Fitch Ratings has affirmed the ratings for Morgan Stanley and revised the rating outlook to Negative from Stable. It also placed the ratings for Discover Bank on Rating Watch Negative following the announced spin-off of Discover Financial Services today.

Fitch’s explains that its outlook revision, “is prompted by Morgan Stanley reduction of common equity from the spin off and expected common stock repurchase activity, the loss of earnings from Discover Financial Services and expected increase in revenue volatility as efforts to double revenues and pretax profits continue.” Fitch believes that Morgan Stanley’s market and credit risk appetites will expand in certain industries and may reach beyond levels expected for firms possessing a credit rating in the ‘AA’ range.

“To date, increases in risk appetite have been met with sufficient retained earnings and the maintenance of an appropriate funding and capital structure. Today’s announcement concerning the spin of Discover Financial Services eliminates a stable and diversifying source of earnings,” it says. “While material efforts have resulted in improvements to earnings contributions from Global Wealth Management and Asset management, they are not at levels that are considered sufficient to dampen volatility from Institutional Securities.”

Fitch believes Morgan Stanley possesses significant competitive advantages in investment banking, prime brokerage and commodities trading and advisory businesses. “However, market share gains will be difficult to achieve without the willingness to commit greater access to financing and leverage – potentially compromising the current balance sheet strength. In addition, each of these businesses currently generates significant profit margins which in turn are attracting material competition,” it adds.

The reduction of common equity from the spin off and the stock repurchase program combine to reduce common equity support of the balance sheet, the rating agency says.

If warranted, Fitch expects any downgrade to be limited to one notch.

Discover Bank’s rating was directly linked to the support provided by Morgan Stanley. Discover’s standalone financial profile would warrant the assignment of a lower, albeit investment grade, long-term debt rating, Fitch says. It does not believe Discover’s operations will be negatively affected by the divestiture. The Outlook is expected to be Stable.

Meanwhile, Dominion Bond Rating Service confirmed its ratings of Morgan Stanley, and the trends for its ratings remain Stable. DBRS says it views the proposed transaction as neutral to Morgan Stanley’s credit ratings.

DBRS says it does not see this transaction as weakening the company’s balance sheet. “At the same time, the company frees up resources to devote to its core businesses across its increasingly global franchise,” it says. “While this spinoff will reduce the diversification of Morgan Stanley’s earnings, DBRS regards Morgan Stanley without Discover as a broadly diversified player in the global securities industry with leading positions in investment banking, equities, and fixed income sales and trading.”

“The company’s earnings resilience reflects both its strong positions by business line and its increasingly global diversification across international markets,” it adds. “The company’s new management has improved trends across the asset management and private-client wealth management businesses that are likely to further strengthen earnings diversity.”

“While the credit card business has been an important source of relatively stable earnings that helped in the past to balance fluctuations in other segment businesses, DBRS views this additional stability as becoming less important with the expansion of the company’s other businesses,” DBRS says. “Moreover, DBRS believes that Discover with its primary focus on retail clients in the United States did not offer many synergies with the other parts of Morgan Stanley.”

Moody’s Investors Service has also affirmed the ratings of Morgan Stanley and placed the ratings of Discover Bank on review for downgrade.

These rating actions follow Morgan Stanley’s announcement of its decisions to spin-off Discover Bank and execute a share repurchase program of $6 billion to be executed over the next twelve to eighteen months.

In reacting to the spin-off, Moody’s said that Morgan Stanley bondholders will no longer benefit from the Discover Bank’s earnings stream that reduced Morgan Stanley’s earnings volatility and could offset periodic charges. These benefits were largely offset by the competitive challenges facing Discover, as well as the credit and liquidity risks presented by the receivables portfolio and reflected in Discover Bank’s C- financial strength rating. Therefore, Moody’s views the spin-off as neutral for Morgan Stanley’s bondholders.

@page_break@“Morgan Stanley has an impressive global platform, holds enviable positions in high-margin investment banking and prime brokerage, and has a well-balanced and profitable trading business,” said Moody’s senior vice president Peter Nerby, in explaining the drivers of the rating. “The institutional business is Morgan Stanley’s core earnings engine and it showed solid revenue and profit momentum during 2006.”

Moody’s said that Morgan Stanley’s profitable asset management business also adds a reliable stream of less capital-intensive earnings, but noted that Morgan Stanley’s retail brokerage segment (Global Wealth Management) lags best-in-class peers in terms of scale, profitability and advisor productivity.

Morgan Stanley also has a consistent track record of successful risk management, the rating agency noted, but management intends to pursue riskier activities (such as principal investing and emerging markets), Moody’s said. “This means that Morgan Stanley is employing more economic capital in its institutional businesses and this could pressure its credit ratings in the future,” it said. Moody’s expects that Morgan Stanley will maintain a strong liquidity profile notwithstanding the growth in less-liquid positions over the next two to three years.

Moody’s said that the share repurchase program is marginally negative for bondholders but held no rating implications. The repurchases will be funded largely through earnings, as well as through issuance of hybrid securities which will satisfy Moody’s conditions to receive a substantial amount of equity credit. Therefore the program is not expected to result in any meaningful reduction of Morgan Stanley’s tangible equity base. Also, the firm is expected to continue to employ sufficient economic capital when capitalizing its individual business lines.

Discover Bank’s current financial strength rating, which has been affirmed, reflects the intrinsic creditworthiness of the bank as a stand-alone entity without the benefits of outside support. Moody’s said that the review of Discover Bank’s debt and deposit ratings reflects the removal of implied parental support from Morgan Stanley to these ratings.

The current plan for the spin-off is expected to result in a capitalization of Discover Bank with approximately $4.5 billion in tangible common equity, as well as significant liquidity support in the form of a securities portfolio and borrowing facilities as well as minimal double leverage.

Although Discover has taken steps recently to increase merchant acceptance particularly among small to mid-size merchants, Moody’s noted that Discover has lost market share in recent years. This has been due to consolidation amongst major card issuers and heightened competition, including continued innovation in card and reward products for consumers. Increasing consumer acceptance, growing share, and strengthening returns on receivables will remain a challenge for Discover, in Moody’s opinion.