Buried in a footnote1 a while back I ruminated on the fact that, in the deal where Morgan Stanley bought a chunk of its Morgan Stanley Smith Barney brokerage JV from Citigroup, Morgan Stanley got a sort-of-free option to buy the rest of Smith Barney, and how that option is (1) valuable and (2) sort of cheap funding. That was basically all wrong, sorry! The lesson is, never read footnotes.
Charlie Gasparino is reporting that “Morgan Stanley chief James Gorman is making a full-court press with regulators to expedite the purchase of the remaining piece of the Smith Barney brokerage firm from Citigroup, moving up the buyout date as much as two years ahead of schedule,” so I guess Gorman puts the time value of that option at zero or less. As for cheap funding, Goldman had a research note this week saying that they met with Morgan Stanley and heard the same story, and also that:
At the margin, full MSSB ownership should have a meaningful impact on ROE as: 1) MS is still paying Citigroup a portion of earnings from the JV despite holding capital to support the entire business, 2) synergies with the Institutional Securities business will grow (i.e. client flow routing), and 3) the funding profile and client product offering mix will improve.
I think the second two things say something like “Citi won’t appreciate us shoving all of our MSSB customers into high-margin Morgan Stanley products, so we have to get rid of them before doing that,” though you could read them otherwise. The first thing calls the cheap-funding argument into some doubt, though maybe not that much doubt; Morgan Stanley’s capital is by some metrics cheaper than Citi’s, while its (credit market) funding is more expensive, so maybe this is still a good deal.
Anyway here’s what Gasparino has to say about the delay:
One concern the Fed has is whether Morgan Stanley, the smallest of the big financial firms, has a large enough capital cushion to snap up the remaining piece of Smith Barney and remain compliant with new banking regulations such as Dodd Frank and the Basel agreement.
One isn’t-it-ironic-dontcha-think response here might be: well, since Citi took a huge hit to income and capital by writing down MSSB to the $13.5bn valuation at which MS is buying it, couldn’t MS have expedited the process by paying more? (That is, if it’s worth an extra $1 billion, then that gives MS an extra $510 million of capital, because it owned 51% of MSSB before this deal. At MS’s ~7% tangible equity to assets, that would support $7 billion more of purchase price.) But of course it doesn’t work that way, or it only half works that way. Here is Citi’s 8-K on the deal:
Citi expects the loss on sale and the impairment charge will impact its third quarter 2012 reported tangible book value and common equity by approximately $2.9 billion (based on the after-tax amount of the total charge). Further, the loss on sale and the impairment charge would have had a negative impact on Citi’s second quarter 2012 Basel 1 Tier 1 regulatory capital ratios of approximately 37 basis points (based on the pre-tax amount of the total charge). The impairment will not impact Citi’s estimated Basel III capital position; however, the sale of the 14% Interest to Morgan Stanley is expected to add approximately 14 basis points to Citi’s estimated Tier 1 Common regulatory capital ratio for Basel III capital purposes.
So that was super boring but the gist is: for Basel I, the valuation of MSSB matters for regulatory capital; for Basel III, it doesn’t.2 Which one applies? I feel like that is the wrong question, or that the answer is everything applies, as you can sort of tell by the fact that Morgan Stanley is discussing whether it has a “large enough capital cushion” with the Fed rather than just showing the Fed some math that shows that it does. A lower MSSB valuation reduces Citi’s capital, but a higher one doesn’t increase Morgan Stanley’s, because the working metric is kind of min(Basel I, Basel III). This means (1) that the MSSB transaction was in some sense net destructive of bank capital, which is kind of weird, and (2) that the Fed gets to do what it wants to increase systemic stability without worrying about Basel-whatever math.
Which I’m still not sure should hurt Gorman’s chances. Basically his argument here is “dear Fed, help Morgan Stanley transition from a risky FICC trading operation to a delightfully steady retail brokerage, while also helping Citi transition from a sprawling confused bank to a slightly smaller, slightly less confused bank with a bit more cash.” That … seems like a good systemic-stability pitch, no?
Morgan Stanley CEO Working to Speed Up Smith Barney Purchase [FBN]
1. LOOK AT THAT DIRECT LINK. That’s service.
2. See also page 18 here if you’re interested.