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Shorts face big Mack attack

The Morgan Stanley chief goes on the offensive after a solid earnings report fails to halt the stock's collapse.

By Roddy Boyd, writer
Last Updated: September 17, 2008: 7:51 PM EDT

Morgan Stanley CEO John Mack told employees, "We're in the midst of a market controlled by fear and rumors."

FORTUNE (New York) -- For Morgan Stanley and Goldman Sachs, the two remaining standalone investment banks, the world has become an ugly place.

So ugly, in fact, that Morgan Stanley (MS, Fortune 500) CEO John Mack sent out a firmwide note Wednesday afternoon blaming nefarious forces for the beating his company took in the stock and credit markets today. Morgan shares plunged to a 52-week low in heavy volume, in spite of a solid third-quarter earnings performance.

"After the strong earnings and $179 billion in liquidity we announced yesterday - which virtually every equity analyst highlighted in their notes this morning - there is no rational basis for the movements in our stock or credit default spreads," Mack wrote.

He continued: "What's happening out there? It's very clear to me - we're in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down."

Mack said he would be contacting regulators and hosting a town hall meeting at 8:30 Thursday morning to address concerns. In the meantime, rumors began circulating late afternoon that Morgan and Wachovia (WB, Fortune 500) might be talking about combining forces.

A roundhouse punch

Both Morgan and Goldman's stocks were savaged Wednesday: Morgan declined 24% and Goldman (GS, Fortune 500) was down 19%.

But it was the market for credit default swaps, particularly in Morgan's case, that was delivering the real roundhouse punch Wednesday.

The cost to insure a $10 million block of Morgan Stanley debt for one year reached $2 million to $2.2 million upfront, plus the annual contract cost of $500,000, at one point Wednesday afternoon. Last week, Morgan Stanley swaps cost about $325,000 annually, with no upfront cost.

In the credit default swaps market, which often reflects investor concern over balance sheets before the media or regulators catch on, trades that require upfront points are taken as a sign of trouble.

Morgan's woes come after two of its peers - Lehman Brothers and Merrill Lynch (MER, Fortune 500) - were eliminated in the course of a weekend from the ranks of independent investment banks.

Also causing resolve on trading desks to weaken is the Federal Reserve's statement today that it needed to expand its balance sheet in order to digest what effectively was a takeover of insurance behemoth AIG.

Fear seems overdone

Mack's blaming of short-sellers may have a depressing air of deja vu - Bear Stearns and Lehman management, after all, blamed them, too - though it became abundantly clear that those firms had much bigger problems. Short sellers make bets that a company's share price will decline. They're familar bogeyman for management to blame.

But the shellacking Morgan Stanley is suffering does appear overdone.

The firm has exposure to problematic mortgage-backed securities, but it also has institutional and private wealth businesses that are resilient income generators.

It did indeed take billions of write-downs, but it was never the player in toxic collateralized debt-obligations that Merrill and Citi were. Nor did it use its balance sheet to hold over $100 billion in sub-prime mortgages like UBS (UBS).

In other words, Morgan appears to have been significantly less stupid with its finances than most of its peers.

For the moment, however, none of that matters.

Rumors flew Wednesday that hedge fund managers were pulling their prime brokerage accounts and moving them to commercial banks, especially J.P. Morgan Securities (largely run and staffed by ex-Bear Stearns officials) and Citigroup (C, Fortune 500).

Prime brokerage is a service provided to hedge funds and other investment managers in which a bank processes trades, provides capital and borrows stocks, bonds and options for managers to use as hedges. The bank collects fees and trading commissions and gets access to short-term capital.

Morgan's regulatory filings, at least its 10-Q, are not clear as to how much prime brokerage contributes to the firm's income mix. But on Tuesday Mack praised its contribution to the equity unit's "record results."

On Tuesday, Goldman chief financial officer David Viniar dismissed questions of that firm needing to merge with a commercial bank.

A call to a Morgan Stanley spokesman was not returned.  To top of page

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