Minyan Mailbag: Morgan Stanley Questions

Before we get to the questions about Morgan Stanley, here is the background story: Morgan Stanley posts first quarterly loss, and welcomes Chinese investor.

Morgan Stanley posted its first quarterly loss ever Wednesday after taking an additional $5.7 billion write-down related to subprime mortgages. The investment bank also said it would sell a $5 billion stake to China Investment Corp., a sovereign wealth fund, to shore up its capital.

The sale, which would give the Chinese government a stake of about 9.9 percent in one of Wall Street's biggest investment banks, is the latest example of a foreign investor aiding a Western financial firm after the housing meltdown.

In taking a major investment from the Chinese sovereign wealth fund, Morgan Stanley is following a model set by Citigroup and UBS, two other financial giants badly damaged by their exposure to securities backed by risky home loans. Citigroup sold a 4.9 percent stake to Abu Dhabi's investment arm, while UBS sold stakes to the Singapore government and an unidentified Middle Eastern investor.

Question On Lower Cost Options

Mr. Shedlock,

Can you please explain why Morgan Stanley would take a capital infusion at 9% interest when there are so many other lower cost options available on the market? My suspicion is that the conversion stipulation allows Morgan to treat this as equity now (an accounting trick as the accountants will assume that the conversion will take place) while not currently diluting shareholders (as the conversion is later) but being booked as equity for reserve requirements.

Any insight is greatly appreciated.

I do thorough enjoy your perspective on the current condition of economics. As a person with a Ph.D. in a quantitative area (statistics), your arguments make a lot of sense.

Best Wishes,

Scott

My Reply:

Minyan Scott

Thanks for the question.

I am not sure there are other low cost options. Yes they can raise credit far cheaper, but only by selling assets can they raise actual cash.

Their balance sheets are so impaired they need the latter. Citigroup (C), Countrywide (CFC), MBIA (MBI), Etrade (ETFC), and now Morgan Stanley (MS) are all in the same boat: needing capital and needing it in a hurry.

Mish

Followup Question On Convertibles

Inquiring minds do not give up so easily so I received a second question from Scott.

Mish,

I agree with your thoughts, but am still stuck on the approach to raising capital this way. Clearly raising cash by selling assets creates a problem: it sells assets at a time when they are worth substantially less creating a hit to reserves (converting a more valuable asset to a less valuable asset will reduce equity).

Borrowing money creates the same problem as the asset and liability aspects of the balance sheet are enhanced, which would also provide a hit to a reserve ratio. Thus, they clearly need a capital infusion. What fascinates me is that this infusion is effectively a liability until it is converted to common or preferred shares, so it should affect the reserve ratios now as a liability. I believe that accounting “tricks” allow the liability to be treated as capital because of the so-called “intent” of the transaction – to create an equity position in the future.

I am struggling with the “why” behind this? Why doesn’t Morgan simply issue stock in exchange for the infusion? Why the delay in the conversion? Is this a means to get around shareholder covenants? Will the market react negatively to a straight stock issuance rather than a convertible security? Is it the time necessary to file SEC documents? Countrywide did this with BofA too (as did many others)? What am I missing that seems so obvious to the street?

Thank you for your time. This stuff is fascinating. As an aside, a quick and dirty poll of the economists at my university a few months ago (including a former Fed Governor) showed absolutely no belief that a recession was coming. I felt pretty isolated with my opinion, but have stuck with it. It is no fun being a bear when you have been a bull all of your life, and everyone you know is still bullish.

Best Wishes,

Scott

My Reply:

Countrywide, Citigroup, and Morgan Stanley all needed capital immediately. Private deals are the fastest way to do business. Perhaps money could have been raised cheaper by secondary offerings perhaps not. Both cause shareholder dilution.

I pinged Minyan Peter on this today and received this additional input. "Institutional investors prefer private deals in the form of convertibles because the structure grants the new investors senior rights in case of liquidation. In addition, private deals establish relationships which may or may not have tangible benefits down the road".

Getting back to the idea that things might have been done cheaper, I would now like to add this thought: imagine the mess if a large secondary offering was not received well by the market.

So the answers are:

• Speed
• Single Party Negotiation
• Certainty the deal gets done at a known guaranteed price
• Senior rights in case of liquidation
  
• Possible tangible benefits down the road from a one on one relationship

Morgan Stanley One Time Charges?

Looking down the road at so called "one-time" charges Minyan Peter offered the following pertinent thoughts this morning on a Buzz and Banter.

My thoughts on Morgan Stanley's (MS) results:

Of all the earnings headlines I have seen this year, “Firm Further Bolsters Its Strong Capital Position With a Long-Term Investment…”clearly takes the prize.

If capital were so “strong” why did Morgan Stanley feel compelled to cut its balance sheet assets by $125 bln or 18% during the quarter? Do you think that maybe a 15% reduction in tangible common equity ($4.6 bln) during the quarter may have had something to do with that? Even so, Morgan Stanley’s leverage ratio increased to 32.8X from 32.2X at the end of the third quarter.

While clearly Morgan Stanley has cleaned its “subprime” house this quarter, I would caution that the spreading credit malaise subjects Morgan Stanley and others to further “one time” charges.

Peter

Looking ahead it's easy to see that when unemployment ticks up, credit card defaults rise, and commercial real estate tanks further there are many more “one time” charges coming. Some companies will not even survive those “one time” charges.

From the point of view of those providing the capital, senior rights in liquidation are the key. For example, the deal between Bank of America (BAC) and Countrywide (CFC) that looked so great at the time for BAC (they received an option that was $8 in the money), but looks so poor on paper now with the option $9 under the strike price, just may not be so bad for BAC regardless of what happens.

Arguably Bank of America is hoping Countrywide goes bankrupt. If that happens, Bank of America will have first crack picking up pieces of Countrywide, notably their servicing operation, for an extremely cheap price.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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