Morgan Stanley Seeks Fixed-Income Rebound After Target Miss
Morgan Stanley, which last year missed an internal trading-revenue target by more than 40 percent, is under pressure to show improvement after a two-year effort to turn around the firm’s fixed-income trading business.
The fixed-income unit failed to deliver on a promised revenue increase last year, leading to the missed target, according to a person with direct knowledge of the figures. It has been beset by management turnover, weak markets, bad bets and a struggle to win back clients lost when the firm retrenched during the financial crisis, according to interviews with nine current and former executives who requested anonymity because they weren’t authorized to speak.
Chief Executive Officer James Gorman, 53, is looking to prove to investors this week when results are reported that the firm is advancing toward his goal of boosting market share in fixed-income trading by 2 percentage points. With the stock down 69 percent since 2006 to $21.09 last week, Colm Kelleher and Ken deRegt, both 20-year veterans of the company, aim to succeed at a task that has taken down three senior executives.
“I’m absolutely surprised at how slow it has been,” said Brad Hintz, an analyst at Sanford C. Bernstein & Co. who has a “buy” rating on the firm’s shares and is a former Morgan Stanley treasurer. “I’d love to tell you what the trajectory is going to be, but I don’t know how rapidly one can come back.”
Morgan Stanley (MS) has made some progress. About 70 percent of clients in a Greenwich Associates survey reported using the New York-based firm as a fixed-income dealer last year, up from 56 percent in 2009. The company said revenue at its interest-rates unit climbed 10 percent in the first quarter from a year earlier, while total revenue in that business for the 10 largest U.S. and European banks fell about 11 percent, according to London-based research firm Coalition Development Ltd.
More evidence of progress may come July 21, when the bank announces second-quarter results. While Citigroup Inc. and JPMorgan Chase & Co. (JPM) both reported that fixed-income trading revenue dropped at least 18 percent from the first quarter, Fiona Swaffield, an RBC Capital Markets analyst, and David Trone at JMP Securities expect Morgan Stanley to post fixed-income revenue of $1.9 billion, little changed from the first three months of the year. That would represent a market-share gain.
The bank may reap $200 million in the second quarter from hedges against monoline insurers, including MBIA Inc., after $318 million of losses in the first quarter, Howard Chen, a Credit Suisse Group AG analyst, said in a note last month.
Mary Claire Delaney, a spokesman for Morgan Stanley in New York, declined to comment on the firm’s fixed-income business.
Morgan Stanley fell behind rivals in 2009 as fixed-income trading became the dominant capital-markets business for the largest global banks. Fixed-income units include banks’ trading in government and corporate bonds, currencies, commodities, mortgage-backed securities, interest-rate swaps, credit-default swaps and other derivatives.
Fixed income, currencies and commodities, or FICC, has topped combined revenue from equities trading and investment banking at the biggest banks in each of the past two years. It also has a pretax margin of about 25 percent, almost double that of equity trading, according to Hintz.
The firm had a market share based on revenue of about 6.5 percent among the top nine U.S. and European investment banks last year, up from about 5.5 percent in 2009 and down from about 9 percent in 2006, according to an April report by Glenn Schorr, a Nomura Holdings Inc. analyst. That dropped to 6 percent in the first quarter, according to RBC’s Swaffield. Both analysts excluded losses and gains tied to the banks’ own debt, known as debt-valuation adjustments, or DVAs.
JPMorgan had the largest market share last year, with 14.9 percent, while Citigroup, London-based Barclays Plc and Goldman Sachs Group Inc. (GS) each had more than 13 percent, Swaffield wrote in a June note. JPMorgan and Citigroup both reported results last week. Goldman is scheduled to announce them tomorrow and Barclays on Aug. 2.
Gorman, an Australian and former McKinsey & Co. consultant who previously led the firm’s wealth-management business, has put forward a strategy that relies more on Morgan Stanley’s 17,000-plus brokers and less on principal risk-taking. Still, he has called repairing the fixed-income unit his priority.
