Morgan Stanley's first-quarter profit fell nearly 50 percent, but the results were better than many analysts had forecast thanks to stronger-than-expected fixed-income trading revenue.

The bank's shares rose 1.7 percent as investors grew hopeful that its long-troubled bond trading business was closer to being fixed.

Morgan Stanley definitely still has a lot of work to do on revamping the fixed-income trading desk. But this quarter is a testament to the progress they've made, said Shannon Stemm, a stock analyst at brokerage Edward Jones.

The investment banking business was the biggest reason for Morgan Stanley's steep earnings decline, and despite performing better than expected, fixed-income trading was the main source of that drop.

Morgan Stanley's bond trading business generated big losses for the bank during the financial crisis, and then lagged rivals during a recovery in 2009. Chief Executive James Gorman is pushing the division to gain market share and improve its performance.

In an interview with Reuters Thursday morning, Chief Financial Officer Ruth Porat said the division performed well in the first quarter in trading currencies and interest rate products like government debt, two key areas for Morgan Stanley's turnaround effort.

We're making progress, she said.

She attributed the decline in overall fixed-income trading to weak client volumes in areas like corporate bond trading.

The investment bank and brokerage also said Mitsubishi UFJ Financial Group Inc would own 22.4 percent of its shares after the Japanese bank agreed to convert preferred securities into common stock.

The exchange will reduce Morgan Stanley's preferred dividend expense by about $780 million a year and boost its capital levels. It will also result in a third-quarter charge estimated at $2 billion for converting the stock ahead of schedule.

Overall, Morgan Stanley posted quarterly net income for shareholders of $736 million, or 50 cents a share, down from $1.41 billion, or 99 cents a share, a year earlier. Revenue fell 16 percent to $7.63 billion.

FEELING COMFORTABLE

Morgan Stanley is building its fixed-income trading business, but its wealth management business is also a work in progress. The bank made a big, expensive bet in 2009 when it agreed to buy the Smith Barney franchise from Citigroup over a period of five years.

Morgan Stanley combined its own wealth management business with Smith Barney and paid $2.7 billion to acquire a controlling stake in the venture.

The bank has the option to acquire another 14 percent in 2012, 15 percent in 2013, and the rest on May 31, 2014. Each of those purchases will be made at market prices, which are expected to be higher than when Morgan Stanley initially entered the deal.

Those purchases are expected to consume most of the bank's excess capital for some time, which is expected to prevent it from announcing share buybacks or dividend hikes that regulators began allowing for rivals last month.

Gorman is eventually targeting profit margins of 20 percent for the wealth management business, but high overhead and compensation costs have kept profitability in check so far.

A hedge fund investor said that Morgan Stanley may be headed in the right strategic direction long term, but the key for investors will be how long it takes to get there.

MITSUBISHI PARTNERSHIP

One significant influence on earnings in the quarter was the bank's joint venture in Japan with Mitsubishi UFJ Financial Group.

MUFG came to Morgan Stanley's rescue at the height of the financial crisis, buying $9 billion of convertible preferred shares from the U.S. investment bank in October 2008. Five months later, the two companies created a joint venture in Japan focusing on investment banking.

The trading division of that business, known as Mitsubishi UFJ Morgan Stanley Securities, faced $1.7 billion in losses for the year ended in March due to large interest rate bets that went bad. Morgan Stanley absorbed 40 percent of those losses, which hurt earnings by 26 cents per share.

Mitsubishi UFJ is responsible for the day-to-day operations at the joint venture and has taken steps to overhaul the management and put better checks and balances in place, Gorman said.

The Japanese bank will contribute $370 million in fresh capital to the venture this month, which will help mitigate the damage to Morgan Stanley's book value by about $145 million in the second quarter.

The preferred stock conversion will also bolster Morgan Stanley's capital levels ahead of stricter capital rules and the impending Smith Barney deal. The new stock issuance will dilute existing shareholders by about 26 percent, but will also lift Tier 1 common capital ratio by 2.70 percentage points.

The bank's quarterly results included several other special items. Morgan Stanley earned 30 cents a share by selling its stake in a stalled casino project in Atlantic City, New Jersey. It also faced $159 million worth of charges, known as debt valuation adjustments, from tightening of credit spreads on its own debt and $318 million in losses related to hedges on its loans to municipal bond insurer MBIA.

It was not immediately clear how Morgan Stanley's bottom line compared to the average Wall Street forecast, given the special items and the fact that not all analysts included the Japanese joint venture losses in their forecasts.

Morgan Stanley shares rose 44 cents to close at $26.48. According to management's calculations, after the dilution from the MUFG preferred conversion, Morgan Stanley's book value is about $29.36 per share. Investment banks' shares often trade above their book value, which is why some investors view Morgan Stanley stock as worth buying now.

(Reporting by Lauren Tara LaCapra, additional reporting by Dan Wilchins; editing by John Wallace, Bernard Orr)

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