Morgan Stanley losses show risk push downside

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.

Housing prices continue to sag and mortgage markets continue to plunge. Underwriters and traders who put CDOs on their balance sheet, even supposedly safe "super senior" portions, earlier this year have found there are no buyers.

The S&P 500's financial companies .GSPF has lost $600 billion in market value since peaking in May and dropped further on Thursday amid worries the subprime crisis is only getting warmed up.

Morgan executives on Wednesday told analysts it may take three to four quarters before conditions return to normal.

Royal Bank of Scotland's chief credit strategist Bob Janjuah warned clients there may be as much as $500 billion in potential losses from assets at the largest banks and brokers.

Standard & Poor's credit analyst Tanya Azarchs said the market is probably in "inning two" of a nine-inning crunch. "It's inevitable there will be more markdowns," she said.

The biggest losses would come from "level 3" assets, illiquid securities valued by firms on their own estimates. RBS said Morgan had $88 billion of these assets while Goldman had $72 billion.

Wall Street banks overall may mark down between $30 billion and $40 billion in the fourth quarter, Portales Partners analyst Charles Peabody said.

Even Goldman and Lehman, so far largely unscathed, may not have hedged sufficiently. "I really don't believe those two organizations have come clean," Peabody said.

(Reporting by Joseph A. Giannone)