Being Morgan Stanley With Stock Up 50% Means JPMorgan Debt Wins
By Christine Harper and Shannon D. Harrington
April 6 (Bloomberg) -- Being Morgan Stanley is a struggle between bond investors who expect the worst and shareholders who say the best is yet to come.
By its own admission, Morgan Stanley is the preeminent adviser to companies, governments and investors. The New York- based firm has outperformed the Standard & Poor’s 500 Index and the financial industry this year with a 50 percent advance on its shares. That’s no comfort to the people who trade Morgan Stanley debt, which costs almost twice as much to insure against default as that of JPMorgan Chase & Co., the bank from which Morgan Stanley was created in 1935.
“It wouldn’t surprise me in the least if bankers at JPMorgan point to the fact that Morgan Stanley’s credit-default swaps are trading outside their own to help win business,” said William Cohan, a former investment banker and author of “House of Cards,” a book about the collapse of New York-based securities firm Bear Stearns Cos.
The Wall Street that shaped the financial world for two decades ended last September after the bankruptcy of Lehman Brothers Holdings Inc. That’s when Goldman Sachs Group Inc. and Morgan Stanley persuaded the Federal Reserve to let them become deposit-taking institutions, concluding there is no future in remaining investment banks as long as investors considered the leverage-based model for making money broken.
Morgan Stanley’s five-year swaps, the equivalent of insurance against its bonds defaulting, are trading at 3.7 percentage points a year, compared with 1.9 percentage points for JPMorgan bonds, according to prices provided by CMA DataVision of New York. The spread means it costs $180,000 more each year to protect $10 million of Morgan Stanley debt than to insure the debt of JPMorgan.
Credit Spreads
The dichotomy gives New York-based JPMorgan, the second- biggest U.S. bank by assets, an advantage in over-the-counter derivatives and prime brokerage, where clients depend on a bank’s creditworthiness. Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in interest rates or the weather.
“When a financial institution’s credit spreads get too wide, it makes it more difficult to engage in otherwise routine transactions,” said Robert Claassen, chairman of the derivatives and structured-products group at New York-based law firm Paul, Hastings, Janofsky & Walker LLP.
John J. Mack, chief executive officer at Morgan Stanley, declined to comment for this story, as did Jamie Dimon, JPMorgan’s CEO.
Deposit Base
The conversion of Morgan Stanley last year into the fifth- largest U.S. bank by assets ended its 73-year life as a securities firm. The move has yet to persuade investors that the company is as creditworthy as JPMorgan, which was forced to divest its investment bank after the Glass-Steagall Act of 1933.
Half of JPMorgan’s liabilities are deposits, compared with 7 percent at Morgan Stanley. JPMorgan had $1.01 trillion in deposits among its $2 trillion in liabilities at the end of 2008, according to the bank’s annual report filed with the U.S. Securities and Exchange Commission. Morgan Stanley’s $608 billion of liabilities included $42.8 billion of deposits at the end of November, according to reports submitted to regulators.
“One of the key drivers in perception of credit quality is the deposit base,” said Emmanuel Weyd, a former JPMorgan credit analyst who is now a fund manager at Louis Dreyfus & Cie. SA in Paris. “Even if Morgan Stanley and Goldman Sachs just got a bank license last year, to build up the deposit base is going to take a lot of time.”
October Surge
Goldman Sachs, which was the largest U.S. securities firm before becoming the sixth-biggest bank by assets, has a lower credit-default swap price than Morgan Stanley’s, even though only 3 percent of the New York-based firm’s liabilities are deposits. Its swaps are trading at 2.7 percentage points.
CDS prices are nowhere near the level they reached following the Sept. 15 bankruptcy of Lehman Brothers, when panic about another investment bank collapsing caused a surge in the cost of protection on Morgan Stanley and Goldman Sachs.
At its worst, in mid-October, investors were paying as much as 24 percent upfront and 5 percent a year to protect against a Morgan Stanley default for five years, according to prices from broker Phoenix Partners Group in New York. That means it cost $2.4 million upfront and $500,000 a year to insure $10 million of bonds for five years.
Morgan Stanley Loss
While the decline in swaps prices since October is good for Morgan Stanley’s business, it also means the firm will have to book a loss on its credit spreads in the first quarter, according to analysts. Accounting rules require the firm to mark up the value of structured notes tied to Morgan Stanley’s bond prices, which will increase the firm’s liability. Roger Freeman, an analyst at Barclays Capital in New York, estimates that will cost the firm $950 million in the quarter.
Morgan Stanley will report a loss of 5 cents a share in the first quarter, according to the average estimate of seven analysts surveyed by Bloomberg. The predictions range from a loss of $1.30 a share to a profit of 41 cents a share.