Kelleher, 54, an accountant at Arthur Andersen LLP before joining Morgan Stanley in 1989 as a fixed-income salesman, took charge of trading after Gorman ousted Mitch Petrick in late 2009. Kelleher, the firm’s chief financial officer during the crisis, has overseen a rebound in the equities business, which last year topped all U.S. rivals except Goldman Sachs.
Gorman and Kelleher have set optimistic goals for the turnaround. Kelleher’s 2010 trading-revenue target that the division missed was about $26 billion, $10 billion more than the firm produced in 2009, and executives pushed for him to lower his 2011 fixed-income target by as much as $3 billion, according to two executives who left the bank this year. Delaney, the spokeswoman, declined to make Kelleher available for comment.
Gorman laid out his plan for a 2 percentage-point increase in February, which would bring the firm’s market share among the top nine banks to 8.5 percent, according to Schorr’s figures. That came almost a year after he set a 15 percent pretax profit- margin goal for the firm’s brokerage, a target executives said five months later they wouldn’t hit.
“This management team tends to put out somewhat lofty targets,” said Shannon Stemm, an analyst at Edward Jones & Co. in St. Louis who rates the stock a “buy.” “I don’t think they need to get to 2 percent at all. The market has pretty pessimistic expectations for this company, and if we can see any improvement, it will be applauded.”
The effort to fix FICC began two years ago, when then-CEO John Mack, who started at Morgan Stanley as a bond salesman in 1972, vowed to close the gap with competitors. The bank reported $5 billion less FICC revenue than each of its U.S. rivals in the first half of 2009 as it cut risk after a near-collapse in 2008 during the financial crisis.
The firm announced plans to increase hiring for its client- flow units, which focus on buying and selling securities for customers and had been shunned before the credit crisis as Mack, 66, focused on proprietary trading and the securitization business. It also brought in Jack DiMaio to run interest-rates, bond and currency trading with then-president Walid Chammah, 57, deeming him “ideally suited” to turn around the business.
DiMaio, 44, a Long Island native who played baseball at New York Technical College, made his name at Credit Suisse First Boston, from which he defected to Barclays in 2001 with his 43- member team, only to be lured back a day later by a contract guaranteeing the group $300 million over three years. DiMaio worked under Mack at Credit Suisse and later started his own credit hedge fund.
Mack and Chammah hired DiMaio to replace Roberto Hoornweg, 43, without letting Gorman and Kelleher, then co-president and CFO of the firm, interview DiMaio, three people said.
The bank wasn’t alone in its effort to push further into the client-trading business in 2009. UBS AG (UBSN) and Credit Suisse, both based in Zurich, were also increasing staff after recovering from the financial crisis. As competitors increased their presence, opportunities diminished, analysts said.
That was an “unusually profitable year in FICC, one which we may never see again,” said Frank Feenstra, managing director at consulting firm Greenwich Associates in Stamford, Connecticut. “The pie was very large, and the number of firms able to take a sizable slice out of that pie was pretty small because some firms had just come through a very difficult period and others were just not geared up for that kind of business.”
The turnaround didn’t show the desired results in 2010, as Morgan Stanley posted less than half the fixed-income trading revenue of its biggest U.S. rivals for the second straight year.
“The problem is that clients have long memories,” said Hintz, the Sanford Bernstein analyst, who is based in New York. “If you’re no longer the first button on a phone, it takes a long time to become the first button.”
As 2010 ended, DiMaio and Kelleher clashed over the unit’s 2011 revenue target, as well as compensation for fixed-income traders, according to two people. Kelleher, who moved to London from New York this year, and Gorman also lost confidence in DiMaio’s ability to improve performance at his unit, two former executives said. DiMaio declined to comment.
DiMaio had a background in credit trading, which includes trading in corporate bonds, and less experience with interest rates and foreign exchange, three executives said.
