Toomre Capital Markets LLC

Real-Time Capital Markets -- Analytics, Visualization, Event Processing, and Intelligence

Morgan Stanley Takes $9.4 Billion Mortgage Write-down

As The Wall Street Journal reported in the article Hard-hit Morgan Stanley Gets $5 Billion From China, Morgan Stanley's fourth quarter 2007 earnings report was simply horrendous. On Wednesday December 19th 2007, Morgan Stanley announced a "$9.4 billion write-down for its fiscal fourth quarter on U.S. subprime and other mortgage investments. Morgan Stanley posted a net loss of $3.59 billion for the fiscal fourth quarter ended Nov. 30, compared with net income of $2.21 billion in the same period a year earlier."

Perhaps Toomre Capital Markets LLC ("TCM") is a bit naïve. However, does not $9.4 billion seem a bit large? The write-down translates into losses each and every one of the approximately sixty-one trading days in the quarter of more than $154 million. Maybe Wall Street has really changed in the last decade, but TCM suspects that Morgan Stanley executives have had far fewer days when the gross revenues from the fixed-income trading floor exceeded $150 million in a single day. The spin put out by Morgan Stanley is that these losses resulted from one desk of traders in the firm's mortgage trading area.

Toomre Capital Markets LLC and others wonder how such a small group could be allowed to take so much risk that approximately ten percent of the firm needed to be sold for $5 billion to the Chinese sovereign fund, China Investment Corporation ("CIC"), to stabilize its capital levels. In former days when the Wall Street firms were run as partnerships, there was considerably more emphasis placed on prudent risk management and the relative size of illiquid positions since it was the partners' personal wealth that was at risk should something go awry. As public corporations, it is not at all clear where responsibility for prudent risk management really lies. Yes, supposedly senior managements like those at Morgan Stanley are nominally responsible, but who besides CEO John Mack really suffered as a result of this $9.4 billion write-down? Other areas of Morgan Stanley supposedly are receiving healthy bonuses so the real losers yet again appear to be the common equity shareholders who have relatively little say in how the investment bank is run.

Such corporate culture and compensation practices makes one wonder just how prudent it is for any investor to ever invest in the common stock of any Wall Street firm. As an investor in Wall Street, the rule seems to be "heads: one gets to share in some of the upside; tails: one gets all of the downside." Such return patterns are rather asymmetrical and likely to raise Wall Street's cost of capital going forward. Perhaps investors will begin to differentiate between those firms who primarily focus on customer flow business and those that speculate with the firm's capital. Morgan Stanley has just demonstrated that it did not speculate well. Is it not interesting that earlier this week during its earnings call, the Goldman Sachs CFO was stressing how much of their FICC revenue was tied to the level of customer flows?

Perhaps Goldman Sachs already understands that the stock market will pay a higher multiple for stable earnings and proprietary trading results can in fact be too large a percentage of a firm's revenue mix. UBS seems to understand the same message. It will be interesting to see how Morgan Stanley and the other sub-prime losers like Merrill Lynch, Citigroup and Bank of America position their Capital Markets businesses for what surely will be a period of continued stress. Will they position themselves as proprietary traders putting the firm's capital at risk or as more traditional brokers primarily focused on executing customer order flow?