Jan. 26 (Bloomberg) -- It was early September, and the Standard & Poor’s 500 Index was down 15 percent for the year. The credit squeeze was grinding on. Deals were few. Morgan Stanley’s John Mack, a chief executive officer who loves a prank, sent three of his deputies small, gray electronic blood pressure machines with Velcro wristbands.

He had no idea how much they’d use the devices. For the next six weeks, Morgan Stanley, the securities firm carved from J.P. Morgan & Co. in the depths of the Great Depression, was hammered so hard that Mack and his executives were left gasping for air. On Sept. 26, with the bank’s shares down 39 percent for the month, Chief Administrative Officer Thomas Nides was so alarmed by his blood pressure reading that he raced to a hospital. It was a panic attack.

Morgan Stanley is still in business. That’s something after the colossal failures in 2008 of Lehman Brothers Holdings Inc.’s Richard Fuld and Bear Stearns Cos.’ James Cayne, Mack’s rivals for almost four decades. After Lehman’s bankruptcy and Merrill Lynch & Co.’s hasty sale to Bank of America Corp. in mid- September, Mack had to hustle. He persuaded government officials to suspend the short selling he said was sending his firm’s shares into a free fall and sold 21 percent of the bank to Japan’s Mitsubishi UFJ Financial Group Inc. He was first to sign up when U.S. Treasury Secretary Henry Paulson injected $125 billion into nine banks, $10 billion of it into Morgan Stanley.

Less Risk

Together with Goldman Sachs Group Inc. CEO Lloyd Blankfein, Mack also shut the door on the Wall Street he had always known, seeking safe harbor as a Federal Reserve-supported bank holding company. On Jan. 13, he stepped deeper into the retail business, paying $2.7 billion to take control of Citigroup Inc.’s Smith Barney brokerage and create the world’s biggest team of financial advisers.

Morgan Stanley’s future now lies with Mack’s gamble to reinvent his bank as a company that takes less risk, helps thousands of individuals with their investments and waits for clients to once again seek advice on mergers and raising capital. It’s a far cry from two years ago, when global markets were close to setting records and Mack, a grocer’s son from Mooresville, North Carolina, with a hot temper and a locker room motivational style, personified the swagger of Wall Street.

“It would be really nice to go back to the way things were, but that and the tooth fairy aren’t going to happen,” says Brian Barish, who oversees about $6 billion as president of Cambiar Investors LLC in Denver.

‘Busted Beyond Recognition’

“Enormous elements of the Wall Street model are busted beyond recognition. I’m not sure there’s anything Mack could do to make me buy their stock.” Barish sold about 2 million shares of Morgan Stanley in 2006 and hasn’t owned it since.

The autumn attack on Morgan Stanley -- with a run on the bank by hedge fund clients, a scramble to secure $9 billion from the Japanese and a 74 percent plunge in the share price over four weeks -- almost killed the company. Those weeks brought out in Mack what many who’ve worked with him say he does best: motivate the troops, attend to clients, cajole investors and draw on his government connections. What he didn’t reveal to employees were his doubts about whether the firm would survive.

“I said to my wife, when things were really crazy, ‘You know, there’s a chance I will lose this firm,’” Mack says in an interview in his 40th-floor midtown Manhattan office on a frigid January afternoon. “But I would rather be doing this than sitting on a beach reading a book.”

Bold Moves

Mack, wearing a checked shirt and a grass-green tie, looks younger than his 64 years. He is weary after a nine-day trip to Asia and Europe. Still, he’s heading to a vegetarian dinner with his wife, Christy, and Mehmet Oz, the heart surgeon, author of You: On a Diet (Free Press, 2006) and The Oprah Winfrey Show celebrity doctor.

He’s also facing what may be the most difficult challenge of his career: setting a strategic course for Morgan Stanley in a slimmed-down financial world -- and doing it in a way that lets him step back with his image intact. Morgan Stanley has no mandatory retirement age, although Mack’s approaching 65th birthday has the board, which he chairs, discussing who may take over as CEO, he says.

Mack has struggled with bold strategic moves before. In 1997, as president during a previous stint at Morgan Stanley, he captained a merger with Dean Witter Discover & Co., only to help create a culture clash that wounded the bank for almost a decade and led to his departure in 2001.

