Morgan Stanley on Wednesday said third-quarter profit fell as the summertime freeze in mortgage and corporate loan markets forced the bank to mark loans down by $940 million, but shares held their own on optimism that financial markets may be starting to revive.

The No. 2 investment bank by market value said net income fell 17 percent to $1.54 billion, or $1.44 a share, in the fiscal quarter ended Aug. 31, from $2.58 billion, or $1.75, a year earlier.

Excluding earnings from Discover Financial Services, a credit card company spun off in June, income from continuing operations fell 7 percent to $1.47 billion, or $1.38 a share.

On that basis, Morgan Stanley fell short of the average analyst forecast of $1.54 a share, according to Reuters Estimates.

Morgan Stanley shares ranged between a 1.6 increase and a 0.6 percent decline, and were hovering around unchanged from Tuesday's close at $68.51, as some investors bet that the recent credit crunch is easing. The Federal Reserve on Tuesday cut benchmark rates, a move expected to boost lending and deal activity.

Other investment bank shares were higher. Goldman Sachs Group Inc, which reports results Thursday, climbed 2.8 percent.

The price movement, the lack of liquidity, the behavior of hedges in August was clearly very stressed and very pronounced, but I do believe the worst is over, said Colm Kelleher, Morgan Stanley's global head of capital markets and its incoming chief financial officer.

We're seeing some clear signs of recovery, said Kelleher, who will succeed a retiring David Sidwell at the end of the year. This will take some time to work through the credit markets. I would suspect you're talking about one to two quarters.

ENDLESS SUMMER

Wall Street suffered its worst summer in years as a slowdown in housing markets triggered a broader credit crunch that hammered the value of mortgages, asset-backed securities and corporate loans earmarked for buyouts. Announced takeover activity slowed to a crawl and brokers' stocks swooned.

As feared, Morgan reported $940 million of losses from writing down loans and commitments in its fixed- income sales and trading business. Overall net revenue from debt trading, Morgan's largest business, fell 3 percent to $2.2 billion.

This is disappointing, said Meg McMullen, president of New England Research & Management. When Morgan Stanley has lower trading revenue, we have problems.

Overall net revenue rose 13 percent to $7.96 billion from last year. Morgan's weak fixed-income results were offset by surging M&A advisory, stock underwriting and equities trading. Morgan also got a boost from its brokerage and asset management businesses.

Fox-Pitt, Kelton analyst David Trone said the weaker results now could lead to better performance next year.

The big picture is that Morgan Stanley took its medicine and wrote down leveraged loans and mortgage, he said. We see a stronger fourth quarter ahead, as the credit crunch begins to crumble.

Income from discontinued operations, namely Discover, fell 74 percent to $69 million.

Morgan Stanley shares fell 24 percent during the second quarter, when broker dealers on average fell 4 percent, driven by fears of sinking asset values.

(Additional reporting by Tim McLaughlin)

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