|
Page 1 of 8
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:  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)
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.
|
