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Moody's Raises Outlook on Morgan Stanley (MS) to Positive

July 24, 2014 2:41 PM EDT

Moody's Investors Service affirmed Morgan Stanley's (NYSE: MS) Baa2 senior debt rating as well as the ratings of its subsidiaries and changed the ratings outlook to positive from stable. Morgan Stanley continues to make progress in strengthening its profitability, particularly within its non-capital markets businesses, and in reducing the risk profile of its global capital markets business. At the same time, the firm has maintained its strong risk-based capital position and liquidity profile. The positive outlook reflects the potential that, should these trends continue, Morgan Stanley's ratings could be upgraded over the medium term.

RATINGS RATIONALE

Over the past two years, Morgan Stanley has made sustainable improvements to the profitability of its Wealth Management business. It has raised the business segment's pre-tax margin from 12.4% in 2012 to 19.9% during the first half of 2014, compared with Moody's previous expectations for pre-tax margin in the mid-teens.

"Earnings at Morgan Stanley's non-capital markets businesses now provide more robust shock absorbers relative to the more volatile earnings from its capital markets business," said Moody's senior vice president David Fanger. Non-capital markets businesses now account for approximately half of core earnings, compared with Moody's previous expectations of 25%-30% by 2014. Moody's expects the firm's shock absorbers to be sustained around this higher level going forward.

The firm is also reducing the risk profile of Institutional Securities, its capital markets business, most notably by reducing risk-weighted assets within fixed income and commodities.

"Notably, Morgan Stanley had reduced its fixed-income risk-weighted assets without a significant loss of market share," Moody's Fanger said. "As a result, the firm has been able to gradually increase its core profitability."

Moody's adds that Morgan Stanley's profitability gains have been further aided by cyclical factors such as improving market conditions for advisory and underwriting activities and higher asset management fees on higher equity valuations. The firm's recent reported earnings volatility has also been lower than for many of its similarly-rated global investment bank peers.

The positive outlook also reflects the firm's peer-leading Basel III risk-based capital position, which provides a buffer to absorb unexpected losses, and improvement in its supplementary leverage ratio to 4.6% as of June 30, 2014, which reduces the execution risk of achieving the required regulatory minimum of 5%.

Notwithstanding these improvements, Morgan Stanley remains more heavily reliant on its capital markets business than many of its global investment bank peers. In particular, Moody's believes a critical challenge to improving firm-wide profitability will be strengthening returns in fixed income without adding more risk. This challenge weighs more heavily on Morgan Stanley than at many of its peers given the still-significant contribution of this business to firm-wide risk-weighted assets. In addition, the firm remains heavily reliant on wholesale funding compared with peers, leaving it more exposed to a loss of creditor confidence.

Morgan Stanley's return on equity also remains below management's targets. Moody's believes that over the longer term, the firm will need to generate higher returns on capital by enhancing profitability -- particularly in its fixed income business - and/or returning more capital to shareholders. Otherwise, the firm will face pressure to increase its risk taking or undertake more significant restructuring or re-engineering to generate increased shareholder returns.

"To the extent Morgan Stanley can demonstrate additional, sustainable progress in growing its profitability without increasing its risk profile, this could result in a ratings upgrade," Moody's Fanger concluded.



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