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Morgan Stanley Heeding Frenemies' Advice About Trading Less, Better

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Here's an interesting set of slides that Morgan Stanley CFO Ruth Porat presented at the Barclays conference today. For some reason this one struck me:

Morgan Stanley: basically a mutual fund! Half a mutual fund. Really barely at all an investment bank, which I guess is the way of the world for investment banks, but still sort of stark to see it there in black and white, er, navy and yellow. And Morgan Stanley will be shifting even more toward wealth/asset managing after today's hotly negotiated purchase of Morgan Stanley Smith Barney.1 As Reuters puts it:

For Morgan Stanley, buying more of the brokerage is part of a strategy to become less reliant on the volatile securities trading business and the investment banking business, which has been in a long rut.

I'll leave investment banking in that rut - and that 11% of revenues - but let's talk about that volatile securities trading business a bit. Yesterday brought a GS research note suggesting that Morgan Stanley could shrink the amount of balance sheet it devotes to FICC trading while still making almost as much money in FICC trading, because certain physical laws have been suspended and it no longer takes money to make money, at least not in FICC. That seems to be Morgan Stanley's idea as well, with slide 17 detailing a plan involving:

  • Reduce capital in assets that are not accretive to future revenue growth
  • Act as rapidly as possible while acknowledging market limitations and client relationships
  • Consider returns in each sub-business in context of adjacencies, size and scale

I like the first one - "stop putting all our money in things that lose us money" - and it seems to have paid off; the next slide is "Case Study: Securitized Products Balance Sheet and Revenues." I will non-expertly hypothesize that this is a cherry-picked case study of a product area where more balance sheet in recent years has meant more negative revenues but anyway go ahead Morgan Stanley:

Imagine a counterfactual universe where regulators, creditors, shareholders, etc. didn't care about balance sheet or capital: would Morgan Stanley have made the choice to reduce securitization balance sheet and increase revenues? I feel like that would be an interesting question to answer.2

One thing that looks increasingly unlikely in a post-Dodd-Frank-Volcker-what-have-you world is a return to the old-school standalone investment-banking-and-trading businesses; the legacy bank-n-trade firms are slimming down bits of their banking-n-trading but also bulking up complementary businesses like retail banking or asset management or whatever. (Ex Goldman, which makes like 80% of its money on banking and trading, but everyone will assume Goldman is hiding a giant hedge fund somewhere even if it actually isn't.) You could ponder a variety of unsavory explanations for that; one goes in cynical outline:

  • "investment banks"3 can't cover their cost of capital and so need to be subsidized by the cheap funding of deposits and/or captive audiences of retail brokerage, while
  • "investment banks" provide value to bankers who sit on retail deposits and/or brokerage accounts by allowing them to (1) gamble those deposits and/or (2) cross-sell terrible investment banking products to the retail investors.

Is that right? Meh, probably not. Still, as a rule of thumb, it might be a good idea not to celebrate Morgan Stanley's shrinking reliance on risking its own balance sheet to create revenues, until you figure out whose balance sheet MS is now risking to create (bigger!) revenues.

Ruth Porat presentation, 2012 Barclays Global Financial Services Conference [Morgan Stanley]
Morgan Stanley, Citigroup settle brokerage dispute [Reuters]
Morgan Stanley's MSSB 8-K and joint press release [EDGAR]

1.Uhhh so let's talk about that purchase price? MS (current 51% owner) is buying 14% from Citi (current 49% owner) today, with forwards/options to buy the remaining 35% between now and 2015, at a price equivalent to a $13.5bn valuation for the whole thing - vs. MS's $9-ish billion and Citi's $23-ish billion valuations. Random thoughts:

  • Perella Weinberg was brought in as a valuation agent in terrorem but ended up not doing any actual valuating. Do you think they still got paid?
  • I submit to you that even the $13.5 billion stated price of MSSB rather overstates matters, since Morgan Stanley basically gets an interest-free loan to buy most of it between now and 2015 at the same valuation, whenever it can get around to raising the cash. (Actually it's part loan and part call option; MS has to try to get in 15% more at the $13.5bn valuation, but can dawdle on the rest, and if it doesn't buy it by June 2015 Citi can put it to MS but at the [presumably lower, if MS hasn't bought!] then-fair market value, not at the $13.5bn, so maybe Perella Weinberg will earn its keep.)
  • But I guess that makes sense? Consider that (1) Citi 5-year CDS is ~183, MS is ~260 and (2) Citi price/book is 0.52, MS is 0.56. So it's more expensive for Morgan Stanley to raise a dollar than for Citi to do so, but a dollar in Morgan Stanley's hands is worth 4 cents more than a dollar in Citi's hands. (Neither is worth a dollar!) Ergo, Citi using its balance sheet to give Morgan Stanley free funding for MSSB is a brilliant arbitrage. Except for Citi. I dunno, thoughts?

2.Another good one is how broadly applicable is this lesson of "just drastically slash balance sheet in a product area and you'll make more money trading it"; both are left as exercises for the reader.

3.Stupid quotes just for, like "investment bank" = "thing that does investment banking and sales & trading and not so much asset management or commercial banking or what have you." As opposed to "investment banking" a ways above, which was just "investment banking."