Morgan Stanley Sags on Fixed Income, Needs Trading to Pick Up the Slack


Morgan Stanley ( MS ) recently reported earnings which showed progress in its investment bank and wealth management units recovering, but the bank faced some difficulty in fixed income trading on lower activity in the last half of the year. Morgan Stanley competes with Goldman Sachs ( GS ), JP Morgan ( JPM ), Credit Suisse ( CS ), UBS ( UBS ) and other large banks in trading, investment banking and asset management services.

Trading Environment Improving Post Crisis

Though trading activity is down, the fundamentals of the trading business are starting to improve. This is an area where MS could make an impact on its earnings in 2011.

Banks are allocating more capital for their trading operating off which we estimate a yield to come up with an estimate of profits from the trading divisions. The trading assets for these businesses increase has varied from as high as nearly 20% by UBS and 17% by Deutsche Bank to only 3% by Citigroup. Goldman Sachs, Morgan Stanley and Credit Suisse have been on the conservative side with their Bonds, Currencies & Commodities trading assets increasing from 8% and 12% and 11% respectively since 2009 respectively.

We consider the trading assets for banks as the fair value of their financial instruments, which they use for trading purposes. It reflects the proprietary capital they can leverage for generating returns. For most of the investment banks we cover we have separated their sales & trading division into BCC and equities trading, including the respective derivative assets in them. Then we calculated their relative contribution to each of the banks' stock price. We have found that the the trading division is one of the largest drivers to value compared to M&A, equity underwriting and debt origination.

We estimate that Goldman Sachs' ( GS ) Fixed Income, Currencies & Commodities (FICC) division accounts for around 37% of our $167 price estimate , and Equities Trading 17%. Similarly for Morgan Stanley ( MS ), the FICC division accounts for around 26% of our $21.54 price estimate , and Equities Trading 21%. And for Citigroup ( CS ), we estimate that the Sales & Trading division as a whole accounts around 36% of our $4.17 price estimate.

Trading Asset Bases Among Banks

Fixed Income, Currencies and Commodities

In sales & trading we believe that the FICC assets have more ability to influence earnings for a bank as they are often grouped together and cover a much wider range of asset classes that often trade in larger volumes than equities. Between 2006 and 2009, trading assets for FICC declined. This was largely a consequence of the subprime crisis and later the global economic downturn, which resulted in a fall in liquidity and volumes due to which when the banks marked-to-market their assets, a lot of them went deep out of money, becoming toxic assets on their balance sheets.

The way the trading assets for the above banks has trended between 2006 and 2009 can be identified as a major  indicator of the performance of their sales & trading divisions in particular, and the whole bank in general, as we discussed above, the contribution of sales & trading to the stock price of different banks.

Morgan Stanley Could Gain on Better Trading Environment

While all banks would benefit from an improving environment, Morgan Stanley could benefit disproportionately given that it has a heavy exposure to trading by our estimates. The yield on trading assets for FICC decreased from 3.6% in 2006 to 0.34% in 2008, with the bank incurring trading losses when returns across most major asset classes were sharply declining. However, with the global economic environment slightly improving in 2009, the yield increased to around 2.1%.

We expect the yield to gradually trend towards 3% by the end of the Trefis forecast period, with the improving economic environment increasing liquidity and improving returns across asset classes. If instead it trended close to 5%, for FICC this would add around 35% to our price estimate, bringing it in line with the current market price.

See our full estimates here.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

This article appears in: Investing , Investing Ideas , Stocks , US Markets

Referenced Stocks: CS , GS , JPM , MS , UBS



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