That same year, he took over Credit Suisse First Boston, the global securities unit of Zurich-based Credit Suisse Group AG, where he eliminated 10,000 jobs, settled legal problems and was asked to leave after three years, partly because his brash manner alienated board members, according to people familiar with the events. In 2006, back at Morgan Stanley, he oversaw a 52 percent jump in trading risk and bought mortgage companies at the peak of a housing market that has since crashed.

Head Winds

The economic head winds are fierce. With the world in what may be the worst economic crisis since the Great Depression, some investors doubt that anyone can rehabilitate Morgan Stanley. The company lost $2.2 billion in the three months that ended on Nov. 30, and business contracted in each of its three divisions: institutional services, asset management and global wealth management. Moody’s Investors Service cut Morgan Stanley’s credit rating on Dec. 17 to A2, its lowest level in at least 16 years. The bank’s shares closed 2008 down 70 percent; they gained 17 percent this year through Jan. 23.

So far, Mack is paring his business to save at least $2 billion a year. He has fired 9,000 of the firm’s 48,000 employees; cut back in prime brokerage, proprietary trading and commercial real estate; and trimmed the balance sheet from more than $1 trillion at the start of 2008 to $658 billion as of Nov. 30.

Buying Smith Barney

Since the third quarter of 2007, Morgan Stanley has written down about $20 billion in bad assets and raised a total of $24.6 billion in capital. The firm lifted its average cash balance to $175 billion, almost triple the $64 billion it held in February 2007.

Mack’s decision to buy a controlling stake in Smith Barney and pursue a retail strategy creates a division of the company that will have 20,390 brokers, 1,006 branch offices and $1.7 trillion in client assets. That’s up from 8,426 brokers and $707 billion in client assets now. The deal, which won’t be completed until July at the earliest, expands the empire of Co-President James Gorman, 50, whom Mack hired away from Merrill in 2005 to revamp wealth management and is now a leading candidate to succeed him.

It’s also a different strategy from Goldman Sachs, Morgan Stanley’s closest competitor, where Blankfein said in November that he doesn’t plan to deviate from the firm’s business of making markets, offering advice and managing money.

‘Gold Mine’

Gorman, who grew up in Melbourne and is a former senior partner at McKinsey & Co., says adding financial advisers is wise for Morgan Stanley, partly because it doesn’t require much capital. He knows joint ventures are hard to pull off.

“Will it be easy? No, it won’t,” Gorman says. “But we are only in the first days.”

Brad Hintz, an analyst at Sanford C. Bernstein & Co., says blending the two brokerage systems may take three years. With competitors offering lucrative contracts to top talent, Gorman will have to pay up to retain brokers and the client assets they control. Hintz also says many individual investors are fed up with big banks and are starting to look for independent financial advisers. “But if it’s executed correctly, this could be a gold mine for Morgan Stanley,” he says, because the business is capable of producing 25 percent profit margins.

Some investors say Morgan Stanley and Goldman Sachs, both chastened by the credit freeze, are biding their time until companies start raising money and doing deals again.

Plunging ROE

“It’s not a surprise that people are chasing stability -- until the institutional side comes roaring back,” says Michael Vogelzang, president of Boston Advisors LLC in Boston, which manages $1.6 billion. “Then they’ll drop everything and chase that. It’s the way of the business.”

Mack says trading profit won’t ever hit the heights of 2006 and ‘07, when, with leverage of as much as 33 times, Morgan Stanley’s return on equity topped 23 percent. In institutional securities, including investment banking and trading, it rose as high as 30 percent. Last year, as global markets plunged, the bank cut leverage to 12.9 times, and ROE dropped to 4.9 percent. Return on equity is a measure of how well a firm uses earnings to generate more earnings.

“There are a lot of ways to skin the cat to get higher returns,” Mack says. That’s why the firm is making investments in brokerage and asset management, which tend to generate more- consistent returns on equity than trading or banking. Still, that doesn’t always play out. In 2008, asset management lost money because of drops in the value of real estate and private equity investments.

