Risk Cuts at Morgan May Lead to a Loss

Last year, after the financial crisis, Morgan Stanley made a decision that its biggest rivals avoided: burned by the crisis, it would take far fewer risks in its trading.

That decision is costing it — at least for now.

Unlike earnings at Goldman Sachs and JPMorgan Chase, which quickly returned to profitability

by taking on risk in trading for their customers, Morgan Stanley’s earnings from those operations are predicted to be less in the second quarter.

As a result, these profits will not be high enough to offset some unusual charges and expenses, and Morgan Stanley is expected to post a loss for the quarter, while its Wall Street rivals post robust quarterly profits.

Analysts say that Morgan Stanley’s expected second-quarter loss is not a cause of major concern, given the circumstances. But the contrast between its performance and others underscores how strategic decisions made during the financial crisis are playing out.

Later this month, Morgan Stanley is expected to report a loss of $400 million, according to analysts estimates tracked by Thomson Reuters, although some analysts say that the firm’s loss could be as high as $1 billion.

The reasons are a combination of lower trading profits than its rivals and higher charges. Those charges include $892 million the bank incurred when it joined its Wall Street brethren in repaying taxpayer support. Much more is likely to be caused by an accounting rule that requires banks to book losses on improvements in credit spreads, which act as an indication of investor confidence in the creditworthiness of a bank.

Now that the financial system is healing, Morgan Stanley and others must record losses as their credit spreads improve because they are deemed more likely to pay off all their debt. That charge at Morgan may be as high as $1.8 billion this quarter, according to Howard Chen, an analyst at Credit Suisse, who wrote in a report this week that Morgan has $4.1 billion in possible charges in future quarters related to its credit spreads alone.

Morgan will not be the only one to take charges related to its credit spreads. Goldman, its perennial rival, is also expected to take such a charge. But analysts say they think that Goldman will still make a profit because its charge will be smaller than Morgan’s and its revenue higher.

Mr. Chen, for instance, estimates that Morgan’s charge for credit spreads will be $1.8 billion, compared to $400 million for Goldman.

Yet the improvement in credit spreads, while costly to earnings, are a “positive signs for franchise health,” Mr. Chen said, because it signals the market has more faith in the bank’s creditworthiness.

Morgan can cover its losses in part because it raised billions in equity just before it returned the bailout money. The company’s executives have described 2009 as a transition year and cautioned against expectations for high profits. There are also likely to be bright spots in Morgan’s results in parts of investment banking, where Morgan is at the top of league tables for equity underwriting and merger and acquisition deals, according to Dealogic.

And over the long term, Morgan Stanley’s decision to pare risk and expand its footprint in wealth management may remake the company and produce long-term, stable profits. Morgan executives acknowledge they have been cautious in areas like fixed income.

But reducing risk can also cut into profits. Mr. Chen estimated that Morgan Stanley would generate $2.3 billion in fixed-income revenue before write-downs. By contrast, he expects Goldman to generate $6.8 billion.

“The rest of the market is going to be booking extremely good fixed-income numbers,” said Brad Hintz, an analyst with Sanford C. Bernstein & Company. “If Morgan Stanley doesn’t book good fixed-income numbers, it tells investors that Morgan is really holding the reins on their traders.”

But the expected second-quarter loss at Morgan may surprise those who saw good days ahead in the bank’s eagerness to repay the government.

“The intuition was that the losses are behind these companies,” said Douglas Elliott, a fellow at the Brookings Institution. “I’m a little surprised that Morgan Stanley would lose money. Among folks in Washington, they seem to have decided that the losses are over.”

Of the 10 large banks that returned the bailout money, Morgan is one of just two that analysts expect to lose money in the quarter, according to Thomson.

The other is Capital One, a regional lender in Virginia with a large credit card book that analysts expect to lose $205 million, or 48 cents a share. A spokeswoman for Capital One declined to comment, but the bank’s executives have said they expect to incur consumer credit losses for quite some time.

There is no indication that Capital One or Morgan Stanley will have to return to the government trough. The government’s stress tests and decisions about how they could repay the bailout money were centered on the banks’ capital levels, not the likelihood that they would profit.

“The government has determined they can stand on their own, that they can sustain their losses on their own without the government money,” said George Allayannis, a professor at the Darden School of Business at the University of Virginia.