Does Morgan Stanley Deserve to Be Free of TARP?

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Morgan Stanley headquarters in New York City

Correction appended: June 11, 2009

Hey, Morgan Stanley, dost thou protest too much?

The financial firm was the first to announce this week that it was among the 10 banks approved to repay $68 billion in rescue money the companies had received from the Treasury Department last October. Since then, executives of Morgan have said that they thought the stress test was "appropriate" and that the financial crisis has bottomed out. (See the 10 worst business deals of last year.)

Among the 10 banks allowed to pay back their Troubled Asset Relief Program (TARP) funds, though, Morgan Stanley looks to be the unlikeliest. For one thing, Morgan, unlike many of its rivals, is still in the red. The company lost $177 million in the first quarter, a period during which many of its rivals turned nice profits. Goldman Sachs, which was also approved to repay its TARP money, made $1.8 billion during the same time. What's more, Morgan Stanley is the only bank approved to return TARP funds that actually failed the stress test. Just a month ago, regulators said Morgan was short $1.8 billion worth of capital. The bank has raised $7.6 billion through stock and asset sales in the past month. But now Morgan says it plans to repay $10 billion, which is all the money it received from the Treasury Department back in October. Do the math, and the firm now appears to be about $4 billion short of what the stress test said it needed to be well capitalized. That, along with some other measures of Morgan's financial health, has a few analysts proclaiming the firm is weaker than it is letting on.

"I don't see any basis for Morgan Stanley being allowed to repay their TARP money," says Audit Integrity's Jim Kaplan, who founded the Los Angeles–based independent research firm, which focuses on accounting and governance issues. "They have raised capital, but whether it is enough is suspect." (See 25 people to blame for the financial crisis.)

A Morgan spokesman says the stress test and the requirements for paying back TARP were focused on different types of capital. The stress test was focused on a specific type of bank capital — common equity, in which Morgan was found to be deficient. TARP repayment requirements, however, are based on the total capital of the firm. And based on that measure, the Morgan spokesman says, Morgan is the strongest of the banks repaying TARP, not the weakest.

Indeed, a number of market watchers think allowing any of the banks to repay their government rescue is folly. Observers say the government may have feared that not allowing Morgan Stanley to repay its funds while permitting Goldman and others to do so would have made Morgan seem weaker than it is perceived to be.

In its latest report on TARP, the Congressional Oversight Panel said the banks may be in much worse financial shape than the government's stress tests suggested. The reason: the tests focused only on loan losses that would occur in 2009 and 2010. Look further out, and bank losses, particularly in commercial real estate, could be much bigger. Additionally, TARP was supposed to boost lending. So far it doesn't seem to have done that. In the first quarter of this year, bank lending fell by $150 million, according to the FDIC.

"I would like to see the banking industry have the biggest capital base it can have right now," says Doug Elliott, a former investment banker and a fellow at the Brookings Institution. "Even if the banks are largely fundamentally sound, they are not strong enough to make the volume of loans we would like them to be able to do."

Still, Morgan Stanley stands out among those repaying TARP. Morgan's biggest problem, says Audit Integrity's Kaplan, has to do with the type of assets on its balance sheet. Nearly 20% of its "financial instruments," which include cash as well as mortgage bonds and other securities, fall into the category of Level 3, according to Kaplan. Level 3 assets are generally considered those that are deemed hard to value. As a percentage of the firm's investment portfolio, Morgan has more hard-to-value ones than do any of the other TARP repayers. JPMorgan, for instance, classified just 5% of its financial instruments as Level 3 at the end of the first quarter.

What specific assets are in the Level 3 basket? Morgan doesn't exactly say. But Kaplan guesses that a large percentage of those assets are collateralized debt obligations and other derivatives based on now troubled home loans. What would happen if those bets on home loans turned out to be worthless? Morgan would be right back at the government's doorstep. According to Kaplan, Morgan's hard-to-value assets now total 1½ times its total equity.

"The assets are not worthless, but they are worth far less than what the bank is saying," says Kaplan. "If Morgan was to value its Level 3 assets properly, they would have no equity."

The original version of this story stated, based on the analysis of an accounting expert, that nearly 20% of Morgan Stanley's total assets were hard-to-value, or so-called level 3, assets. In fact, the accounting expert meant to say financial instruments, not total assets. Only 11% of Morgan's total assets fall into the hard-to-value category.

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