Bank Holding Company

Retail brokerage has another advantage: It requires little borrowed money. As a bank holding company, Morgan Stanley will have to limit its leverage, a measure of how much it depends on debt funding. Chief Financial Officer Colm Kelleher, 51, says the firm will operate with leverage of 14-20 times, which means total assets will remain below 20 times shareholder equity. Access to Fed financing gives Morgan Stanley a reprieve from funding concerns, he says.

Over the next two years, Kelleher plans to reduce the firm’s dependence on short-term borrowing from 67 percent of its liabilities at the end of August to less than 50 percent.

Morgan Stanley’s demise as a lightly regulated broker-dealer that bet billions in borrowed money was a shock to veteran executives. Their lifeblood -- the ability to raise money in the capital markets -- ran dry after one weekend in September.

The drama began when Mack and Kelleher were summoned to a 6 p.m. meeting at the New York Fed on Friday, Sept. 12.

Fed Meetings

The two sped through the rain to lower Manhattan and stepped into a high-ceilinged room filling up with Wall Street’s top dogs: Goldman’s Blankfein, Merrill CEO John Thain, Citigroup CEO Vikram Pandit, JPMorgan Chase & Co. CEO Jamie Dimon and dozens more. Noticeably missing was Fuld from Lehman, the 158-year-old firm whose stock had plunged 77 percent that week.

Paulson, then Securities and Exchange Commission Chairman Christopher Cox and Timothy Geithner, head of the New York Fed and now President Barack Obama’s nominee for Treasury Secretary, passed out copies of Lehman’s balance sheet. They made it clear they wanted a private solution to bail out the firm before the weekend was over.

Mack and Kelleher drove back to Morgan Stanley at about 8:30 p.m., picking up take-out Italian food on the way. They grabbed co-presidents Gorman and Walid Chammah, 54, who had aborted a trip to a wedding in Dallas, and sat down in Mack’s office.

Chammah’s Couch

“We met until the wee hours of the morning,” Gorman says. “We thought, ‘My god, this was a crisis that really is threatening the heart and soul of Wall Street.’”

That night marked the start of the direst days in the history of Morgan Stanley -- a four-week period that tested Mack and his crew in a manner beyond anything they had imagined when the year, or their careers for that matter, began.

Chammah slept on the pale-brown leather couch in his office during at least two weekends while heading talks with Mitsubishi UFJ, which held meetings in Tokyo when it was 3 a.m. in New York. Kelleher suffered a back injury in a car accident and had to conduct business lying down on his office floor. He lost 14 pounds. Three managing directors, including Nides, went to hospitals after using Mack’s blood pressure monitors.

‘Organized Mayhem’

During what is now remembered as the Lehman weekend, Mack and Dimon led a discussion about what bank investors might lose faith in next. The list began with Merrill Lynch, the smallest of the three remaining Wall Street firms. On Saturday evening, Mack, Chammah and Gorman met with Thain and two other Merrill executives in Chammah’s Upper East Side apartment to talk about a possible merger. Thain said he wanted to announce a deal the next day, according to people familiar with the talks. Mack said he needed time to look at Merrill’s books and speak to his board. Thain turned around and sold his company to Bank of America.

By Sunday morning, Mack and his deputies had concluded that Morgan Stanley could afford to spend $1.5 billion to help digest Lehman’s bad assets.

“We were thinking, ‘We can do that and ride this out,’” recalls Kelleher, an Irishman who had been in the job for about a year. On a shelf in his office is a stuffed Eeyore, the dour donkey from the Winnie-the-Pooh stories, another gift from Mack, who was tweaking his CFO for being the bearer of bad news. “But, in the back of our minds,” Kelleher says, “we were thinking, ‘Is the broker-dealer model sustainable?’”

Just after noon on Sunday, the third day of meetings at the Fed, Paulson announced that a plan for London-based Barclays Plc to buy Lehman had been stymied by U.K. regulators. “Then, it was organized mayhem,” Kelleher says.

Lehman Bankruptcy

He turned to an executive beside him and asked if he’d ever buy an independent broker-dealer’s debt again, Kelleher says. The man shook his head no.

Later, Geithner asked Kelleher and Goldman CFO David Viniar, “Can you guys survive until next weekend?” They both said yes. “It seemed like Geithner just wanted to get through a week at a time,” Kelleher says.

