Even though they told us that they don’t have a liquidity problem, Morgan Stanley late yesterday filed a mixed shelf to raise another undisclosed amount of money "to buy back stock, repay debt or use as working capital".
Outlined below is a post that we wrote after reviewing Morgan Stanley's earnings call late last week. We were wondering why John Mack wasn’t leading the call… and it seems we now know, planning for his next capital raise.
We’ve been negative on Investment Banking, Inc for quite some time and, obviously, this has now morphed into consensus. That doesn’t mean, though, that these stocks are no longer shorts. At a minimum, they are valuation traps. As Keith noted on our Morning Call today, the negative intermediate "Trend" for federal government financials fully intact. “The Investment Banking Inc model of old will go by the way of the horse and buggy whip… BAC is down -29% in the last 2 weeks vs. the SP500 down -5%... they are underperforming miserably in a US tape that continues to shape up bullishly, making higher lows.”
We listened to Morgan Stanley’s earnings call yesterday and reviewed the transcript. Curiously, John Mack wasn’t on the call, which we would have thought would be a logical show of leadership in these trying times, but undoubtedly he has a busy schedule.
The most alarming issue with Morgan Stanley continues to be its high level of Level 3 assets (no pun intended). For those of you who don’t follow financials and don’t know what Level 3 assets are, you are not alone, as by definition no one knows what they are or worth.
A financial blog that we follow gave the following summary of Level 3 assets and partially borrows directly from FASB’s definition:
“Level 3 values are based on "unobservable" inputs reflecting companies' "own assumptions" about the way assets should be priced. In other words, Level 3 assets are based on effectively best guess, or in many situations what firms want to value these items for in order to improve the situation in the books. The majority of derivative instruments carried on the books of brokerages are Level 3 assets.”
In essence, these assets are worth whatever the firm decides they are worth, which is not exactly comforting.
According to Morgan Stanley’s CFO as it relates to Level 3 assets on their recent call:
“Now we are expecting the absolute value of Level 3 assets to increase this quarter and they represent approximately 13% total assets. The increase in the value is primarily due to the volatility seen in the derivatives market, especially given the widening of credit spreads. The dramatic reduction in our total assets this quarter exacerbated the ratio of Level 3 assets to the balance sheet. As we have previously said, there were offsetting hedges to these positions in the other levels of the fair value hierarchy.”
So, these assets that can’t be valued by outside parties are expected to go up as a % of assets on a gross dollar basis. That is more than a little concerning.
We found a few more comments on the call interesting. As it relates to the Prime Brokerage business:
“We remain committed to maintaining a premier Prime Brokerage franchise. While this business is smaller it will benefit from the repricing of services.”
Come again? To us that sounds like Morgan Stanley is taking pricing up on the their prime brokerage customers, which is an interesting way to grow a business when the customer base is losing money. We no longer run hedge funds, but if we were and our prime broker just publicly stated they were going to grow their business by price, we may be looking around for alternatives.
On the proprietary side of the business, MS lost more than $700MM in the quarter, so not surprisingly an analyst on the call asked the following question:
“Can you just talk about the balance between pulling back in proprietary trading and taking risk where you see some upside?”
The CFO’s response was as follows:
“What we're doing is we're reallocating businesses on a risk adjusted basis to where we think we can generate alpha. So these (losses) were not unexpected insofar as the market away from what the market did itself.”
I definitely didn’t quite follow that one, but I guess in summary they are searching for alpha.
The CFO was then asked:
“I guess in listening to your commentary about risk positioning and appetite for principal investing going forward, how do you think about your approach to markets once they -- when we get to this eventual point where credit markets stabilize and we see increasing asset values again.”
To which he answered:
“Well, I mean, it is clear that we are very negative on these markets at the moment and have been for some time, Roger, as you know, right?”
Find that confusing? That makes two of us. They are searching for alpha and are now negative on the markets after a 40% decline in most assets classes.
Keith’s chart and levels are below. We covered this name a lot lower, and we will be re-shorting MS on strength.