By Lauren Tara LaCapraMorgan Stanley <MS.N> posted a surprisingly strong profit during a rough-and-tumble third quarter for Wall Street, helped by a large accounting gain and an increase in stock-trading revenue.
The bank's earnings came mostly from an accounting oddity that allows companies to book gains when the value of their own debt declines.
But even excluding that $1.12 per share benefit, Morgan Stanley still would have earned 2 cents per share from core operations -- a stark contrast to rival Goldman Sachs Group Inc <GS.N>, which lost money for shareholders during the period.
"Morgan Stanley has proved it can definitely get in there with the heavy hitters," said Shannon Stemm, financial services analyst for Edward Jones. "Especially as Goldman is losing its ground a little bit here."
Morgan Stanley shares rose as much as 6.6 percent on Wednesday but by afternoon were unchanged at $16.63.
The third quarter was tough on Wall Street as the European debt crisis threw markets into turmoil, cut into securities issuance, and slowed down mergers.
But a sharp climb in stock-trading revenue, driven by intense market volatility, helped Morgan Stanley stay in the black. A moderate decline in bond-trading revenue and improved profitability from wealth management also helped.
Morgan Stanley has also been looking to boost profit by reining in costs. On a conference call to discuss results with analysts, Chief Financial Officer Ruth Porat said the bank is on track to save $1.4 billion over the next three years through a program that includes layoffs, pay cuts and other expense reductions, higher than a previous target of $1 billion.
Some investors were surprised by the bank's solid performance during a difficult market environment that had overtones of the financial crisis.
"Up until a week or two ago, it was Armageddon for these names, particularly with all the rumors swarming around for Morgan Stanley," said Walter Todd, a portfolio manager at Greenwood Capital, which owns Morgan Stanley shares. "From where we were to where we've come, I feel a lot better as a shareholder."
The European debt crisis weighed heavily on Morgan Stanley's debt during the quarter as investors fretted about the bank's exposure to France and other euro zone countries. But the bank said on Wednesday that its exposure to troubled countries was limited.
"When you look at credit spreads and it's inconsistent with the strength we're seeing in our business ... of course it's frustrating," Porat said in an interview.
Morgan Stanley said on Wednesday that its gross exposure to Greece, Ireland, Italy, Spain and Portugal was $5.69 billion at September 30, or $2.1 billion including hedges. The bank's equity, a measure of its net worth as a company, was about $60 billion as of June 30.
The bank said its exposure to France at September 30 was $1.53 billion, or a negative $286 million including hedges. A report on the financial blog Zero Hedge on September 22 pegged the bank's exposure to France at $39 billion at the end of 2010, which sparked fears about losses it might incur.
The biggest revenue contributor for Morgan Stanley last quarter, apart from accounting gains, was stock trading.
Morgan Stanley managed to post $1.38 billion in stock-trading revenue, up 23 percent excluding the impact of debt valuation adjustments. On the same basis, JPMorgan Chase & Co <JPM.N> posted a 15 percent decline.
As a result, Morgan Stanley's overall core trading revenue rose 2 percent, even as core bond trading revenue fell.
Another bright spot in the bank's results was its Morgan Stanley Smith Barney retail brokerage business, a joint venture with Citigroup Inc. <C.N>
Morgan Stanley's share of that unit's income in the third quarter was $169 million, up from $144 million a year earlier. The unit's pretax profit margin rose to 11 percent from 9 percent. Its long-term goal is 20 percent.
Asset management revenue of $215 million fell 73 percent from the year-ago period and 67 percent from the second quarter due to paper losses on principal investments in its merchant banking and real estate investing business.
Overall, the bank earned $2.15 billion, or $1.15 per share, including a penny in earnings from discontinued business. That compared with a loss of 7 cents per share in the year-ago period. Revenue climbed 46 percent to $9.89 billion.
Analysts had been expecting Morgan Stanley to earn 30 cents per share during the quarter, according to Thomson Reuters I/B/E/S, but many of them underestimated the size of its debt valuation adjustment. Some had pegged it at less than one-third of the $3.4 billion gain Morgan Stanley reported.
Although Morgan Stanley's stock was higher on Wednesday, it is still trading at nearly a 60 percent discount to the bank's stated tangible book value of $27.79 as of September 30.
Responding to an analyst's question about potential share repurchases, Chief Executive James Gorman indicated that he is open to postponing plans to buy the rest of the franchise from Citi if buying back stock is deemed a better use of capital.
"The strategic intent is pretty clear," said Gorman. "We want to and intend to own this business. The timing of executing on that is flexible."
Morgan Stanley, which now owns 51 percent of the business, has the option to buy another 14 percent in May 2012. It can acquire the rest in two installments through 2014, all priced at market value.
(Reporting by Lauren Tara LaCapra in New York; editing by John Wallace, Dan Wilchins and Matthew Lewis)