At about 10 p.m. that night, Kelleher left Morgan Stanley headquarters, on the north end of Times Square, and observed Lehman workers carrying boxes out of their building on Seventh Avenue. “I thought, ‘I’m not going to have Morgan Stanley employees walking out of this building with a cardboard box,’” he says. “I mean, you may say these are fat-cat bankers, but these are real people. It was all very emotional.”

A few hours after midnight, Lehman filed for bankruptcy protection.

‘Run on the Bank’

Markets responded violently the next day. The S&P 500 dropped 4.7 percent, and the price of two-year U.S. Treasuries surged the most since the September 2001 terrorist attacks as investors fled to the safest and most-liquid investments.

Morgan Stanley, struggling to soothe investors after its stock fell to $28.70 a share, released third-quarter earnings early, on Sept. 16, to show $1.4 billion in profit. The following day, after the Fed said it was lending $85 billion to keep American International Group Inc. afloat, Morgan Stanley shares sank another 24 percent to $21.75. News was traveling fast that the bank might be the next to go.

“Wednesday was an absolute disaster,’” says Kelleher. “I don’t mind admitting it -- in prime brokerage, we had a run on the bank.”

The prime brokerage unit lends money and securities to hedge funds. When some funds learned that money they had parked at Lehman was now frozen in legal proceedings, they decided to pull cash and assets from Morgan Stanley.

Darth Vader

The firm, drawing on the $178 billion it had set aside for just such an emergency, was able to pay every client who asked, Kelleher says. It limited client access to so-called excess margin, a service in which it lends money against other assets held at the firm.

“We realized in prime brokerage that we were effectively running an ATM,” he says.

The next day, Mack held a town hall meeting with bank employees, his second of the week. He spoke quickly. “We are in a market today where rumor and innuendo are much more powerful than real results,” he said. “The issue is how do you get through chaos? This is chaos. It pains me to go on the floor and see how you guys look.”

Mack, whose nicknames over the years have included Darth Vader, is known for furious outbursts. Yet throughout the crisis, he was even keeled, say executives and other employees who observed him. He walked the trading floors, ate pizza with salespeople and stopped in at client meetings in an effort to keep his staff calm and working. He delivered pep talks, saying Morgan Stanley was in battle mode.

Raising Capital

He also reached outside the firm. Mack called Cox and New York senators Charles Schumer and Hillary Clinton and helped initiate a two-week SEC ban on short selling.

It wasn’t enough. After watching what happened to Lehman and Merrill, Mack knew the only way to regain the market’s confidence was to raise new capital or pursue a merger, according to people familiar with the events. He couldn’t just assure investors the firm had enough money; he had to show he could find a partner who had enough faith in the firm to team up.

Mack talked to Pandit about a deal with Citigroup, entered merger talks with Wachovia Corp. CEO Robert Steel and asked Gao Xiqing, vice chairman of China Investment Corp., the Chinese sovereign wealth fund that had invested $5.6 billion in Morgan Stanley the previous year, to come to New York. He even arranged for a couch to be moved from the Morgan Stanley dining room to the executive suite and brought in a physical therapist for Gao, who has a bad back.

Sushi, Mitsubishi

By the end of the week, the stock had declined 27 percent and no deal was obvious. Kelleher walked across the street for dinner at a restaurant called Blue Fin. He was eating sushi when he got a call from Jonathan Kindred, president of Morgan Stanley’s business in Tokyo. Mitsubishi UFJ, Japan’s biggest bank, was interested in buying a piece of the firm.

The news was unexpected. Three days earlier, Ryosuke Tamakoshi, Mitsubishi UFJ’s chairman, told a conference in Tokyo that his bank wouldn’t make further investments in U.S. financial institutions in the wake of Lehman’s collapse. Mitsubishi was already paying $3.5 billion to take full control of San Francisco-based UnionBanCal Corp., a consumer bank, in a deal reached in August that was awaiting U.S. regulatory approval. Kelleher asked whether the Japanese could move fast enough. Yes, Kindred said, they knew they had to.

Lifeline for Mack

For a second weekend, lights were ablaze at 2 a.m. in Morgan Stanley’s executive suite. Bankers and lawyers were working on four projects: a merger with Wachovia, a second capital infusion from the Chinese, an investment from Mitsubishi UFJ and the paperwork to become a bank holding company.

