Morgan Stanley's Gaffes

While the woes afflicting Lehman Brothers Holdings are the result of a balance sheet weighed down by toxic assets, Morgan Stanley in its fiscal second quarter, ended May 31, was tripped up by bad trades, poor management and investments, as well as less-than-stellar risk management. Without big gains related to the sales of assets, Morgan Stanley's net profit of about $1 billion would have been closer to break-even. The firm did take some balance-sheet hits, on things like leveraged loans, commercial real estate and securities backed by troubled monoline insurers. But investors should perhaps be more worried by a bad bet on the direction of electricity prices and a $120 million loss due to a rogue trader. Chief Financial Officer Colm Kelleher acknowledged that Morgan faced a tough quarter, both in terms of market conditions and trades failing to work as planned. But he added that "more often than not, we get those right" and that the firm "continues strengthening our capital and liquidity positions." Morgan Stanley's stock rose Wednesday, suggesting investors were willing to shrug off the quarter. That might make a lot more sense if the company's shares were cheap. They aren't. Despite taking a beating this year, the stock still trades at nearly 1.5 times tangible common equity of about $29.5 billion, which excludes junior subordinated debt that the firm includes in its own calculation of this figure. Morgan Stanley clearly deserves a better valuation than Lehman, which trades at 0.7 times tangible common equity and is deservedly at a lower multiple than Goldman Sachs Group, which trades at about 2.15 times. Still, it is tough to justify Morgan Stanley's premium until the firm shows it has the basics under control and can prevent its traders from causing whiplash volatility. Take a look at the performance of Morgan Stanley's fixed-income business in the second quarter. Revenue at this key business plunged to $414 million from $2.9 billion in the first quarter. Even worse, it is almost impossible for outsiders to tell how the sharp decline came about. Morgan Stanley's commodities traders, for example, placed some bad bets on North American electricity prices, but the firm didn't disclose how much that contributed to the decline in fixed-income revenue. While investors may be willing to give the commodities unit a pass this time, the market has no tolerance for sloppy risk-management -- and that is another factor that could weigh on Morgan Stanley's valuation. The firm's record doesn't appear to be improving after a trading strategy went badly awry in the fourth quarter of fiscal 2007, leading to massive losses. In the second quarter, Morgan Stanley booked a $120 million loss after a now-suspended London trader improperly valued trades that apparently went undetected for at least a quarter. Morgan Stanley can't fumble this way and hope to be spoken of in the same breath with Goldman.