Using Veritas to Construct the "Per…

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This is the update to my forensic deep dive analysis of Morgan Stanley. It is still, in my opinion, the "riskiest bank on the street". A few things to make note of as you browse through my opinion and analysis:

  • Morgan Stanley still has the most illiquid assets as a proportion to net tangible equity of any bank on the Street, save Bear Stearns.
  • I believe Morgan Stanley still has the most net counterparty exposure
  • Morgan Stanley has significant exposure to loss through off balance sheet vehicles
  • Morgan Stanley has misleading accounting profits through FAS 159 which allowed it to overstate its economic profit by roughly 50%
  • The investment banking industry's high leverage, high risk, high compensation, low liquidity, low transparency business model was ripe for disintermediation though a significant credit crisis. What we have here ladies and gentlemen, is a severe and significant credit crisis.
  • This is my thoroughly researched opinion, and is in no way intended to be, or should be taken as, investment advice. 

 

My "uber buyside", outside the box, realistic perspective of leverage, risk, and solvency produced the Breaking the Bear analysis in January which, in hindsight, turned out to be quite prescient. I am just as confident in my outlook on Morgan Stanley as I was on Bear Stearns. That's pretty much my 50 cents. No, I am not that wanna be hip hop guy. It was initially my 2 cents, but I levered up 25X! Now, let's get on with the analysis. For those who want to view it in full fidelity with all pro formas intact, download the pdf: icon Morgan Stanley_final_040408 (1.38 MB), otherwise, read on... 

 

 

    

I.          Investment summary

 
The declining values of mortgage-backed securities amid concerns of slowing US economy and turmoil in the global credit markets underlines the strong possibility of further write-downs by Morgan Stanley in the coming periods. While the bank reported better-than-expected performance figures in 1Q2008, fast declining ABX indices indicate that smooth sailing could be a difficult proposition for Morgan Stanley in 2008, and most likely in 2009. Its highest exposure to level 3 assets (as a % of the total equity) among its peers and relatively higher leveraged position (total adjusted assets to adjusted equity) has drawn some concerns in the investment community. In addition, the counterparty risks associated with its exposure to monolines (through hedging of its portfolio risks) could prove to be a bane to the bank’s balance sheet and earnings in view of the current distressed condition of the monolines. Morgan Stanley has recently managed to raise additional capital of $5 bn from China Investment Corporation to secure adequate liquidity which currently looks to be at a reasonable level, but the position could reverse due to significant losses off asset write-downs. We expect Morgan Stanley to witness asset write-downs of $16.5 billion and $7.6 bn in 2008 and 2009, respectively, which coupled with a possible slow down in investment banking and trading revenues is likely to drag its valuation to $25.31 per share from the current $48.88 per share. 
Increasing level 3 assets likely to cause further losses: Morgan Stanley’s hard-to-value assets, represented by level 3 assets have grown persistently, rising from 4.3% of the total assets in 1Q2007 to 7.0% in 1Q2008 partly off the transfer of assets from level 2 to level 3 due to unobservable market inputs. As liquidity crisis and credit spread widening continues to hamper the global financial markets, we expect the increasing proportion of level 3 assets in Morgan Stanley’s balance sheet to translate into higher losses and asset write-downs for the company. Also noteworthy is the fact that Morgan Stanley’s level 3 assets as a proportion of its shareholders’ equity are the highest in its peer group which makes it one of the most vulnerable companies to be hit by continuing credit market turmoil. 
Highly leveraged balance sheet could hinder capital raising: At 37.3x Morgan Stanley’s adjusted leverage ratio (a measure of the extent to which the company relies on borrowed money) is the highest among its peers. Morgan Stanley’s high leverage could hinder the company’s ability to raise capital to maintain statutory capital levels in future (or at the very least make the cost of said capital extreme) and take advantage of any near-term business opportunities amid tight credit conditions. 
Continued asset write-downs to impact profitability: While the financial sector continues to clean its balance sheet by writing off bad assets, the global credit crisis doesn’t appear to have subsided. UBS and Deutsche Bank expect $19 bn and $3.9 bn of write-downs, respectively, for 1Q2008. Morgan Stanley’s $9.4 bn asset write-down in 4QFY07 was followed by a $2.3 bn mortgage-related asset write-down in 1Q2008. Amid continuing housing sector problems and credit spread widening, financial sector could see further write-downs in the coming quarters.  The following charts attempt to outline what we see as a potential downside to commercial (retail) and residential property values, respectively. According to these charts, companies such as Morgan Stanly, which hold significant securities and related assets written at the top of the real estate and credit bubble with high leverage, have quite some way to fall before equilibrium (ex. a bottom) is reached, and when that point arrives, history portends that we will coast along the bottom in lieu of experiencing a “V” shaped curve where asset values immediately bounce upwards – further lending to illiquidity in the said markets. (Source: Case Shiller) 
 
