Morgan Stanley May Avoid Big Downgrade Pain: Analyst

NEW YORK (TheStreet) --Morgan Stanley(MS) may see a less severe downgrade from Moody's(MCO) than what the market currently anticipates, presenting a short-term, catalyst-driven opportunity for the stock, according to Wells Fargo Securities analyst Matthew Burnell.

Wall Street is bracing for a multi-notch downgrade of investment banks by the rating agency, expected to be announced sometime in June. In February, Moody's said it was reviewing its ratings of global banks including Morgan Stanley, Goldman Sachs(GS) , JPMorgan Chase(JPM) , Citigroup(C) and Bank of America(BAC) in the context of their significant capital markets operations.

A downgrade could result in banks having to post more collateral to their counterparties, increasing their cost of funding. Lower rated banks also face the threat of losing clients in their derivatives trading operations because of their higher risk profile.

The market has been particularly concerned about the impact of a downgrade on Morgan Stanley. According to Burnell, both the fixed income market and more recently the equity market have been pricing in a three-notch reduction in its rating, which would mean its stand-alone rating is non-investment grade. That is "overly punitive given MS's improved balance sheet strength and risk profile, improved business diversification, and growing partnership with MUFG," the analyst wrote in a report late Wednesday.

Instead, a two-notch downgrade might be more likely, according to Burnell, going by recent ratings actions by Moody's, which could result in a short-term outperformance of Morgan Stanley's shares.

According to its latest quarterly filing, Morgan Stanley would have to post additional collateral of upto $9.6 billion or a third of its market-cap to counterparties and exchanges in the event of a three-notch downgrade. The additional collateral in the event of a two-notch reduction would be about $6.7 billion.

Burnell thinks the market's fears about the impact of a three-notch downgrade are exaggerated. "Longer-term risks of Moody's downgrade are reduced by higher debt ratings at S&P and Fitch," Burnell wrote. "Repo funding (-32% yr/yr, as the balance sheet has shrunk) does not containratings triggers and we believe MS will move derivatives activity to central clearing opportunities over time, which should reduce the impact of lower ratings."