Oct. 10 (Bloomberg) -- Morgan Stanley dropped for a fifth day after Moody's Investors Service said it may reduce the U.S. investment bank's credit rating on concern the financial crisis threatens earnings and investor confidence.

Morgan Stanley fell as much as 40 percent in New York trading after sinking 26 percent yesterday to the lowest level since 1996. Moody's put Morgan Stanley's A1 long-term rating on review for a possible downgrade and lowered its outlook for Goldman Sachs Group Inc.'s Aa3 long-term rating to negative. Goldman shares also slid today.

``An extended downturn in global capital market activity will reduce Morgan Stanley's revenue and profit potential in 2009, and perhaps beyond this period,'' Moody's said in an e- mailed statement. ``Investor, counterparty and customer confidence is critical to the funding and profit generation of the firm, especially in a hostile market environment.''

The possible downgrade adds to pressure on Chief Executive Officer John Mack, 63, as he seeks to assure shareholders, creditors and clients about the firm's health. The bankruptcy of Lehman Brothers Holdings Inc. and emergency sales of Merrill Lynch & Co. and Bear Stearns Cos. sparked concern that firms like Morgan Stanley that depend on debt markets will run out of funding.

`Extraordinary Pressure'

Morgan Stanley's stock has ``been under extraordinary pressure as of late, for no apparent fundamental reason, as we estimate liquidity, the balance sheet, and long-term earnings prospects are sound,'' David Trone, an analyst at Fox-Pitt Kelton Cochran Caronia Waller, wrote in a note today. ``However, as we've seen with Bear Stearns and Lehman, once the fear virus has infected the story, it is tough to shake.''

Shares of Morgan Stanley dropped $4.41, or 35 percent, to $8.04 at 12:12 p.m. in New York Stock Exchange composite trading, after sinking to $7.45. Goldman fell $19.45, or 19 percent, to $81.90.

Egan-Jones Ratings Co. said Morgan Stanley probably needs to raise $60 billion in new equity to reassure customers and investors, up from a $30 billion estimate yesterday. The investment bank has about $900 billion of assets and an equity market value of $8.5 billion. Mark Lake, a Morgan Stanley spokesman, declined to comment.

Snowball Effect

``The analogy is a snowball rolling down a mountain; the mass needed to stop that negative momentum increases as that snowball picks up speed and size,'' Egan-Jones's Sean Egan said in a phone interview today. ``Perception trumps reality. They need a massive injection to stop the slide and hopefully they don't commit the Bear Stearns or Lehman mistake.''

Morgan Stanley and Goldman Sachs declined yesterday in New York Stock Exchange composite trading as a short-selling ban expired and concern grew about their earnings prospects. The New York-based firms have transformed themselves into bank holding companies and raised money from outside investors to help weather the credit market turmoil that toppled Lehman Brothers.

The Morgan Stanley credit review affects about $200 billion of debt, Moody's said. The ratings company affirmed its Prime-1 grade for Morgan Stanley's short-term debt. The outlook for Goldman affects $175 billion of debt, and the company's short- term ratings were also affirmed at Prime-1.

Mitsubishi UFJ

Moody's in August cut Morgan Stanley's long-term credit rating from Aa3. At A1, the firm now has the fifth-highest investment grade rating.

Morgan Stanley is selling more than 20 percent of itself to Japan's Mitsubishi UFJ Financial Group Inc. for $9 billion. Morgan Stanley and Mitsubishi UFJ have moved to quash speculation that the deal would collapse, as the U.S. firm's shares tumbled 48 percent this week. The deal will close Oct. 14 ``as planned,'' Mitsubishi UFJ spokesman Takashi Takeuchi said today in an interview. Mitsubishi UFJ agreed to pay $6 billion for preferred stock and $3 billion for common stock at a value of $25.25 apiece, or 50 percent more than yesterday's closing price.

``I would be angry if I were a Mitsubishi shareholder and I got the same amount of Morgan Stanley when the stock has been cut in value,'' said Kenneth Crawford, a senior portfolio manager at Argent Capital Management in St. Louis, Missouri.

`Incredible Scenarios'

Crawford said he sold his Morgan Stanley stock last month after Lehman went bankrupt and American International Group Inc. was forced to rely on government support to fund itself.

``After Lehman was allowed to go bust and then AIG couldn't come up with the liquidity they needed, all of a sudden it seemed more likely that incredible scenarios could be more credible,'' he said.

Closing the investment from Mitsubishi UFJ will be ``critical'' for Morgan Stanley to keep its current credit ratings, Moody's said.

``Morgan Stanley's recent performance has been relatively solid, it has acted to solidify its capital base, it has maintained a good liquidity profile, and it has benefited from a level of systemic support that is factored into the rating,'' Moody's said in its release.

For Morgan Stanley and Goldman, becoming bank holding companies regulated by the Federal Reserve may ``limit profit opportunities,'' while at the same time lower risks, Moody's said.

Goldman's `Noteworthy' Controls

``Mitsubishi UFJ Group convincingly indicated that it would make the $9 billion investment in Morgan that it had promised,'' Richard Bove, an analyst at Ladenburg Thalmann & Co. in Lutz, Florida, wrote in a note to investors today. ``The risk, however, remains in the stock if the company's assurances are not accepted by the market.''

Goldman has raised $10 billion, including $5 billion from billionaire investor Warren Buffett. The company, led by Chief Executive Officer Lloyd Blankfein, has recorded $4.9 billion of credit market losses since August last year, compared with $15.7 billion at Morgan Stanley.

``Goldman's commitment to controls is noteworthy,'' said Moody's analyst Peter Nerby in the statement.

Morgan Stanley said yesterday that its hardest-to-value assets rose 13 percent in the quarter ended Aug. 31. The firm classified $78.4 billion of its assets, or about 8 percent of the total, as so-called Level 3 in the third quarter, up from $69.2 billion, or 7 percent, in the previous period.

To contact the reporter on this story: Christine Harper in New York at charper@bloomberg.net.

Last Updated: October 10, 2008 12:26 EDT