Let's Break Up Whichever Bank Is More Wrong About What Morgan Stanley Smith Barney Is Worth

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There's been sort of an impromptu referendum on whether the big US universal banks should be smashed into itty-bitty pieces, and how itty-bitty, and which ones should be smashed first, and for some reason the leading contenders seem to be Citi and Morgan Stanley. Those two seem uninterested in that free advice, though, since they're now hagglingover the price of Morgan Stanley Smith Barney, the joint venture that is slowly migrating from Citi's bloated clutches into Morgan Stanley's also apparently bloated clutches. Whee.

Morgan Stanley owns 51% of this wealth management venture, while Citi owns 49%, and MS is looking to exercise an option to buy 14% more at a contentiously negotiated price. Citi carries MSSB on its books at a $22bn valuation and wants Morgan Stanley to pay a bit more than that to buy another chunk of it, while Morgan Stanley carries it at something like a $14bn valuation and wants to pay $9bn for it.* I submit to you that that bid/ask spread is not well calculated to make you feel good about (1) the intellectual rigor and independence of Citi's and/or Morgan Stanley's investment banking valuation work or (2) the balance sheet transparency of major banks. Thing (1) is I guess why the parties hired Perella Weinberg to be their neutral appraiser.** Thing (2) sparked Citi to put out an 8-K last week saying "oh btw we might have a huge hit to earnings when we mark down our 'reasonable and supportable' $22bn valuation to whatever Perella Weinberg finds," which would not be great for earnings or Basel I capital or general confidence in Citi.***

That said I liked this approach to valuation:

Executives from Morgan Stanley Smith Barney will give an overview of the business to Perella Weinberg in a meeting Thursday at Morgan Stanley’s offices in Purchase, N.Y., said people who had been briefed on the talks but were not authorized to speak on the record because the discussions were private.

Officials from Citigroup and Morgan Stanley will also attend the first meeting with the appraisers, these people said. Representatives for both companies declined to comment on the meeting.

Then, next week, Citigroup and Morgan Stanley will separately make their cases to Perella Weinberg.

So let's say you are a senior person at Morgan Stanley Smith Barney. Sometimes you meet with your current quasi-bosses / future total bosses at Morgan Stanley and they ask you casually "so, how's the business look for next year?" Your natural instinct is optimism is it not? Telling your bosses that you're going to grow the business rapidly is a good way to get, y'know, paid, and also to get resources to actually grow the business etc. Telling your bosses "meh, we'll underperform our comps by a ton" is a good way to not be a senior person at MSSB any more.

But then the next day you're hauled in front of Perella Weinberg and asked how the business looks for next year, with MS and Citi officials sitting behind the Perella Weinberg people signalling frantically at you. What are they signalling? At a guess the Morgan Stanley boss who yesterday was thrilled to hear about your plans to grow the business would now be really happy to hear you talk about how clients are fleeing in droves and next year you'll be lucky if you can find any retail clients to stuff with overpriced IPO stock.

If Morgan Stanley Smith Barney were an independent publicly traded wealth management company, its value would be determined by public shareholders buying and selling its stock. Its value would also be around $11bn. (Maybe?****) Since it's not an independent publicly traded company, its value is somewhere between zero-ish (with Morgan Stanley trading at around half of its $54bn tangible book value, you could in theory buy all of MS, sell off its securities portfolio and stuff, and end up with its MSSB stake for free*****) and $22bn-ish. Because some people have incentives to undervalue it, and other people have incentives to overvalue it, and none of them have any incentives whatsoever to come together.

This is a common problem of bank balance sheets: if there's no directly on point market price, your valuation discretion is often wide and your biases often point you in one direction or another. If you want an honest result, it's good if some biases point you up and some point you down and maybe you roughly meet in the middle. (This is why it's often a good thing for tax and GAAP accounting to mostly converge.) MSSB execs are in the awkward position of wanting to impress their bosses with their optimism, while also wanting to save their bosses money with their pessimism. That's as good a way as any to get an honest assessment of MSSB's value. Well, except for spinning it off to the public markets as an independent business. But why would anyone want to do that?

In Spat Between Citigroup and Morgan Stanley, Appraisers Are Called In [DealBook]
Citi could get burned by its sunny brokerage appraisal [Reuters]

* Numbers are for the whole thing. Citi's valuation is explicit, MS's is not - DealBook estimates it at $10-$14bn; Goldman in a research note last week estimated it at $15bn. That makes their $9bn bid look awkward for them too; Goldman adds that "While MS doesn’t disclose their carrying value, we previously estimated it closer to $15bn which raises the question of why MS hasn’t marked down the value of C’s minority interest. We believe this is largely because a write-down of C’s minority interest is actually capital accretive for MS (i.e., they get the same assets at a lower price), implying that if their valuation is correct their accounting is conservative rather than aggressive."

** Why Perella Weinberg and not, like, Goldman Sachs? It's obviously stupid to say "because classic-investment-banking-only boutiques like Perella Weinberg are better at valuation than universal banks like Citi, MS, and GS, as witnessed by Citi & MS's 100+% valuation gap." But! The actual answer is pretty clearly "because it would be fucking bonkers for MSSB to invite Goldman (or BAML, or another competing wealth-manager-investment-banker-megabank) in to look at its business, and you couldn't trust their valuation because they might have ulterior motives in making wealth-management businesses look more valuable or making MSSB look less valuable or whatever." And another way of saying that is "because the universal banks are often really conflicted in their investment banking business." Break up the banks! etc. etc.

*** Remember how fun it was when JPMorgan disclosed that they had been carrying their $100bn synthetic credit portfolio at ~$500mm (0.5%) above its true value? Are you excited for when Citi maybe discloses that it was carrying MSSB at, y'know, 100% above its true value?

**** Goldman research again:

They also do a DCF with a ~$15bn valuation at a 10% WACC / 7% earnings growth rate. To be fair are Stifel Financial and Raymond James good comps for a firm with not one but two of the most famous names in retail financial advice? I dunno, are they?

***** But don't try that.

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