is at $1.31, although on the high end it’s $1.66 per share, and on the low end, it is $0.79 per share. The uncertainty comes from just how much of an impact the ongoing credit crunch is going to have on the firm’s investment banking activity, assets and proprietary trading. This uncertainty has been reflected in the gradual decrease of these quarterly estimates from $1.59 per share ninety days ago to a level of $1.31 today.

On a year-over-year basis, Morgan Stanley is expected to earn $5.60 per share this fiscal year (ending November 2008), up from last year’s $2.37 per share. This is an average of 19 analyst targets, and spans another large range from $4.35 on the low end to $6.35 on the high end. High estimates for next year (2009) range all the way up to $8.00 per share, showing that over the longer haul, there is going to be a recovery here, at least in the opinions of analysts.

Revenue achievement seems to be at a regular level of $8.0 to $8.5 billion per quarter, which will result in a full year level of $34.0 billion annual revenues. November 2007 full year revenues were about $28 billion, so we are seeing some decent year-over-year growth numbers despite the market’s general malaise.

In line with the rest of the brokerage sector, the Price / Sales and Price / Book metrics of Morgan Stanley make them out to be “value” plays. With a price to sales ratio of 2.0x and a price to book ratio of 1.7x, these stocks could be classified as pretty well beaten down. Any good news, or even an improvement on the regular stream of bad news from the sector, could be the catalyst to ignite a rally.

Investment Recommendation

We recommend that investors purchase a June 2008 $50 call on MS and sell the June $60 strike price call. Current prices indicate that buying the MS June $50 Call ($2.20 at present) and selling the MS June $60 call ($0.05 at present) would result in a net cost to investors of approximately $2.15, or $215 per spread. With MS presently trading at $48.95, investors will be close to “in the money” with the lower priced calls. The break-even point on this spread is approximately $52.15 on the stock (calculated as the strike price of the lower priced calls ($50) plus the net cost of $2.15 for the spread).

Investors will have just about two months (until expiration on June 21st, 2008) to realize these levels. We would look to exit this call spread at a price point of $8.25 or greater. This means that if you can sell the $50 call and buy back the $60 call in the near future for a total price of $8.25, or $825 per spread, we would exit the trade. This ‘trigger’ order can be entered with your broker.

Please note: Options trades all involve a high degree of risk and the potential to lose some or all of your investment. These recommendations are general in nature, and you should consult your own financial professional who is familiar with your situation as to the appropriateness of these trade ideas.

Disclosure: Analyst has no position in MS options.

Comments

[PJ568]

IMO the author got carried away on a few statements.

The program doesn't result in transferring toxic waste off the balance sheet, it results in additional balance sheet debt with increased liquidity. They still own the pledged asset. There is no dollar for dollar exchange, the amount of the haircut varies on the collateral and level 3's have larger haircuts than level 2's. Granted, they can borrow more from the Fed than they could from anyone else in todays climate.

[arkay]

Can you clarify?

I cannot understand the logic of selling June $60 calls as you get a premium of only $0.05. Considering that I need to shell of only $2.20 for June $50 calls, I can breakeven at $52.20 instead of $52.15.

You are going to make money only if stock raises above the break even point. So what is the point of having a sell call option as the premium does not justify the benefits.

[Daniel Jones]

User - your point is well taken. I would clarify and not sell that June 60 call for a nickel. I would still buy the June 50's and wait to sell the 60's at a later date, after the stock has run up. You are correct that a $2.20 breakeven is not materially any different than a $2.15 point.

[helplessobserver]

Good shot User. Now he is awake!

[coco_coco]

Who is PJ568?? Does he speak for the intented audience?

Will someone please get User a sense of humor!

Keep rubbing it in their face!!

[yj777]

Wow.. that "investment recommendation" worked brilliantly.. whoever followed his brilliant advice is now holding two sets of calls out of the money and out of a few thousand dollars.. excellent LOL!

[yj777]

actually the "huge transfers of assets from "level 2" into "level 3"" are due to the deteriorating mortgage market, so as the level 2 assets basically lose their rating they have to be marked as level 3 assets..
This is definitely a BAD thing.. not something you should use as a investment strategy unless you are planning on shorting MS or writing puts..