Saturday, 05 April 2008 01:00

Reggie Middleton on the Street's Riskiest Bank - Update

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

image016t.gif
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)

Last modified on Saturday, 05 April 2008 01:00

16 comments

  • Comment Link Ken Sunday, 13 April 2008 22:59 posted by Ken

    STIGLITZ

    http://calculatedrisk.blogspot.com/2008/04/stiglitz-worst-recession-since-great.html

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  • Comment Link Ken Sunday, 13 April 2008 22:52 posted by Ken

    http://calculatedrisk.blogspot.com/2008/04/stiglitz-worst-recession-since-great.ht

    all I hear lately is "the worst is behind us" and "expect write-UPS upcoming". But when you're dealing with this crazy 25-40 times leverage on assets where a 3% downside move could wipe away the entire equity of some of these investment banks I don't think the worst is over. Reggie, do you have anything to say about all this talk about banks having written down so much that there is now "nothing more to write down"? That their toxic assets have been valued and written down to nearly ZERO so that now there is only upside? If real estate drops 10% to 20% more than EVERTHING mortgage related gets marked down MORE. I think the public is being blatently mislead again..........

    Are you calling for an additional halving of MS shares from their current 40's?

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  • Comment Link Reggie Middleton Sunday, 13 April 2008 17:51 posted by Reggie Middleton

    BTW, if you strip away Lehman's FAS 159 gains and their Level II to Level III shell games, you will find they actually took a deep loss last quarter. I will try and illustrate these, and their effect on P/E valuation in detail, tonight or tomorrow as a new blog post.

    Leh and Morgan Stanley are doing more of a PR stunt/marketing manuever than actually trying to report economic earnings - similar to what GGP is doing. The spikes that result from those who don't have the time or expertise to look deeply into these issues are allowing me to pile up on my bear positiions at a higher basis and lower put costs.

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  • Comment Link Reggie Middleton Sunday, 13 April 2008 17:45 posted by Reggie Middleton

    This was illustrated in detailed in my riskiest bank update, above. Barron's is late to the party. You're also busted - now I know you didn't read my long post :D

    [b]Since most of these securities are not 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. [/b]

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  • Comment Link Spencer Hall Sunday, 13 April 2008 15:53 posted by Spencer Hall

    Morgan Stanley was cited as reporting illusory gains, by booking gains from the declining value of their own debt. I.e., they provide no cash benefit. "When a company's credit weakens and the yield on its debt rises relative to risk-free Treasuries, the debt becomes worth less to the holder. The financial company which is the debt issuer, then takes a gain, because theoretically it could buy back its debt below face value" (FASB fair-value accounting of both assets & liabilities). "Morgan Stanley reported a $848 million gain related to the widening of its credit spreads". In the long run "virtually all long-term debt matures at par, meaning that "mark-to-market" gains generated durng the life of any issue of long-term debt reverse over time".

    So, Morgan Stanley will report lower earnings going forth? Or will their earnings henceforth be understated?

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  • Comment Link Reggie Middleton Monday, 07 April 2008 08:50 posted by Reggie Middleton

    Although government intervention is aimed at boosting the viability of banks, government intervention has historically botched the job. For instance, the BSC rescue came at the price of additional regulation, probably mandated capital reserves and deleveraging. This is coming at a time when borrowing costs are rising for banks amid their need and search for more capital. If I am not mistaken, is similar regulation that helped push the S&Ls over the edge. Of course, it is arguable that the weaker one's needed to be pushed over the edge.

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  • Comment Link M M Monday, 07 April 2008 08:15 posted by M M

    Thoughtful insights as usual. The L3 to equity ratio is alarming, as does the amount of leverage carried by MS and company. My question is simple - whilst the facts do not support the current valuations of the financial institutions, and i am in the camp that credit destruction portends a substantial effect on the real economy - $1 of capital destroyed removes 30X of assets and potential activity - could the situation be so bad as to warrant a gvt response along the lines of improved regulation (which is in process) but more importantly for the fed and other central banks to accept the impaired collaterial (ie L3 assets) and hold it at par value until the banks have replenished reserves to take the loss. It might take six or seven years (as it did when US banks went long Latin american loans in 1980 and were bust bar wink/wink nudge nudge the Fed which allowed banks to mark this stuff at par and control the impairment process - which took till 1986)
    Could the market have effectively priced this in? I look at UBS and other financials which are up 40% off their lows. Mister Market has prounced judgement (perhaps). Is the analysis valid in the market context? Great work however. Rgds

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  • Comment Link John2 Sunday, 06 April 2008 20:54 posted by John2

    Other than the cap madness, I like the format of the new site !!!!! As long as you fix the caps and stop putting in exclations points !!!!!!!!!!!!!!

