Fed Puts MS Portfolio Shift on Hold

Morgan Stanley’s ( MS - Analyst Report ) plans of moving a large portion of its $52 trillion derivatives portfolio to its subsidiary bank have been put on hold by the U.S. Federal Reserve. The company’s decision to shift this huge amount comes in the wake of a possible credit downgrade by credit rating agency Moody's Investor Service, a wing of Moody's Corp. ( MCO - Analyst Report ) .

The Fed has not ruled out Morgan Stanley’s appeal to transfer its derivative portfolio. However, under the Dodd-Frank financial reforms, the Fed needs to formally discuss the matter with another regulatory authority, the Federal Deposit Insurance Corporation (FDIC). That is why the announcement of the final decision is being delayed.

The Fed is entrusted with safeguarding the stability of the entire financial system, whereas FDIC’s objective is to safeguard banks’ deposits. Both regulatory bodies differ on their objectives. As a result, the issue has become a bit complicated.

From Morgan Stanley’s point of view, this is a strategic action to reaffirm the trading partners’ confidence in its financial strength. Moreover, the growth in earnings is anticipated, propelled by lower funding costs if the derivatives are moved to Morgan Stanley’s bank. The bank retains a long-term credit rating of A1, whereas Morgan Stanley as a whole retains A2 rating by Moody’s.

Moody’s is anticipated to downgrade the entire banking sector, which is bound to affect nearly 17 global and 114 European financial institutions. The decision to downgrade reflects the increasing impact of European debt crisis across the global financial markets.

Morgan Stanley’s ratings could further fall three notches to Baa2. Several other banks like JPMorgan Chase & Co. ( JPM - Analyst Report ) , The Goldman Sachs Group, Inc. ( GS - Analyst Report ) and Citigroup, Inc. ( C - Analyst Report ) are on review for a two-notch downgrade, whereas Bank of America Corporation ( BAC - Analyst Report ) is on review for one notch downgrade.

However, if the Fed restricts Morgan Stanley of moving the derivatives to its bank subsidiary, it can very well transfer it to a separate wing, known as Morgan Stanley Derivative Products. This division also possesses a higher credit rating from Moody’s.

Conclusion

Morgan Stanley’s idea of diverting derivatives to its subsidiaries should work in its favor in case there is a downgrade in the rating. Firstly, it will be able to retain its business which, in given circumstances, could have been taken up by its rivals with higher ratings. Moreover, the diversion would positively impact the financials as the interest expense would come down because of lower funding costs.

Currently, Morgan Stanley retains its Zacks #3 Rank, which translates into a short-term Hold rating. Considering the fundamentals, we also maintain our long-term Neutral recommendation on the stock.