The firm’s share price has climbed 50 percent to $24.06 on April 3, while JPMorgan’s stock has dropped 7 percent to $29.28 since the end of December. In the past 12 months, Morgan Stanley is down 49 percent, compared with JPMorgan’s 36 percent decline.
Bank executives watch their CDS prices as closely as they monitor stock prices. Not only do CDS prices signal the company’s cost of borrowing, they also show how expensive it is for trading partners to hedge themselves against the risk they take doing business with a bank. When CDS prices become too high, counterparties may back away because they don’t want to pay so much to protect themselves.
‘Scared Off’
“These things are absolutely crucial,” said Michael Johannes, an associate professor of finance at Columbia Business School in New York who does research on derivatives. “Insofar as the clients of those firms get scared off, it could make a difference. If I were a big client, I’d probably look at it.”
Morgan Stanley’s prime brokerage business, which provides loans and other services to hedge funds, lost 65 percent of its assets in the three months that ended in November, mainly because funds withdrew money following the Lehman bankruptcy.
While Morgan Stanley executives said some customers have since returned, the firm is shrinking the business. Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York, said in a March 13 report that he expects JPMorgan to overtake Morgan Stanley as the biggest prime brokerage, as clients seek safety and brokers who can lend at the lowest rates.
‘Flight to Quality’
A JPMorgan executive acknowledged that the firm told investors at an analysts meeting on Feb. 26 that it benefited from a “flight to quality” during the last few months of 2008. One slide shown at the session noted that “markets client revenue” had jumped 40 percent from a year earlier.
JPMorgan is the top-ranked manager of U.S. bond sales so far this year, as it was in 2008, and has arranged $12.8 billion of rights offers in Europe, twice as much as Goldman Sachs, the closest competitor, according to data compiled by Bloomberg. Morgan Stanley ranks fourth in U.S. bond sales this year and eighth in European rights offerings.
“JPMorgan has captured the hearts and minds of a lot of investors, maybe excessively,” said Ricardo Kleinbaum, a credit analyst at BNP Paribas SA in New York. “But it became self- fulfilling. They’ve gained market share in new deal activity.”
Among the 11 largest credit-default swaps dealers, only Citigroup Inc. and Bank of America Corp.’s Merrill Lynch unit have greater CDS spreads than Morgan Stanley’s, according to CMA, a London-based data provider.
Citigroup, Merrill
Citigroup swaps have widened 4.5 percentage points this year to 6.4 percentage points as the U.S. government rescued the New York-based bank for the third time, raising concerns among holders of the most junior debt and debt-like securities that they may have to take losses.
“It’s not a perfect hedge, but let’s just say that if you’re worried Citi isn’t going to pay your trust preferred, then you go out and buy CDS,” Kleinbaum said.
Swaps on New York-based Merrill Lynch, which Bank of America acquired in January after reaching an agreement in September as Lehman was failing, trade at 5.3 percentage points, wider than its parent’s, because the bank has said it isn’t formally guaranteeing Merrill Lynch’s debt. Bank of America’s swaps trade at 3.5 percentage points, largely because of concerns about “the risk of nationalization,” said Weyd at Louis Dreyfus in Paris.
“People aren’t concerned about the risk of nationalization for JPMorgan,” he said.
Government Guarantees
Bank creditworthiness isn’t in the spotlight as much as it was in September and October, before the U.S. government provided capital to the nine biggest banks and started supplying federal guarantees on their new debt issues for three years. A new clearinghouse to handle over-the-counter trading for credit- default swaps has mitigated concerns about so-called counterparty risk, because it provides a reserve to cover any losses if a participant fails to honor its contracts.
“The paranoia of the fall that underpinned the flurry over counterparty diversification has definitely tapered off,” said Jack McDonald, CEO of Conifer Securities LLC, a San Francisco- based hedge fund administrator that last year started a prime brokerage through JPMorgan. “People feel much more confident in the longevity of a lot of these financial institutions and the backstop that the government is willing to provide.”
The MSCI World Index jumped 7.2 percent in March, the biggest monthly gain in six years. The rally improved market psychology and reduced concerns about the health of trading partners, though that could reverse if stocks tumble again, said an executive at one European bank who declined to be identified.
‘Bailout Fatigue’
“We’re running into bailout fatigue, also a reduction in the perceived resources for federal government bailouts,” said Sean Egan, president of Egan-Jones Ratings Co. in Haverford, Pennsylvania. “Bankruptcy is not an alternative, but a government takeover certainly is, and a squeezing down of the bondholders is a real possibility.”
One solution for Morgan Stanley’s Mack may be to capitalize on the recent gains in his stock price by selling shares and using the proceeds to buy back bonds. That would lower his firm’s CDS prices, said Cohan, the former banker and author.
“The best way to defeat the risk implied in credit-default swaps would be to raise equity and pay down debt,” Cohan said."
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