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Back on June 11th, we examined the financial health of Morgan Stanley (MS) and asked the question: could it be the next Lehman Brothers? There were several important metrics on the table: the pending (and eventual) downgrade of the firm’s debt (two notches), the current level for credit default swaps (407 basis points on 6/11) and overall exposure to the Eurozone crisis.

Since then, the default swap levels have subsided to 364 basis points as of last Friday, but concerns over Europe have grown. That’s been reflected in the stock price of Morgan Stanley, which has fallen 9.2% or $1.26 since June 11th. It remains the most exposed US bank to the contagion taking place in the Eurozone. Each week, as Spain, Greece and Italy see their bailout needs increase, the aftereffects on Morgan Stanley are clear as investors sell off the stock.

Counterparty perception risk at Morgan Stanley is our chief concern. As perceptions that Morgan is vulnerable grow, as reflected in its stock price, counterparties can, and do, respond to that by dialing back their exposure (their level of business activity) to the firm. This can create a vicious cycle where perception fuels reality.

Morgan Stanley: Decision Time  - MS TIMEBOMB

If shares move low enough, the lack of confidence could trigger the equivalent of an institutional bank run. This can continue until one Friday you have a bank and on Monday you have a bankruptcy (pardon the pun). All eyes are focused on Morgan Stanley at this point in time.

Even though the company’s liquidity and capital are much improved vs. 2008, the market is trading it as though there is no implicit US backstop. Further deterioration of the situation in Europe or in its core business lines could precipitate this counterparty perception risk.

The chart we’ve posted above really reflects the growing concerns associated with MS. The correlation between Europe’s banking crisis and Morgan Stanley is strong. We expect the stock will remain weak until the September 12 German Constitutional Court vote.

We remain bearish on Morgan Stanley across the TRADE (3 weeks or less) and TREND (3 months or less) durations.