Morgan Stanley Profit Drops After Losses on LBO Loans (Update6)
Sep 25, 2007

Sept. 19 (Bloomberg) -- Morgan Stanley, the world's second- biggest securities firm, reported quarterly earnings that fell short of analysts' estimates because of losses on loans for leveraged buyouts and a decline in fixed-income trading revenue.

Third-quarter profit from continuing operations dropped 7 percent to $1.47 billion, or $1.38 a share, from $1.59 billion, or $1.50, a year earlier, the New York-based firm said today in a statement. Earnings missed the $1.55-a-share average estimate in a Bloomberg survey of 17 analysts, the first time in at least six quarters that Morgan Stanley failed to surpass expectations.

Morgan Stanley shares fell 2.2 percent after incoming Chief Financial Officer Colm Kelleher said credit-market dislocations will last at least another quarter or two. That may prolong the slump that undermined fixed-income trading and forced Morgan Stanley to record a $940 million loss on loan writedowns.

``The world that the investment banks live in has changed at least for some time,'' said Jordan Posner, who helps manage $1.8 billion, including Morgan Stanley shares, at Matrix Asset Advisors Inc. in New York. ``The company has taken appropriate action.''

Firms including Morgan Stanley have committed to provide about $320 billion of LBO loans under terms set before credit markets began deteriorating. New York-based Lehman yesterday took a $700 million loss after writing down mortgage holdings and loan commitments.

Worse Than 1998

Kelleher, who succeeds CFO David Sidwell at year-end, said in an interview that the current credit crisis is worse than the turmoil that followed Russia's debt default and the collapse of hedge fund Long-Term Capital Management LP in 1998.

``There were amazing market disruptions during this quarter,'' Sidwell said.

Morgan Stanley, whose shares surged yesterday after Lehman Brothers Holdings Inc. reported better-than-expected earnings and the U.S. Federal Reserve cut interest rates, fell $1.48 to $67.03 as of 4:19 p.m. on the New York Stock Exchange.

Lehman declined 0.6 percent today. Goldman Sachs Group Inc., the world's largest securities by market value, advanced 2.5 percent. Goldman and Bear Stearns Cos., both based in New York, report earnings tomorrow.

Uncommon Miss

``Even in a down quarter, it is not often that bulge firms miss consensus, and results did not match up with Lehman's yesterday,'' David Trone, an analyst at Fox-Pitt Kelton Cochran Caronia Waller LLC in New York, said in a note to investors.

Total revenue for the period ended Aug. 31 rose 13 percent to $7.96 billion. Return on equity from continuing operations, a measure of how effectively the firm reinvests earnings, dropped to 17.2 percent from 23.3 percent. Including results from the Discover credit card unit Morgan Stanley spun off in June, net income fell 17 percent to $1.54 billion, or $1.44 a share.

While equity-trading revenue rose 16 percent to $1.8 billion, it included a $480 million loss ``resulting from unfavorable positioning'' in Morgan Stanley's Quantitative Strategies group. Fixed-income revenue slumped to $2.2 billion, down 3 percent from a year earlier, on ``significantly lower'' credit results and a decline in commodities, Morgan Stanley said.

Sidwell said on a conference call with analysts that credit- trading revenue fell to $260 million from $1.3 billion in the second quarter, a decline unrelated to the loan markdowns.

Morgan Stanley ended the fiscal third quarter with $31 billion in LBO financing commitments, down from $42.8 billion as of May 31. That compares with $27 billion for Lehman, a firm about half Morgan Stanley's size.

Markdowns

Morgan Stanley wrote down the value of that LBO loan ``pipeline'' by $1.2 billion, or $726 million after accounting for fee revenue, Sidwell said. The $940 million total markdown, equivalent to 33 cents a share, includes loans already made and commitments to corporate clients. When fees are added, it drops to $877 million.

Deals being financed by Morgan Stanley include the $31 billion takeover of TXU Corp. by Kohlberg, Kravis Roberts & Co. and TPG Inc. and the $19.5 billion buyout of Clear Channel Communications Inc. by Thomas H. Lee Partners LP and Bain Capital LLC.

Morgan Stanley provided bridge financing to help pay for the $7.1 billion purchase of U.S. Foodservice by KKR and Clayton Dubilier & Rice Inc. when a bond sale fell through. It also helped fund Clayton Dubilier's $5 billion purchase of ServiceMaster Co.

Unhedged Loans

The LBO loans aren't hedged because Morgan Stanley plans to resell them to investors, Sidwell said.

While Morgan Stanley is the third-ranked arranger of mergers and acquisitions announced this year, it ranks seventh on private-equity deals, according to data compiled by Bloomberg. Goldman is the top adviser in both categories.

Investment banking produced $1.4 billion of revenue for Morgan Stanley during the third quarter, an increase of 45 percent. Asset-management fees increased 61 percent to $1.36 billion and Morgan Stanley's retail brokerage had revenue of $1.68 billion, up 23 percent from a year earlier.

The securities industry has been hurt by the decline in demand for mortgage-backed bonds, collateralized debt obligations, high-yield bonds and leveraged loans, as borrowers with poor credit histories fell behind on home-loan payments at the fastest rate in 10 years.

Borrowers may get some relief after the Fed lowered its benchmark short-term interest rate yesterday by a half-point to 4.75 percent. The cut also reduced the cost of financing trades and loans for the securities industry.

Mortgage Decline

Morgan Stanley took a bigger role in mortgages in December, just as the subprime crisis was unfolding, when it bought Saxon Capital Inc. for $705 million. In addition to being a mortgage provider, Saxon services home loans to people with patchy credit histories by collecting payments, maintaining records and foreclosing on delinquent borrowers.

New York-based Merrill Lynch & Co., the third-biggest U.S. securities firm, said earlier this week that it's eliminating jobs at First Franklin Financial Corp., the subprime lender bought nine months ago for $1.3 billion. Lehman and Bear Stearns also are cutting back in mortgages.

Morgan Stanley didn't comment on mortgages in its statement.

``We're looking at this point very hard at the resources we have dedicated to this business in light of current market conditions and expectations,'' Sidwell said.


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