Morgan Stanley's Stress Test Math (Correct)

TheStreet.com

Update to correct revenue information and include Morgan Stanley comment.

NEW YORK (TheStreet) -- Morgan Stanley is in sharp disagreement with the results of the Federal Reserve over how much the company would lose if a terrible recession were to begin this year.

Diverging estimates of losses during an immediate and severe economic downturn are important, given Morgan Stanley's relatively low pass rate in the 2013 stress tests.

Overall, the Fed projects Morgan Stanley would lose about $20 billion in a financial crisis, pushing the bank's Tier 1 common equity ratio as low as 5.7%, just above the 5% level needed to remain well-capitalized, under regulatory guidelines.

In contrast, Morgan Stanley projects its overall losses would be just $12.6 billion, with a minimum Tier 1 common ratio of 6.7%, under the Fed's stressed economic scenario.

But the difference in calculations may simply hinge on how Morgan Stanley sees its revenue in a time of crisis and not accounting adjustments related its credit spreads, as an earlier version of this article indicated.

Morgan Stanley spokesperson Mark Lake confirmed late on Friday that the bank did not project any increase in revenue related to a debit valuation adjustment in the firms calculation of its finances in a stressed economic scenario. The adjustment relates to accounting gains that banks like Morgan Stanley book when their credit spreads widen.

There is a $5.1 billion difference in what each test sees as the bank's revenue in a stressed economy. While Morgan Stanley pegs its pre-provision net revenue at $6.3 billion under a stressed scenario, the Fed sees just $1.2 in revenue in its crisis-like stress test.

While the $5.1 billion figure is also about equal to a confusing piece of accounting, a debit valuation adjustment that helped to reduce Morgan Stanley's losses during the 2008 financial crisis, Lake, the Morgan Stanley spokesperson confirmed the bank is not projecting any DVA gain in its own stress test calculations.

The DVA adjustments allow banks to book revenue when their credit spreads widen on eroding investor confidence. It reverses in good times, meaning banks like Morgan Stanley have seen very large negative hits to revenue as investor trust increases. The potential gain is equal to the amount a bank would gain if it bought back all of its debt at discounted prices, and what it would lose if buying debt back at higher prices.

Banks like Morgan Stanley, Goldman Sachs , Bank of America , JPMorgan and Citigroup all began recording adjustments in 2007, after opting into the what's called the Fair Value Option, which forces lenders to mark-to-market many assets and liabilities.

The accounting impacts Morgan Stanley's earnings the most as a result of its size and because a hedging program put in place by Goldman Sachs reduces the company's DVA swings.

In 2008, Morgan Stanley booked $5.1 billion in revenue as a result of the widening of its credit spreads, split between a $3.5 billion gain from the company's fixed income division and a $1.6 billion gain from its equities unit. The gain equaled about 40% of the bank's overall trading revenue of $14 billion that year.

Since most stress test figures match up -- both the Fed and Morgan Stanley see trading and counterparty losses at about $11 billion -- the revenue divergence stands out as the biggest point diffference in Thursdays stress tests.

An earlier version of this article sought to explain the revenue difference by questioning whether Morgan Stanley was including DVA in its stress tests calculation. The analysis was incorrect, given Lake's late Friday confirmation that there was no inclusion of the figure in Morgan Stanleys calculation.

-- Written by Antoine Gara in New York

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