Will Europe Transform Morgan Stanley Into Lehman?


Much of the financial world appears to have recently been convinced Morgan Stanley (NYSE:MS) will be unable to survive the European sovereign debt crisis because of its relatively small size, dependence on skittish short-term credit markets and exposure to troubled French banks.

As evidence of this, Morgan Stanley’s stock price has plunged to 2008 levels, the cost to insure its debt has even exceeded that of French banks and the rumor mill is churning out a stream of doomsday chatter.

However, because of drastic changes to its balance sheet, lessons learned during the last Wall Street crisis and distance from today’s toxic assets, most analysts believe Morgan Stanley is no Lehman Brothers.

Morgan “is under broad-based attack,” said Dick Bove, a banking analyst at Rochdale Securities. “If they’re correct, the company will be bankrupt. If they’re wrong, and I don’t see how they can be right, the stock will turn out to be a pretty attractive investment.”

Morgan Stanley declined to comment for this article because the company is in a "quiet period" before its earnings, which are set to be released on October 20.

Is Morgan Next in Line?

There are countless similarities -- and differences -- between the turbulence in the marketplace today and the scary situation that nearly collapsed the capital markets in 2008. Some believe the European debt debacle will eventually freeze U.S. credit markets, relaunching a series of falling dominoes.

Before the government acted to stop the bleeding and unfreeze the credit markets in 2008, big banks perceived to be the weakest were brought down one by one. First, Bear Stearns agreed to a Fed-brokered firesale to JPMorgan Chase (NYSE:JPM). Then, Lehman Brothers collapsed and Bank of America (NYSE:BAC) made an ill-advised buyout of Merrill Lynch and its basket of problems.

“Morgan Stanley was the next domino to fall in 2008,” said Jim Rickards, senior managing director at Tangent Capital in New York, who was the lead negotiator of the 1998 rescue of imploding hedge fund Long-Term Capital Management. “Now that things are picking up where they left off, people remember that and figure Morgan Stanley is the next one to fall this time."

Those bets are most clearly illustrated in the murky credit default swap market, which measures the cost to insure the debt of companies and countries against default. The cost to insure $10 million of Morgan Stanley’s debt for five years hit $565,000 on Wednesday, up 34% from the week before and an incredible 75% from a month earlier, according to Markit.

Morgan’s CDS levels are significantly higher than other big banks -- 25% higher than Goldman Sachs (NYSE:GS) and 38% above Citigroup’s (NYSE:C). Alarmingly, Morgan’s CDS levels are higher than those seen in French banks that hold much of the Greek bonds that some fear may now be worth just a fraction of their former values. In fact, it now costs more to insure Morgan’s debt than that of French giants Credit Agricole and BNP Paribas -- combined.

“I think the market is expressing a strong degree of concern,” said Otis Casey III, the director of credit research at Markit. “These types of CDS spread levels are implying ratings that are below investment grade. If that persists that is concerning.”

Threat of Frozen Credit Looms

The biggest fear appears to be that Morgan Stanley, which depends on the overnight repo markets more than its peers, will be frozen out of the credit markets if the European crisis spirals out of control. Bear and Lehman collapsed in 2008 after counterparties refused to trade with them because they were scared they wouldn’t get their money back.

“Secured financing can go away when markets become frozen. Liquid assets can become illiquid,” said Brad Hintz, an analyst at Sanford Bernstein and chief financial officer at Lehman from 1996 to 1998.

In an effort to prevent a repeat of 2008, Morgan Stanley has seriously bolstered its balance sheet and reduced its dependence on the edgy overnight funding markets.

Like many banks, Morgan cut its leverage -- 15 to 1 now, down from 30-1 previously, Hintz estimates.

Total assets on Morgan’s balance sheet have shrank to about $830 billion, down from $1.1 trillion previously during the crisis. To cushion against possible losses, Bove said common equity has jumped to $59 billion from $30 billion and bank deposits have increased to $65 billion from $31 billion.

Morgan Stanley also had a liquidity pool (cash and cash equivalents) of $182 billion as of the end of last quarter, twice as high as during the crisis.

“They’ve reshaped the balance sheet pretty dramatically and written down a substantial amount of their debt,” said Bove, who has a “buy” rating and a $30 price target on Morgan. “There’s a huge difference in the company today from what it was then.”

