Why Morgan Stanley's real comp ratio is only 40%, and its bonuses may be lower for 2010

There was a brief burst of excitement this afternoon when it emerged that Morgan Stanley had achieved a 62% compensation ratio for 2010. Although lower than the 68% ratio mooted a few weeks ago, this was nevertheless considerably more generous than the 33% put aside for compensation at JP Morgan's investment bank.

However, before Morgan Stanley bankers get too excited, it's worth noting that 62% may be overstating their good fortune.

In the first place, 62% refers to the bank as a whole (brokers included). The compensation ratio in the institutional securities division alone was 57%, down from 58% last year.

And in the second place, even 57% may be too high. On this afternoon's conference call, Morgan Stanley CFO Colm Kelleher said the real compensation ratio in the institutional securities business is a far more disappointing 40%.

The discrepancy is caused by a narrowing of the spreads on Morgan Stanley's bonds, with the result that they're more expensive to buyback. The bank has to account for the theoretical cost of purchasing its bonds on its revenue line. Hence, revenues this year were depressed to the tune of $5.5bn. When these revenues are added in again, comp ratios fall.

Last year, this phenomenon was reversed (with spreads widening and bonds becoming cheaper to buyback), with the result that 2008 revenues were artificially inflated. As a result, last year's real comp ratio in institutional securities would have been even higher than the 58% stated in the bank's results, and the drop to 40% for 2009 is even more substantial.

In a final note of caution, Kelleher also said ongoing confusion over the UK bonus tax means the impact of the tax is likely to be a 2010 "event" instead of a 2009 event. The implication would appear to be that Morgan Stanley bonuses could take a hit next year.