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Morgan Stanley's $5 Billion Stress Test Game

Tickers in this article: BAC C GS JPM MS

NEW YORK ( TheStreet) -- Morgan Stanley (MS) is in sharp disagreement with the results of the Federal Reserve over how much the company would lose if a terrible recession were to begin this year.

Diverging estimates of losses during an immediate and severe economic downturn are important, given Morgan Stanley's relatively low pass rate in the 2013 stress tests .

Overall, the Fed projects Morgan Stanley would lose about $20 billion in a financial crisis, pushing the bank's Tier 1 common equity ratio as low as 5.7%, just above the 5% level needed to remain well-capitalized, under regulatory guidelines.

In contrast, Morgan Stanley projects its overall losses would be just $12.6 billion, with a minimum Tier 1 common ratio of 6.7%, under the Fed's stressed economic scenario.

But the difference in calculations may hinge on how Morgan Stanley discloses accounting adjustments similar to the ones that helped the standalone investment bank through the crisis and which continue to cloud its earnings.

Most of the calculations by the Fed and Morgan Stanley match up, however, there is a $5.1 billion difference in what each test sees as the bank's revenue in a stressed economy.

While Morgan Stanley pegs its pre-provision net revenue at $6.3 billion under a stressed scenario, the Fed sees just $1.2 billion in revenue.

As a consequence, the Fed and Morgan Stanley match up on calculations of trading losses and loan write-downs, but see vastly figures on the bank's overall earnings

As it turns out, the $5.1 billion figure is also about equal to a confusing piece of accounting, which helped to reduce Morgan Stanley's losses during the 2008 financial crisis.

The divergence may hinge on debit valuation adjustments (DVA) and credit valuation adjustments (CVA) that Morgan Stanley records on its earnings statements, and which swung to a $5 billion benefit at the 2008 crisis peak.

The adjustments allow banks to book revenue when their credit spreads widen on eroding investor confidence. It reverses in good times, meaning banks like Morgan Stanley have seen very large negative hits to revenue as investor trust increases. The potential gain is equal to the amount a bank would gain if it bought back all of its debt at discounted prices, and what it would lose if buying debt back at higher prices.

Banks like Morgan Stanley, Goldman Sachs (GS) , Bank of America (BAC) , JPMorgan(JPM) and Citigroup(C) all began recording adjustments in 2007, after opting into the what's called the Fair Value Option , which forces lenders to mark-to-market many assets and liabilities.

The accounting impacts Morgan Stanley's earnings the most as a result of its size and because a hedging program put in place by Goldman Sachs reduces the company's DVA and CVA swings.