Morgan Stanley Just Got a $6.8 Billion Headache

Updated with Morgan Stanley's reaction to the downgrade of its credit ratings by Moody's Investor Service.

NEW YORK (TheStreet) -- Based on the company's own liquidity stress tests at the end of the first quarter, Morgan Stanley faces additional requirements of $6.8 billion, following a two-notch credit rating downgrade by Moody's Investor Service.

Moody's late Thursday afternoon announced that it had "repositioned the ratings of 15 banks and securities firms with global capital markets operations," with four companies seeing their long-term credit ratings lowered by one notch, 10 firms by two notches, and one firm by three notches.

Morgan Stanley CEO James P. Gorman

The ratings agency lowered its long-term senior unsecured debt rating for Morgan Stanley to Baa1 from A2, with a negative outlook, while cutting its short-term rating for the firm to P-2 from P-1.

Morgan Stanley previously disclosed in its first-quarter 10-Q filing that according to the company's stress tests of its March 31 trading positions, its trading counterparties could call "additional collateral, termination payments or other contractual amounts" of $5.2 billion in the event of two-notch downgrades from Moody's and Standard & Poor's.

In addition to the counterparty calls, Morgan Stanley could face "increased collateral requirement at certain exchanges and clearing organizations" of $1.6 billion from the two-notch long-term rating downgrade.

In after-market trading, just minutes after Moody's made its ratings action announcement, Morgan Stanley's shares were up 3.5% to $14.42. Many analysts and investors had been anticipating a three-notch downgrade from Moody's, which would have brought Morgan Stanley's collateral call up to $9.6 billion, based on the company's liquidity stress tests as of March 31.

Morgan Stanley released a statement saying that "While Moody's revised ratings are better than its initial guidance of up to three notches, we believe the ratings still do not fully reflect the key strategic actions we have taken in recent years."

The firm also said that the acknowledgement by Moody's of Morgan Stanley's "long-term partnership withMitsubishi UFJ Financial Group as well as our industry-leading capital and liquidity highlight some of the transformative steps we have taken," adding that "with our de-risked balance sheet, stable sources of funding, diverse business mix and strong leadership team, we are well positioned to deliver for clients and shareholders."

Credit Agricole analyst Mike Mayo said on Wednesday that the downgrades by Moody's seemed "inevitable given the correlation of banking with sovereigns and the weaker geopolitical outlook given the macro slowdown, problems in Europe, and less government backstops (or at least this intention by governments)," but that "most of these expectations are likely already in the stock prices."

Mayo -- who rates Morgan Stanley "Underperform" -- also said that "a multi-notch downgrade, almost by definition, seems like a move that is well behind the market," and that "the banks arguably have excess funding given the deposit surge, and these excess deposits will only increase as Europe and its banks look more vulnerable."

Before the announcement by Moody's, Morgan Stanley's shares pulled back 2% to close at $13.96. The shares have now declined 7% year-to-date, after dropping 44% during 2011.

At the market close, the shares traded for just over half their reported March 31 tangible book value of $27.37 and for six times the consensus 2013 EPS estimate of $2.25. The consensus 2012 EPS estimate is $1.39.

After meeting with Morgan Stanley CFO Ruth Porat, UBS Analyst Brennan Hawken said earlier on Thursday that Morgan Stanley expected that a rating downgrade would "not have an outsized impact on the firm," and that "the primary revenue impact" from a downgrade would be "in its long-dated, uncollateralized interest rate derivatives, which MS has already de-emphasized."

Hawken rates Morgan Stanley a "Buy," with a $19 price target, saying the shares "are cheap, even when we assume very negative outcomes from some of the exogenous issues facing the firm."

Deutsche Bank analyst Michael Carrier late on Wednesday lowered his price target for Morgan Stanley to $20 from $22, and said that despite the company's "upside potential in wealth management and its current valuation" and "potential for the stock long term," he was sticking with his neutral rating on the shares "given some near term pressures" on the company's return on tangible equity, "the negative impact from a Moody's downgrade and to tangible book value with the MSSB buy-in, and continuing macro uncertainty."

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-- Written by Philip van Doorn in Jupiter, Fla.

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