DBRS Confirms Morgan Stanley at AA (low), Changes Trend to Negative

DBRS has today confirmed all ratings for Morgan Stanley (the Company). At the same time, DBRS has changed the trend on all long-term ratings to Negative from Stable. The trend on all short-term ratings remains Stable. The confirmation includes the Company’s Issuer & Senior Debt rating of AA (low), now with a Negative trend, and its Short-Term Instruments rating of R-1 (middle), with a Stable trend.

This rating action follows recent market events and Morgan Stanley’s mixed Q3 2008 earnings results. In confirming the Company’s ratings, DBRS takes into account the continuing strength of Morgan Stanley’s globally diversified franchise, the persistence of its client-driven revenues, its enhanced liquidity resources, reduced leverage and strengthened capital position. Morgan Stanley has made further progress in lowering its remaining exposure to problematic assets to more manageable levels. Even though the operating environment remains very difficult, DBRS views the Company as having the necessary franchise strengths, funding, liquidity and capital to successfully manage through this very challenging operating environment.

The Negative trend reflects the impact of the sustained disruptions in the financial markets, unprecedented recent market events and the weakening of economies around the world at a time of increased concern over inflation. These events have resulted in diminished investor confidence, increased volatility in asset prices, lower client activity, increased risk aversion and higher funding costs. DBRS sees this environment as having the potential to diminish Morgan Stanley’s earnings power over the intermediate term. Additionally, the Company faces increased investor skepticism over the prospects for the stand-alone broker-dealer business model after the significant problems incurred at other large broker-dealers. Given the diversity of its business mix and the geographic reach of the Company’s franchise, DBRS expects Morgan Stanley to successfully adjust to the changing environment. Given the constraints on the use of bank deposits for funding capital markets activities, DBRS does not view access to deposits as a replacement for solid financial results. In this environment, Morgan Stanley can best demonstrate to the markets that the business model works by delivering acceptable earnings.

Morgan Stanley reported income from continuing operations of $1.4 billion, which was approximately $400 million higher than Q2 2008. In weathering the difficult environment, however, the Company relied on a gain of $745 million related to a follow-on offering of MSCI and had a total benefit of $1.4 billion related to the widening of credit spreads on its own debt. Excluding these gains and the $277 million charge related to the auction rate securities settlement, pretax earnings were only modestly positive. In total, net revenues were up on both a linked quarter and year-over-year basis. Positively, prime brokerage, foreign exchange, and equities businesses all performed well and the commodities business recovered from a weak second quarter.

Write-downs continued to weigh on results, but DBRS notes that the Company has made progress on reducing its legacy exposures to problematic assets. During the quarter, Morgan Stanley had net write-downs of $640 million related to its legacy mortgage proprietary trading business, net losses of approximately $410 million primarily related to leveraged finance, $245 million in investment losses, and losses in its real estate and private equity businesses. DBRS notes that Morgan Stanley now has no net exposure to ABS CDO and subprime exposure. Furthermore, net exposures to prime residential and commercial mortgages are manageable.

Balance sheet reductions combined with retained earnings further improved Morgan Stanley’s capital position. Morgan Stanley expects its Tier 1 Ratio to improve to approximately 12.7% from 12.4% last quarter. Both parent company and subsidiary liquidity improved during the quarter as well with average parent company liquidity of $81 billion in the third quarter. DBRS views the Company’s capital and liquidity positions as adequate.

While DBRS believes the Company’s franchise and credit fundamentals continue to support its current rating, irrational exuberance has turned into excessive fear. Since confidence is so central for a financial institution’s business, DBRS must take into account market behavior and sentiment in its credit assessment. DBRS notes that the government is working hard to help restore market confidence and provide more extensive liquidity. If earnings remain positive until markets normalize, the ratings trend will revert back to Stable. However, any quarterly losses that are not offset by capital raises would likely result in negative rating pressure. Furthermore, declining liquidity or weakening capital metrics could also lead to negative ratings pressure.

Morgan Stanley, based in New York City, reported $988.8 billion in assets as of August 31, 2008.

Note:
All figures are in U.S. dollars unless otherwise noted.