Business Context and Reporting Period
Company: Morgan Stanley
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: May 31, 2008
Business Overview: A global financial services firm operating through three primary segments: Institutional Securities, Global Wealth Management Group, and Asset Management. The reporting period was characterized by significant credit market dislocation, illiquidity, and wider credit spreads, impacting trading revenues and investment valuations.
Key Financial Metrics
| Metric | Three Months Ended May 31, 2008 | Six Months Ended May 31, 2008 |
|---|---|---|
| Net Revenues | $6,510 million | $14,832 million |
| Net Income | $1,026 million | $2,577 million |
| Earnings Per Share (Diluted) | $0.95 | $2.40 |
| Total Assets | $1,031,228 million | $1,031,228 million (Period End) |
| Shareholders' Equity | $34,493 million | $34,493 million (Period End) |
| Long-Term Borrowings | $210,724 million | $210,724 million (Period End) |
| Cash and Cash Equivalents | $23,782 million | $23,782 million (Period End) |
| Return on Average Common Equity | 12% (Annualized) | 16% (Annualized) |
Material Changes vs. Prior Comparable Period
- Revenue Decline: Net revenues decreased 38% for the quarter and 28% for the six-month period compared to the prior year, primarily due to difficult market conditions and unfavorable positioning in fixed income sales and trading and corporate lending.
- Profitability Drop: Net income fell 60% for the quarter and 51% for the six-month period year-over-year. Diluted EPS dropped from $2.45 to $0.95 for the quarter.
- Expense Reduction: Non-interest expenses decreased 28% for the quarter and 17% for the six-month period, driven largely by lower compensation and benefits costs (down 41% for the quarter) due to reduced revenues, partially offset by severance expenses related to staff reductions.
- Segment Performance:
- Institutional Securities: Income before taxes dropped 77% due to declines in investment banking and sales/trading revenues.
- Global Wealth Management Group: Income before taxes increased significantly (from $264M to $989M) largely due to a $698 million pre-tax gain from the sale of its Spanish wealth management business (MSWM S.V.).
- Asset Management: Recorded a loss before taxes of $227 million, compared to income of $303 million in the prior year, driven by principal transaction net losses in real estate and private equity.
Guidance, Outlook, Risks, and Unusual Items
Unusual Items and Gains:
- Business Dispositions: The quarter included a pre-tax gain of $732 million from the secondary offering of MSCI Inc. shares and a pre-tax gain of $698 million from the sale of Morgan Stanley Wealth Management S.V., S.A.U.
- Valuation Adjustments: Results included a cumulative negative adjustment of $84 million ($120 million pre-tax) resulting from incorrect valuations of a London-based trader's positions related to prior quarters.
Risks and Contingencies:
- Credit Market Events: The firm recorded significant writedowns related to credit market dislocation, including approximately $400 million in mortgage proprietary trading writedowns and $500 million in net losses associated with "event-driven" lending to non-investment grade companies.
- Subprime Exposure: Total U.S. subprime trading exposure was $11.1 billion as of May 31, 2008. The firm recorded losses on securities issued by structured investment vehicles (SIVs) and exposures to monoline insurers.
- Legal Proceedings: New class action complaints were filed regarding Auction Rate Securities. The firm is also involved in various subprime-related litigation and regulatory investigations.
- Rating Actions: Subsequent to the quarter end, Standard & Poor's lowered the firm's long-term rating from AA- to A+ with a Negative outlook. Moody's placed the long-term ratings on review for downgrade.
Liquidity and Capital:
- The firm maintained total liquidity reserves of $169 billion as of May 31, 2008.
- Adjusted leverage ratio improved to 14.1x from 17.6x at the prior year-end.
- The firm did not repurchase any common stock through its open market share repurchase program during the six-month period.
Investor Verification Checklist
- Credit Exposure: Verify the current fair value and potential further writedowns of the $11.1 billion U.S. subprime trading exposure and $22.1 billion commercial mortgage-backed securities/commercial whole loan exposure.
- Monoline Insurer Impact: Assess the ongoing impact of the $390 million loss related to monoline insurer exposures and the potential for additional collateral calls or losses.
- Legal Reserves: Monitor the status of the new Auction Rate Securities class action lawsuits and the potential for material settlements or fines.
- Valuation Controls: Review the firm's response to the $120 million pre-tax valuation error regarding the London trader's positions to ensure internal controls are effective.
- Rating Downgrade Consequences: Evaluate the financial impact of the recent credit rating downgrades, including potential collateral calls (estimated at $1.15 billion for a one-notch downgrade) and increased funding costs.
- Real Estate Investments: Track the performance of the Crescent Real Estate Equities Limited Partnership investment, which saw $150 million in writedowns during the quarter.