On The Road Again

I was on the road today so I am not in my usual form. However, I need to discuss Morgan Stanley. Morgan Stanley reported disappointed earning versus analyst estimates. Reasons for the disappointing earnings were reduced leverage and risk taking by the Firm's fixed income traders and the marking up of Morgan Stanley bond values.

The current financial crisis was caused by poor (or derelict) risk management. However, most firms (JPM, GS and BAC) did not abandon the fixed income trading arena. According to the earnings report, Morgan Stanley reduced its leverage to 11 time. Has Morgan Stanley gone too far? Possibly, especially considering that it is a BINO (bank in name only) and does not have the diverse income sources of the larger financial institutions. Historically, investment banks have taken more leverage than money center banks. However, Morgan Stanley is a TARP institution and management may have felt that it should not take in too much risk. How much risk and leverage is enough? That is something which will be debated for years to come. I think it is safe to say that we will not see Bear and Lehman levels of 25 to 30 times anytime soon..

Another reason for Morgan's disappointing earnings was that it had to mark its debt up. One would think that one's bonds trading at higher prices would be a good thing. After all, higher prices equal lower yields and therefore, lower borrowing costs. However, there is accounting trickery afoot. As demonstrated by another large bank which reported earnings last week, how one marks one's bonds can lead to profits or losses.

Last week, a large bank which doesn't sleep recorded unrealized profits by marking down (accurately) the value of its outstanding bonds. The accounting theory is that as company can retire its debt below par by purchasing its bonds in the open market. The problem is that when a company's bonds trade at a deep discount it is because its in poor financial condition and not able to retire debt. Morgan Stanley was on the other side of this coin. Last quarter, MS took advantage of accounting rules and marked down the value of its bonds, but as spreads tightened and treasury benchmarks remained low, MS was forced to mark its bond prices higher, giving up unrealized profits. Live by clever accounting, die by clever accounting.


Late in the day, GM announced that it will not be paying of $1 billion of bonds coming due on 6/1/09. Instead it is hoping to cut a deal with creditors which will allow the company to give investors cents on the dollar in the form of equity shares. It will be interesting to see how creditors react to what amounts to a technical default. If bondholders do not agree to a deal with GM, they could force an involuntary bankruptcy. Stay tuned.