Morgan Stanley: The Riskiest Bank on the Street
Reggie Middleton

The Riskiest Bank on Wall Street - Morgan Stanley (MS) has US$74 billion of Level 3 assets, over 200 times its equity, which is the highest amongst its peers. Although the Level 3 assets have declined from the previous quarters, a result of huge writedowns, the reclassification of assets from from Level 2 to Level 3 categorization continues as the liquidity for the troubled mortgage paper drys up.

Declining ABX index indicates troubled times are not over yet - Morgan Stanley used the performance of the ABX index as one of the benchmarks to writedown US$9.4 billion in 4Q 07. As this index continiues to witness downward trend, we believe that the asset writedown done so far, may not be sufficient.

Forensic Accounting of ABS Assets yields more woes - a security by security accounting of MSs ABS inventory shows at least 30% and probably 56% in additional losses coming down the pike, as well as tests to its excessive exposure to the anemic capital reserves of its counterparties, namely monoline insurers and hedge funds.

Losses from unconsolidated VIEs of $38 billion can wipe out almost half of the company's total equity - Morgan Stanley has $20 billion of its unconsolidated VIEs assets in credit & real estate portfolio where the company expects a maximum loss ratio of 65%. Considering the worsening real estate markets, we believe that the company will incur huge losses on this portfolio. In addition, the company has $7 billion towards MBS & ABS portfolio and $10 billion of strucutured finance products.

Exposure toward Bond Insurers/private funds raises counterparty risk - The failure of bond insurers, on whose shoulders lie the rating of $2.4 trillion of bonds, raises a serious doubt about a systemic failure in the U.S. financial services industry. Morgan Stanley's exposure of $3.6 billion toward the bond insurers may result in unforeseen losses for the company. The company has a counterparty credit risk exposure of $13.9 billion toward parties rated BBB and lower.

Need to raise additional capital if current crisis worsens - Morgan Stanley raised $5 billion from China Investment Corp to maintain its capital ratios as it reported huge losses in 4Q 07. Going forward, as the credit market environment, the housing and real estate markets continues to crack, the company will likely report huge and may have to raise additional capital.

Worsening macro and market conditions to restrict revenue growth - Financial services industry witnessing its toughest times in recent history faces a tough task of getting things back to normal. The deteriorating macro environment coupled with flagging confidence among investors/customers alike, things are more likely to get worse than better. Furthermore, the decline in structured product revenues, risk averse nature owing to recent turmoil and the less active M&A environment will exert pressure on the company's revenue growth in the coming quarters.

We value Morgan Stanley at US$20.76 per share, 58% lower than the current market price. We have analyzed Morgan Stanley exposure toward the Level 3 assets and its exposure to unconsolidated VIEs. To value Morgan Stanley, we have used the Discounted Cash Flow [DCF], Price-to- adjusted book [P/BV] and Price-to-Earnings [P/E] multiple methods. Based on our weighted average valuation, we arrive at a fair value of $20.76 which represents a downside of 57% from current levels of $48.25.

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Morgan Stanley (287.96 kB 2008-02-11 12:49:56)

Reggie Middleton

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