Morgan Stanley in the Crosshairs

Why is the stock market down this morning? Haven't we just averted catastrophe? Shouldn't the fears -- and shorts -- of earlier this week be unwound?

Madlen Read of the AP reports:

Stocks skidded again Wednesday, with anxieties about the financial system still running high even after the government bailed out the insurer American International Group Inc.

The "even" is the giveaway that Madlen knows that this doesn't make a lot of sense. When the US government bails out Wall Street, one expects Wall Street to rally in gratitude.

Part of what's going on, I suspect, is that there's very little trust in equities as a store of value any more -- certainly not in leveraged companies, anyway. Shareholders have been systematically slaughtered of late, whether they held Fannie Mae or Freddie Mac or Merrill Lynch or Lehman Brothers or AIG or Washington Mutual or any number of other financial companies, including even relatively strong ones like Goldman Sachs (down another $11 today) and Morgan Stanley (down 17% despite stronger-than-expected earnings).

Meanwhile, bondholders in all of those companies bar Lehman have emerged unscathed so far, and are likely to remain unscathed for the foreseeable future (which, admittedly, isn't very far). In any event, bank debt is cheap, and if you want to be long financials, it makes much more sense to make that bet by buying debt, which has a tendency to be bailed out, rather than equity, which has a tendency to be wiped out.

So what we could be seeing here is a rotation out of equities and into debt, since debt right now would seem to offer a far more attractive risk/reward profile.

On the other hand, there's no indication at all that debt spreads are tightening. On the contrary, Morgan Stanley's credit default swaps are now trading at 925 basis points, which is a very distressed level.

Does this mean that Morgan Stanley is now in the crosshairs? It would certainly appear so, yes. That alone could explain the stock-market drop: there was a brief rally yesterday afternoon on the AIG bailout, but Morgan Stanley's balance sheet is just as big as AIG's.

My feeling is that it's high time Morgan Stanley found a buyer. Or things could get very ugly again very quickly.