image006.gif

 Counter party risks looming large amid threat of monolines’ failure: Investment banks could face significant counter party risks on the bonds insured with monolines to hedge their CDO risks, as monolines themselves are reeling under pressure from substantial losses and rating downgrades. Hedging with monolines could turn ineffective with a failure of these insurers to honor their commitments. Fearing such an outcome, a downgrade in the ratings of monolines is driving investment banks to write-down their monoline exposures. In addition to the credit risk faced with monoline contracts, several monoline companies are attempting to use legal means to forego honoring their credit defaults swap agreements. The success of these moves, not to mention the costs and time investments to reach final judicial solutions, poses risks to the investment banks. 
 
Exposure to variable interest entities (VIEs): Unconsolidated VIEs that allow firms to keep riskier assets off their balance sheets could be a significant source of potential losses for investment banks. According to Credit Sights, a credit research firm, VIEs have a total of $784 bn in commercial paper which could cause estimated $88 bn losses to banks. Morgan Stanley has $37.7 bn in exposure towards unconsolidated VIEs with maximum loss exposure to unconsolidated VIEs of $15.9 bn. The maximum loss of $33.6 bn (consolidated and unconsolidated) from VIEs could alone wipe off its entire adjusted shareholder’s equity of $29.2 bn as of February 29, 2008. 
 
Capital market activity expected to remain under pressure: As credit and equity markets deteriorate, the global capital market trends continue to remain challenging in the near-to-medium term. A decline in new debt and equity issuance along with a slowdown in M&A transactions could affect Morgan Stanley’s revenues from investment banking activity, further constraining the bank’s profitability. 
 
Strong liquidity position: On the positive front, Morgan Stanley appears to carry strong liquidity on its balance sheet. The bank’s average liquidity increased to $123 bn in 1Q2008 up from $85 bn in 2007 as a result of $5 bn capital infusion by China Investment Corporation and realization from asset disposals. Additionally, Fed’s initiative to allow brokerage firms to borrow from its discount window would ease temporary liquidity problems for Morgan Stanley and other brokerage firms.  However, burgeoning losses and declining confidence in capital markets in form of stringent lending standards could put a strain on the bank’s liquidity in the medium term, in our view.

{mospagebreak}
 

II.        Valuation

Owing to continuing write-downs off widening credit spreads and persistent weakness in the credit markets, we expect valuations of financial services firms to remain under pressure until the credit market situation eases off significantly. We have valued Morgan Stanley using an adjusted price-to-book value multiple since we believe that under the current volatile market conditions DCF or an earnings-based valuation approach would not be appropriate. We have used tangible shareholders’ equity (shareholders’ equity less goodwill and other intangibles) to measure adjusted book value per share.    
 
    Price Shares o/s   Revenues     BVPS     EPS  
        2008 2009 2010 2008 2009 2010 2008 2009 2010
Morgan Stanley MS 48.9 1104.6   25,137   31,940   38,587 24.6 26.1 27.5 1.12 2.69 4.91
Bear Stearns BSC 10.7 118      6,737      7,892      9,526       90.0       97.8     109.9 6.48 8.95 9.63
Goldman Sachs GS 176.5 395   38,056   43,293   46,890     102.7     118.1     157.7 16.59 20.70 21.80
Merrill Lynch MER 45.9 969   31,500   36,761   38,706       37.7       42.7       43.9 3.95 5.73 5.83
Lehman Brothers LEH 43.3 554   17,128   20,113   22,115       43.7       49.5       62.2 4.88 6.75 7.06
 
Company Market Cap
(US$ mn)
  Price/ Revenue
per share
    P/B     P/E  
    2008E 2009E 2010E 2008E 2009E 2010E 2008E 2009E 2010E
Morgan Stanley       53,995        2.15            1.69        1.40        1.99        1.87        1.78      43.55      18.20        9.95
Bear Stearns         1,266        0.19            0.16        0.13        0.12        0.11        0.10        1.65        1.20        1.11
Goldman Sachs       69,749        1.83            1.61        1.49        1.72        1.49        1.12      10.64        8.53        8.10
Merrill Lynch       44,468        1.41            1.21        1.15        1.22        1.07        1.05      11.62        8.01        7.87
Lehman Brothers       23,991        1.40            1.19        1.08        0.99        0.88        0.70        8.88        6.42        6.14
Industry Average   1.21 1.04 0.96 1.01 0.89 0.74 8.20 6.04 5.80
Excluding Bear Sterns   1.55 1.34 1.24 1.31 1.15 0.95 10.38 7.65 7.37
 
