Bond rating agency Moody's Investors Service has said it may cut Morgan Stanley by at least two notches in June, to just two or three steps above junk status. Many investors see such a cut as all but certain.

Many U.S. banks are at risk of a downgrade, but ratings cuts could affect Morgan Stanley most because of the severity of the cut and because of its relatively large trading business.

Even before any downgrade, the bank is suffering in the bond markets. Prices for Morgan Stanley's bonds and credit derivatives have been trading at junk levels since last summer, according to Moody's Analytics. Prices moved further into the non-investment-grade category over the past two weeks amid troubles in Greece and other Euro zone nations.

"The numbers have changed for the worse," said Otis Casey, director of credit research at Markit. "What has driven that, obviously, is Europe. The perception is - correctly or incorrectly - that Morgan Stanley is one of the U.S. banks most exposed to Europe's problems."

Over time, Morgan Stanley's weaker bonds will translate to higher borrowing costs for the bank. Morgan Stanley already has higher interest expenses relative to its assets than does chief rival Goldman Sachs Group Inc.

Between downgrades and higher funding costs, "Morgan Stanley is going to make less money than Goldman doing the same types of activities," said Jason Graybill, senior managing director at Carret Asset Management, which owns Morgan Stanley bonds.

Morgan Stanley's troubles are manifold now.

Investors have been worried about the bank's exposure to Europe for months, despite the bank's disclosures indicating that its potential losses are limited. Its Morgan Stanley Smith Barney retail brokerage joint venture is not generating the returns that investors had expected.

Unexpected losses at its joint venture with Mitsubishi UFJ Financial Group last year also caused concern about management's ability to deliver more consistent trading profits.

Morgan Stanley's problems were compounded by its handling of the Facebook IPO - its high price and large size, and selective disclosure of an analyst's reduction of his forecasts for the social network's revenue and earnings. Facebook shares ended regular trading at $27.72 on Friday, down 27 percent from their offering price of $38.

Ratings cuts do not threaten the bank's survival but will weigh on its revenue and increase its costs, analysts said. Morgan Stanley could struggle to win certain kinds of business, such as medium-term derivatives trades, and will have to post more collateral in those trades.

"A bank with a near-junk rating is in 'no man's land,'" said Edward Marrinan, credit strategist at Royal Bank of Scotland Group in Greenwich, Connecticut. "Banks rarely thrive with non- or borderline investment grade ratings."

STREET MOVING AHEAD

Some of the costs of being downgraded are already manifest. Larry Fink, chief executive of the money-management giant Blackrock Inc, said in an interview with the New York Times in April that his firm has no choice but to shift business to higher-rated institutions when banks are downgraded.

In a May 7 securities filing, Morgan Stanley said it might have to post $7.2 billion worth of additional collateral and termination payments in the event of a downgrade to Baa2, the second lowest investment-grade rating, up from a $6.5 billion estimate it provided three months earlier.

But bond markets are not waiting for a downgrade. On Friday, it would have cost Morgan Stanley 1.20 percentage points more to raise five-year debt than its chief rival, Goldman Sachs Group Inc. The bank would even have to pay a little more than much-smaller competitor Jefferies Group.

"The Street is pretty efficient and is really moving ahead of the ratings agencies," said Carret Asset Management's Graybill. "It's never good in this business to have a disadvantage against a strong competitor."

Given the difficulties associated with a ratings cut, Morgan Stanley executives are lobbying Moody's to keep the bank's rating at current levels. Standard & Poor's and Fitch have not outlined plans for similar ratings cuts. S&P downgraded Morgan Stanley to A- in November, putting it four notches above junk. Fitch rates the company one notch higher, at A.

Morgan Stanley Chief Executive James Gorman has met with Moody's officials since the agency said in February it might downgrade the bank, hoping to persuade the agency against a three-notch downgrade.

"The kind of company we are now from a few years ago, it's very, very different, and part of the discovery process with Moody's is to share that information," Gorman said in a CNBC appearance on Thursday.

"We have doubled our liquidity, we have doubled our capital, we have more than half that leverage and sold 22 percent of the company to the third-largest bank in the world, Mitsubishi Bank ... We have now put a lot in front of Moody's to consider as they go through their process."

Morgan Stanley has also been working with clients to adjust affected derivatives contracts, moving some to its higher-rated bank subsidiary. The bank has taken other steps to lessen the blow of a triple-B rating on its balance sheet, by paying down debt and getting rid of trades funded with unsecured debt.

Morgan Stanley spokeswoman Mary Claire Delaney declined to comment.

FRAGILE FUNDING

Moody's said in February it would consider downgrades for Morgan Stanley and 16 other major banks because the world had changed dramatically since 2008, with "more fragile funding conditions, higher credit spreads and a more treacherous macro environment."

Giant global financial firms are at the mercy of increasingly skittish financial markets, the ratings agency's analysts said.

Morgan Stanley, Bank of America Corp and Citigroup Inc are all at risk of a downgrade to Baa2, but Morgan Stanley could be the most affected by a downgrade because more of its revenue comes from trading.

Morgan Stanley has said that the downgrade will mainly affect its over-the-counter derivatives business, estimating that just 8 percent of those contracts will have to be revised or terminated as a result of a three-notch drop.

Much of that business will eventually move to exchanges or central clearing under new regulations, which would make an individual dealer's credit rating less of an issue. But the most complex and profitable derivatives trades will still happen between banks and their clients and not through clearing houses, leaving Morgan Stanley at a disadvantages to higher-rated competitors.

The bank's risks are also reflected in its share price. The stock closed at $12.73 on Friday, or 47 percent of the bank's tangible book value at March 31. Banks typically trade at some premium to their tangible book value, or the value of tangible assets minus liabilities.

The stock is down 16 percent so far this year, compared with a 2.4 percent gain for Goldman Sachs and no change in the NYSE Arca Broker/Dealer Index.

(Editing by Dan Wilchins, Steve Orlofsky and Martin Howell)

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