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.

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.

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.

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.

Failure of bond insurers increases counterparty credit risk

Bond insurers have guaranteed a monstrous $2.4 trillion of outstanding debt besides providing insurance coverage to troubled structured finance products such as CDOs. Banks active in the ABS RMBS and CMBS real estate markets have more than one reason to worry having bought protection through credit-default swaps (CDS) from bond insurance companies. Since the CDS market is not regulated, it is difficult to assess the amount of exposure banks have to bond insurer counterparty risk. ACA Capital Holdings is facing difficulties in paying claims due to its exposure in the CDO sector and subprime market. This prompted Merrill Lynch to write down its exposure to ACA by $1.9 billion. Sell side analysts such as Meredith Whitney of Oppenheimer, estimate that banks may have to write off securities (worth $10.1 billion) insured with ACA. Morgan Stanley’s exposure to net counterparty credit aggregates $51 billion. Nearly 27% of this was rated BBB and lower as of 30 November 2007. This reflects the $10 billion increase since August 31, 2007.

Morgan Stanley Issued Securities with Exposure to Ambac and MBIA

Morgan Stanley has exposure to bond insurers through bonds insured by them and their status as counterparties to derivative contracts. The inability of bond insurers to pay claims has become a serious concern for parties exposed to such firms.

The significant concentration in subprime home equity lines, who are subject to playing 2^nd fiddle to the primary lender in first position in terms of claim on the what is increasingly highly encumbered property, leaves MS open to unprecedented losses - losses that can extend significantly past the next two quarters.

Additional capital may be required

Morgan Stanley reported a net loss of $3.61 per share, well above the market’s expectation of $0.35. The company wrote down $9.4 billion (as against the $3.7 billion write-down announced in November), leading to higher-than-anticipated losses. The write-downs were across the board – subprime/CDOs ($7.8 billion); CMBS, Alt-A, non-performing loans, and other mortgage loans ($1.2 billion); and the ABS exposure of its subsidiary ($435 million).

The company also announced China Investment Corp’s $5-billion equity investment in the form of mandatory convertible equity units. Morgan Stanley will pay 9% as annual interest (7% after tax), translating to an interest expense of $450 million per year. This would result in the dilution of 9.9% of outstanding equity at the time of conversion in 2010. Considering the $9.4-billion asset write-down and challenging near-term outlook, the company raised $5 billion by selling equity units with a mandatory conversion into common stock to China Investment Corp. The management has denied facing any pressure from regulators or rating agencies. However, we believe Morgan Stanley was compelled to some extent by rating agencies and regulators, as it did not appear to be in any need of capital until May 2007. The deteriorating credit situation forced the company to raise capital as it has significant exposure to subprime and CDO assets. We expect the company’s EPS to decline further due to the dilution resulting from the $5-billion equity issue to China Investment Corp.

We remain concerned about the high proportion of Level 3 assets in Morgan Stanley’s portfolio, and deterioration in the CMBS real estate market, where the company has only written down $1.2 billion. This could be the harbinger of further write-downs. Most top banks on Wall Street such as Citigroup and Merrill Lynch have raised capital to cover losses resulting from the subprime fiasco and turmoil in credit markets. If the situation worsens, Morgan Stanley may be required to raise additional capital to sustain its business and manage losses, going forward.

Failure of risk management practices in fixed income business lead to losses

Morgan Stanley reported negative revenues and (consequently) a huge loss in 4Q 07. The company reported negative revenues mainly due to the write down of $9.4 billion and charges incurred during the quarter. Morgan Stanley’s risk management practices failed to achieve results, while it lacked management oversight in the fixed income division. The company completely failed to understand the dynamics of the markets in which it had invested billions of dollars. It is believed that Morgan Stanley was not even monitoring its position related to exposure in the subprime market. This raises questions about its risk management practices.

Worsening macro environment and market conditions to restrict revenue growth

The operating environment is likely to remain challenging in 2008 due to deteriorating macro conditions following slower GDP growth in the U.S., flagging confidence, and signs of inflation. These factors could dent Morgan Stanley’s revenues during the current year. The sharp decline in structured credit revenues, reduction in risk taking capacity, and decrease in M&A could also exert undue pressure on its top line. An economic hard landing, recession or decline in global equity markets could dent revenues from institutional securities, asset management and retail brokerage activities. Sales of new one-family houses stood at a seasonally adjusted annual rate of 604,000 in December 2007. This was 4.7% below the revised figure (634,000) for November 2007. Privately owned housing starts stood at a seasonally adjusted annual rate of 1,006,000 in December 2007, down 14.2% from the revised estimate of 1,173,000 for November 2007. This validates the growing weakness in the U.S. housing industry and its repercussions on the general economy. Considering the scenario, we expect Morgan Stanley to report lower revenue growth in near future.

According to Standard & Poor’s (S&P), losses from securities linked to subprime mortgages may exceed $265 billion as regional U.S. banks, credit unions and overseas financial institutions also start writing down assets. S&P has cut or put on review the ratings on $534 billion of bonds and CDOs tied to home loans made to people with poor credit, the most ever by the New York-based firm in response to rising mortgage delinquencies. The risk of companies defaulting is also rising. The spread on CDS on the benchmark Markit CDX North America Investment Grade Index rose to 110.25 basis points reflecting the continued deterioration in credit quality perception. CMBS and CLOs are facing widening spreads as the underlying assets react to shriveling liquidity and a deteriorating macro environment.

Downsizing of employees insufficient to counter current crisis

Morgan Stanley, which employs approximately 50,000 people, plans to lay off about 2% of its workforce to reduce expenses as market conditions get tougher for investment bank. The company is expected to cut roughly 1000 jobs. Considering the current market scenario, Morgan Stanley is reassessing its personnel needs and business priorities. The company plans to cut jobs mostly in the back-office, technology, operations and support functions of its wealth management division. Morgan Stanley was forced to increase compensation expense by 18% for the full year 2007, despite incurring losses in 4Q 07. Non-compensation expenses (excluding a one-time expense reversal of $360 million) were also much higher – 20.5% sequentially and 14% y-o-y. The increase in marketing and technology costs, and professional fees due to the seasonality and continued expansion of its global franchise pushed non-compensation expenses higher. The company is focusing on trimming its workforce, as its top line is likely to stay under pressure, going forward.

Our sensitivity analysis of exposure to riskier assets

Weighted Average Fair Price

We analyzed Morgan Stanley’s exposure to Level 3 assets and to VIEs while assigning the fair value. To value Morgan Stanley, we have used the Discounted Cash Flow (DCF), price-to-adjusted book value (P/ABV) and price-to-earnings (P/E) multiple methods. Based on our weighted average valuation, we arrived at a fair value of $20.76, which represents a downside of 58% from the current level of $49.34.