NEW YORK - MORGAN Stanley said its quarterly earnings plunged after it absorbed US$2.3 billion (S$3.2 billion) of write-downs, but robust trading results helped the No. 2 US investment bank trounce expectations by a wide margin.

Morgan overall had the best quarter among the big Wall Street banks, generating more profit than arch-rival Goldman Sachs, suffering the smallest year-over-year profit drop and posting a 20 per cent return on equity.

Wednesday's results gave a boost to Chief Executive John Mack, trying to rally a bank that recorded US$9.4 billion in mortgage trading losses last year and steer it through the most difficult market environment in decades.

'We are all but out of the woods. What the Fed has provided the banks is unprecedented, and helps take the liquidity issue off the table,' said David Killian, a money manager at StoneRidge Investment Partners.

The good feelings didn't last long. Merrill Lynch on Wednesday sued XL Capital Assurance, urging the insurer to meet obligations for credit default swaps. That fuelled speculation that the largest brokerage faced another round of steep write-downs, which sent its shares down 11 per cent.

The news also reversed a bullish day for investment banks.

Morgan Stanley, whose shares had soared 19 per cent on Tuesday and were up as much as 10 per cent on Wednesday at US$47.07, closed just 1.4 per cent higher at US$43.45. Goldman shares ended the day down 5 per cent, while Lehman stock was down 9 per cent.

Positive surprises
Morgan's income from continuing operations fell 42 per cent to US$1.55 billion, or US$1.45 a share, in the fiscal first quarter ended Feb 29, from US$2.31 billion, or US$2.17 a share, a year earlier. Revenue fell 17 per cent to US$8.3 billion.

The results trounced the analysts' average forecast of US$1.03 a share.

Positive surprises from three of the country's largest investment banks helped markets pull out of a tailspin last week, when the Federal Reserve bailed out a nearly insolvent Bear Stearns. On Monday, pessimism reigned as Bear accepted a firesale offer from JPMorgan to avoid insolvency.

'I'm pleased - relieved is the word - following Monday's complete capitulation,' said Erin Archer, a senior research analyst at Thrivent Financial for Lutherans. 'Going in this week, people were concerned about the size of write-downs. The interesting thing is now all three banks say they see opportunities in the market dislocation.' Goldman analyst Bill Tanona added Morgan to the firm's 'conviction buy' list and sees shares reaching US$50.

Morgan's investment banking and trading division produced its third-best quarter ever, although revenue fell 14 per cent to US$6.2 billion from last year's boom-time results.

Fixed-income posted its second-best quarter at US$2.9 billion of revenue, down 15 per cent from a year ago, on record results in the trading of interest rates, credit and currencies and a second-best effort in commodities. These gains were offset by US$1.2 billion of proprietary mortgage write-downs.

'Trading was a lot stronger than I was looking for, which implies they were well-positioned,' said Jeff Harte, brokerage analyst at Sandler O'Neill & Partners in Chicago.

Long-term view
Morgan also reported US$1.1 billion of net losses marking down leveraged loans slammed by the credit crunch and a US$161 million loss in asset management. Looking ahead, Morgan officials took a positive but still cautious tone.

'There are near-term cyclical challenges, but none of it challenges the long-term secular growth opportunities for the firm,' Chief Financial Officer Colm Kelleher told Reuters.

Mr Kelleher, who in August voiced concerns about the markets and focused on building up cash levels, said the bank has reduced exposure to mortgages, loans and other hard-to-sell assets, lightened the balance sheet and boosted capital.

Buybacks, he said, will stay suspended until markets rebound.

Morgan has also cut its spending, slashing headcount by 2 per cent, and reorganised its trading division. The bank's money-losing mortgage trades, for example, are managed by a team of traders charged with recovering value from these securities.

Mr Kelleher also hinted that these steps, plus US$5 billion of new capital from China, will let Morgan go back on offence.

'These measures put us in a solid position to take advantage of market opportunities that will arise from dislocations in these markets,' Mr Kelleher said.

A series of lifelines thrown by the Federal Reserve and the US Treasury have also helped change market sentiment for the better, including giving brokers unprecedented access to ultra-cheap credit. Investors said these measures may help markets, frozen since last summer, finally begin to thaw out.

'There's an opportunity not just for brokers to access that liquidity, and put bids on the toxic paper sitting on their balance sheets, it also lets Wall Street provide capital to other investors,' StoneRidge's Mr Killian said.

Morgan's quarter was also aided by a 51 per cent jump in equity trading revenue to US$3.3 billion and 19 per cent growth in merger advisory fees. The bottom line enjoyed a US$850 million accounting gain on its own debt and a lower tax rate. -- REUTERS