Ratings Downgrade Cuts Deeply at Morgan Stanley

As Moody’s Investors Service prepared to cut the ratings of some of the world’s biggest financial firms on Thursday, Morgan Stanley’s chief executive, James P. Gorman, was in St. Petersburg, Russia.

Morgan Stanley
Oliver P. Quillia for cnbc.com
Morgan Stanley

He spoke to a group of business and economic leaders about how banks would have rethink their roles in an environment characterized by more regulation and falling profits.

It is a topic Mr. Gorman knows all too well.

Bruised by the financial crisis, he has moved to transform Morgan Stanley over the last three years from a risk-taking brokerage house to a smaller, steadier bank. Even so, his moves were not enough to shield Morgan Stanley from a two-notch downgrade.

On Thursday, Morgan Stanley was among the 15 big banks to watch its credit rating tumble. Morgan Stanley’s worst case — a full three-notch downgrade — did not come to fruition, but its new rating, the lowest in at least 20 years, posed some significant challenges, potentially increasing its borrowing costs and requiring it to post more capital against trades. The firm had previously estimated that a two-notch downgrade could require it to post $6.8 billion in additional collateral to some trading partners.

It is also a psychological blow for the bank, which is no longer an A-rated company. In an e-mail sent to staff members after the downgrade was announced, Mr. Gorman tried to reassure employees about the bank’s future.

“While we do not believe that this outcome reflects all of the transformative changes we have made to the firm, there is an acknowledgment in Moody’s decision today that real progress has been made at Morgan Stanley, in what is an extremely difficult environment for our industry,” he wrote.

Since Moody’s put the company on watch in mid-February, the blunt-speaking Australian chief has met with the credit rating agency several times, hoping to convince analysts that their view on Morgan Stanley has been too harsh. These meetings often resembled a monologue with Morgan Stanley talking and Moody’s listening, according to one attendee who spoke on the condition of anonymity.

Morgan Stanley was fighting an uphill battle. Moody’s had decided that the existing ratings of the banking industry were too high.

These institutions, Moody’s has argued, were not transparent enough, and when they falter they can run into trouble quickly. The level of failure among banks is not consistent with a sterling rating, Moody’s has said.

Mr. Gorman, 53, faced specific Morgan Stanley issues, as well. The bank, which like its rivals, had a near-death experience during the financial crisis, made bad bets on real estate. It had a $9 billion trading loss during this period, the type of risk-management mistakes Moody’s considers when setting ratings.

Morgan Stanley emerged from the crash a much-diminished institution. Since taking the helm in 2010, Mr. Gorman has been on a mission to reduce the firm’s level of risk. He has expanded the firm’s wealth management operations, a steady fee-based business that does not require Morgan to invest much capital.

Regulators have forced change in other areas. Like much of the industry, Morgan Stanley has left riskier businesses like proprietary trading and increased its capital cushion, a move that should help in tough times.

The firm also has found a strong financial partner to bolster its position. The Mitsubishi UFJ Financial Group, which made a significant investment in the bank at the depths of the crisis, now owns more than 20 percent of Morgan Stanley.

Such changes were at the crux of the case Mr. Gorman made to Moody’s. It is the sort of turnaround story that should give rating agencies like Moody’s some comfort that Morgan Stanley has made real changes.

Still, Moody’s remained cautious. In its previous reports, the credit rating agency has noted the push into wealth management, but it indicated that the business was still a work in progress.

Industry forces, too, played a role. In May, JPMorgan Chase announced that it had an unexpected trading loss, which could eventually reach $5 billion. The mishap only served to bolster Moody’s view that the country’s big banks needed to be downgraded. In an unfortunate turn of events, Mr. Gorman was scheduled to meet with Moody’s just days after the loss, according to people briefed on the meeting but not authorized to speak on the record.

Still, Moody’s gave Morgan Stanley credit for some of its work. Robert Young, a managing director at Moody’s, said without the support from Mitsubishi, Morgan Stanley could have faced a three-notch downgrade. The credit rating agency also gave Morgan Stanley credit for some of the recent changes to its business mix, saying “its reduced risk appetite, improved liquidity profile and stronger capital position” factored into its rating.

A big test for Morgan Stanley will come on Friday when investors get a chance to weigh in on the credit rating cut. Shares of Morgan Stanley, which have fallen more than 25 percent since Moody’s announced its review in February, were up modestly in after-hours trading.