Morgan Stanley Earnings Call NUGGETS: Impact of Moody’s Downgrade, Fixed Income Optimization

On Thursday, Morgan Stanley (NYSE:MS) reported its second quarter earnings and discussed the following topics in its earnings conference call. Here’s what executives shared with analysts and investors.

Impact of Moody’s Downgrade

Roger Freeman – Barclays Capital: I guess venture comments on will you think some of the, sort of direct impact of Moody’s downgrade was, have you seen — was most of that, that you could quantify before the actual downgrades or after? Have you seen any change in behavior as the full impact of this settlement?

Ruth Porat – EVP and CFO: There are a couple of pieces to it, the portion that I quantified the $225 million came after the Moody’s downgrade, so to be clear, it was associated with valuation allowances and contrast adjustments. There are a couple of items we can’t quantify for example our bankers spend a lot of time with clients and counterparties, throughout the period addressing questions they may have had at that time, which otherwise would have been spent capturing new business. And as the quarter wore on, with increasing speculation on the ratings outcome, some clients seem to take a wait-and-see approach, so those are tougher to quantify, but we certainly felt in particular given the elongated deliberation process that it did weight towards the end of the quarter. Overall with the ratings action on the sector finally resolved we are seeing real relief and clients have reengaged it’s helpful to have that uncertainty addressed.

A Closer Look: Morgan Stanley Earnings Cheat Sheet>>

Roger Freeman – Barclays Capital: Has there been any utilization of clients, particularly like pension funds that kind of more sensitive to transacting with the bank?

Ruth Porat – EVP and CFO: So, if you’re asking has much gone into the derivatives, there is not much of note, we have seen an acceleration of foreign exchange into the bank, we’ve been writing more new foreign-exchange business in the bank.

Roger Freeman – Barclays Capital: Then just last question on this topic, the collateral postings. It looks like you’ve posted a little less than half of what you’re potentially obligating? Two, is that just a function of the other half not having been called?

Ruth Porat – EVP and CFO: So, we posted the $2.9 billion. Just to give you an update on the total collateral subject to call, it’s actually a bit lower than in our first quarter Q. We had an estimate of $6.8 billion in the first quarter; it’s now ballpark around $6.3 billion. I think it’s fair to say that we’ve been pleased with the pace of call that has just been very measured, which in our view underscores that clients have real comfort with the firm. Since the end of the quarter, in July we’ve had another $800 million called, but again this pace does seem to be quite measured. We do expect more to be call going forward, hard to forecast how much that is, but as we’ve talked about on prior calls, we are fully reserve for the full amount of potential collateral call and the sizing of our liquidity reserve.

Roger Freeman – Barclays Capital: Just last question, overall, you talked about some of the initiatives streamlining within the units focused on headcount. Any rough quantifications maybe given current sort of run rates what impact — benefit they’re going to have to run rate expenses?

Ruth Porat – EVP and CFO: No.

Fixed Income Optimization

Howard Chen – Credit Suisse: James, on fixed income the targets you mentioned at the beginning of the call appear like a meaningful strategic shifts on the rebuild that began before you took the helm. The RWA targets are interesting, but it’d be really helpful to just hear exactly what and where you want the firm to be in fixed income businesses today? How quickly you want to get there? What were some of the drivers of that thinking if in fact you agree with what I’m saying?

James P. Gorman – Chairman and CEO: Sure, I’ll let Ruth start on some of the targets and maybe then I’ll let you know where we’re going to end up.

Ruth Porat – EVP and CFO: So, the focus is continuing to be on fixed income optimization as Colm and Kenny have talked about for quite some time. They focus on share capital efficiency and cost structure and we’re focused on ensuring that our footprint is consistent with what we need to do strategically so we have a cohesive suite of products that is consistent with the strength we have across our platform beginning with Investment Banking, what we’re doing on the institutional equities side and a number of areas within fixed income, but there are certain businesses within the fixed income that maybe nice to have, but they are not necessary and they are RWA-intensive, and that’s really what James was getting at in the reduction in risk-weighted assets that we’re focused on driving; so down 15% from the third quarter to the second quarter, targeting being down 25%, and aggregate by 2013, and we’re really targeting active business unit management. So, this essentially doubles the RWA reduction from the business. I think the other point is, as we reduce more complex areas, it’s not just the capital benefit, but there is a funding benefit and an expense benefit as well.

James P. Gorman – Chairman and CEO: I’d just add, I sort of see it as couple of different chapters. The first was we had some legacy positions that for the last couple of years we’ve had to deal with, and you have to deal with that (thoughtfully), you don’t want to take unnecessary pain, and we’ve worked our way out of those positions, so I think most significant obviously was the Republic of Italy and the MBIA exposures and so on. The second is that we’ve been building footprint on the flow side of the business, which also has been a couple of years in the working, and the third is now adjusting the focus on particularly the heavier risk-weighted asset businesses which we have been and increasingly have been more aggressive on and are reflective of the environment and the world as we see going forward. We’ve consistently said that our focus is going to be on the flow, high velocity, lighter risk-weighted assets businesses, and if anything, that focus has been – the dial has been turned up on that.

Howard Chen – Credit Suisse: Just on the FID RWA reduction targets, I just want to confirm that’s on a Basel III basis and then for starting point purposes what’s the FID RWA today on Basel III, Ruth?

Ruth Porat – EVP and CFO: That is on a Basel III basis and what we’ve been doing is guiding to an overall Basel III ratio, not breaking out RWAs by business for the firm.

Howard Chen – Credit Suisse: The reason I ask I guess is if FID is the majority of the firm’s RWA, and let’s just say it’s $300 billion, and you put 10% equity against that, that’s $30 billion, and that’s larger than the market cap of the Company today, I’m just curious is there – where are you James and Ruth in terms of more transformational thinking within the business because that just seems incorrect in my opinion?

Ruth Porat – EVP and CFO: Well, I guess there are a couple of points in there. Risk-weighted assets obviously are across the business GWM. Our (indiscernible) business and the lending business, and smaller obviously in institutional equity. So we’re trying to give you a sense of the decline in risk-weighted assets, or more important, strategically, what we are driving within our fixed income business.

James P. Gorman – Chairman and CEO: I would add to it, Howard. I understand exactly what you’re saying, if all the risk-weighted assets and capital have tied up in that business, why wouldn’t we be more aggressive. I think what Ruth is saying is it’s not quite as simple as that. We have risk-weighted assets and capital tied up across the firm. That said, in the areas where it is most lumpy and has generated the least returns, we are being the most aggressive and we’ll be increasingly so. It’s a balancing act here of not trying the baby out with the bathwater. We have some great businesses within fixed income, and we had obviously a very difficult quarter, there is no – we’re not going to hide from that in fixed income, is the tough quarter and disappointing quarter, but we had some great businesses within there, and we need to manage that very carefully going forward, which is what we’re doing.