September 18, 2008 – 5:55 pm

Morgan Stanley and the financial media tried to play that “beat the Street by a penny” game one more time, but things are so bad out there it didn’t work.

Third quarter results at Morgan Stanley one of only two independent investment banks left, after the collapse of many previous competitors — were down but clearly far from horrible. On Tuesday, the Wall Street firm reported a better-than-expected 7.7 drop in profits, as net revenues rose; the company recorded a profit of $1.43 billion, or $1.32 per share, compared to $1.54 billion, or $1.44 per share, in the year-ago period.

But better-than-expected results apparently have done little to quell speculation that the company may merge with a bank.

Someday they’ll have to explain who keeps the penny, but yesterday the shares dropped anyway. And why not?

Part of the reason is that Morgan Stanley benefited from the same accounting quirk that has helped more than a few monolines in recent periods: a sharp drop in the value of Morgan Stanley debt (reflecting investor concern) led the firm to book $1.4 billion in paper gains.

Yup. Our old friend SFAS 159, which says they can do exactly that. Here’s our old pal now:

Recently, SFAS 159 has come into the news because some securities firms used it to book gains because the market value of debt that they issued had fallen.

Love it or hate it, we have to live with it. Since the company seems shy to talk about its SFAS 157, otherwise known as low level 3, we’ll count the SFAS 159 in lieu of it.

In other matters of business, Morgan Stanley produced write-downs of $640M in the mortgage proprietary trading business and $410M for leveraged loan buyouts.

  • Fixed income sales and trading net revenues of $1.9 billion included higher revenues in commodities, offset by lower revenues in interest rate, credit & currency products and net writedowns in the mortgage proprietary trading business of $640 million.
  • Other sales and trading net losses of approximately $410 million primarily resulted from mark to market losses on loans and commitments, largely related to acquisition financing to non-investment grade companies, partly offset by gains on hedges.

That comes to about $1.1B in credit-related write-downs. Morgan Stanley was spared the embarrassment of forced capital raising, but $45B forced refund from the auction arms settlement is in their future.

The total charge related to the ARS settlement was $288 million, of which $11 million is included in the results of the Institutional Securities business segment.

To hear management speak about it, you might think things were great:

Chief executive John Mack said the firm was taking steps to position itself for stability through 2008: “While many of our businesses are facing challenging market conditions that we expect to continue in the months ahead, we are satisfied with how Morgan Stanley navigated the ongoing market turbulence.”

If being the best of the worst is great, then these guys are terrific because of their $1.4B in accounting magic. Nobody rush to tell them that this sword cuts both ways. 

Down on the street, where people get paid to be right about things like this, Morgan Stanley can’t give their debt away.

Sellers of credit-default swaps on Morgan Stanley demanded as much as 21 percentage points upfront and 5 percentage points a year today to protect the company’s bonds for five years, according to broker Phoenix Partners Group. That means it would cost $2.1 million initially and $500,000 a year to protect $10 million in bonds. Contracts on Goldman climbed as much as 265 basis points to 685 basis points

Yeah, that’s right: 21 points upfront. About a year ago you could be institutionalized for suggesting that Morgan Stanley’s debt should cost 21 percent upfront. But this is where the credit crunch has taken us. 

Even the rating agencies are cutting Morgan’s debt, and you know what that means. But Morgan Stanley’s, problems don’t stem from overleveraged risky loans, panic selling of mortgages to illegal aliens earning minimum wage or any other internal financial disaster. Nope. Morgan Stanley would be fine were it not for scourge of the earth: short sellers!

Morgan Stanley Chief Executive John Mack lashed out at short sellers Wednesday after watching his firm’s shares plunge as much as 42 percent and seeing prices for its debt-default insurance soar into distressed territory.

What’s happening out there? It’s very clear to me — we’re in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down,” Mack said in a memo obtained by Reuters.

Well, John can blame his company’s problems on short-sellers, but I blame short-sellers on his company’s problems. I only wish short-sellers could take down Morgan Stanley. I understand John. Really, I do. The truth is a little too messy for a company desperately seeking a buyer:

Morgan Stanley, one of the two major Wall Street firms still standing independent after unprecedented upheaval this past week, is pursuing “multiple tracks” to help it weather a worsening storm in financial markets, the source said.

The firm’s executives have again approached CIC, which in December acquired a 9.9 percent stake in Morgan Stanley for $5 billion, about increasing its equity stake. Some news reports said the China fund may acquire as much as 49 percent

They may even find one, but I hope not. I would not be sorry if anyone should buy Morgan Stanley, but I would pity the fool.


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