P/B approach  
Price-to-book value (2009)           1.15
   
Book value per share (excluding VIE loss) 26.1
Estimated share price         29.95
   
Book value per share (including VIE loss) 22.0
Estimated share price         25.31
Upside (downside) -38.7%
   
Current share price 48.9
   
   
P/E approach  
P/E           7.65
EPS (2009) 2.69
   
Estimated Price         20.55
Upside (downside) -58.0%
 
Valuation based on P/BV method under various scenario    
           
       
All Figures in Millions of Dollars, unless othrerwise stated Base Case Optimistic Case Worst Case
BVPS (2009)     $24.60 $31.54 $17.23
           
Fair Value Per Share     $28.24 $36.20 $19.78
           
P/B trading multiple     1.15 1.15 1.15
           
(We have excluded Bear Sterns from peer average owing to the recent liquidity crisis faced by the firm in the repo market. 
We belive that recent initiatives by Fed to open the discount window to prime brokerages firm will help them manage their short term liquidity 
and they will be able to avert similar crisis.)        
           
Valuation based on P/BV method including impact of unconsolidated VIE's under various scenario
           
       
All Figures in Millions of Dollars, unless othrerwise stated Base Case Optimistic Case Worst Case
BVPS (2009)     $22.05 $29.85 $12.13
           
Fair Value Per Share     $25.31 $34.26 $13.92
           
P/B trading multiple     1.15 1.15 1.15
Upside (downside) potentail     -48% -30% -72%
 
  
 Base case: Under our base case scenario, we expect US to witness a hard landing, with a decline in its macro-economic fundamentals including capital spending, employment levels and retail sales. We have assumed a negative GDP growth in the next 2 quarters, followed by recovery. Under the base case scenario, we expect Morgan Stanley to report total write-downs of $16.5 bn in 2008. 
 
Optimistic case: In the optimistic case scenario, we assume that US would be able to negotiate an economic slowdown in order to avoid negative GDP growth, thus avoiding a recession, but still succumbing to slower economic growth. We expect that, like our base case scenario, problems in the credit market will be primarily limited to structured and leveraged financial products. We expect Morgan Stanley to report total write-downs of $5.0 bn in 2008. 
 
Worst case: In our worst case scenario, we expect a prolonged recession in US to last over the next 12-18 months as the turmoil in US housing and financial markets spread to other sectors of the economy. We expect Morgan Stanley to report total write-downs of $28.6 bn for 2008 under the worst case scenario. Under our base case scenario, Morgan Stanley’s adjusted book value per share, including the impact of losses from unconsolidated VIEs comes to around $22.05 for 2009. Using a P/B multiple of 1.15 for the peer group (excluding Bear Sterns), we arrive at a $25.31 per share valuation for Morgan Stanley implying a downward potential of 48.2% from the current share price of $48.88 as of April 2, 2008. {mospagebreak}
 

III.      Investment Highlights

Morgan Stanley’s significant level 3 exposure and high leverage remain a cause for extreme concern

Large write-downs likely due to level 3 assets exposure: Morgan Stanley’s level 3 asset exposure, which stood at 261% of its equity as of February 29, 2008, is likely to cause a significant drag on its valuation in the near future. These assets, for which the bank uses proprietary models to gauge their value, will witness the largest write-downs of all asset categories amid the current credit market turmoil. When compared with other leading investment banks, Morgan Stanley clearly stands out to be the most vulnerable to falling values in these hard-to-value assets. It is worthwhile to mention that Bear Stearns, which last month witnessed significant erosion in its market capitalization, had level 3 assets equal to 239% of its equity, next only to Morgan Stanley. Although the Fed has mitigated liquidity concerns of investment banks in significant part, the balance sheet solvency is a far more difficult problem to address – and one in which Morgan Stanley leads the pack. 
 
