Moody’s Investors Service has upgraded its outlook on the ratings of Morgan Stanley and its subsidiaries to stable from negative.

During 2005, Morgan Stanley endured a messy battle over succession and strategy of the firm, Moody’s notes. This resulted in the selection of a new CEO and almost wholesale turnover of the board of directors and senior management. This turmoil produced only negligible damage to Morgan Stanley’s outstanding institutional securities franchise, which is the key profit generator for the firm, and underpins the ratings, Moody’s said.

“Morgan Stanley still 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. “The institutional business showed solid revenue and profit momentum in the first quarter of 2006.”

The firm has a consistent track record of successful risk management, although trading results have increased in volatility since 2003, the rating agency says. Management also intends to pursue less liquid and riskier activities (such as principal investing, power plants and emerging markets), it notes. 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 noted that Morgan Stanley’ corporate governance has stabilized to a large extent. “Managing director turnover also has trended back to historic norms. However, governance remains in transition, as new board members and new management build working relationships,” it says. Moody’s will continue to monitor governance developments, but, at this time, governance is considered neutral to the ratings.

“A central challenge for the firm and the board will be to forge a more cohesive and meritocratic “one-firm” culture, many years after the merger of Morgan Stanley and Dean Witter,” says Nerby.

Moody’s noted that Morgan’s profitable asset management business also adds a reliable stream of less capital-intensive earnings, but noted that its retail brokerage segment (Global Wealth Management) lags best-in-class peers in terms of scale, profitability and advisor productivity. The rating agency added that the recent US$2.5 billion sale of the aircraft portfolio is positive for bondholders as is the objective of the firm to achieve $600 million in cost savings by 2008.

Moody’s also affirmed Discover Bank’s ratings, noting that Discover Card provides some diversification benefits and an uncorrelated earnings stream that can offset periodic litigation charges and improves overall earnings stability. Nonetheless, Discover has lost market share recently due to consolidation amongst major card issuers and continued innovation in card and reward products for consumers, it observed.

Increasing consumer acceptance, growing share and strengthening returns on receivables will remain a challenge for Discover in Moody’s opinion. Morgan Stanley’s management has decided to retain Discover, but retaining or divesting Discover is neutral for ratings at this point.

In discussing what could affect the ratings in the future, Moody’s said that the capital intensity of the securities industry is rising. This results from greater litigation risks, more principal risk-taking and ongoing margin compression in liquid products. This means that it is unlikely that ratings for Morgan Stanley could move up in the future. Alternatively, a decrease in Morgan Stanley’s liquidity or an increase in its earnings volatility, possibly as a result of increased position taking in less liquid instruments, could lead to downward pressure on the firm’s ratings.