Money Will Be Returned to Investors Who Were Harmed

Moody’s Investors Service raised its outlook on Morgan Stanley MS +0.15% from stable to positive, saying the firm continues to make progress on strengthening its profitability.

Earlier this month, Morgan Stanley reported a near doubling of its second-quarter profit, as revenue gains from wealth-management and investment-banking businesses helped offset a trading slump that has dogged much of Wall Street for a year.

Separately, Morgan Stanley agreed to pay $275 million to settle allegations it misled investors in a pair of mortgage bonds, the only Securities and Exchange Commission case it has faced related to the financial crisis.

Moody’s said Morgan Stanley’s progress is particularly apparent within its noncapital-markets businesses, adding that the firm has reduced the risk profile of its Institutional Securities arm, mainly by reducing risk-weighted assets within fixed income and commodities.

The ratings firm said that if these trends at Morgan Stanley continue, the investment bank’s ratings could be upgraded “over the medium term.” The firm had cut its rating on Morgan Stanley—along with several of its peers—in November by one notch, after updating its views on U.S. government support.

In the second quarter, Morgan Stanley’s wealth-management arm, fortified by the firm’s acquisition of Citigroup Inc.’s majority stake in Smith Barney, reported its highest pretax profit margin since the deal was hatched in the wake of the crisis. The unit’s pretax profit margins jumped to 21% from 19% in both the year-earlier period and the first quarter of 2014.

“Earnings at Morgan Stanley’s noncapital-markets businesses now provide more robust shock absorbers relative to the more volatile earnings from its capital- markets business,” said Moody’s Senior Vice President David Fanger. “Notably, Morgan Stanley had reduced its fixed-income risk-weighted assets without a significant loss of market share.”

Still, the report wasn’t all sunny. Moody’s said Morgan Stanley “remains more heavily reliant on its capital markets business than many of its global investment bank peers.” The ratings firm said that “a critical challenge to improving firm-wide profitability will be strengthening returns in fixed income without adding more risk,” a problem it said weighs more heavily on Morgan Stanley than at many of its peers given the still-significant contribution of this business to firm-wide risk-weighted assets.

Moody’s also highlighted that Morgan Stanley remains heavily reliant on wholesale funding compared with peers, leaving it more exposed to a loss of creditor confidence. Separately, it said that the firm’s return on equity remains below management’s targets.

A spokesman for Morgan Stanley declined to comment.

On the SEC mortgage-bond case, a spokesman for the firm, which resolved the case without admitting or denying wrongdoing, said it was “pleased to have settled this matter.” Morgan Stanley disclosed earlier this year it had reached agreement in principle on the pact with the SEC.

The SEC’s case against Morgan Stanley related to two residential-mortgage-backed securities deals, backed by home loans totaling more than $2.5 billion, which Morgan Stanley packaged and sold in 2007 amid “unprecedented distress in the subprime market,” the agency said.

The SEC alleged that Morgan Stanley underreported how many of the loans backing the mortgage bonds were delinquent.

For one of the bonds, the bank had a chart showing that about 17 % of the loans had been delinquent at some point, the SEC said. But it used different data and disclosed to investors that less than 1% of the loans were delinquent, the agency added.

“Morgan Stanley understated the number of delinquent loans behind these securitizations during a critical juncture of the financial crisis and denied investors the full extent of the facts necessary to make informed investment decisions,” said Michael Osnato, chief of the SEC’s complex-financial-instruments enforcement unit.

Wall Street Journal