 
Bank Level 1 Assets Level 2 Assets Level 3 Assets Shareholder Equity Total Assets Level 1 Assets-to-Total Assets Level 2 Assets-to-Equity Level 3 Assets-to-Equity Leverage (X)
Citigroup $223 $934 $133 $114 $2,183 10.2% 822% 117% 19.21
Merrill Lynch $122 $768 $41 $32 $1,020 12.0% 2405% 130% 31.94
Lehman Brothers $73 $177 $39 $26 $786 9.2% 687% 152% 30.59
Goldman Sachs $122 $277 $72 $47 $1,120 10.9% 586% 153% 23.71
Morgan Stanley $115 $226 $74 $31 $1,045 11.0% 723% 236% 33.43
Bear Stearns $29 227 $28 $12 $96 30.7% 1926% 239% 8.15
 
Based on latest quarterly filings and transcripts 
 
Also, the growing proportion of level 3 assets in Morgan Stanley’s total asset exposure is raising investors’ concerns over expected write downs in the coming quarters. The bank’s level 3 assets have increased partly due to re-classification of assets from level 2 to level 3 on account of unobservable inputs for the fair value measurement. During 4Q2007, Morgan Stanley re-classified $7.0 bn of funded assets and $279 mn of net derivative contracts from level 2 to level 3. Morgan Stanley’s level 2 assets-to-total assets ratio declined to 5.2% in 4Q2007 from 8.9% in 1Q2007 while its level 3 assets-to-total assets increased to 7.0% in 4Q2007 from 4.3% in 1Q2007 indicating growing uncertainty associated with valuation of assets not readily marketable. The trend can be expected to continue in the coming quarters as uncertainty associated with realizing values from illiquid assets continues to grow.  
image0121x.gif
image014x.gif
 
High leveraging could hinder capital raising abilities: While expected asset write-downs could continue eroding Morgan Stanley’s equity at least for the next few quarters, the company’s higher-than-peers leverage levels could prove to be an impediment in raising additional capital to maintain its statutory capital levels. Morgan Stanley’s leverage (computed as total tangible assets over tangible shareholders’ equity) stood at 37.3X as of February 29, 2008, while the bank’s balance sheet size had been reduced to $1,091 bn as of that date from $1,182 bn on November 30, 2007. The bank’s leverage is the highest among its peers which could be a cause of concern amid falling income levels and tight liquidity conditions in the financial markets.
image0121.gif
 * Adjusted assets / adjusted shareholder's equity 
 
Morgan Stanley taking initiatives to “de-risk” its balance sheet: In the wake of issues underpinning the current crisis in the markets, Morgan Stanley is making continued efforts to “de-risk” its balance sheet by reducing its exposure to risky credit positions. Morgan Stanley’s total non-investment grade loans decreased to $26 bn in 1Q2008 from $30.9 bn in 4Q2007. In addition Morgan Stanley reduced its gross exposure towards CMBS and RMBS securities to $23.5 bn and $14.5 bn, respectively, in 1Q2008 from $31.5 bn and $16.5 bn, respectively, in 4Q2007. {mospagebreak}
 

Worsening credit market to impact Morgan Stanley’s financial position

The current gridlock in the credit market has drastically pulled down the mark-to-market valuation of mortgage-backed structured finance products, resulting in significant asset write-downs of banks and financial institutions. It is estimated that further write-downs by investment banks could touch $75 bn in 2008 after an estimated $230 bn already written off since the start of 2007. With the situation not expected to improve in the near-to-medium term, investment banks are likely to face a sizeable erosion of their equity from large write-downs in the coming periods. Though the recent mark-down revelations by UBS and Deutsche Bank have injected some positive sentiment in the global capital markets with the hope that the credit crisis has reached an inflection point, it is overly optimistic to believe that the beginning of the end of the current turmoil is at hand before the causes of the turmoil, tumbling real asset prices and spiking credit defaults, cease to act as catalysts.
image013x.gif
* expected 
 
Morgan Stanley wrote off a significant $9.4 bn of its assets in 4Q2007. However, the write down in 1Q2008 was much lower with $1.2 bn mortgage related write-down and $1.1 bn leveraged loan write-down, partly offset by $0.80 bn gains from credit widening under FAS159 adjustments. One of the factors which the bank considers while estimating asset write-downs is the movement in the ABX index which tracks different tranches of CDS based on subprime backed securities. Nearly all tranches of ABX index have witnessed a significant decline over the last six months. While Morgan Stanley’s 4Q2007 write-down of $9.4 bn appeared in line with a considerable fall in the ABX index during the quarter, a similar nexus is not evident for 1Q2008. Morgan Stanley recorded a gross write-down of $2.3 bn in 1Q2008 though the decline in ABX indices seemed relatively severe (however not as steep as in the preceding quarter). The disparity raises a concern that Morgan Stanley might report more losses in the coming periods. 
 
image015y.jpg
 
ABX BBB indices (September 26, 2007, to  April 2, 2008) Source: Marki.comt Although the ABX indices showed a slight recovery in March 2008, this is expected to be a temporary turnaround before the indices resume their downward movement owing to expected continuing deterioration in the US housing sector and mortgage markets. The following is a detailed, yet not exhaustive, example of Morgan Stanley's "hedged" ABS portfolio - icon Morgan Stanley ABS Inventory (1.65 MB).
"Hedged" is a parenthetical because we believe that large scale investment bank hedges are far from perfect. We discuss this later on in the report.
 
