Updated with information on brokerage venture, layoffs and CEO comments.
NEW YORK ( TheStreet) -- Morgan Stanley's (MS - Get Report) big second quarter earnings miss is a result of abysmal trading figures and not a botched initial public offering of Facebook (FB - Get Report) shares. Given the second quarter results, the bank's strategy of exiting some trading businesses in favor of its underwriting and wealth management prowess will come under scrutiny.
Earnings at the nation's sixth largest bank by assets were weighed by far weaker than expected debt and equity trading results, and a two-notch ratings downgrade by Moody's, which propelled profits from continuing operations nearly 80% lower from the first quarter.
Morgan Stanley reported total trading revenue of just $2.9 billion and earnings of $158 million missing analyst estimates, as rating downgrades and a withdrawal of client activity likely precipitated the sharp profit drop. "These results are clearly very disappointing, however MS was facing a potential downgrade by Moody's during the quarter, and that likely impacted their trading revenues," wrote UBS analyst Brennan Hawken, in a note to clients.The bank reported adjusted earnings per share of 16 cents and revenue of $6.6 billion, missing estimates as overall trading revenue tumbled on a year-over-year and sequential basis. Analysts polled by Bloomberg expected Morgan Stanley to earn 29 cents in adjusted earnings per share on $7.6 billion in revenue. Including accounting gains on the bank's rising credit spreads, Morgan Stanley earned 28 cents in EPS, missing expectations of 51 cents but reversing a first quarter loss. In the first quarter, Morgan Stanley's trading unit -- called Institutional Securities -- reported adjusted revenue of $5 billion and a profit of $1.7 billion, driving its big earnings beat . The unit's second quarter weakness resulted from fixed income trading revenue of just $770 million that was roughly half of UBS analyst Hawken's projections and equities trading revenue of $1.1 billion, which also fell short of expectations. Still, Morgan Stanley's investment banking revenue of $884 million, was in-line with expectations, signaling that Moody's late June ratings downgrade cast a larger pall over earnings than the negative publicity that the bank received for its underwriting of Facebook's May 18 share listing. With earnings overwhelmed by a big trading drop, Nomura Securities analyst Glenn Schorr wrote that it was "hard to pick out too many positives," citing investment banking earnings and pretax margin improvements in wealth management as highlights. "Results disappointed on a sharp decline in fixed income trading," wrote Wells Fargo analyst Matthew Burnell. A key question now is whether Morgan Stanley's trading weakness is a one-time miss or an indication of lasting issues. For instance, Moody's ratings downgrade was estimated to impact Morgan Stanley more than competitors because the bank doesn't hold much of its derivatives trading operations in a higher rated subsidiary that would soften the financial impact of cuts. As a result of the downgrade, Morgan Stanley posted $6.3 billion in additional collateral and other payments as part of trading agreements with its counterparties -- primarily in derivatives trading. The bank said that $2.9 billion was called and posted at June 30, 2012, just over a week after Moody's downgraded the bank's rating to Baa1. On an earnings call with investors, Morgan Stanley CFO said that downgrade hit trading revenue by an estimated $225 million "Having that ratings action addressed, now having clarity on it and having that uncertainty gone, we're seeing real relief among clients. Clients have re-engaged," she said. Credit Suisse analysts led by Howard Chen expected Morgan Stanley's trading operations to earn $2.5 billion of core revenue, amid a sharp drop in equity and debt trading revenue, which puts it far behind competitors like Goldman Sachs (GS - Get Report), JPMorgan (JPM - Get Report) and Citigroup (C - Get Report) with second quarter trading results that generally beat expectations. Morgan Stanley's earnings miss also clouds progress on core initiatives like its push into brokerage operations. The bank reported improving margins at its Morgan Stanley Smith Barney brokerage unit and $3.3 billion in revenue, slightly beating estimates. Overall, the unit's profits rose over 20% to $393 million, on a year-over-year basis. Many were watching for improving margins at Morgan Stanley Smith Barney as a key to second quarter earnings. "The Morgan Stanley story has been an execution story for a long time," said Morningstar analyst Michael Wong, citing the company's push into brokerage and wealth management businesses, in an interview prior to earnings. "I will be concentrating on where operating margins are going," added Wong. The unit's margin's increased to 12.1%, indicating progress as the bank continues to fall short of 20% margins that it projected when entering the brokerage joint venture with Citigroup (C - Get Report) in 2009.