Prior to Moody’s downgrade, Morgan Stanley (NYSE:MS) shuffled derivatives from the holding company balance sheet to that of its bank unit.  The move sought to ensure that a bigger portion of its derivatives portfolio is backed by the higher credit rating of its bank unit. Moody’s downgraded Morgan Stanley’s credit rating two notches late last week – well over four months after the credit rating agency issued its downgrade warning. Incidentally, despite the shuffle, Morgan Stanley still holds the largest share of its derivatives portfolio in its holding company among its biggest competitors JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC), Citigroup (NYSE:C) and Goldman Sachs (NYSE: GS).
We maintain a $23 price estimate for Morgan Stanley’s stock – a considerable premium to the bank’s current near-$14 market price. We believe the difference can be attributed to the significant pessimism among investors towards the investment bank’s stock given the deteriorating economic condition in several European nations, as Morgan Stanley has a sizable exposure to the peripheral economies.
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Nearly A Trillion In Notional Derivatives Moved Within Three Months
Morgan Stanley had active derivatives with a total notional value of $50.34 trillion at the end of Q1 2012 – a decline from the $52.16 trillion value at year-end 2011.  And through the end of 2011, derivatives positions only worth about $1.72 trillion (about 3.3% of the total derivatives value) were a part of Morgan Stanley’s bank unit. This proportion shot up to 5.1% by the end of March 2012, as the bank unit had derivatives with a notional value of nearly $2.57 trillion parked in it by then.
The near-50% jump in derivatives on the bank unit’s balance sheet can be explained by Morgan Stanley’s prudent choice to avoid the complications that accompany a large credit rating cut for an investment bank – like the one Moody’s threatened in early February this year. Back then, Moody’s put Morgan Stanley along with 16 other major banks on its watchlist with a negative outlook (see Moody’s Issues Rating Downgrade Warning For 17 Banks). The agency hinted at a possible three-notch downgrade to the bank’s long-term rating ‘soon.’
So Why Does It Matter?
Credit ratings are watched closely by companies that intend to do business with a bank, as they serve as a third-party proxy to the bank’s financial strength. A rating cut, and more particularly a large rating cut as was expected for Morgan Stanley, could potentially cost an investment bank billions due to an increase in collateral/margin requirements besides an increase in direct funding costs. And to make things worse, many companies would not enter into trades with a bank whose credit rating is below a particular level – leading to a direct loss of revenues.
The result – a decline in Morgan Stanley’s derivatives trading yield from higher funding costs and lower trading activity.
The most readily available solution with Morgan Stanley to combat this situation was to move derivatives positions to its bank unit, which has a credit rating one notch higher (‘A3’) than the holding company (‘Baa1’).Notes:
- Morgan Stanley shifted derivatives in first quarter, Reuters, Jun 22 2012 [↩] [↩]