The US housing markets are yet to stabilize and housing prices are still above their long-term historical median levels, leaving scope for a further downside in prices. Between October 2007 and January 2008, the S&P Case Shiller index declined nearly 6.5% (with 2.3% decline in January 2008 alone). We would like to make it clear that although the CS index is an econometric marvel, it does not remotely capture the entire universe of depreciating housing assets. It purposely excludes those sectors of the housing market that are hardest hit by declines, namely: new construction (ex. home builder finished inventory), condos and co-ops, investor properties and “flips”, multi-family properties, and portable homes (ex. trailers). Investor properties and condos lead the way in defaults due to excess speculation while new construction faces the largest discounts, second only to possibly repossessed homes such as REOs. A decline in this expanded definition of housing stock’s pricing could result in increased defaults and delinquencies, significantly beyond that which is represented by the Case Shiller index, which itself portends dire consequences. As credit spreads continue to widen over the next few quarters, the assets would need to be devalued in line with risk re-pricing. Morgan Stanley and the financial sector in general, are expected to continue with their balance sheet cleansing exercise, recording further asset write-downs till stability is restored in the financial markets.  While it is believe the expected continuing fall in the security market values would indicate more write-downs in the coming quarters, a part of this could be set-off under FAS159 by implied gains from write-down of financial liabilities off an expected widening of credit spreads. Morgan Stanley is expected to record assets write-down losses of $16.5 bn and $7.6 bn in 2008 and 2009, respectively, considering the bank’s increasing proportion of level 3 assets amid falling security values. This would be partially off-set by FAS159 gains of $930.8 mn and$116.1 mn in the two years off revaluation of its financial liabilities. It is important to note the fact that FAS 159 gains are primarily accounting gains, and not economic gains and they do not truly reflect the economic condition of Morgan Stanley. Of the $18.3 bn of total liabilities for which the bank makes adjustments relating to FAS159, $14.2 bn and $3.1 bn of liabilities relate to long-term borrowings and deposits.
 
Since most of these securities are traded in the secondary market, it would be difficult for Morgan Stanley to translate these accounting gains into economic gains by purchasing them at a discount to par during a widening credit spreads scenario.  To explain in simpler terms, marketable securities can be purchased at a discount to par if credit spreads increase as MS debt is devalued. Thus, theoretically, MS can retire this debt for less than par by purchasing this debt outright in the market, and FAS 159 allows MS to take this spread between market values and par as an accounting profit, presumably to match and offset the logic in forcing companies to market assets to market via FAS 157. In reality, only marketable securities can yield such results in an economic fashion, though companies that would be stressed enough to experience such spreads probably would not be in the condition to retire debt. In Morgan Stanley’s case, these spreads represent non-marketable debt such as bank loans, negotiated borrowings and deposits. These cannot be purchased at less than par by the borrower, thus any accounting gain had through FAS 159 will lead to phantom economic gains that don’t exist in reality. For instance, a $1 billion bank loan will always be a loan for the same principle amount, regardless of MS’s credit spreads, unless the bank itself decides to forgive principal, which is highly unlikely. It should be noted that Lehman Brothers actually experienced an economic loss for the latest quarter of about $100 million, but benefitted by the accounting gain stemming from FAS 159, that led to an accounting profit of approximately $500 million. This profit, which sparked a broker rally, was purely accounting fiction. Similarly, Morgan Stanley (in economic profit, ex. “real” terms) overstated its Q1 ’08 profit by approximately 50%. This overstatement apparently induced a similarly rally for the brokers. Quite frankly, we feel the industry as a whole is in a precarious predicament due to dwindling value drivers, a cyclical industry downturn, a credit crisis and a deluge of overvalued, unmarketable and quickly depreciating assets stuck on their balance sheets. Their true economic performance is revealing such, but is masked by clever, yet allowable accounting shenanigans.
Morgan Stanley Write-down -2008 Level 1 Level 2 Level 3 Total
(In US$ mn)        
         
Financial instruments owned        
U.S. government and agency securities                -                 12                 2               14
Other sovereign government obligations                -                   9                 0                 9
Corporate and other debt                 2          2,761          2,223          4,986
Corporate equities             413               71               62             546
Derivative contracts             226          7,252          3,240        10,719
Investments                 1                 1             196             198
Physical commodities                -                 12                -                 12
Total financial instruments owned            642       10,120         5,723       16,485
 