In January, DiMaio left Morgan Stanley with plans to start his own firm, according to two people. He was replaced by deRegt, the firm’s chief risk officer. DeRegt, 55, was head of fixed-income trading from the time of Morgan Stanley’s 1997 merger with Dean Witter until he departed in 2000. Mack brought deRegt back to the firm in 2008 to help manage risk after losses from a fixed-income proprietary bet.
DeRegt, who was Kelleher’s boss in the 1990s, has been given more autonomy than DiMaio, two of the people said. While deRegt has strong backing from Gorman, some employees point out that he hasn’t run a trading group since 2000, four people said.
David Moore, global head of the structured interest-rates unit who had been at Morgan Stanley for more than 20 years, was pushed out in January, and the firm brought in Glenn Hadden from rival Goldman Sachs as global head of the interest-rates business, which includes trading of Treasuries, inflation- protected bonds and interest-rate swaps.
“This is the first time that I have felt comfortable with the leadership across all of our fixed-income businesses,” Gorman said on a conference call with analysts in April. “You’ve got to have that ability at the top, and the investment we made in hiring people combined with the leadership at the top I think is what’s starting to move the needle.”
The management turnover meant that the business has been under three heads of fixed-income trading and two leaders of overall trading in the past two years.
“It’s hard when you have a vision and you’re trying to execute a strategy, and then the people creating that at the top continue to turn over,” said Stemm, the Edward Jones analyst. Gorman is “finally comfortable with the leadership in place, so I’m a little more confident that we’re through that at this point and maybe they can move forward.”
The lack of improvement in trading has helped drive down the firm’s share price, analysts including Stemm and Hintz said. Morgan Stanley’s shares have dropped 26 percent in the past two years, while the Standard & Poor’s 500 Financials Index is up 21 percent. Morgan Stanley trades at 34 percent below book value and 23 percent below tangible book value.
The shares fell 40 cents, or 1.9 percent, to $20.69 at 4 p.m. in New York Stock Exchange composite trading, the lowest closing price since March 2009.
The bank’s largest shareholder isn’t losing faith.
“It’s a kind of change of the platform of the business, and you cannot make it in a few months time,” Nobuyuki Hirano, deputy president of Mitsubishi UFJ Financial Group Inc., which owns 22 percent of the U.S. firm, and the Japanese bank’s representative on Morgan Stanley’s board until May, said in an interview this month. “It takes a few years, and that we’ve been aware of since the beginning.”
Morgan Stanley’s lagging performance predated the crisis in interest-rates and foreign-exchange businesses and was masked by the firm’s strength in commodities, two former executives said.
While the company doesn’t break out revenue for the businesses within the fixed-income unit, it’s among the top three firms in commodities, credit sales and trading, Gorman told investors in February. The bank is looking to gain market share in interest rates, where it increased headcount by about 20 percent, and foreign exchange, where it expanded staffing by 40 percent, he said.
“The macro space -- rates, foreign exchange and emerging markets -- has pockets that are doing very well and pockets that are not,” Gorman said at the time. “There are enormous opportunities, and we’ve been investing in that space, in headcount and in our technology.”
Morgan Stanley aims to increase share in a business dominated by large commercial banks. JPMorgan, Barclays and Frankfurt-based Deutsche Bank AG, dubbed “flow monsters” in the market, handle more than one-third of the volume in the interest-rate, bond, securitization and emerging-markets businesses, according to Greenwich Associates data. Clients are increasing the number of dealers they do business with after cutting back during the crisis, the consulting firm said.
Interest-rates products make up about 80 percent of fixed- income volume for all banks, according to Greenwich Associates, which tracks currency trading separately. Those trades are often lower-margin deals: The category accounts for less than a quarter of client revenue, the consulting firm’s data show.
Morgan Stanley’s low market share in the interest-rates business has not only reduced fees earned from executing client trades, it also has hindered the firm’s effectiveness in making bets, according to three people familiar with the market. Dealers benefit from knowledge about client flows and sharing ideas with buy-side traders, the people said.