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  • Comment Link Chris Marshall Sunday, 06 April 2008 13:15 posted by Chris Marshall

    Reggie,

    Maybe you can start a new rating system called the BS level(BS does not always stand for Bear Stearns!), (from 0 to 10) as to how accurate a PR Dept's quotes are compared to the real figures. IE. "We have plenty of liquidity, and can ride out these temporary problems" attributed to Bear Stearns. ( I think that in hindsight, these may be a 10!!)

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  • Comment Link Johnny Lay Sunday, 06 April 2008 13:03 posted by Johnny Lay

    I promise I didn't post in caps...

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  • Comment Link Chris Marshall Sunday, 06 April 2008 10:58 posted by Chris Marshall

    Reggie, regarding "mark to market", why do Reits not do this? It makes their balance sheets a nonsense.

    I hate artificial comparative targets of performance, that are currently used, such as FFO and EBITDA. Some years ago the EBITDA of Vodafone was a profit of $10 Billion, yet after Taxes, depreciation Etc, it was a loss of $10 Billion.

    I tend to only look at cash flow and income, if I want to see if a company is actually making any money.

    Have you noticed how Annual Reports are getting more and more difficult to interpret?
    Sometimes you have to suffer 20 pages of guff ( chairmans outlook, industry trends, pensions, products Etc Etc. When you finally get to the financials, There are the official figures and the figures that management prefer to use, always tied up to language similar to "we believe", "our assessment", "our target".

    I thought that the new accountancy standards would stop this rubbish, but apparently as long as you declare what you have to, you can hide it in pages and pages of BS!

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  • Comment Link Reggie Middleton Sunday, 06 April 2008 10:40 posted by Reggie Middleton

    @ MuddlinThru
    By taking in unconsolidated debt, investment banks are looking very expensive now. Most people think they are a buy, since they are trading right above accounting book value. If you take adjusted economic book value, ex. the truth, you will see that their PEs and PB are currently illusions. In addition, there is the monoline counterparty risk that is coming home to roost. Fitch on MBIA, FGIC, SCA, etc.

    It would be interesting to see if this sector continues to rally next week. The higher they go, the farther they will have to fall and the more painful it will be.

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  • Comment Link Reggie Middleton Sunday, 06 April 2008 08:33 posted by Reggie Middleton

    @ Chris
    Yes, we do need investment banks, just in a purer form. Many banks have become proprietary hedge funds in and attempt to diversify revenue streams. They have also used their balance sheet as a profit center, when in the past they relied on fee income and advisory services. There isn't necessarily anything wrong with that, but when you lever up in an illiquid and volatile market, you will get burned as the cycle turns. It happens every ten years or so. It is just that this one is a doozy. The best thing to happen as of late was FASB decision to eliminate the QSPE exemptions. If all liabilities and assets were clearly and plainly presented ON balance sheet and marked to market, there would be much less in the realm of surprises.

    The banks can still take their risks, and if (on risk adjusted basis), it pays off, then their share price will reflect it. The problems of today stem mostly from the fact that too much risk was hidden.

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  • Comment Link Chris Marshall Sunday, 06 April 2008 02:42 posted by Chris Marshall

    Reggie, I thought that the analysis was detailed and informative. I am looking seriously at the investment banking industry and have a couple of questions:

    1) Do we really need investment banks?

    2) Should only large commercial (deposit taking) banks be in this field owing to their greater ability to attract funds from individuals?

    Many people will hate the implications, for obvious reasons, but if banks relied, to a greater degree,on their deposits, and a lesser degree on gearing, this may be a more robust financial model.

    On a brighter note, if commercial banks once again hold mortgages on their books, rather than slicing and dicing, maybe they could actually start taking account of the risk, as well as the profit.

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  • Comment Link Eric Brindle Saturday, 05 April 2008 21:43 posted by Eric Brindle

    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. [i][/i]

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  • Comment Link Johnny Lay Saturday, 05 April 2008 18:09 posted by Johnny Lay

    http://market-ticker.denninger.net/

    Man I need a drink!


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