 {mospagebreak}
 

Significant counter-party risks from monoline downgrades to result in further write-downs

While hedging does function as an effective tool in minimizing loses from write-downs of dubious assets, hedging in the form of protection from monolines/bond insurers carries associated counterparty credit risks which cannot be ignored in the current environment of continued weakening of monolines. An increasing probability of counterparty risks materializing for investment banks from the deteriorating financial position of the monolines could contribute to further asset write-downs by the banks. It is estimated that the top five US investment-banks have a combined $23 bn in uncollateralized exposures to triple-A rated counterparties part of which is with the monocline bond insurers including AMBAC, MBIA (may face downgrade from Fitch, same with Ambac), and FGIC (is now rated as junk), which have been a subject of downgrades in the last few months. Merrill Lynch’s total uncollateralized exposure to triple-A counterparties stood at $7.1 bn as of August 31, 2007, while that of Morgan Stanley was $7 bn as of that date. The corresponding figures for GS, Lehman and Bear Sterns were $4.7 bn, $4 bn and $330 mn, respectively. Merrill Lynch has reported that around 50% of its total hedging is in the form of monoline insurance, giving a fair indication of the possible write-downs resulting from downgrades of monolines. Merrill Lynch also reported a $3.1 bn asset write-down in 4QFY07 in response to a downgrade of ACA Capital (to which it had an exposure) to junk status.
 
As of February 29, 2008, Morgan Stanley had $4.7 bn aggregate exposure towards monolines with a $1.3 bn exposure in ABS bonds, $2.6 bn in municipal bond securities and $0.8 bn in net counter party exposure. The deterioration of credit market coupled with significant losses suffered by monolines had caused downgrades of monolines. Any further downgrades of monolines could result in additional write-downs by financial institutions and adversely affect the financial markets. Morgan Stanley recorded approximately $600 mn write-down in 1Q2008 on account of its exposure from monolines. S&P estimates that the total hedges to CDO exposures by bond insurers are currently around $125 bn, though the location of these hedges is not entirely known. A separate report by Oppenheimer & Co estimates that the total write-down by the financial institutions resulting from potential rating downgrades of monolines could range between $40 bn to as high as $70 bn, with Citigroup, ML, and UBS being the most vulnerable as they together hold a large chunk of the credit market risk associated with bond insurers. The coming quarters could thus witness more significant assets write-downs if monolines are downgraded.
 
The possible relief comes from the recent developments whereby monolines have been successful in raising capital to maintain their AAA ratings.  Earlier, in March 2008, both S&P and Moody’s affirmed AAA and Aaa ratings, respectively, to AMBAC after it raised $1.5 bn through sale of common stock and convertible units.  Another factor which may reinforce the banks’ counter party risks on monocline exposure are the recent developments which indicate that the monolines may be looking for means to terminate their guarantee contracts with the banks to evade their liabilities. A case in point is the legal battle initiated between Merrill Lynch and Security Capital Assurance (SCA) wherein Merrill Lynch sued SCA’s XL Capital Assurance unit on the ground that the latter refused to honor the commitments arising on the bank’s CDS worth $3.1 bn. SCA has in turn alleged that Merrill Lynch had not honored the contractual terms by transferring the control rights on the CDOs to a third party. More such legal battles could follow creating increased uncertainty on the true extent of hedging exercisable on monocline exposure. {mospagebreak}
 

Hidden losses from unconsolidated VIE’s a cause of concern for Morgan Stanley

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Morgan Stanley has a significant exposure to MBS, ABS, credit and real estate assets and other structured transactions through VIEs. As at November 30, 2007 Morgan Stanley consolidated $22.4 bn of assets from VIEs, with a maximum loss exposure of $17.6 bn. In addition, the bank also has $37.7 bn in exposure through unconsolidated VIEs with a maximum loss exposure of $15.9 bn, yielding a maximum loss-to-total exposure at 42.4%. Morgan Stanley’s total exposure towards unconsolidated VIEs is in some of the riskiest asset class categories, including a $7.2 bn exposure towards MBS and ABS securities (maximum loss-to-exposure of 3.9%), $20.3 bn towards credit and real estate (maximum loss-to-exposure of 65.4%) and $10.2 bn towards structured transactions (maximum loss-to-exposure of 23.9%).   
 
