Making Sense of Morgan Stanley's Derivatives Moves As regulators and lawmakers take a closer look at derivatives, Morgan Stanley is trying to figure out what to do with $50 trillion of such financial instruments. Some of the biggest players in derivatives, including JPMorgan Chase and Citigroup, have long warehoused nearly all of their derivatives in bank subsidiaries that rely on federally insured deposits to fund themselves. Morgan Stanley does not - and it could weigh on profits in an already lackluster environment. Taxpayer-backed funding is the main reason these bank subsidiaries have higher credit ratings than the financial firms that own them. The banks" derivatives customers typically prefer to deal with entities that have higher credit ratings. So by placing the derivatives in such subsidiaries, the parent banks have been able to get more advantageous terms on nearly all the derivatives trades they make with their customers. JPMorgan Chase locates 99 percent of its derivatives at an insured bank, according to bank regulatory data. The figure for Goldman Sachs is 92 percent. In stark contrast, Morgan Stanley has a mere 5 percent of its $50 trillion of derivatives at its insured bank, which has a higher credit rating than the parent company. The reason the figure is so much lower at Morgan Stanley than at Goldman, its chief rival, goes back to the 2008 financial crisis. At the time, both firms converted into bank holding companies to take advantage of bailout money from the Federal Reserve. As part of that move, the Fed granted extraordinary exemptions that allowed both firms to transfer assets into the insured bank subsidiaries. Goldman used the moment to transfer vast amounts of its derivatives. Morgan Stanley did not. The decision has left Morgan Stanley particularly exposed as it faces the threat of a big downgrade of its credit rating. Moody's Investors Service said in February that, as part of a review of the ratings of many large banks, Morgan Stanley's rating could be cut by as much as three notches. Moody's said it could announce its decision sometime this month. If that happens, the bank's derivatives customers may decide to reduce business with Morgan Stanley, and some may be forced to exit deals because of ratings-downgrade clauses in their contracts. In that case, earnings could get crimped at Morgan Stanley, which has the third-highest amount of derivatives among United States banks, after JPMorgan and Bank of America. Morgan Stanley could protect itself ahead by shifting all its derivatives into the insured bank, which has a higher credit rating. But large transfers are supposedly prevented by regulations that aim to stop financial firms from exploiting the taxpayer subsidy enjoyed by insured banks. In particular, transactions between an insured bank and an affiliated entity cannot exceed 10 to 20 percent of the bank's capital, unless regulators grant an exemption. That means Morgan Stanley cannot shift derivatives valued at more than $2.1 billion, which is 20 percent of the bank's $10.5 billion of capital. But a loophole may exist for banks. The critical question for regulators is how to value the derivatives that a bank wants to transfer. In short, if the derivatives can somehow be measured in a way that minimizes their value, financial firms would be able to shift more of them without bumping up against the limits. Laws limiting derivatives transfers were tightened by the Dodd-Frank financial overhaul legislation, but the new rules did not resolve how to calculate the size of derivatives transfers, said Saule T. Omarova, an assistant professor at University of North Carolina's School of Law. "That's the black box that each institution has," she said. Since the end of 2010, the amount of derivatives at Morgan Stanley's bank has grown by $2.2 trillion, on a so-called notional basis. The increase appears to be the result of transfers, not the insured bank writing new business. Earlier this year, Morgan Stanley's chief financial officer, Ruth Porat, said the firm had a plan to move more derivatives into its bank, adding that it had started doing this with foreign-exchange-related derivatives. It was precisely this type of derivative that accounted for the $2.2 trillion increase in derivatives at the insured bank. How could Morgan Stanley apparently have transferred some $2.2 trillion of derivatives and stayed below its $2 billion maximum threshold? It would seem to be a wide gap. But analysts, quite reasonably, argue that notional measurements vastly overstate the value of derivatives. Instead, they say, derivatives should be measured using something called fair value, an accounting term that means either the actual or estimated value the derivatives would fetch in the market. Even so, such an approach can swing wildly, making fair value a imprecise metric for regulators to use. In the fourth quarter, some of the foreign exchange derivatives at Morgan Stanley's bank had a positive fair value of $30.8 billion, and some had a negative fair value of $24.4 billion, according to the bank's regulatory filings. Subtracting negative from positive gives a net positive fair value of $6.4 billion, well above the putative $2 billion transfer cap. But in the first quarter, the net fair value of those derivatives was just $6 million, underscoring how unreliable fair value may be for measuring derivatives for the purpose of transfers. Last fall, when Bank of America attempted to shift some derivatives into an insured bank, a group of lawmakers, including Senator Sherrod Brown, Democrat of Ohio, protested and asked bank regulators to clarify their positions on the transfers. Morgan Stanley's moves may attract similar scrutiny in Congress. Senator Brown said on Wednesday that he was going to look into Morgan Stanley's moves and any associated regulatory responses. "American taxpayers should not have to pay for risky Wall Street practices," he said.