Reggie Middleton on the Street's Riskiest Bank - Update

Posted by: Reggie Middleton in Research, Investment Banks, Financial Shenanigans, Earnings on Apr 06, 2008 Print PDF

Reggie Middleton

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 St