MORGAN STANLEY quarterly report, Q3 FY2011

Morgan Stanley — Form 10-Q Summary

Reporting period: Quarter and nine months ended September 30, 2011. Morgan Stanley is a global financial services firm operating through Institutional Securities, Global Wealth Management Group, and Asset Management. Financial statements are unaudited; the independent accountant performed an interim review, not an audit.

Financial performance and position

MetricQ3 2011Q3 2010Nine months 2011Nine months 2010
Net revenues$9.892bn$6.780bn$26.809bn$23.815bn
Income before tax from continuing operations$3.678bn$0.801bn$6.494bn$5.019bn
Net income attributable to Morgan Stanley$2.199bn$0.131bn$4.360bn$3.867bn
Diluted EPS$1.15$(0.07)$1.45$2.15
Non-interest expenses$6.214bn$5.979bn$20.315bn$18.796bn
Net interest$0.140bn$0.103bn$0.069bn$0.612bn
Operating cash flowNot presented quarterly$3.638bn$19.252bn
  • Quarterly revenue rose about 46% year over year and nine-month revenue about 13%. Reported pre-tax margin was approximately 37% for Q3, versus 12% a year earlier; these results include a substantial own-credit-spread benefit (see unusual items below).
  • Nine-month net income attributable to Morgan Stanley rose about 13%, while diluted EPS fell about 33%. The EPS comparison reflects the one-time impact of the MUFG preferred-stock conversion and a larger common-share count.
  • At September 30, total assets were $794.9bn, down from $807.7bn at December 31, 2010. Morgan Stanley shareholders’ equity was $61.8bn, up from $57.2bn; total equity was $70.1bn.
  • Cash and cash equivalents were $53.9bn at September 30, 2011, versus $33.1bn at September 30, 2010. Nine-month operating cash flow was lower year over year; trading and securities-financing balance changes materially affect this measure.
  • Long-term borrowings were $189.1bn, down from $192.5bn at year-end 2010. Other secured financings rose to $22.2bn from $10.5bn. Deposits were $66.2bn; short-term borrowings were $2.9bn.
  • Regulatory capital at September 30: Tier 1 capital ratio 15.2%, total capital ratio 16.4%, and Tier 1 leverage ratio 6.4%. The company reported compliance with applicable Basel I requirements.
  • Global Liquidity Reserve was $180bn at September 30, compared with $182bn at June 30; management said it could be monetized within five business days in a stressed environment. Average total liquidity in Q3 was $183bn, versus $160bn in Q3 2010.

Material changes and segment results

  • Institutional Securities: Q3 net revenues were $6.448bn versus $2.895bn, and pre-tax income was $3.433bn versus $0.241bn. Trading revenue benefited significantly from own-credit-spread gains. Investment banking revenue declined 14%; fixed-income and commodities trading improved sharply on a reported basis, despite credit-product losses and monoline exposure.
  • Global Wealth Management: Q3 net revenues were $3.260bn versus $3.104bn; pre-tax income was $362m versus $281m. Fee-based revenue and net interest increased, while trading revenue declined. Retail net new assets were $15.5bn; fee-based asset flows were $10.1bn. Client assets were $1.564tn, down from $1.603tn a year earlier, reflecting weak markets.
  • Asset Management: Q3 net revenues were $215m versus $802m and the segment recorded a $117m pre-tax loss versus $279m income. Private-equity and real-estate investment losses were important factors. Assets under management or supervision were $268bn, roughly flat year over year.
  • For the nine months, Asset Management reported $675m of losses related to Morgan Stanley’s 40% stake in Japanese securities joint venture MUMSS. The company transferred certain fixed-income trading risks to its consolidated subsidiary and received $659m consideration; MUFG contributed about $370m of capital to MUMSS.

Outlook, unusual items, and risks

  • Own-credit accounting: Widening Morgan Stanley credit spreads generated $3.410bn of Q3 revenue and $3.465bn for the nine months from fair-value changes in the company’s own debt, primarily structured notes. Q3 2010 had a $731m loss from tightening spreads. These gains are not equivalent to recurring operating performance and may reverse as spreads change.
  • MUFG conversion: Conversion of $8.1bn carrying value of Series B preferred stock into 385.5m common shares produced a one-time, non-cash negative EPS adjustment of about $1.7bn, or $0.92 per diluted share, in the nine-month period.
  • Taxes and costs: Nine-month continuing-operations tax included a $447m net benefit from remeasuring a deferred tax asset and reversing a valuation allowance related to Revel. The U.K. bank levy was expected to cost about $125m for 2011; $94m was accrued in Q3. The company also incurred $130m of initial costs for its China securities joint venture.
  • Market and regulatory outlook: Management described European sovereign-debt concerns, slower global growth, volatile markets, and uncertainty around U.S. and international regulatory changes. Basel III capital estimates were preliminary: Tier 1 common ratio above 7% as of September 30, with a projected 8%–10% by end-2012, subject to regulatory implementation and other uncertainties. No specific revenue or earnings guidance is provided in the supplied filing text.
  • Liquidity and ratings risk: A one-notch downgrade could trigger about $1.3bn of additional collateral or termination payments under specified agreements, plus $323m of exchange and clearing collateral; a two-notch downgrade could trigger about $5.9bn and $2.245bn, respectively. Fitch placed company and bank ratings on Rating Watch Negative in October 2011.
  • Credit, valuation, and legal exposures: The company disclosed substantial derivative and credit-protection activity, European exposures, and $86.7bn of corporate lending exposure, including commitments. It warned that fair-value estimates rely on judgment and that market or economic deterioration could cause future impairments. Litigation includes mortgage-related claims and other significant matters; the company states that some possible losses cannot currently be estimated.
  • Selected legal matters: The filing estimated potential losses of up to $269m plus interest in the Citibank Capmark dispute, $240m plus costs and interest in the China Development Industrial Bank matter, and $223m plus costs and interest in the MBIA matter. FHFA complaints concern mortgage certificates with an original unpaid balance of about $11bn; the filing does not provide a clear estimate of potential loss. These are stated potential exposures, not necessarily accrued amounts.
  • Subsequent events: The board declared a $0.05 common dividend payable November 15, 2011. Morgan Stanley agreed to sell Saxon mortgage servicing, with closing expected in Q1 2012.

Key investor verification points

  • Separate recurring trading and client-driven earnings from the $3.410bn Q3 own-credit-spread benefit and evaluate the possible volatility or reversal of that item.
  • Reconcile the MUFG conversion’s share issuance and $1.7bn EPS adjustment, and assess the resulting dilution against common-equity growth.
  • Review cash-flow volatility, the increase in other secured financings, debt maturities, and the availability and location of liquidity across the parent and subsidiaries.
  • Confirm capital ratios and Basel III estimates in light of the Federal Reserve’s October 2011 direction to revise OTC-derivative collateral treatment.
  • Track MUMSS performance and capital needs, monoline and European sovereign exposures, downgrade-related collateral calls, and mortgage litigation—including matters for which losses are not estimable.
  • Assess the sustainability of Wealth Management net new assets and fee-based flows, and Asset Management’s investment valuations and performance-fee exposure.