Aside from its new deposits, Morgan Stanley can also fall back on a huge pool of assets from strategic partner Mitsubishi UFJ (NYSE:MTU), the Japanese lender that has a market cap of $60 billion and this week reaffirmed its commitment to Morgan.

Rumblings About French Connection

Others are worried about Morgan Stanley’s ties to French banks. The concern is that these lenders will be forced to take heavy losses on their holdings of Greece’s toxic debt, causing some of the banks to fail and incur heavy losses for U.S. institutions.

According to FEEIC data, Morgan had $28 billion of gross (before hedges and collateral and including cash in French clearinghouses) exposure to French banks at the end of the second quarter, down from $39 billion at the end of 2010. By comparison, Goldman had $108.5 billion in gross exposure to French banks at the end of the second quarter.

Morgan Stanley has said when collateral and hedges are included, its total risk to France and its lenders is less than $2 billion, a relatively small figure for a bank this size. Moreover, a person familiar with Morgan Stanley's finances said its net exposure to France is zero, and that includes the banks in France.

In a recent research note, Wells Fargo analysts said Morgan Stanley's French exposure "appears to be quite manageable" and "overly discounted by the markets in recent weeks."

It’s not clear the markets buy this argument.

“The company argues they have hedged that down to $2 billion, but who the hell knows? I don’t know what the hedges are or if they are any good,” said Bove.

Still, analysts point to the fact that France appears willing to stand behind its banks and prevent a Lehman-style collapse. That view was bolstered by the quick actions by France and Belgium to support Dexia, the troubled lender that some believe may be insolvent.

Lehman Lessons

Some argue Morgan Stanley is the victim of a whisper campaign in the opaque derivatives markets aimed at spreading false rumors that can be capitalized on.

“I think what we’re seeing and hearing from the market is the sort of trick that money market people play on institutions that they think they can make a few bucks off of,” said Charles Geisst, a professor at Manhattan College and author of Wall Street: A History.

Morgan Stanley CEO James Gorman seemed to allude to that in a recent internal memo leaked to the press. “In fragile markets, where fear triumphs over common sense, these things are bound to happen. It is easy to respond to the rumor of the day, but that is not usually productive,” Gorman wrote. “Instead we should let balanced third parties do their own analysis and let the facts speak.”

True or not, there are questions about how the government would react to a potential collapse of a big U.S. bank. On the one hand, there is little political will for more bailouts (see: Occupy Wall Street protests). On the other, it’s clear allowing Lehman to collapse caused painful unintended consequences the economy has yet to recover from.

Tim Geithner, the Treasury secretary, told lawmakers on Thursday the European crisis would “absolutely not” bring down Morgan or another major bank.

“I don’t anticipate that having moved heaven and earth like the Fed and the U.S. Treasury did” in 2008, policymakers “would allow a major too-large-to-fail capital markets firm to fail,” said Hintz.

While the government may have learned lessons from Lehman, it’s not clear if Wall Street has.

“It’s always fun to make fun of Wall Street, but they do learn from their mistakes,” said Hintz, pointing to higher capital levels and less dependence on short-term credit markets.

Rickards said big banks learned the opposite lesson. “They learned you can be reckless and still make money. Wall Street is as arrogant, confident and greedy as ever -- if not more so,” he said.

Will Morgan Survive?

A failure to learn lessons from the past is part of the reason why Rickards believes Morgan won’t be skipped over in the doomed list of dominos.

“I’m not picking on Morgan Stanley,” said Rickards. “I don’t think they’re more or less deserving than anybody else. I don’t think they’re any more badly managed. I just think they’re next.”

Geisst believes there is a chance there are serious problems at Morgan Stanley that have yet to emerge.

“Someone knows something we don’t. I don’t think you pick on something like an institution without some justification,” said Geisst. “I think they’ve gone after them for a reason. The rest of just don’t know what it is.”

Still, most analysts believe the links between the current situation and 2008 are overblown and Morgan Stanley will manage to survive.

It seems the equity markets are coming around to that thinking in recent days. Since plunging as low as $11.58 on Tuesday, hopes for a strong policy response from Europe have sent Morgan’s stock soaring to $15.18 on Thursday -- a 31% surge.

“We could have a challenging situation ahead of us, but it’s hard to believe that anyone of us and certainly not our government wants another Lehman Brothers,” said Hintz.