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In this research note, we discuss Morgan Stanley's (NYSE:MS) third quarter, and the new regulations in the swaps market. Morgan Stanley is one of the weaker financial services firms in terms of its financial position and performance. In the swaps market, swaps trades will have to be cleared soon, and there is confusion over how and when to start clearing deals.

Morgan Stanley's Third Quarter

In the third quarter, Morgan Stanley lost $1 billion because of a $2.3 billion charge related to the value of its debt. Without the debt valuation adjustment, income from continuing operations was $561 million. Morgan Stanley is examining ways to reduce compensation costs further.

Morgan Stanley reported better-than-expected adjusted earnings, as it boosted revenue from trading bonds. Bond-trading revenue in the third quarter climbed 33 percent from a year earlier to $1.5 billion. Overall, adjusted trading revenue rose 21 percent, to $3.6 billion, with gains in interest rate and credit trading.

The firm changed the way it measures value-at-risk (VAR). Instead of using the last four years of volatility in its measurement, Morgan Stanley now looks back just one year. That reduces volatility measures, and thus the amount of capital that must be held against assets. The change in the way volatility is measured underestimates potential volatility and value-at-risk. Thus, Morgan Stanley is taking on more risk than it is stating.

Valuation

Morgan Stanley's multiplier model valuation may be nearing a short-term peak. However, the valuation is still well below the 2012 high. On an absolute basis, the multiplier model price-sales ratio suggests the firm is fairly valued to undervalued. That said, the firm doesn't have a price-earnings ratio because unadjusted earnings don't exist.

Swaps

The securities industry misinterpreted rules it assumed allowed as many as nine months to start moving swaps into clearing houses, meant to limit risks to the financial system.

Firms dealing in $648 trillion of outstanding swaps contracts expected that trading during a phase-in period wouldn't need to be processed by central clearing houses, according to an October 5th e-mail sent to clients by Davis Polk & Wardwell LLP, which represents the Securities Industry and Financial Markets Association. It was wrong, misreading one sentence in 17,000 words of regulation.

Unless lobbyists convince the Commodity Futures Trading Commission to soften the deadlines, derivatives users that speculate on or hedge against losses on everything from changes in interest rates to corporate bankruptcies may need to find cash and Treasuries to back the trades sooner than they anticipated. The 2010 Dodd-Frank Act is requiring trades be moved to the central counterparties to limit the kinds of risks that fueled panic during the 2008 credit crisis.

Clearing the trades sooner than expected may soak up as much as $50 billion in additional collateral for swaps users, according to Anshuman Jaswal, senior analyst at financial research firm Celent in New York.

The CFTC may clarify the rules before they are completed as early as next month, though it's too early to know what changes may be made, Commissioner Scott O'Malia said in a telephone interview.

Clearing swaps improves counterparty risks and increases transparency in a widely used financial instrument. Some firms will have to increase the collateral set aside for swap transactions. That said, I think the CFTC will soften its stance and allow for the orderly transition to cleared swap transactions.

Morgan Stanley Explores Sales of its Commodities Business

Morgan Stanley is exploring the sale of its commodity business. I estimate the business to be worth up to $6 billion. The firm is exploring the sale of the commodity business because of new regulations.

Conclusion

Morgan Stanley is failing to deliver on the bottom line. Given the changes in earnings and sales growth, the firm's operating loss and generally weak competitive position, I would short sell Morgan Stanley shares as equity markets could decline in the coming weeks. If the share price rises to $19.50, investors should cover the short. That said, we could see a decline to $12 a share.

Disclaimer: This article is not meant to establish or continue an investment advisory relationship. Before investing, readers should consult their financial advisor. Christopher Grosvenor does not know your financial situation and ability to bear risk and thus his opinions may not be suitable for all investors.

Source: Short Morgan Stanley Shares