Updated from 12:21 p.m. EDT

Morgan Stanley's ( MWD) investors got what they expected Wednesday: second-quarter earnings that reflect Wall Street's deft use of the fixed-income markets to make up for anemic performance in equities and mergers. What they weren't prepared for was the black eye the investment bank got from problems afflicting an unrelated industry: airlines.

Morgan earned $599 million, or 55 cents a share, in the latest quarter, down from $797 million, or 72 cents a share, last year. The decline reflected a big charge against the bank's aircraft-leasing business, a writedown that lowered after-tax earnings by $172 million, or 16 cents a share.

The hit to earnings overshadowed performance in the company's fixed-income division, which enabled Morgan to squeeze out a 1.5% rise in revenue to $5.05 billion during a severe bear market.

The Thomson First Call consensus estimate had called for the firm to earn 68 cents a share.

Separately, Bear Stearns ( BSC) reported an 18% drop in profits that reflected a one-time gain in the year-ago period.

Expectations

For much of this year, Morgan Stanley executives sought to downplay the impact of the travel sector's woes on its aircraft portfolio. In April, the firm indicated it might take an impairment charge, but did not say how much.

In a conference call with reporters, Morgan Stanley Chief Financial Officer Stephen Crawford said the writedown reflected the impact on airlines of the war in Iraq and SARS.

"The future of the aircraft-leasing business is very heavily tied to the economy," said Crawford, who added that the brokerage intends to remain in the leasing business because it expects the fortunes of the aviation industry to rebound.

In early afternoon trading, the shares were recently down $2.36, or 4.75% to $47.3.

Besides the trouble with its aircraft business, Morgan Stanley also continued to suffer from the downturn in Wall Street's traditional lines of business. Net revenue in its individual investor group was down 11% to $924 million. Its investment management group saw revenue decline 14% to $535 million.

In a worrisome note for other financial services firms, Morgan Stanley's firm's Discover credit card business experienced a sharp rise in customer delinquencies. Customer bills more than 90 days overdue jumped to 6.21% from 3.01% a year ago. That's an indication Discover customers are having a tough time paying off their credit-card debt.

"Unlike our competitors, we don't feel credit trends have turned to the positive,'' said Crawford. "For us the challenges remain in consumer credit and airplanes.''

On the bright side, however, total net revenue rose thanks to the firm's institutional securities division, which posted an 11% rise in net revenue to $2.7 billion. Like many Wall Street firms, Morgan Stanley benefited from strong gains in its bond business. But by its own admission, bond trading is not Morgan Stanley's strongest line of business, especially compared to other Wall Street firms.

Evidence of a recovery in other lines of investment banking business is slim at best. Morgan Stanley's Crawford said there have been so many "false starts" that he's wary of predicting a revival in corporate dealmaking later this year.

Morgan's bad news was tempered a bit by Bear Stearns, which earned $280 million, or $2.05 a share, in the latest quarter compared with $333 million, or $2.59 a share. Analysts had expected the firm to earn $1.72 a share in the quarter a year ago.

Last year's numbers were inflated by a big gain the firm posted from its investment in Aeropostale ( ARO), which went public a year ago. Bear recorded a $260 million gain on that initial public offering, which accounted for $1.04 a share of its 2002 second-quarter earnings.

High Hopes

With the big rally in brokerage stocks this year, investors are banking on a strong second-half recovery and a return to better days for Wall Street.

The Amex Broker-Dealer Index is up 34% this year, easily outpacing the 12% gain in the Dow Jones Industrials and the 15% surge in the Standard & Poor's 500.

But there also are fears that the rally in brokerage and bank stocks may be overdone. Signs of an economic recovery are anything but clear-cut, and the third quarter traditionally is one of the slowest periods on Wall Street.

Thomson First Call reports that the current price-to-earnings ratio for the financial sector is 15, right around the historical average. Based on 2003 earnings projections, however, the P/E for the financials is 13, compared to the 18.5 multiple at which the entire S&P 500 trades.

Many brokerage stocks, however, are trading at valuations that are higher than the rest of the financial sector. Morgan Stanley, at $49.67 a share, trades at a forward 2003 P/E of 16. Bear Stearns, meanwhile, at $82.48 a share is just a tad below the average with a P/E of 12.6.

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