Morgan Stanley Posts Loss, Borrows From China
By Christine Harper
December 19, 2007

Dec. 19 (Bloomberg) -- Morgan Stanley wrote down its subprime-infected mortgage holdings by a greater-than-expected $9.4 billion and received a $5 billion cash infusion from state- controlled China Investment Corp.

The second-largest U.S. securities firm rose 4.2 percent in New York Stock Exchange composite trading. The "significant capital raise'' and writedowns may suggest to investors that Morgan Stanley has put the worst of its subprime losses behind it, Jeffery Harte, an analyst at Sandler O'Neill & Partners LP, wrote in a note today.

Chief Executive Officer John Mack called the fourth-quarter loss of $3.56 billion, the first in the New York-based firm's history, "embarrassing.'' He'll forgo his bonus for the year, the company said today in a statement.

Mack's strategy of expanding in mortgages and making bigger trading bets backfired as losses from securities linked to home loans more than doubled in November. He ousted Co-President Zoe Cruz, who had overseen the fixed-income unit responsible for the mortgage trades, last month and promoted James Gorman and Walid Chammah, who previously ran wealth management and the New York- based firm's European operations.

"They quantified damages, quantified remaining exposure and assigned accountability," said Douglas Ciocca, who helps manage $1.6 billion, including Morgan Stanley shares, at Renaissance Financial Corp. in Leawood, Kansas. There's "a bit of a relief rally given that the stock was heavily shorted and down 28 percent since Nov. 1."

Cash Infusions

The loss of $3.61 a share in the three months ended Nov. 30 compares with net income of $1.98 billion, or $1.87, a year earlier. Analysts were estimating a loss of 39 cents, according to a survey by Bloomberg. The company, which went public in 1986, has never reported a loss.

Morgan Stanley had dropped 29 percent this year in NYSE trading through yesterday, the worst annual decline since 2001. The shares rose $2.01 to $50.08 at 4:03 p.m. in New York.

The firm joined competitors including Merrill Lynch & Co., Citigroup Inc., Bear Stearns Cos. and Zurich-based UBS AG in booking losses on investments in securities, such as collateralized debt obligations, that contain subprime home loans.

Citigroup and UBS also received cash infusions from outside investors to shore up capital. Bear Stearns sold a six percent stake to China's government-controlled Citic Securities Co. for $1 billion in October. Bear Stearns said it would invest the same amount in Citic.

'Depressed Valuations'

China Investment, the nation's sovereign wealth fund, will acquire as much as 9.9 percent of Morgan Stanley, making it the company's second-largest shareholder after Boston-based State Street Corp., according to data compiled by Bloomberg.

The fund, advised by New York-based investment bank Lazard Ltd., is buying securities that convert into Morgan Stanley shares and pay annual interest of 9 percent. China Investment won't get a seat on the board or play a role in management, Morgan Stanley said in the statement.

The fund is "not really looking for voting rights or control but trying to take advantage of surging asset values in China and depressed valuations here in the U.S.," said Winston Wenyan Ma, author of "Investing in China: New Opportunities in a Transforming Stock Market," published last year by Risk Books. "They like minority stakes, so as not to raise the ire of politicians in Washington."

'Pay for Performance'

For the full year, Morgan Stanley's revenue fell 6 percent to $28 billion from $29.8 billion and net income decreased 60 percent to $2.56 billion.

Return on equity, a measure of how effectively the firm reinvests earnings, dropped to 7.8 percent from 23.8 percent in 2006. Goldman Sachs Group Inc., which reported a record profit yesterday, said its return on equity was 32.7 percent in 2007.

"Accountability for our results rests with me," Mack said in the statement. "I believe in pay for performance, so I've told our compensation committee that I will not accept a bonus for 2007."

Mack reaped a $40 million bonus in 2006, the biggest ever paid to a Morgan Stanley CEO.

Morgan Stanley is the third of Wall Street's largest firms to post results for the fiscal quarter that ended Nov. 30. Lehman Brothers Holdings Inc., the fourth-biggest by market value, reported last week that profit dropped 12 percent, the second consecutive decline, and said losses from the collapse of the subprime mortgage market will probably extend into next year.

Subprime Fallout

Goldman, the biggest U.S. securities firm, reported fourth- quarter earnings yesterday of $3.22 billion on higher revenue from investment banking, stock trading and gains from selling power plants.

Morgan Stanley said its fixed income sales and trading group recorded a net loss of $7.9 billion in the fourth quarter, after the writedowns, which included $7.8 billion for subprime- related losses. The remainder stemmed from a decline in the value of loans, commercial mortgage-backed securities, and so- called Alt-A mortgage securities.

"Our assumptions included what at the time was deemed to be a worst-case scenario," said Colm Kelleher, the firm's chief financial officer, in a phone interview today. "History has proven that that worst-case scenario was not the worst case."

Kelleher said conditions in the credit markets "clearly got worse" after September.

Credit Drag

"The credit environment remains challenged, it will take several quarters to return to more normal markets," he said. "Credit is going to be a drag on the fixed-income business going forward for the next few quarters."

Equity sales and trading revenue climbed 72 percent to $2.5 billion and investment banking revenue rose 4 percent to almost $1.6 billion.

Revenue at the global wealth management unit, still overseen by Gorman, increased 23 percent to $1.8 billion and pretax profit advanced 124 percent to $378 million. Asset management, run by Owen Thomas, reported a 9.7 percent gain in pretax profit, to $294 million.

The company ranks second after Goldman among the world's biggest advisers on mergers and acquisitions announced in 2007, data compiled by Bloomberg show. The firm advised on $42.2 billion of takeovers completed during the fiscal fourth quarter, more than double a year earlier.

Kelleher said the firm's pipeline of merger assignments was unchanged from the previous two quarters.

'Increasing Caution'

"We are seeing increasing caution" in conversations with the firm's investment-banking clients, he said.

In equity underwriting, Morgan Stanley managed $14.1 billion of offerings during the quarter, up from $13.6 billion a year earlier, Bloomberg data show.

Morgan Stanley said in October that it was eliminating 900 jobs, mostly in the mortgage units. The firm said Nov. 7 that investments in subprime mortgages and related securities lost $3.7 billion of value in September and October.

"There was a huge risk-management failure here," said Steve Roukis, who helps oversee $1.8 billion at Matrix Asset Advisors Inc. in New York, including Morgan Stanley shares. "You're going to see a broad undertaking by the Street to have more diversification and more hedging of all positions."

To contact the reporter on this story: Christine Harper in New York at .

Last Updated: December 19, 2007 16:36 EST

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