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The market appeared relieved last week when Moody's downgrade of Morgan Stanley's (NYSE:MS) long-term senior unsecured credit rating turned out to be 2 notches instead of the feared 3 notches. Notably, Morgan Stanley CDS fell to 353.92bps Friday, down 7.64% to their lowest level in nearly two months, while the firm's stock rose 1.29%. For Morgan Stanley's part, the firm noted 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...[including] our de-risked balance sheet"

The firm is responding to the following assessment of its risk profile mentioned in Moody's press release:

The third group of firms includes Bank of America, Citigroup, Morgan Stanley, and Royal Bank of Scotland. The capital markets franchises of many of these firms have been affected by problems in risk management or have a history of high volatility, while their shock absorbers are in some cases thinner or less reliable than those of higher-rated peers. Most of the firms in this group have undertaken considerable changes to their risk management or business models, as required to limit the risks from their capital markets activities. Some are implementing business strategy changes intended to increase earnings from more stable activities. These transformations are ongoing and their success has yet to be tested. In addition, these firms may face remaining risks from run-off legacy or acquired portfolios, or from noteworthy exposure to the euro area debt crisis.

It might be misleading however, to put Bank of America (NYSE:BAC) and Citigroup (NYSE:C) in the same category as Morgan Stanley in terms of risk. Recall that firms use (among other things) VaR or 'value-at-risk' to determine the risk profile for a portfolio of assets. Importantly, Morgan Stanley uses a 95% confidence interval to calculate its VaR:

The Company uses VaR as one of a range of risk management tools. VaR methodology has various strengths and limitations, which include, but are not limited to: use of historical changes in market risk factors, which may not be accurate predictors of future market conditions, and may not fully incorporate the risk of extreme market events that are outsized relative to observed historical market behavior or reflect the historical distribution of results beyond the 95% confidence interval;

By contrast, Bank of America and Citigroup use a 99% confidence interval. In order to understand how dangerous it is to use a 95% confidence interval to calculate VaR, consider that academic research (cited in the quote below) has shown that even using a 99.7% confidence level is inadequate to guard against the unpredictable nature of the market:

"...traditional value at risk models (which use a three sigma, or 99.7% confidence level) assume normal Gaussian distributions and do not take into account the fact that asset prices often follow a fat-tailed Cauchy distribution. As such, VaR models run the risk of underestimating the probability of 'Black Swan' or 'Grey Swan' events and should only be used if risk managers explicitly acknowledge their limitations"

In order to properly guard against risk, firm's should use a six sigma confidence level, which would provide a much larger margin of safety. Therefore, Morgan Stanley's use of a 95% confidence interval (two sigma) to calculate VaR isn't even close to adequate. Consider what the Office of the Comptroller of the Currency has to say about Morgan Stanley's VaR calculations:

Morgan Stanley calculate VaR using a 95% confidence interval. If [the] firm used a 99% confidence interval, as does Bank of America and Citigroup, their VaR estimates would be meaningfully higher.

Add to this concern the fact that Morgan Stanley is offloading a considerable portion of its derivatives exposure to its A-rated deposit-taking banking entity from its downgraded holding company (effectively shifting the risk of a derivatives trading loss to the depositors), and you get a company that is far more risky than investors might think. Short Morgan Stanley, or long MS puts until it proves its risk management is adequate.

Source: Morgan Stanley Is Far More Risky Than Investors Think