Stock Market Predictions

Morgan Stanley bond trading unexpectedly strong

Stock Market Predictions

The investment bank and brokerage said its bond trading revenue rose compared with last year's first quarter, stripping out an accounting quirk, even as its chief rival, Goldman Sachs Group Inc, posted a decline. Morgan Stanley shares were up 1 percent at $17.85 in Thursday afternoon trading.

"We had identified several years ago that we were punching below our weight in fixed income products," Chief Financial Officer Ruth Porat said in an interview. "I think you're beginning to see the fruits of all we've done here."

Morgan Stanley also showed some progress in its wealth management business.

In spite of those gains, the bank lost money during the first quarter because an accounting adjustment cost it $2 billion. Analysts typically exclude that item, known as debt valuation adjustment (DVA), from their performance assessments.

The bank reported a net loss of $119 million, or 6 cents per share, compared with a profit of $736 million, or 50 cents per share, a year earlier.

Excluding the debt adjustment, which requires companies to record gains when their own debt weakens and losses when their debt strengthens, Morgan Stanley earned $1.4 billion, or 71 cents per share.

The bank's trading revenue was much higher in the first quarter than the 2011 fourth quarter, thanks in large part to improvements in the fixed-income markets. U.S. competitors including Goldman, JPMorgan Chase & Co, Citigroup Inc and Bank of America Corp also posted gains.

But Morgan Stanley's trading results were also significantly better compared with the first quarter of 2011, a level of improvement that eluded many rivals.

"This clearly demonstrates company-specific improvement," said David Trone, an analyst with JMP Securities.

Goldman reported a 14 percent year-over-year decline in trading revenue, although its results are not exactly comparable because it separates client trading from its own trading.

Following Morgan Stanley's report, several analysts said the company surpassed their earnings and revenue forecasts, attributing the outperformance to its trading business.

"Those trading results were well ahead of our expectations," said Edward Jones analyst Shannon Stemm. "The fact that Morgan Stanley stood out from its peers really told us that the investments in that business are starting to pay off."

Much of the increased client activity in bond trading came as a result of the European Central Bank's Long Term Refinancing Operation (LTRO), announced in December, Porat said.

The LTRO offered a lifeline to struggling European banks, easing investor concerns about the European debt crisis and creating less-volatile trading conditions.

"We've had thousands of investors literally on some of our weekend calls trying to understand what's going on in the Eurozone," Porat said.

Morgan Stanley profited by advising clients on how to hedge risk related to Europe, particularly in foreign exchange, and by executing those trades, she said.

Morgan Stanley's wealth management business, a joint venture with Citigroup, posted higher profit margins during the quarter -- 11 percent compared with 10 percent a year ago and 7 percent in the fourth quarter.

Investors and analysts have been watching wealth management closely because Morgan Stanley has been slow to hit profit targets as it integrates Citigroup's Smith Barney business into its own.

Management initially aimed for a pretax margin of 20 percent for retail brokerage but lowered that target to the mid-teens last year, saying low interest rates and weak client activity were hurting performance.

The wealth management business reported more client assets in fee-based accounts and more revenue and assets per financial adviser. Some of those gains are the result of efforts to fire hundreds of unproductive advisers. Morgan Stanley's financial adviser headcount was 17,193 at March 31, down 2 percent from the end of the fourth quarter and down 5 percent from a year earlier.

The bank plans to complete a technology integration this summer that will put all of the financial advisers on the same platform, an effort that will save the bank an estimated $500 million a year.

The bank plans to buy another 14 percent of the business from Citi after May 31, when a previously agreed option becomes available.

About 51 percent of the business is owned by Morgan Stanley, and Citi holds the rest. Sources told Global Markets last month that Morgan Stanley wanted to buy all of Citigroup's stake this year, but Morgan Stanley Chief Executive James Gorman said on a conference call with analysts on Thursday that his bank had "no particular compulsion or anxiety to accelerate" the pace of its purchase.

DOWNGRADE THREAT

Moody's Investors Service may downgrade Morgan Stanley soon, but the bank has been preparing for such an event, CFO Porat said. Ratings cuts can raise a bank's funding costs, increase its collateral requirements, and force clients and counterparties to move their business elsewhere.

To prepare for a possible downgrade, Morgan Stanley has been moving derivatives into its higher-rated bank entity and has reduced the size of its structured products business, which would be most impacted by the change, Porat said.

Since many derivatives contracts will be centrally cleared on exchanges, due to new regulations, the impact on Morgan Stanley's long-term, over-the-counter derivatives business will be limited, she said. Only about 8 percent of those contracts would be affected by a Moody's cut, she said.

Moody's warned in February that it might lower Morgan Stanley's rating by three notches to Baa2, putting its rating below peers, including Goldman Sachs.

The bank has said it would have to post an additional $6.52 billion in collateral if that happened.

In the first quarter, Morgan Stanley's net revenue totaled $6.9 billion. Excluding the debt adjustment, revenue was $8.9 billion, up from $7.8 billion a year earlier.

Excluding debt adjustments, Morgan Stanley's trading revenue rose 33 percent to $5 billion. Pretax income from trading, excluding DVA, more than doubled, to $1.67 billion from $621 million. Its fixed income trading division delivered $2.6 billion in revenue, excluding DVA, up 34 percent from a year ago.

(Reporting By Lauren Tara LaCapra; additional reporting by Jed Horowitz and David Henry; Editing by Dan Wilchins, Maureen Bavdek and John Wallace)