Mitsubishi UFJ was a long shot. Mack already knew Wachovia’s Steel, a fellow Duke University alumnus, and CIC’s Gao. Mack didn’t have a relationship with Mitsubishi UFJ CEO Nobuo Kuroyanagi, who was half a world away.

As the weekend progressed, Morgan Stanley executives realized Mitsubishi UFJ was their best option. By Sunday night, following negotiations conducted over the phone with translators, Mitsubishi UFJ signed a letter of intent to buy 10-20 percent of Morgan Stanley. The same night, the Fed approved the firm’s request to become a bank holding company.

For Mitsubishi UFJ, it was an opportunity to buy a piece of a storied financial firm and gain a seat on the board as the Japanese bank was expanding in the U.S. For Mack, who met Kuroyanagi, 67, in Tokyo on Sept. 27, it was a lifeline. Two days later, the terms were announced: The Japanese bank would buy $3 billion of Morgan Stanley’s common stock for $25.25 apiece, as well as $6 billion of convertible preferred stock with a 10 percent dividend. They’d own a fifth of the firm.

Bank Bailout Bill

That same day, when Paulson’s first attempt to pass a $700 billion bank bailout bill was blocked in Congress, the S&P 500 plunged 8.8 percent, the most since 1987.

Morgan Stanley shares fell 15 percent. Mitsubishi UFJ’s pending purchase was already in the hole.

When the government’s financial rescue package finally became law on Oct. 3, it didn’t soothe Morgan Stanley investors, who feared that the Japanese bank might pull out. By Oct. 8, the two companies had assured investors the purchase would go through and the Fed had approved Mitsubishi’s application for UnionBanCal to become a bank holding company, a process that often takes up to three months. Morgan Stanley shares had fallen another 30 percent.

Mack held a town hall meeting in London. “It is clearly a panic,” he told employees watching on screens around the world.

Yom Kippur Pizza

Nides, the chief administrative officer, went home to Washington to observe Yom Kippur, the Jewish holiday, which began at sunset. The next day, while he was fasting, a Domino’s pizza was delivered to his door every hour for seven hours. Nides quickly figured out who had placed the order.

“It was classic,” he says. “Everyone is freaking out, and John is like, ‘You guys have got to lighten up.’”

Morgan Stanley stock collapsed that day and the next, after Moody’s threatened to downgrade the firm’s credit rating. The stock closed on Oct. 10 at $9.68, the lowest since 1996. Mitsubishi UFJ faced a paper loss of more than $1.8 billion, and it was clear the deal would have to be renegotiated by Monday morning.

“It was becoming a crisis of confidence,” says Nides. “We had plenty of money, plenty of liquidity, but it was a spiraling effect. The stock price goes down, clients stop doing business with you.”

Paulson Calls

Morgan Stanley wasn’t alone in trying to hold itself together. Mack was in regular contact with Geithner and Paulson, who he says regarded Morgan Stanley’s survival as important to the financial system.

“Everybody was involved at this stage,” Kelleher says. “Government, regulators, everybody.”

On Oct. 10, the same day the shares hit their low point, Mitsubishi UFJ’s Kuroyanagi was meeting with members of the Fed’s board of governors in Washington, receiving assurances that if the government injected capital into Morgan Stanley, his bank’s equity investment wouldn’t be wiped out. Spokespeople for Mitsubishi UFJ in Tokyo and the Fed declined to comment.

Chammah and Kelleher worked through the weekend, fueled by take-out food from Baldoria, a theater-district restaurant. On Sunday, Mack and Gorman were in Washington for International Monetary Fund meetings and went to a cocktail party hosted by Mitsubishi UFJ. On the way back to the airport, Mack got a call from Paulson to meet at the Treasury the next day. Paulson, a Wall Street competitor of Mack’s when he ran Goldman Sachs from 1999 to 2006, wouldn’t elaborate.

$9 Billion Check

Before the stock market opened in New York the next day, Mitsubishi UFJ had a new deal. The Japanese bank would get preferred stock instead of the common stock that was already underwater, raking in an extra $300 million in annual dividends.

