The Riskiest Bank on the Street

Key highlights of my research on the "Riskiest Investment Bank on the Street":

The Riskiest Bank on Wall Street – Morgan Stanley has US$74 billion of Level 3 assets, over 200% of its equity, which is the highest amongst its peers. Although the Level 3 assets have declined from the previous quarters owing to huge writedowns, the reclassification of assets from from Level 2 to level 3 category continues as the liquidity for the troubled mortgage paper drys up.

Declining ABX index indicates troubled times are not over yet – Morgan Stanley used the performance of the ABX index as one of the benchmarks to writedown US$9.4 billion in 4Q 07. As this index continiues to witness downward trend, we believe that the asset writedown done so far, may not be sufficient.

Forensic Accounting of ABS Assets yields more woes - a security by security accounting of MSs ABS inventory shows at least 30% and probably 56% in additional losses coming down the pike, as well as tests to its excessive exposure to the anemic capital reserves of its counterparties, namely monoline insurers and hedge funds.

Losses from unconsolidated VIEs of $38 billion can wipe out almost half of the company’s total equity –Morgan Stanley has $20 billion of its unconsolidated VIEs assets in credit & real estate portfolio where the company expects a maximum loss ratio of 65%. Considering the worsening real estate markets, we believe that the company will incur huge losses on this portfolio. In addition, the company has $7 billion towards MBS & ABS portfolio and $10 billion of strucutured finance products.

Exposure toward Bond Insurers/private funds raises counterparty risk – The failure of bond insurers, on whose shoulders lie the rating of $2.4 trillion of bonds, raises a serious doubt about a systemic failure in the U.S. financial services industry. Morgan Stanley’s exposure of $3.6 billion toward the bond insurers may result in unforeseen losses for the company. The company has a counterparty credit risk exposure of $13.9 billion toward parties rated BBB and lower.

Need to raise additional capital if current crisis worsens – Morgan Stanley raised $5 billion from China Investment Corp to maintain its capital ratios as it reported huge losses in 4Q 07. Going forward, as the credit market environment, the housing and real estate markets continues to crack, the company will likely report huge and may have to raise additional capital.

Worsening macro and market conditions to restrict revenue growth – Financial services industry witnessing its toughest times in recent history faces a tough task of getting things back to normal. The deteriorating macro environment coupled with flagging confidence among investors/customers alike, things are more likely to get worse than better. Furthermore, the decline in structured product revenues, risk averse nature owing to recent turmoil and the less active M&A environment will exert pressure on the company’s revenue growth in the coming quarters.

We value Morgan Stanley at US$20.76 per share, 58% lower than the current market price – We have analyzed Morgan Stanley exposure toward the Level 3 assets and its exposure to unconsolidated VIEs. To value Morgan Stanley, we have used the Discounted Cash Flow (DCF), Price-to- adjusted book (P/BV) and Price-to-Earnings (P/E) multiple methods. Based on our weighted average valuation, we arrive at a fair value of $20.76 which represents a downside of 57% from current levels of $48.25.

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Morgan Stanley (287.96 kB 2008-02-11 12:49:56)

Report summary

I have dubbed Morgan Stanley as the “Riskiest Bank on the Street”! Morgan Stanley’s exposure to Level 3 assets (for those not familiar with my take on the industry, I recommend reading Banks, Brokers, & Bullsh1+ part 1 and part 2 as a primer) is substantial at 209% of its equity, and also the highest amongst its peers on Wall Street. As of November 30, 2007, the global financial services behemoth’s Level 3 assets totaled $73.6 billion. The continuous slide in the ABX index, which the company used as one of the benchmarks while marking down assets worth $9.4 billion (mainly in the ABS CDO portfolio) in 4Q 07, may necessitate further write-downs in the coming quarters. Morgan Stanley’s exposure to ABS CDO subprime whittled to $1.8 billion following the substantial write-downs in 4Q 07. However, its exposure to the CMBS portfolio continues to remain high. I have performed significant research in the commercial real estate arena, and this area has already entered what looks to be a sharp and steep correction, as exemplified by the General Growth Properties analysis. To add to its woes, Morgan Stanley’s direct exposure to bond insurers aggregates $3.7 billion. In our opinion, rating and actual credit concerns (yes, I literally differentiate the terms) related to bond insurers, such as Ambac and MBIA, may have increased the company’s counterparty risk significantly during the quarters gone by. Through unconsolidated variable interest entities (VIEs), the company has significant exposure to credit and real estate assets, the bane of the ongoing credit turmoil. This has aggravated the situation. The ongoing credit market turmoil has resulted in asset write-downs totaling $133 billion so far. If conditions continue to worsen, the company may have to raise additional capital in the near term.

