(Adds background, updates share price)
* Q1 profit lower excluding accounting adjustment
* Fixed-income, commodity trading revs drop on adj basis
* Adj shr $0.61 vs Street view 0.57
* Wealth management revenue rises 5.4 percent
* Shares down 4.9 pct in afternoon (Adds detail on fixed-income and competitors, updates share price)
By Lauren Tara LaCapra and Tanya Agrawal
April 18 Morgan Stanley posted a 14 percent drop in adjusted earnings as its bond trading unit faltered in the first quarter, raising fresh questions about how quickly the bank can turn around the long-lagging business.
The results put more pressure on Chief Executive James Gorman, who has been building Morgan Stanley's wealth management arm and reducing assets on its trading books. He is trying to make the bank's profits durable even during economic downturns, but some investors fear his efforts are weakening Morgan Stanley's investment bank too much.
The bank's shares fell 4.9 percent to $20.41 in afternoon trading.
Investors are starting to "realize that the new business model looks more utility-like than it does big, sexy bank-like," said Douglas Ciocca, CEO of Kavar Capital Partners, which manages $270 million in client money.
"It's a mind shift from the investor perspective," he said. "At one time, banks like Morgan Stanley had gained outsized profit from risky trading businesses."
Morgan Stanley's first-quarter bond and commodity trading revenue fell by about 40 percent to $1.5 billion, excluding adjustments for changes in the value of the bank's debt. The results lagged peers like Goldman Sachs Group Inc and JPMorgan Chase & Co, whose fixed-income trading revenue declines were shallower. Banks this week broadly posted weaker revenue as the industry struggles with low interest rates, weak loan demand, and other headwinds.
Chief Financial Officer Ruth Porat blamed Morgan Stanley's fixed-income trading decline on a slowdown in interest-rate products and commodities, as well as a sharp drop in overall market activity in March.
Some of the business's issues are cyclical, particularly in commodities, and areas like credit, mortgages and foreign exchange will help pick up the slack in the future, Porat said.
"We don't think $1.5 billion in revenue is a ceiling," said Porat.
Wealth management revenue rose 5.4 percent to $3.47 billion, the highest in the firm's history. Profit generated by the unit jumped 29 percent to $255 million. The unit represented about 41 percent of the total revenue generated by the No. 6 U.S. bank by assets.
"What we are trying to do is get this firm back on the rails, which we've done over the last couple of years on a very deliberate path," Gorman said during a conference call. "We believe we are now well on that path."
Even so, total revenue, excluding accounting adjustments, fell 4.8 percent from a year earlier to $8.48 billion. The bank's income from continuing operations excluding adjustments fell about to $1.2 billion from $1.4 billion.
Gorman views wealth management as a stabilizing anchor for Morgan Stanley, to help offset volatility in the bank's trading business, once a foundation of its franchise.
Morgan Stanley's revenue from wealth management grew to $13.5 billion last year from $5.5 billion a year before the financial crisis.
In the first quarter, the unit's pretax profit margin held firm at 17 percent, compared with 11 percent a year earlier. Gorman had promised margins in the mid-teens by June, after initially aiming for 20 percent.
The wealth management profit of $255 million excludes $121 million that was returned to Citigroup for its ownership stake in the unit. Morgan Stanley, which bought a majority stake in Citi's Smith Barney unit in January 2009, plans to buy the remaining 35 percent by year-end, Gorman said.
Morgan Stanley is looking to dispose of non-strategic commodity and fixed income businesses, and said on Thursday its efforts to that end were "on schedule."
Other areas of the institutional securities business, which includes merger advisory, stock and debt underwriting and trading, also lagged. Revenue excluding certain accounting adjustments for the division dropped to $4.41 billion from $5.11 billion a year earlier.
All told, Morgan Stanley's net income in the three months to the end of March amounted to $958 million, or 49 cents a share, compared with a year-earlier loss of $119 million, or 6 cents.
The bank's profit fell last year after it took an accounting hit for changes in the value of debt it issued, known as the debt valuation adjustment. This year, the adjustment boosted profit.
Excluding those adjustments, income from continuing operations in the latest quarter was 61 cents a share. On that basis, analysts had expected 57 cents.
Expenses, including compensation, fell to $6.54 billion from $6.72 billion a year earlier quarter but were up from $6.11 billion in the 2012 fourth quarter. Compensation expense slipped to $4.2 billion from $4.4 billion a year earlier.
Record earnings from wealth management came not just from a pickup in stock and bond market values, but from higher transaction revenue, Porat said in an interview.
Higher closed-end fund issuance also helped as firms tapped retail investors for new funds in equities and high-yield debt, she said.
"It really highlights the operating leverage in this business because it's not as though the markets have a robust new issue environment, and yet you see the impact on profitability," she said. (Reporting By Lauren Tara LaCapra in New York and Tanya Agrawal in Bangalore; Writing by Frank McGurty; Editing by Supriya Kurane and John Wallace)