Morgan Stanley posts deeper than expected Q1 losses

It was bound to happen. After several US banks managed to beat street estimates on earnings, yesterday came one that did not. And quite predictably this set off another slide in financial stocks, which were already weakened after Bank of America's first-quarter numbers earlier in the week sparked renewed concerns about loan losses.

Being primarily an investment bank, loan losses were never going to be a big drag on Morgan Stanley's results, but the first-quarter earnings released by the bank in the US morning yesterday were well below analysts' expectations and, contrary to those of its peers that have already reported such as Goldman Sachs, J.P. Morgan, Citi, and Bank of America, the bank remains in the red. It did note that this was partly due to an accounting issue related to its long-term debt, but even so, its share price dropped 9% overnight to $22.44.

Morgan Stanley reported a net loss of $177 million, or 57 cents per share for the first quarter -- whereas analysts expected a loss of 8 cents per share. This compared with a net profit of $1.4 billion, or $1.26 per share, in the first quarter of 2008 and a loss of $10.9 billion in the fourth quarter last year. After the payment of preferred dividends, the loss to common shareholders widened to $578 million in the first quarter. The shortfall was mitigated by a tax benefit of $331 million, or 33 cents per share.

Net revenues amounted to $3 billion, which is down 62% from the first quarter last year but a significant improvement from the fourth quarter last year when the bank had negative net revenues to the tune of $12.8 billion.

Like Goldman, Morgan Stanley, as part of its conversion into a bank holding company, has moved from a fiscal year ending in November to one that corresponds with the calendar year and ends in December. The previous year's numbers have been restated on a calendar basis to make them comparable.

Revenues were negatively impacted by $1 billion in net losses on its commercial real estate investments amid an industry-wide decline in this market, and were reduced -- somewhat counter-intuitively -- by another $1.5 billion due to a tightening of the credit spreads on some of Morgan Stanley's own long-term debt. Tighter spreads is actually a good thing as it reflects the fact that investors are less concerned about the possibility that the company will default on its debt payments and will result in lower borrowing costs. However, as the spread tightens the company has to write up the value of these liabilities to reflect the higher cost of repurchasing the debt, thus resulting in a negative non-cash item on the profit and loss account.

"Morgan Stanley would have been profitable this quarter if not for the dramatic improvement in our credit spread, which is a significant positive development, but had a near-term negative impact on our revenues," Morgan Stanley's chairman and CEO, John Mack, commented in the earnings release.

It is worth noting, however, that Morgan Stanley posted a net loss of $1.3 billion, or $1.62 per share, in December on revenues of $805 million, which it was able to leave out of the equation for the latest reporting period because of the change in its accounting year. After the payment of preferred dividends, the December loss to common shareholders was $1.6 billion, or 2.8 times the loss for the entire third quarter, which offsets any gains that the bank would have made without the credit spread tightening.

While the markets remained challenging markets in the first quarter, Morgan Stanley saw improved performance across most of its businesses during the past three months, according to Mack. In particular, the bank delivered strong results in investment banking, commodities, interest rates and credit products, as well as a solid performance in global wealth management, he said.

He also stressed that the bank has been focusing on a "prudent stewardship" of its balance sheet, capital and risk profiles, and pointed to its strong capital ratios; a tier-1 capital ratio of 16.4% (based on Basel I), or 12.9% excluding the capital it has received from the government, and a tangible common equity to risk-weighted assets ratio of 9.3%.

In a conference call with analysts, chief financial officer Colm Kelleher said the bank is "more than comfortable" with those numbers and then, somewhat surprisingly, proceeded to add Morgan Stanley to the list of banks that wishes to repay the money it has received under the government's Troubled Asset Relief Programme (Tarp).  

"We will await the outcome of the stress test, but if permitted and supported by the supervisors, we would like to repay the Tarp funds," Kelleher said.

This marks a different view from that expressed by Mack in a conference call in March when he said that now was not the right time to return the Tarp funds. The change of heart may have been prompted by the fact that Goldman Sachs and J.P. Morgan have both said they want to repay their funds, sending a signal to their investors that they are strong enough to go it without the support of the government. Morgan Stanley received $10 billion under Tarp.

In an attempt to save $1 billion of common equity annually, Morgan Stanley said it will reduce its quarterly dividend payment to 5 cents per share from 27 cents. It also said that it is "on track" to achieve an earlier announced annual cost savings target of $2 billion. Overall expenses were reduced by 33% and compensation expenses declined 46% to $2.1 billion in the first quarter from a year earlier, primarily due to lower revenues, although the firm did reduce its headcount by 5% during the quarter.

Fixed-income sales and trading was a key revenue driver and added $1.3 billion to the top line, which would have been on par with the $2.4 billion revenue in the first quarter last year, had it not been for the $1 billion of credit spread-related losses (the remaining $500 million of credit spread-related losses were booked under equity sales and trading). In the previous year, fixed-income sales and traded saw a $1 billion positive impact due to credit spread widening.

Interest rate and credit products as well as commodities produced a strong result thanks to an increase in customer flows and market volatility, although this was partly offset by a significant decline in emerging markets resulting from credit exposure to certain Eastern European counterparties, the bank said.

Equity sales and trading generated $900 million of revenues, down from $3.4 billion a year earlier. The decline was due to lower results in prime brokerage, derivatives and the cash business, reflecting reduced levels of client activity. Investment banking generated $886 million of revenues, which was up 37% from the fourth quarter last year, but down 9% versus a year earlier. Advisory revenues increased 2% from the first quarter last year to $411 million, while underwriting revenues fell 9% to $401 million.

Overall, the institutional securities division, which includes the above sales and trading and investment banking items, generated net revenues of $1.7 billion, down from $5.1 billion a year earlier, and posted a pre-tax loss of $434 million. The latter compared with a pre-tax profit of $1.2 billion in the first quarter 2008.

The global wealth management group posted a pre-tax profit of $119 million, which was down from $949 million a year earlier. Net revenues fell 20% to $1.3 billion, reflecting a decline in client asset levels and a reduction in market activity. Total client assets declined by 26% from the first quarter last year to $525 million, mainly due to asset depreciation. The combination of Morgan Stanley's global wealth management business with Citi's Smith Barney unit, which has been announced earlier, is due to be completed by the end of the third quarter at the latest and will create an industry leader in wealth management under the operational control of Morgan Stanley.

Asset management reported an 87% decline in net revenues to $72 million and a pre-tax loss of $559 million, up from a loss of $112 million a year earlier. Within this division, losses on principal investments in real estate and private equity led to negative net revenues of $319 million for the merchant banking business, compared with a positive $31 million in the first quarter 2008. Assets under management fell 38% to $356 million, reflecting a continued reduction in asset values and a high level of customer outflows within the industry.