Consolidated VIE's  ($ mn) 30-Nov-07
US$ mn VIE assets consolidated  Maximum exposure to loss
     
 Mortgage and asset-backed securitizations 5,916 1,750
 Municipal bond trusts 828 828
 Credit and real estate 5,130 5,835
 Commodities financing 1,170 328
 Structured transactions 9,403 8,877
 Total 22,447 17,618
     
    78.49%
     
Unconsolidated VIE's ($ mn) 30-Nov-07
US$ mn VIE assets not consolidated Maximum exposure to loss
 Mortgage and asset-backed securitizations 7,234 280
 Credit and real estate 20,265 13,255
 Structured transactions 10,218 2,441
 Total 37,717 15,976
     
    42.36%
 
 
 
Net losses Optimistic Case  Base Case Worst Case
 Mortgage and asset-backed securitizations                          28                           42                      84
 Credit and real estate                     2,187                      3,314                6,628
 Structured transactions                        564                         854                1,709
Total in US$mn                     2,779                      4,210                8,420
 
 
As can be ascertained from its high maximum loss-to-exposure ratio of 65.4%, the credit and real estate product is the most vulnerable of all the products in respect of a probability of defaults considering that most of the US housing problem is linked to loans originated with poor underwriting standards to marginal buyers at the peak of the housing bubble. Falling housing prices coupled with stringent lending standards are making it increasingly difficult for borrowers to refinance existing loans resulting in higher delinquency and foreclosures for these loans. Under our base case scenario we have estimated total losses of $4.2 bn from unconsolidated VIEs primarily off losses from the credit and real estate sectors. Also it is worth mentioning that some investment baking firms (prominently UBS and Lehman) are spinning off or considering a spinoff of their riskier assets into separate subsidiaries, CLOs and SIVs as an off-balance sheet exposure in an attempt to shrink their balance sheet through accounting shenanigans designed to deceive investors by presenting a rosy picture of their financial affairs. {mospagebreak}
 

Despite Fed’s initiatives, liquidity concerns remain persist

Drying liquidity in the repo market: The rapid contraction of liquidity in the $4.5 trillion repo market, comprising 20-25% of the total assets of the top five investment banks, is posing a difficult and challenging operating environment for these companies. With a declining value of securities used as collateral, lenders in repo markets have tightened their lending standards, besides being over-cautious and selective. In addition, they are also demanding higher collateral. For instance, for every $100 to be lent, lenders require $105 for bonds backed by Fannie Mae and Freddie Mac (up from $102 a few weeks ago) and $130 for bonds backed by 'Alt-A' loans. Last month, Bear Stearns faced a severe liquidity problem before it sought an emergency funding from the Federal Reserve, as its clients withdrew assets while their creditors stopped renewing short-term loans. The financing crisis at Bear Stearns has created wide spread concerns over the financial stability of other brokerage firms which rely heavily on repo markets for day-to-day cash requirements.
 
 Like Bear Sterns, Morgan Stanley also relies on short-term financing with $162.8 bn or 16% of its total assets in the form of repo financing as of November 30, 2007. Traditionally, brokerage firms have borrowed money in the repo market to fund their short-to-medium-term financing needs. Now with credit being harder to come by in spite of falling interest rates, brokerage firms will operate at lower leverage levels (total adjusted assets to adjusted equity), thus impacting their future profitability. 
 
Signs of reduced liquidity also emerged when Morgan Stanley found it difficult to renew its credit line to back up its commercial paper, and had to accept a reduced credit line. Instead of seeking to extend the entire $11 bn line, Morgan Stanley originally sought a $7.5 bn credit line. However, banks were willing to extend only under $4.9 bn. 
 
Although the recent Fed-led initiatives will help banks and brokerages temporarily swap their mortgage-backed securities for treasury debt and restore some liquidity, the problem is far from being solved with additional losses from write-downs expected in 2008 and 2009. We have alleged that the Fed’s liquidity injections address and mitigate, in large part, the symptoms of the problem that formed the credit crisis but fail to address the cause – which is balance sheet insolvency. This, unfortunately, is beyond the reach of even the Fed’s many economic tools, and the only way for it to be remedied is to allow the assets to properly deflate and be redistributed throughout the market at market prices. We have witnessed significant resistance to this event, for if many of the investment, regional, mortgage and commercial were to truly mark their inventory to market, rampant insolvencies would result. We believe the Fed’s attempts at injecting liquidity are ploys to buy time for the lending and financial engineering institutions to delever and redistribute risk and assets at a controlled pace. The major problem with this tactic is that since the assets were written at the top of an historical real asset bubble that just popped, and were levered at the top of a historic credit bubble that just popped, there is absolutely no market for these securities for anything remotely near a price that would allow the lending and financial engineering agencies to remain fully solvent. This is not to say that they will all go the way of Bear Stearns, but we do believe that there is a lot of pain ahead as these entities attempt to delever, shrink their balance sheet and reduce risk. In addition, there is a significant probability of another institution going belly up. 
 
