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Morgan Stanley (MS)
Give Morgan Stanley Sometime to Adjust to the New World
Poor John Mack. Last year, he was criticized for overseeing the excessive leveraging of Morgan Stanley's balance sheet since his return to the firm in 2005. The storied Wall Street shop almost went the way of Lehman and Bear but Mack, with his dogged resilience, brought MS back from the precipice getting some help from his Japanese friends (Mizuho Financial) and the US taxpayer via TARP along the way. So he probably thought we came so close to being extinct that it might not be a bad idea to take it easy for a couple of quarters, cut back on proprietary trading and regain our bearings. Ordinarily, after the amount of red ink banks used up last year, this notion would have been well received. But then last week, after Goldman reported earnings and knocked the cover off the ball, MS was expected to do something similar. However, on Wednesday, the street, to its great disappointment found out that Mack is apparently on a no-risk diet.
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Morgan Stanley's numbers were way off. The company reported a net loss of $177 million or 57 cents a share. The street was expecting anywhere from a loss of only 6 cents a share to a small profit. It should be noted that MS had to take a $1.5 billion paper loss due to the increase in value of its own bonds (it would have turned a profit without this). When the firm was struggling last year, and the value of that debt was plummeting, MS benefited as it took a paper profit due to the fact that it would be cheaper to pay off those obligations. Well, now the reverse is happening. But that's mostly an accounting issue. The real disappointment for analysts was the fact that the fixed-income sales and trading businesses generated only $1.3 billion in net revenues. The comparable # at Goldman was $6.6 billion. This is a clear sign that Morgan Stanley's risk appetite this quarter was really low and it chose to play it safe. Executives at the firm mostly agreed with that assessment during the conference call.
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The question is whether they chose to play it too safe. After all, Morgan Stanley is in the business of taking risk and if it can't demonstrate a supreme ability to take on calculated risks and earn commensurate returns, shareholders have every right to question whether deploying their capital in MS is a wise choice. By most accounts, there were tremendous opportunities for a supposedly savvy player like Morgan Stanley to make hay this quarter especially in the first two months, given the spread in corporate bonds and the severely reduced lack of competition on the street. So investors were justified in pushing the stock down in the wake of the earnings report.
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But it was overdone. MS deserves a break. The firm is just settling into its new role as a bank holding company and John Mack has had a genuine change of heart in terms of the firm's risk trading profile. He is no longer trying to emulate Goldman and that's a good thing. He is doing what he thinks is best for his firm. The key for him will be to demonstrate whether he can strike that balance between risk and return. MS doesn't need to be competing with Goldman for income statement supremacy. It can get by generating relatively smaller gains for shareholders provided there is a consistency to those revenue streams. The boom-bust cycle has to be made a thing of the past. So the trading revenues are going to have to increase, this quarter they were way too low but again, they don't have to approach Goldman levels.
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After the disappointment of this quarter blows away, investors will give Mack a couple of quarters to get it right as long as the firm shows progress towards increased calculated and thoughtful risk trading. Most rational people realize that changing the culture of a firm as big as Morgan Stanley takes time. The firm clearly turned the dial too far to the safety side but now it has the opportunity calibrate to the optimal level of risk taking. If Morgan Stanley can do that and avoid any additional landmines, they will be just fine.
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