Jan. 14 (Bloomberg) -- Morgan Stanley’s joint venture with Citigroup Inc.’s Smith Barney will create the biggest group of financial advisers at a time when some investors and brokers are seeking independence from Wall Street titans.

The venture, which New York-based Morgan Stanley will control with a 51 percent stake, would employ 20,390 brokers in more than 1,000 branches. The new entity would surpass the 16,000-strong “thundering herd” of brokers at Merrill Lynch & Co., which was acquired by Bank of America Corp. on Jan. 2.

“Brokerage is such a personal, intimate business that it’s defied by the ‘thundering herd’ concept,” said Arthur Levitt, a senior adviser to the Carlyle Group and former chairman of the U.S. Securities and Exchange Commission who serves on the board of Bloomberg LP. “What we’re going to see in the brokerage business is breakaways from these managed institutions and the beginnings once more of boutique brokerage firms.”

Morgan Stanley Chief Executive Officer John Mack may face hurdles in retaining brokers and their clients after the worst financial crisis since the Great Depression undermined faith in the biggest brokerages. A poll of millionaires in November by Spectrem Group found that more of them had a negative opinion of banks and brokers than of independent financial planners.

Morgan Stanley and Citigroup, which is led by CEO Vikram Pandit, announced the venture yesterday. Morgan Stanley, which was the second-biggest U.S. securities firm before converting to a bank holding company in September, will pay Citigroup $2.7 billion for control of the new company. It has an option to increase its stake after three years and to take full control after five years.

Retaining Brokers

The venture, to be overseen by Morgan Stanley Co-President James Gorman and managed by Citigroup’s global wealth management chief Charles Johnston, will cut expenses by $1.1 billion and retain brokers with competitive bonus packages, the companies said.

“Will there be financial-adviser attrition? That’s possible,” Gorman told analysts and investors on a conference call yesterday. “It’s obviously a hot recruiting market out there” he said, adding that a good cultural fit and the retention packages may forestall “excessive” attrition.

Spectrem Group, a Chicago-based consultant and research company for financial companies, conducted focus groups of people worth more than $1 million and did an online poll of more than 750 millionaires in November. The research found that the millionaires had lost 30 percent to 40 percent of their net worth since September and that they had lost faith in their advisers, especially those at bigger firms.

Angry Investors

“Full-service brokerage firms were the firms whose investors were the most angry and had the lowest performance levels, they were the most likely to say they’re unhappy with their adviser,” said Catherine McBreen, a managing director at Spectrem. “They feel that the full-service brokerage firms, as opposed to the independent financial planning firms, are more in it for the commissions, for the stock selection, for pushing product.”

Investor ire is more pronounced than it was during the last market decline in 2002 and 2003, Spectrem’s McBreen said.

“We did see a lot of people changing advisers but we didn’t see the anger that we see now and the lack of confidence, this distrust,” she said.

Citigroup and Morgan Stanley are among the U.S. financial companies that have suffered losses in the credit crisis and taken government investments. Citigroup, which has received $45 billion from the U.S. Treasury and guarantees on $306 billion of toxic assets, is considering a broader reorganization that may entail exiting businesses, according to people familiar with the plan. It is expected to post a fifth consecutive quarter of losses, according to 14 analysts surveyed by Bloomberg.

Raising Capital

Morgan Stanley, which has taken about $21 billion of writedowns and trading losses, has raised money from the Chinese government, the biggest bank in Japan and took $10 billion from the U.S. Treasury in October. All three of the firm’s biggest divisions lost money in the three months that ended in November and the company had its smallest annual profit in 13 years.

Executives at smaller brokerage firms that haven’t been saddled by billions in credit writedowns and trading losses said they expect to benefit from the shakeup in the industry.

“We’ve had a steady stream of interviews and people joining or pledging to join -- this week alone we’ll have two or three brokers joining us,” said Edward Wedbush, chief executive officer of Wedbush Morgan Securities, a closely held investment bank in Los Angeles, California. “People are looking for continuity, they’re looking for financial stability.”

Revenue

While Morgan Stanley and Smith Barney aim to cut costs by eliminating overlapping expenses and those brokers who are the least productive, the combined firms may find it difficult to grow revenue because the market’s decline will make clients more conservative, cutting into trading commissions. Fee income will also be lower because clients are taking out money and their assets have dropped with the market.

“The luster has come off,” said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York. “The real challenge to this is going to be what percentage of the client assets can you retain from the merger? The relationship of individual investors is more to their broker than it is to the company that the broker works for.”

In the fourth quarter that ended in November, Morgan Stanley’s client assets in fee-based accounts dropped 25 percent from a year earlier.

Prospects for Growth

“I do question the growth of the retail brokerage business as a going-forward business,” said George Ball, chairman of Sanders Morris Harris Group Inc. in Houston. “It is a business that depends on product sales and commission business that’s apt to be tilting downward rather than being a real growth business in the future.”

Gorman acknowledged yesterday that the industry is likely to face a difficult period in the near future, although he said he still likes the business’s long-term prospects.

“If you’d define strategy based on what’s going to happen in the near future you wouldn’t try to run 10,000-, 20,000-, 30,000-person organizations,” Gorman said. “But these things come back, people don’t want to stop investing over the long haul.”

One benefit to the new venture may be the scandal surrounding Bernard L. Madoff, whose closely held firm is alleged to have defrauded investors of as much as $50 billion. The losses may persuade investors that the advantages of a large firm outweigh the drawbacks.

Investors “felt the government would never let a large organization fail and so they feel like there will be more protection there,” said Spectrem’s McBreen. “They want to go to a place where they feel they’re important and people know who they are, but they don’t feel that even the smaller banks are safe.”

To contact the reporter on this story: Christine Harper in New York at charper@bloomberg.net.

Last Updated: January 14, 2009 00:00 EST