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Morgan Stanley Shortfall Underlines Capital Markets Slowdown

The weakening bond market, in particular, takes a toll on fourth-quarter numbers.

Morgan Stanley Dean Witter's


profit shortfall Tuesday didn't shock anyone. But the weak numbers illustrate just how poorly the brokerages may fare as capital markets continue to slow.

Morgan Stanley Tuesday posted fourth-quarter

earnings of $1.06 a share, far short of the already reduced consensus estimate of $1.29, according to

First Call/Thomson Financial

. (The estimate had dropped from $1.36.) Revenue of $5.7 billion was flat with the year-ago period, while the firm said weak bond markets and higher compensation costs pressured profits.

The No. 2 broker may be just the first in a line of financial companies that will report soft earnings this quarter, as a drop in investment gains, underwriting fees and trading commissions dent the bottom line. Merger partners




J.P. Morgan

(JPM) - Get Free Report

shook up the sector last week with an earnings warning.

The most noticeable weakness was in Morgan Stanley's securities business, where net income dropped 36% to $888 million from the year-ago record performance. In a conference call, analysts focused on weak performance in the broker's fixed-income business and questioned whether the results were linked to the departure of high-level executives including co-head Dwight Sipprelle. Sipprelle's October departure was marked by

speculation about substantial trading losses. CFO Robert Scott brushed off that notion, saying that "each of the departures are pretty unique as far as risk management goes."

Though the

expectation of good news from this afternoon's Fed meeting was temporarily keeping the stock -- and the rest of the financial sector -- aloft, the market is increasingly cautious about how severe the revenue problems will be. Morgan Stanley was up $4.06, or 5.9%, to $73.31, while the

American Stock Exchange Broker/Dealer Index

was 3.5% higher.

"I guess I was surprised at the magnitude of the shortfall on the trading side," says Mark Constant, analyst at

Lehman Brothers

. (He rates Morgan Stanley a neutral.) "Trading revenues are unpredictable, but the unpredictable trading revenues were even lighter than expected in this case," he says.

One issue that drew considerable attention during the call was Morgan Stanley's emphasis on higher compensation costs, which the firm said hurt profits. But some analysts argued the level was typical for fourth quarter levels and should not have had a material impact. And Constant points out that both Morgan Stanley and

Goldman Sachs

(GS) - Get Free Report

, which also reported earnings today, "were able to take a hatchet to their compensation expenses" after incurring heavy recruiting costs in the first half of the year.

As for Goldman, which

beat lowered estimates today, Constant said it "played two tricks" by bringing its tax rate down in addition to lowering expenses. He added that both firms used what "I would argue are unsustainable" moves to boost results. "People are saying this is a pretty good quarter considering the adverse trading environment. My point is, don't look at these

returns on equity as, 'Gee if this is as bad as it gets then I love these stocks.'"