Morgan Stanley losses show risk push downside

By Joseph A. Giannone

NEW YORK (Reuters) - When John Mack returned to take the helm at Morgan Stanley in 2005, he pushed a risk-averse investment bank to close the gap on rivals by making bolder bets in the markets and expanding its presence in mortgages.

Those moves contributed to Mack's first major setback on Wednesday, when Morgan disclosed that its mortgage traders suffered $3.7 billion in fourth-quarter losses. The damage, which could deepen if markets weaken, shows the downside of boosting risk.

"These proprietary trading losses show that management's increased risk appetite is a double-edged sword," Sandler O'Neill analyst Jeff Harte said on Thursday.

Morgan Stanley isn't the only Wall Street firm to stumble while trying to match Goldman Sachs Group Inc (GS.N). Merrill Lynch & Co MER.N wrote down $8.4 billion, while Citigroup Inc (C.N) warned it may mark assets down by as much $11 billion.

Goldman, which like Morgan was late in expanding its mortgage business, has not disclosed any mortgage write-downs. A spokesman said the firm does not comment on results between quarterly reports.

Among Mack's priorities when replacing Philip Purcell as chief executive in 2005 was to take more trading risk, following a successful path blazed by Goldman.

He also expanded Morgan Stanley's presence in leveraged lending and mortgages that drove profit for rivals like Lehman Brothers Holdings Inc LEH.N. The strategy paid off in the form of record profit earlier this year and restored much of its lost luster.

Yet the expected fourth-quarter losses stem from the trades that generated surprising gains in the first half of the year, when Morgan reported a profit even as subprime markets were melting down.

Morgan's proprietary trades, which shorted the subprime market in late 2006, turned into a long position as mortgage markets worsened. A lack of liquidity prevented Morgan from adjusting its hedges or shedding assets.

Several debt traders were terminated as a result of the losses, but Mack says the firm would not change its approach.

"To be successful in this business, you need to be willing to take smart and disciplined risks," Mack wrote in an internal memo on Wednesday. "The most important thing for us to do is to learn from those mistakes and focus on continuing to build our business as we navigate these challenging markets."

Morgan spokeswoman Jeanmarie McFadden declined to comment.

Bernstein Research analyst Brad Hintz expects Morgan Stanley to break even in the fourth quarter, versus earnings of $1.81 a year earlier, and cut his 2008 profit forecast on expectations Morgan will pull in its horns.

WORSE NOT OVER

Morgan Stanley's losses, while a setback, were smaller than those reported by rivals such as UBS (UBSN.VX), Merrill and Citi and came in below analyst forecasts. Morgan Stanley shares, which had plunged 26 percent since Oct 31, rose 4.3 percent in afternoon trade.