While Bear Stearns' (NYSE: BSC) quick demise certainly caused investors to start sweating bullets, Morgan Stanley (NYSE: MS) became the last of the major investment banks to report better-than-expected earnings this week, sweetening some of the market's viciously sour mood.

It could have been much, much worse
Morgan Stanley reported first-quarter net income of $1.55 billion, or $1.45 per share, down sharply from the $2.67 billion, or $2.51 per share in the first quarter of 2007. The big drop in earnings is about on par with the performances reported this week by rivals  Lehman Brothers (NYSE: LEH) and Goldman Sachs (NYSE: GS).

When comparing Morgan Stanley's year-over-year earnings, it's important to note that 2007's numbers include the results of Discover Financial Services (NYSE: DFS), which was spun off last summer.

The institutional securities unit, which houses the firm's investment banking and trading divisions, largely drove the company's earnings. By taking on more risk than usual, and capitalizing on the market's increased volatility, equity traders were able to score the best quarter in the unit's history. Fixed-income trading didn't do much worse, pulling down its second-best quarter in history. That's some pretty impressive stuff, considering how wildly the debt markets have reacted lately.

On top of the stellar performance from its traders, Morgan Stanley achieved impressive results in several other areas:

  • Investment banking advisory revenue jumped 19% to $444 million.
  • Global wealth management revenue climbed 6%, bringing in $11 billion in new assets.
  • International business units had their best year ever, with $4.5 billion in revenue.

Flocking toward safety
Those top-notch results are crucial for investment banks right now, as the market continues to reassess its current health. After JPMorgan (NYSE: JPM) scooped up Bear Stearns over the weekend, the remaining players find themselves plunged into a "survival of the fittest" scenario. Morgan Stanley's strong quarterly performance -- which by most measures surpassed every other Wall Street bank -- bodes well on its ability to keep skittish clients at ease and reassure the world that its liquidity won't become an issue. Morgan currently holds $77 billion in liquid assets, and it saw core liquidity rise by 45% in the recent quarter.

Nonetheless, management remains on guard over the recent turmoil. CFO Colm Kelleher commented that while Bear's collapse didn't put Morgan's operations in immediate jeopardy, it certainly made management a bit paranoid.

Acting to allay fears before they even became an issue, Morgan began drawing on the Federal Reserve's discount lending window, which was recently opened to investment banks for the first time since the Great Depression.

In the past, banks that relied on the discount window were seen as doomed for failure. But now, even strong banks like Morgan Stanley and Goldman Sachs have opted to test the system, showing the world that it bears no stigma. And with rock-bottom lending rates, banks that aren't even close to becoming insolvent have the opportunity to replenish their coffers with cheap cash.

Patience, grasshopper
Going forward, the recent changes to Fannie Mae and Freddie Mac could have a serious impact on investment banks like Morgan Stanley. By lowering the amount of excess capital that Fannie and Freddie are required to set aside, the stubbornly deadlocked debt market may finally get the push it needs to get credit markets flowing again.

It'll take some time, of course, but with a little luck, the Fed's recent moves might help investment put some of the credit crunch behind them for good. Cross your fingers.

While you're waiting, check this related Foolishness:

JPMorgan is an Income Investor recommendation. Discover Financial Services is an Inside Value pick. Try any of our newsletters free for 30 days.

Fool contributor Morgan Housel doesn't own shares in any companies mentioned in this article. He appreciates your questions, comments, and complaints. The Fool's disclosure policy is all about investors writing for investors.