$9.4 Billion Write-Down at Morgan Stanley

Date: Thursday, December 20, 2007
Author: Landon Thomas Jr., The New York Times

Morgan Stanley reported the first quarterly loss in its 72-year history Wednesday, heightening fears that the financial toll would keep mounting from the fast-spreading crisis in the subprime mortgage market.

The company took a $9.4 billion charge on subprime-linked investments for the fourth quarter, bringing its cumulative charges for subprime mortgages to $10.8 billion. In a stark reflection of its diminished status it also said it would sell a $5 billion stake to a Chinese investment fund to shore up its capital.

Wall Street banks so far have reported more than $40 billion of losses as a result of the crisis in the mortgage market. Worst-case estimates put the eventual bill at $200 billion or more. The tally is likely to rise again Thursday when Bear Stearns is expected to report a quarterly loss.

The developments on Wednesday were a stunning turn of events for Morgan Stanley, an offshoot of the Morgan banking dynasty that has counseled corporate America since the Depression. John J. Mack, the bank’s chief executive, said he took full responsibility and would forgo a bonus for 2007.

Like Citigroup and UBS of Switzerland, Morgan Stanley has turned to a wealthy investor from the East after losing billions of dollars on subprime-tainted investments. Morgan Stanley lost $3.59 billion for the fourth quarter. It said its remaining subprime exposure was $1.8 billion.

The drastic losses may heighten speculation about the fate of Mr. Mack, who returned to the firm in 2005 after the removal of his predecessor, Philip J. Purcell. One of Mr. Mack’s signature changes was to push the firm further into trading using its own capital, an effort to emulate its profitable archrival, Goldman Sachs. His strategy worked for a while but then backfired when trades in tricky subprime-linked securities went wrong, resulting in the biggest write-down in the firm’s history. While Mr. Mack is expected to keep his job, his compensation will plummet — one of the harshest punishments meted out on Wall Street, short of showing an executive the door. Last year, he made $40 million; this year, he will take home about $800,000. His paycheck is particularly humiliating since Lloyd C. Blankfein, the chief executive of Goldman Sachs, is likely to receive a $70 million bonus. James E. Cayne, the chief executive of Bear Stearns, is also expected to forgo a bonus.

In a conference call on Wednesday, Mr. Mack was quick to take responsibility. “The results are embarrassing for me and the firm,” he said.

But he also pointed out that the bulk of the $9.4 billion loss occurred on one trading desk and that other areas of the firm, particularly the investment banking, asset management, retail brokerage and hedge fund servicing businesses, performed well.

As for the investment from China, Mr. Mack framed the transaction not as a desperate act but as a strategic move. And he refused to concede that Morgan Stanley was a weakened firm. “We remain bullish on Morgan Stanley’s significant growth potential,” he said.

Still, the investment shows how reliant Morgan Stanley and Wall Street are on foreign funds and gives additional credence to the joke now circulating on trading floors: “Shanghai, Dubai, Mumbai or goodbye.”

The fund, the China Investment Corporation, has agreed to purchase almost 10 percent of Morgan Stanley; it will have no role in the management of the firm.

Citigroup recently sold a stake to a Middle East fund.

The deal is an abrupt shift in strategy for China’s $200 billion sovereign fund and underlines the extent to which it appears to be under the direct control of the country’s leaders.

Morgan Stanley executives first began discussing an investment with the fund this summer, but it was not until recently that the deal was struck.

For Morgan Stanley, the terms are severe. The firm will pay annual interest of 9 percent on bonds that will be convertible into Morgan Stanley stock in 2010.

The China Investment Corporation is under the control of China’s finance ministry, with some influence as well from the People’s Bank of China, the country’s central bank. There has been discussion in the Chinese government over whether even more foreign currency should be injected into the investment fund, as the People’s Bank of China continues to accumulate $1 billion a day as it buys up dollars to prevent the value of China’s currency from rising in international markets.

The loss at Morgan Stanley highlights a sense of strategic confusion within the firm. Going back to the firm’s early days when it broke off from the Morgan Bank, Morgan Stanley’s strength has been its investment banking and advisory business areas; both did well this year.

Mr. Mack, however, was eager to strike a more aggressive pose when he took over from Mr. Purcell, who had been criticized for his cautious approach. By encouraging his traders to take on more risk, Mr. Mack plunged Morgan Stanley into a complex, sophisticated and dangerous area that has never been a core area of competence for the firm.

In the conference call, Mr. Mack confronted tough questions from analysts.

“How could this happen?” asked William F. Tanona, an analyst with Goldman Sachs. “How could one desk lose $8 billion?”

Mr. Mack, generally a brash, expansive man, struck a chastened tone. He said the firm would be dialing back from making big trading bets.

“We had been sprinting,” he said. “Now we will be jogging. But we are in a risk business, and we will be in the market taking risk.”

Mr. Mack blamed the firm’s inadequate risk-monitoring procedures and said the firm’s risk managers would now report to the chief financial officer, which is the practice at Goldman Sachs. Previously the risk managers had reported to Zoe Cruz, the co-president overseeing trading, who was ousted by Mr. Mack last month, a further indication that the firm’s big bets lacked objective risk oversight.

Investors, while upset over the loss, seemed to be giving Mr. Mack the benefit of the doubt. Shares of Morgan Stanley’s rose $2.01, to $50.08.

“He can’t have another screw-up,” Brad Hintz, a securities analyst at Sanford C. Bernstein & Company, said of Mr. Mack. “But the clients I have talked to have not been calling for his scalp.”

Morgan Stanley had previously said it would take a $3.7 billion write-down from the trading. Now, the total loss from that trading is $7.8 billion. Morgan Stanley reported an additional $1.2 billion in write-offs from nonperforming loans. The total loss wiped out fourth-quarter revenue. For the year, Morgan Stanley has taken nearly $11 billion in trading and subprime-related charges.

Other Wall Street firms have ousted their chief executives after such losses. Charles O. Prince III of Citigroup and E. Stanley O’Neal of Merrill Lynch lost their jobs over escalating subprime write-downs.

By all accounts, Mr. Mack still has the support of his board, which includes four holdovers from the Purcell era. And unlike Mr. Prince and Mr. O’Neal, who were to some extent outsiders, removed from the culture of their respective firms, Mr. Mack, has ties to the firm’s glory days in the 1970s and 1980s and with his ability to charm, he is still liked within the firm.

In addition to keeping his board fully briefed, Mr. Mack has also reached out to the former executives who led the campaign to oust Mr. Purcell. On Wednesday, he called Robert Scott, a retired senior executive of Morgan Stanley, and briefed him on the results.

“We are here to help,” said Mr. Scott, according to a person who was briefed on the call.

For the moment, the board seems to be in no position to force Mr. Mack from his job. Not only is he well liked, but he also has no ready successor and as the protracted search for a Citigroup head demonstrated, there is a dearth of outside executives ready and willing to take on such a job.