Threat of Credit Downgrade Persists for Morgan Stanley

Morgan Stanley‘s rebuilding efforts are starting to take hold, as it posted one of its strongest quarters since the financial crisis.

The bank showed healthy gains in core areas like wealth management and equity sales. Bond trading – the great profit machine on Wall Street – also kicked into high gear. In all, first-quarter profit surged 27 percent to $1.4 billion, excluding one-time accounting charges.

The results were proof, chief executive James P. Gorman told analysts during a conference call on Thursday, that Morgan Stanley was “on the right track.”

But a cloud still looms over the bank: the threat of a credit rating downgrade that could hurt its huge derivatives business.

The group, which facilitates trading in the complex securities, may lose business and have to come up with billions of extra dollars if Morgan Stanley’s credit rating is cut.

Moody’s Investors Service, which is considering whether to downgrade 17 large financial companies, said Morgan Stanley’s rating could decline by as much as three notches to a level below that of the bank’s chief rivals.

Morgan Stanley cannot easily protect itself from this potential blow.

In 2008 at the height of the financial crisis, the investment bank kept its derivative business in its core operations rather than shifting it into a subsidiary that enjoyed greater taxpayer protection and a higher credit rating. If Morgan Stanley had made that move as Goldman Sachs did, a ratings cut would not have the same sting.

Morgan Stanley might not have that option anymore. With the financial system more stable, bank regulators are unlikely to allow Morgan Stanley, or any other bank, to move large parts of its derivatives business into a taxpayer protected subsidiary, where the government could be on the hook for potential losses.

Morgan Stanley has played down the effect of a downgrade, saying only 8 percent of its derivative contracts have rating triggers that could immediately prompt customers to move their business. And, Morgan Stanley notes, clients look at other data, including the bank’s ratings by agencies, when picking trading firms.

Mr. Gorman has also been emphasizing that the bank has taken steps in the last three years that should help buoy its credit rating. It has ended or reduced its presence in certain high-risk trading operations and expanded into wealth management, a lower risk business that tends to produce steadier results.

The latest financial results reflect some of the changes.

In the first quarter, Morgan Stanley reported earnings of 71 cents a share, handily beating analysts’ estimates. Its institutional securities group, which includes stock and bond trading, reported revenue of $5 billion, excluding the accounting charge. That is up from $3.76 billion a year earlier. Revenues in the global wealth management division, which includes Morgan Stanley Smith Barney, were essentially flat.

Shares of the bank rose 2.3 percent on Thursday to close at $18.07.

“We have done a lot to narrow the impact of any potential ratings change,” Ruth Porat, Morgan Stanley’s chief financial officer, said during the conference call. Despite significant improvements, Morgan Stanley executives still face questions about the threat of a downgrade, and how it affects business. A big concern is the derivatives book, which is the third largest among American banks, according to figures from the Office of the Comptroller of the Currency.

Derivatives are big business on Wall Street. Banks, pension funds and other big investors use them to bet on the direction of stocks, bonds, interest rates and commodities.

Those customers pay close attention to the credit rating of the bank executing the derivatives trades, because they need to be certain the bank can pay what it owes. If a bank loses its credit rating, clients may opt to move their business elsewhere. Or they could demand the that bank post more cash to back its derivatives trades. Either can be costly.

“Definitely, Morgan Stanley’s credit rating is a pressing issue for the bank right now,” said Mike Mayo, a bank analyst with the brokerage firm CLSA Asia Pacific Markets.

Morgan Stanley’s derivatives business is even more vulnerable than those of its rivals. In the financial crisis in 2008, Morgan Stanley and Goldman Sachs converted to bank holding companies. While the designation came with added regulation, it also allowed the companies to take advantage of the government’s bailout funds and other perks.

A few months later, the Federal Reserve exempted Goldman from a rule intended to stop a financial company from using a deposit-taking bank subsidiary with taxpayer backing to support other parts of the company.

With the waiver, Goldman was able to move much of its derivatives business into an insured bank, where it remains. Normally, a strict limit on the size of such transfers would have prevented Goldman from making the shift.

Goldman now warehouses $44 trillion of its derivatives – 92 percent – in that subsidiary, Goldman Sachs Bank USA, according to figures from the Office of the Comptroller of the Currency. The credit rating on the insured bank is one notch higher than on Goldman’s parent company because the subsidiary has the backing of the government.

Morgan did not make the same choice. While it received the exemption from the Fed, it mainly shifted other types of assets into its insured bank. Ms. Porat said Morgan Stanley had been slowly moving derivatives into the insured bank. But only 3 percent of Morgan Stanley’s $52 trillion of derivatives are at Morgan Stanley Bank N.A., the insured subsidiary.

“It really surprises me that Morgan Stanley didn’t move all its derivatives into the bank,” said Saule T. Omarova, a professor at University of North Carolina School of Law who has written about exemptions the Fed granted to banks in the crisis.

Morgan Stanley declined to explain why it did not shift its derivatives like Goldman.

The bank does not have many options now. It could move a large amount of derivatives into a higher-rated nonbank affiliate. But it probably would need to raise or transfer a lot of capital to support the rating of the subsidiary, which would be costly.

If Morgan Stanley asked the Fed for an exemption to shift the derivatives into the government- insured bank, Morgan Stanley might meet with resistance from regulators and lawmakers.

Last October, several members of Congress wrote to bank regulators to express their concern that Bank of America had moved derivatives from its Merrill Lynch subsidiary into an insured bank.

While the Fed did not mention any specifics about Bank of America in its response a month later, it highlighted the rule that caps the amount of business that can be transferred into, or transacted with, an insured bank. The transferred business is not permitted to exceed 20 percent of the insured bank’s capital.

That cap could severely limit how much business Morgan Stanley could move.

Its insured bank had $8.8 billion of capital at the end of 2011, according to a regulatory filing, and 20 percent of that is $1.76 billion. That sum probably would be exceeded if Morgan Stanley transferred a large part of its derivative business, given the size of its book.

The overhaul of financial regulation makes it even harder for banks to move large amounts of derivatives.

Part of the Dodd-Frank legislation, effective in July, allows the Federal Deposit Insurance Corporation, a bank regulator, to deny a transfer, even if the Fed approves one. And even if both regulators give waivers, a bank could face scrutiny from Congress.

“We passed Wall Street reform to equip regulators with the tools they need to protect American taxpayers and ensure the soundness of our financial system,” said Senator Sherrod Brown, Democrat of Ohio, who was behind the letters sent to regulators in October about the Bank of America derivatives transfers.

“If the very agencies charged with preventing unnecessary risk in our financial systems are approving huge exemptions, I’m committed to addressing that.”