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Schwab: Closed Eyes, Open Wallet

The news out of Charles Schwab & Co. (SCH) has been bad lately, but mostly explainable. The voracious bear market has taken a big bite out of the discount broker's trading volume, revenues, and profits. But a look behind the recent management shakeup at U.S. Trust Corp.--the private bank Schwab bought in June, 2000, for $2.7 billion--raises a more disquieting issue. In its eagerness to tap upscale markets and become more than the people's broker, did the normally savvy Schwab miss serious warning signs at U.S. Trust?

Schwab's bland Oct. 1 announcement gave little hint of the turmoil at 149-year-old U.S. Trust. Alan J. Weber, former chief financial officer at insurer Aetna Inc. (AET), would succeed Jeffrey S. Maurer as CEO and replace Maribeth S. Rahe as president. She would leave the firm, the release said. Maurer would remain on Schwab's executive committee. Everyone was graciously thanked. Weber and Maurer declined to comment for this story, and Rahe didn't return a call to her home.

But Schwab execs concede that they ran out of patience with their prize after paying 60% more than its market value when the deal closed in mid-2000. "We needed to dramatically increase the pace of change for operational improvements," says Schwab co-CEO David S. Pottruck.

Classic merger problems dogged the union. U.S. Trust managers didn't cut costs fast enough. Longtime portfolio managers and private bankers left, taking clients with them. And the main hope for the acquisition--stopping Schwab's richest customers from defecting to full-service banks such as Merrill Lynch & Co. (MER)--hasn't panned out. Few Schwab customers have $2 million in assets--the rock-bottom minimum for U.S. Trust's pricey hand-holding--and those who do tend to be do-it-yourselfers.

But the biggest shock has been U.S. Trust's outdated technology. Because its computers failed to detect suspicious patterns of cash transactions, the bank had to pay $10 million in July, 2001, to settle charges by the New York State Banking Dept. and the Federal Reserve that it wasn't complying with anti-money-laundering rules. (The bank didn't admit or deny fault.)

How could a company like Schwab, which built its reputation on its tech savvy, miss something so key? Former U.S. Trust employees say Schwab execs were dazzled by the glossy brand and pedigreed clients. Schwab says it inspected U.S. Trust's systems thoroughly. Regulators' prior reports hinted at problems, says Pottruck, but the woes seemed manageable. "We knew there were areas in need of improvement, but we had no idea it had that kind of material weakness." Since the discovery, "the enormous effort to remediate" U.S. Trust's compliance shortcomings has made it hard to address other issues, says Pottruck.

Weber, who has no direct experience in wealth management, will have to find a way to do so. Pottruck has known Weber since they both worked at Citibank. He says he hired Weber for his experience managing a business with many branches, as well as for his tech savvy. Weber supervised Citi's international offices, and his responsibilities at Aetna included tech operations and e-business.

Weber's first job will be to rally the bank's demoralized troops through another painful transition. U.S. Trust was largely owned by its employees, who received Schwab stock, which has since fallen 72%. Last year, U.S. Trust laid off people for the first time in memory, and key managers, including the heads of private banking and operations, left after the regulatory action.

Next, Weber will have to complete the mammoth task of upgrading technology at a company that didn't even use the standard Windows operating system until the late 1990s. Among the remaining pieces of the tech puzzle: putting U.S. Trust's 30 branches onto a single computer system and improving back-office operations, which have crimped earnings since J.P. Morgan Chase & Co. (JPM) stopped handling the function for the bank after the merger.

Weber's biggest challenge by far will be delivering the growth Schwab wants so badly. The company was too optimistic about Schwab's referrals to the bank. "U.S. Trust is used to financial snobs," says a former U.S. Trust employee. "Schwab's high-end [clients] were not at that level. Imagine having a company refer clients to a subsidiary, and then the subsidiary turns them down." That situation shows no signs of improvement. The flow of referrals slowed to 260 in the third quarter from 320 a year ago. Schwab says that's in part because it's more discriminating about whom it sends to U.S. Trust. It also blames the bear market for eroding client wealth.

The compliance mess still weighs on growth. Portfolio managers now perform exhaustive background checks, far beyond what's standard in the industry, on potential and existing clients. They confirm all client information--from kids' birthdays to the reasons for large withdrawals, say former staffers. That eats up time that could be spent scaring up new business. Clients also bristle at the questioning and extra paperwork. A Schwab spokesman says the scrutiny isn't onerous.

Then there's cost-cutting, an area where former U.S. Trust execs dragged their feet--to their ultimate downfall. They "were given a mandate to make changes, and those changes were not being made," says a former employee. "It's a cocoon they lived in." Weber is expected to close U.S. Trust's weakest offices.

For Schwab, getting all it can out of U.S. Trust is imperative. The brokerage's September trading volumes were down 37% from a year ago. Nine-month net income fell 11% year-on-year to $188 million on revenues of $3.13 billion. "The wild card is whether Schwab can transform a high-net-worth business from [one of] steady earnings growth to more dynamic earnings growth," says a Wall Street analyst. Seems marrying up hasn't been the ticket to wealth it was supposed to be. By Louise Lee in San Mateo, Calif.

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