There was still one stumbling block: Because Monday, Oct. 13, was a bank holiday in both the U.S. and Japan, the money couldn’t be wired. Instead, unwilling to risk what would happen to Morgan Stanley’s stock if it waited one more day, Mitsubishi UFJ hand delivered a paper check for $9 billion on Monday morning.

Nides and Kelleher both now have framed photocopies of the check in their offices.

“I can’t even begin to describe it,” Nides says of the weekend negotiations. “It was incredibly intense.”

Hours after receiving the check from Mitsubishi, Morgan Stanley got an even bigger one from Paulson. The meeting Mack had been summoned to, with eight other CEOs, was to announce that the government would make investments in the nation’s biggest banks. Morgan Stanley’s cut was $10 billion.

‘The Abyss’

The combined $19 billion -- and the message to the markets that Morgan Stanley could pull together an investment in the toughest of circumstances -- saved the firm. The stock price more than doubled in two days, trading at $21.94 on Oct. 14. Kelleher says Morgan Stanley’s near-death experience forged a bond among the executives involved.

“We have looked into the abyss,” he says.

It was from another abyss that Morgan Stanley was born in 1935. President Franklin D. Roosevelt was struggling to manage a collapsing economy and skyrocketing unemployment, and bankers were vilified for causing the 1929 stock market crash.

Congress had passed the Glass-Steagall Act in 1933 that sought to protect consumers by separating commercial and investment banks. And so the House of Morgan, the banking empire that J. Pierpont Morgan had built, was divided. His grandson, Henry Morgan, and Harold Stanley, a banker who had developed the bond business, founded Morgan Stanley at 2 Wall St.

Dean Witter Deal

By the time Mack joined in 1972 as a bond salesman, the bank had managed the biggest-ever debt offerings for General Motors Corp. and AT&T Inc. and was building a sales and trading operation. When Mack rose to president, in 1993, his first effort was to unite the firm’s warring fiefdoms. He called the initiative “One Firm Firm” and retooled review and compensation practices.

In the 1990s, as U.S. investors poured money into 401(k) retirement plans, Wall Street was changing. Merrill Lynch, with 15,000 brokers gathering assets and selling stocks and bonds, was winning the game.

In February 1997, Mack and Richard Fisher, his CEO and mentor, chose to sell Morgan Stanley to Dean Witter, the third- biggest U.S. brokerage firm, to emulate Merrill. Mack agreed to be president, leaving the jobs of chairman and CEO to Dean Witter’s Philip Purcell.

Mack Resigns

Twelve years on, the Morgan Stanley-Dean Witter merger is still hotly debated. Days after the agreement, Morgan Stanley executives were deriding the combination as “blue chip-corn chip” and worrying that Dean Witter’s Midwestern heritage -- it was once part of Sears, Roebuck & Co., the department store chain -- spelled the end of Morgan Stanley’s elite reputation. To others, notably trading-floor managers, Dean Witter’s capital enabled more risk taking for clients and the firm’s own books.

“For the first time, we could actually grow our businesses and run larger balance sheets,” says Tom Juterbock, who headed government bond trading at the time. The anticipated financial powerhouse didn’t materialize, though, as Morgan Stanley executives chafed under Purcell. “The most amazing thing was that they didn’t even try to make it work,” says Juterbock, now chief investment officer of Nikko Asset Management Co. in New York. “They tried to run it with two separate cultures.” Mack resigned in January 2001, when it was clear Purcell wouldn’t relinquish control.

Credit Suisse Problems

Six months later, he took charge of Credit Suisse’s money- losing CSFB investment banking division. He recruited a cadre of Morgan Stanley colleagues, including Nides and Wei Christianson, a banker in China; cut jobs; and asked bankers to take smaller bonuses. In his zeal to lower costs, he drove away some of the firm’s biggest moneymakers, including trader Alan Howard, who later founded hedge fund Brevan Howard Asset Management LLP, says one former executive who worked with Mack at the time.

Mack’s demeanor also rubbed some at the bank the wrong way, according to people who worked with him. He bristled at questions from the Swiss bank’s board of directors and once mentioned, during a discussion of the bonus pool, that his net worth, which included about $400 million in Morgan Stanley stock, already exceeded all of their wealth combined, says an executive who attended the meeting. Mack also considered selling Credit Suisse, which some at the bank viewed as poor judgment because of its low valuation at the time, the person says.