Morgan Stanley’s liquidity position remains strong: During 1Q2008, Morgan Stanley’s liquidity averaged $123 bn up from $85 bn in 2007. In 1Q2008, the parent company’s liquidity averaged $71 bn compared with $49 bn in 2007, while liquidity from bank and nonbank subsidiaries averaged $52 bn, up from $36 bn in 2007. Morgan Stanley’s liquidity position increased primarily as a result capital infusion by China Investment Corporation through $5 bn worth of equity units which are mandatorily convertible into 9.9 % of common shares by August 2010, and reduction of CMBS, RMBS and non-investment grade loans during 1Q2008. In addition to Morgan Stanley improving its liquidity by diluting its equity, we believe that continued write-downs along with a declining investor confidence would remain a challenge for the bank’s capital raising efforts in future. We believe that Morgan Stanley may be able to withstand a Bear Stearns-like crisis with the help of the Fed as a liquidity back stop and lender of last resort. This is a conditional belief, though. If there is a significant loss in counterparty confidence, no one (including the Fed) will be able to save Morgan Stanley. The primary reason for such a loss of confidence would be liquidity, which we believe Morgan Stanley has under control, for now. The second most pertinent cause for such a run of confidence would be balance sheet solvency, which is a significant problem for Morgan Stanley – not only in terms of counterparty confidence levels but also in terms of difficulty in raising funds in a tight credit market scenario. 
 
Unfortunately, the current US investment banking model where entities take a relatively small amount of capital, lever it up significantly, then use it to buy, sell, and trade volatile and illiquid assets is based primarily on the market’s confidence in the bank’s ability to both deliver positive returns and remain a solid ongoing concern. This is how they both deliver significantly higher margins and conduct business without truly producing a tangible, consistently proven product. The caveat is that investment banking and brokerage is a highly cyclical business and the profits made in the peaks of the business cycle tend to walk out of the door in the form of relatively (to other industries) excessive compensation, leaving very little to add to equity or cushion for harsher times in the business cycle (which we are now entering). Thus, the highly levered risks are bound to continue and bound to be subject to the whims of the confidence level of the market. Manufacturers of widgets, though operating under much lower margins, can remain in business despite fluctuations in confidence levels. Investment banks under the current business models can easily fall victim. {mospagebreak}
 

Declining capital market activities to affect MS’s core revenues

Widespread uncertainty in the global credit and equity market is likely to impact investment banking and trading revenues of Morgan Stanley as volumes start to decline. M&A transactions and corporate finance activities are expected to drop as firms postpone their growth plans in view of a slower economic growth. Also, due to a decline in investors’ appetite for new issues, stock and equity-linked offerings and high-yield bonds issuance are expected to witness a softer trend. According to Thomson Financial, US mortgage-backed securities issuance declined 75% to $61.0 bn in 1Q2008 from $273.9 bn in 1Q2007. Issuance of US asset-backed securities plunged 83% to $54.7 bn over $323.3 bn in 1Q2007. In 1Q2008 US investment-grade corporate bond issuance declined 31% to $185 bn while junk bond issuance declined 85% to $5.9 bn. Concerns over financial firms’ meltdown amid subprime mortgage crisis and looming fears of recession are expected have a subdued effect in the capital market activities in the near-to-medium term.Although Morgan Stanley reported better-than-expected numbers in 1Q2008, the results were disappointing when compared with its performance in 1Q2007. In 1Q2008 Morgan Stanley’s total revenues declined 8.7% y-o-y to $21.2 bn owing to a 6.8% and 58.1% decline in Institutional Services and Asset Management revenues, respectively, partially offset by a 2.9% increase in Global Wealth Management revenues. In view of an expected slow down in capital market activity, Morgan Stanley’s total revenues for 2008 are expected to decline 16.9% to $70.9 bn. 
 

Negative outlook by rating agencies

Last December S&P placed Morgan Stanley on credit watch with a negative outlook after the bank announced $9.4 bn in write-downs in 4Q2007. However, on April 1, 2008, S&P affirmed Morgan Stanley's credit ratings and removed it from credit watch. Morgan Stanley, along with other investment banks, is now on a negative outlook due to a potential decline in its profitability from capital markets activities. Earlier, on October 24, 2007, S&P had downgraded Merrill Lynch's senior debt to A+ and S&P had put Goldman Sachs Group and Lehman Brothers on a negative outlook due loss of confidence in investment banks amid eroding profitability. These reflected the potential for a more substantial decline in profitability from capital market activities. 


 

IV.     Key charts

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V.   Proformas are available for download: icon Morgan Stanley_final_040408 (1.38 MB)