Key Investment Points

The riskiest bank on Wall Street – High exposure to Level 3 assets despite significant write-downs

Morgan Stanley reported write-downs totaling $9.4 billion in 4Q 07—most of these were necessitated by its position in the U.S. subprime mortgage market. Toward the end of 4Q 07, Morgan Stanley’s exposure to Level 3 assets totaled approximately $73.6 billion, while its exposure to the less risky Level 2 assets aggregated $226 billion. At 209% of total equity, Morgan Stanley has the highest proportion of Level 3 assets compared to its peers on Wall Street. This makes it the riskiest bank on the Street. However, at 641% of total equity, the company’s exposure to Level 2 assets was the lowest among its peers. The value of Morgan Stanley’s Level 2 assets decreased from $588 billion in 3Q 07 to $226 billion in November 2007. In 4Q 07, Morgan Stanley moved assets worth $5.4 billion into the Level 3 category, a sign that the liquidity of these assets is decreasing. Level 3, the most trouble-prone asset category, comprises corporate loans and loan commitments, commercial loans, mortgage loans, high-yield and distressed debt, MBS, ABS and CDO securities, investments in real estate funds, private equity investments, and complex over-the-counter (OTC) derivatives.

The table above indicates that Morgan Stanley’s exposure to Level 2 and Level 3 assets relative to total equity remains extremely high. This reflects the significant leverage with which the company operates. Morgan Stanley as well as some of its peers moved an alarmingly high proportion of assets into the riskier Level 3 category. This situation could deteriorate further if the challenging environment persists and liquidity in the ABS and MBS markets evaporates.

Considering Morgan Stanley’s significantly high exposure to risky assets and the lack of liquidity in some derivative trading contracts, we have estimated the company’s potential losses under various scenarios using different default probabilities. Our default probability for the company’s exposure to Level 2 and Level 3 assets in different scenarios ranges from 2–15%.

Decline in ABX index could increase asset write-downs

In 4Q 07, Morgan Stanley only marked to market its portfolio and did not book any losses on subprime ABS CDOs. In recent quarterly conference calls, the company did mention the performance of the ABX index as one of the parameters for writing down assets in 4Q 07. Morgan Stanley’s portfolio was marked down based on movements in the BBB 2006 vintage index to which it has the highest exposure. The widening of Credit Default Swap (CDS) spread on the company’s bonds has also heckled investors. While Morgan Stanley’s one-year CDS spread increased to 150 basis points, the five-year CDS spread increased to 180 basis points compared to Lehman Brothers’ spread of 192 basis points and Goldman Sachs’ 102 basis points.

Performance of the ABX BBB indices

Source: www.markit.com

Reflecting the worsening conditions in credit markets across the globe, the ABX BBB- 2006 vintage index declined approximately 20% since the company announced 4Q 07 results. If write-downs in 4Q 07 are anything to go by, we expect Morgan Stanley to report further mark-to-market losses in the coming quarters. The index declined 34% in November 2007, causing $9.4 billion to be written off the $45.0 billion portfolio—the write-down represents approximately 21% of the total portfolio. Based on 4Q 07 write-downs, we expect Morgan Stanley to incur additional mark-to-market losses on the portfolio during the current quarter. If the ABX index declines another 20% next quarter, the company may have to write down another $4.4 billion, or 12.5% of its $35.6-billion portfolio.

Morgan Stanley CDS spread on 1-year, 3-year, 5-year and 10-year bonds

Source: Company data

Unconsolidated VIEs could aggravate woes

VIEs have tormented most Wall Street financial majors—several of them have had to consolidate their VIEs to increase liquidity and limit losses. These innovative, structured entities were introduced to boost earnings without transferring actual risk into the balance sheets of banks.

Morgan Stanley has significant exposure to VIEs, with the maximum loss ratio averaging roughly 50% in recent years. The large exposure ($37.7 billion in 4Q 07), high loss ratio and adverse market conditions could force the company out of business if its maximum loss assumptions become reality. Morgan Stanley’s unconsolidated VIEs comprise the most troublesome asset categories – MBS & ABS portfolios (worth $6.3 billion), credit & real estate portfolios ($26.6 billion) and some structured finance products ($8.6 billion). Loss exposure in the credit & real estate portfolio is not expected to be lower than 70% considering the slump in housing demand, falling home prices and rising foreclosures. The growing housing inventory across the U.S. has also raised concerns about the disposal of these assets. Home prices across the U.S. declined 7% (on average), while foreclosures increased 20% during the past year alone. This scenario reflects the bleak prospects of the housing industry and the securities linked to it.

Unconsolidated VIEs, Exposure to loss (in $ mn) and loss ratio (in %)

Source: Company data

To forecast these loss ratios, we have used the maximum exposure to loss as the worst case scenario. For the base case, we expect the loss ratio to be lower than the maximum exposure to loss.