Morgan Stanley (MS)’s fixed-income trading unit will struggle if Moody’s Investors Service follows through with a potential three-level downgrade, according to Brad Hintz, an analyst at Sanford C. Bernstein & Co.
Such a reduction may slice 30 percent off revenue from fixed-income derivatives, which account for 15 percent of total fixed-income revenue, Hintz estimated in a research note yesterday. Equity-derivatives revenue, which is about 20 percent of total equities revenue, could fall 10 percent, according to the note. Based on 2011 trading results, those declines would mean losing about $400 million of annual trading revenue.
“Equity investors should assume this potential downgrade is likely to occur,” wrote Hintz, a former Morgan Stanley treasurer. “The potential downgrade makes it more difficult for MS’s fixed-income business to sustainably outperform,” he added, referring to the New York-based firm by its stock symbol.
Morgan Stanley faces the largest credit downgrade among U.S. lenders by Moody’s, which will take ratings actions on the largest global investment banks by the end of June. Morgan Stanley’s rating may drop to Baa2, two levels above junk, from A2. That could force the firm to post more collateral on derivatives trades and pay more to borrow.
Chief Executive Officer James Gorman and Chief Financial Officer Ruth Porat said last week that they’ve taken steps to ensure any fallout from a downgrade would be manageable.
“MS claims they have numerous alternatives to offset this,” Hintz wrote. “But Bernstein is skeptical.” Mark Lake, a spokesman for Morgan Stanley, declined to comment.
The bank’s ability to execute trades through its triple-A rated subsidiary will be limited by “onerous hedging and risk- management rules and collateral charges that make its use problematic,” Hintz wrote. “This subsidiary’s complex structure did not economically work in the 1990s when it was set up and it probably won’t work economically today.”
Hintz continues to rate Morgan Stanley “outperform,” the same rating he’s had on the stock since August 2007, according to data compiled by Bloomberg.
Moody’s cited new challenges for the industry such as increased regulation and “fragile” funding conditions when it announced the review of 17 firms with capital markets operations in February. It also noted “inherent vulnerabilities” such as the dependence on confidence in the markets and a lack of transparency on risks.
BlackRock Inc. (BLK), the world’s biggest asset manager, said last week that it may be forced to reduce business with some banks if their credit ratings are lowered.
“I don’t think there’s any possibility we’re not going to be doing business with BlackRock,” Gorman said later in the week in an interview on Bloomberg Television. “It’s only certain individual contracts and we’ve created a number of workaround situations where we can deal with this.”
Analysts including Edward Jones & Co.’s Shannon Stemm have said they don’t expect the Moody’s downgrade would have a meaningful impact on Morgan Stanley’s trading business.
“Clients not bound by technical requirements, if they had concerns around facing off with Morgan Stanley as a counterparty, would already have reduced or currently be moving to reduce exposures,” Roger Freeman, an analyst at Barclays Plc’s investment bank, wrote in an April 20 report. “Judging from 1Q results, however, market share within FICC appears to be accruing to Morgan Stanley, not heading in the other direction.”
Ed Najarian, an analyst at International Strategy & Investment Group Inc., wrote in a research note that he doesn’t expect Moody’s to go through with the maximum downgrades it has threatened because of strong opposition from the banks.