Facebook IPO blunder adds to Morgan Stanley woes

May 23, 2012, 2:00 PM UTC

Morgan Stanley CEO James Gorman

FORTUNE — Add Facebook to Morgan Stanley’s growing list of woes. The company’s stock was falling even before last week’s bungled IPO, and is now down 21% in the past month. Despite Morgan Stanley’s (MS) recent disclosures showing it has  lowered its exposure to Europe, investors still seem worried that the company could suffer big losses if the sovereign debt crisis gets worse in Greece and Italy.

But a bigger concern may be Moody’s. The credit rating firm recently warned that it may lower Morgan’s credit rating three notches. Rivals face similar downgrades, but Morgan is likely to end up with a lower rating than the others. Morgan has trailed Goldman Sachs (GS) and JPMorgan Chase (JPM) in debt trading. The debt downgrade will only make it harder for the firm to compete in the area.

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Indeed, James Gorman deserves a lot of credit for saving Morgan after the financial crisis. His biggest move was to push the firm more deeply into the retail brokerage business with his acquisition of Smith Barney. That’s a much more stable and safe business than say trading, where the firm posted a $9 billion loss during the financial crisis. But it has also weighed down Morgan Stanley. The retail brokerage business tends to lag recoveries. Retail investors haven’t come back to the market. So Morgan’s profits haven’t rebounded as much as rivals. Mergers and acquisitions, another big business for Morgan, have been down recently as well.

The one business that has been working for Morgan is equity underwriting, in particular tech deals. Star investment banker Michael Grimes has helped the firm land deals heading up the IPOs of LinkedIn, Zynga, Groupon and most recently Facebook (FB). In all, since the beginning of 2010, Morgan Stanley’s tech banking team has generated $1.2 billion in fees, according to deal tracking firm Dealogic. That’s $250 million more than JPMorgan Chase, its closest competitor in the area. The problem is that as Morgan’s tech business has grown, the rest of the bank’s underwriting business hasn’t followed, making it more and more reliant on its tech team for profits. Since 2010, tech deals have generated 13% of Morgan’s overall investment banking fees, according to Dealogic. That compares to 7% at JPMorgan and 9% at Goldman. That’s why the poor performance of Facebook’s IPO could be a lingering issue for Morgan.

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Facebook’s shares fell another 8% on Tuesday to close at $31, and now stand well below their IPO price of $38. At the very least, it looks like Morgan Stanley mismanaged the offering, by either signing off on a price that was too high, or agreeing to sell too many shares in the deal. A number of investors have complained that they got far more shares than they were expecting in the IPO, causing them to dump shares when Facebook’s stock debuted early Friday, and possibly leading to the trading problems at the Nasdaq. Worse, FINRA on Tuesday said it’s looking into whether Morgan Stanley and other bankers broke rules when the firms’ analysts cut their earnings forecasts on Facebook just days before the IPO. Massachusetts security division says it will also subpoena Morgan on the matter. Morgan said it followed the same procedures for the Facebook offering that it follows for all IPOs. Facebook declined to comment.

Indeed, there is probably a fair amount of blame to go around for Facebook’s bungled IPO. A senior executive at Nasdaq told the Wall Street Journal the exchange wouldn’t have gone forward with the IPO if it was aware of the potential computer glitches. Facebook’s CFO appeared to have pushed to sell more shares. “We’ll never know how the stock would have traded if it had opened on time and without problems,” says tech fund manager Kevin Landis of Firsthand fund, which owns Facebook shares. “I don’t fault the IPO price.”

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Nonetheless, Morgan’s tech team is bound to take a reputation hit as well. “The fact that Morgan Stanley is a powerhouse in equity underwriting is not going change,” says Brad Hintz, an analyst who follows the bank at Sanford Bernstein and recommends Morgan’s shares. “But this is something that other banks will be able to use against them when competing for deals.”

The basic problem for Morgan’s investors is that Wall Street is a volatile business, even without propriety trading. And that’s particularly true of the IPO business, which every few years seems to be a source of trouble for Wall Street. Here’s what one IPO consultant told the New York Times in a positive profile of Morgan’s Grimes right before the Facebook IPO.

“Momentum is everything in Silicon Valley,” said Lise Buyer, the founder of Class V Group, an advisory firm for initial public offerings and a former Google executive. “The Valley tends to go with what worked last time.”

Presumably, the reverse is true as well.

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