Mack Comes Back

In June 2004, Mack’s contract wasn’t renewed. A year later, after Purcell was forced out in a coup triggered by a group of retired Morgan Stanley executives, self-proclaimed “grumpy old men” who complained about lagging profit and stock performance, Mack was hired back.

His return -- marked by a stage-managed arrival on Morgan Stanley’s New York fixed-income trading floor with waves of employee applause and an on-the-spot TV interview -- was well timed. Investment banking was back after three lean years, with the value of announced M&A transactions jumping 33 percent in 2005 from a year earlier, to $2.58 trillion.

More important was the ascent of fixed-income trading, fueled by cheap credit and a boom in structured-finance products, including mortgage-backed securities and collateralized-debt obligations. It had become the biggest portion of revenue for Wall Street’s top firms.

Mack threw his support behind Zoe Cruz, a former head of fixed-income trading whom Purcell had promoted to co-president, naming her acting president of the firm. While the move was attacked by some, who thought she shouldn’t be rewarded for siding with Purcell, Mack saw Cruz as essential to his new strategy.

More Mortgage Lending

That involved beefing up mortgage lending, derivatives and leveraged finance. Mack agreed to pay $700 million to buy Saxon Capital Inc., which originated and serviced home loans, and bought mortgage companies in Italy, Russia and the U.K. He rebuilt the firm’s private-equity business and acquired stakes in at least four hedge funds.

Mack supported Cruz’s using more of the firm’s capital for proprietary trading, and the company expanded in mortgage securitization. While those bets paid off for a while, his loyalty to her didn’t last. He ended Cruz’s 25-year career at Morgan Stanley in November 2007, after the firm revealed $3.7 billion in losses on subprime mortgage positions. The total writedown that quarter was $9.4 billion, and its net loss $3.6 billion.

A year later, the collapse of the mortgage and credit markets led Morgan Stanley to its second quarterly loss under Mack. The bank took a $700 million writedown on Saxon and two commodities businesses he acquired.

Slicing Prime Brokerage

“Some people say he did turn up risk at the top,” says Glenn Schorr, an analyst at UBS AG in New York. “But they really didn’t have the same magnitude of exposure as the worst companies.”

Morgan Stanley has sliced the prime brokerage business in recent months after a 65 percent drop in client assets in the third quarter. Every proprietary trading desk except one has been closed. The firm is scaling back efforts to invest its own capital in companies and real estate and no longer makes home loans. A $4 billion fund for principal investing is being shut down.

Mack himself says profitability will look more like it did in 1986 when he helped pitch Morgan Stanley’s initial public offering. Return on equity was 15-20 percent, he recalls.

Coach K’s Advice

“The craziness of ROEs really didn’t happen until the last three or four years, with taking huge prop risk and private equity,” he says. “That’s when people started doing 25 percent or 35 percent return on equity. I don’t think that’s coming back. But I do think mid-teens is there, and I think it’s stable.”

The youngest of six brothers, Mack attended Duke University on a football scholarship. Now, he says he’s up to the task of motivating his bankers through the tough year ahead.

“This banking crisis, this global recession -- unless you can tell me that it’s going to change the way people do business forever, no one’s explained to me why it won’t come back,” he says.

Mack, who still owns a beach house in North Carolina and is on Duke’s board, is friends with the school’s basketball coach, Mike Krzyzewski, who led the gold-medal-winning U.S. men’s team at the Beijing Olympics last August.

In September, during Morgan Stanley’s fourth-quarter rout, Krzyzewski called to offer his support.

“I told him now is the time to turn this into a win and not a loss,” Krzyzewski, known as “Coach K,” says in an interview. He offered a similar pep talk to Morgan Stanley executives and clients in November at the Regent Palms Resort in the Turks and Caicos Islands.

Some investors approve of Mack’s moves so far. Still, an ailing global economy and Obama-era financial policies may place a Morgan Stanley victory beyond his control. It’s too soon to put those blood pressure machines away.

To contact the reporters on this story: Lisa Kassenaar in New York at lkassenaar@bloomberg.net; Christine Harper in New York at charper@bloomberg.net.

Last Updated: January 26, 2009 10:44 EST