“We believe that where we have insight like commodities, we can position risk of a proprietary nature on the back of those client flows,” Kelleher said in 2008 as he discussed exiting some proprietary-trading businesses.
Whether Morgan Stanley and other banks will be allowed to continue taking proprietary positions depends on how regulators write regulations designed to enforce the Volcker rule, which bars banks from trading for their own accounts.
Morgan Stanley may have seen the downside of such bets. The bank’s interest-rates trading group lost at least tens of millions of dollars in the second quarter on a wager on U.S. inflation expectations, which the firm has been unwinding, two people said last month, declining to be identified because the transaction isn’t public.
Traders at the bank bet that inflation expectations for the next five years would rise, while forecasts for the next 30 years would fall, according to the people. Such wagers on so- called breakeven rates involve paired purchases and short sales of Treasuries and Treasury Inflation Protected Securities, or TIPS, in both maturities. Delaney, the Morgan Stanley spokeswoman, declined to comment on the reported loss.
Even with the missteps, Morgan Stanley has made headway in areas where it previously trailed peers, including hedge-fund relations, risk management and technology.
The bank has improved relationships with its hedge-fund clients in an effort led by Kevin Dunleavy, 51, who was hired by DiMaio from Bank of America Corp. in 2009 after spending 28 years at Merrill Lynch & Co., where he held a similar job, according to two hedge-fund clients. It has also strengthened its presence in interest-rates and bond trading, while still lagging rivals in derivatives, one of the clients said.
Morgan Stanley also has taken more risk to support clients and make markets after cutting its balance sheet almost in half to $626 billion of assets in the first quarter of 2009. Its assets were $836 billion as of March 31.
The firm’s trading value-at-risk, or VaR, an estimate of how much the company could lose in securities markets in one day, went from less than half that of Goldman Sachs in the first two quarters of 2009 to more than its rival’s in each of the past four periods.
The increased risk-taking has been accompanied by more stringent risk management, CFO Ruth Porat said at an investor presentation in June. The firm hired 200 people in its risk- management group from January 2009 to April 2011, she said. It also increased the number of trading limits, better matched the maturities of its assets and introduced a stressed VaR measure.
The bank had only one day in 2009 and 2010 when trading losses exceeded VaR estimates. Over the 19 months from June 2007 through the end of 2008, trading losses exceeded VaR limits on 36 days, or about 9 percent of the time.
Morgan Stanley’s effort to catch rivals in technology and electronic trading are being led by Dexter Senft, hired last year as head of e-commerce for the fixed-income unit from Barclays. He held a similar position at Lehman Brothers Holdings Inc. and was chairman of LiquidityHub Ltd., a company set up by banks in 2006 to make it easier to trade fixed-income products electronically by aggregating prices.
Morgan Stanley started an application in 2009 called Matrix, which provided clients with research, analytics, live prices and trading capability for some fixed-income products.
Electronic foreign-exchange trading volume with Morgan Stanley has tripled since 2009, and revenue is four times greater, Porat said at the June investor conference. Electronic trading volume in the interest-rates business has increased at a compound annual rate of 60 percent, said Porat, 53.
“We expect an increase in electronic volumes in fixed- income as Dodd-Frank is implemented, and we have been positioning ourselves for the change,” Porat told investors.
Most large dealers are investing heavily in electronic trading as clients use it to trade more investment-grade debt and interest-rate products, Greenwich Associates’ Feenstra said. About 53 percent of customer accounts trade electronically, and online trading makes up 43 percent of that volume, an increase from 38 percent a year earlier, he said.
“If you want to gain more traction with clients and gain more share, that’s in some ways a relatively easy, though maybe expensive from a P&L perspective, way of increasing your footprint,” Feenstra said. “It may be great to add relationships and do more volume, but it may not be the most profitable business.”
While Morgan Stanley gained market share in 2010, it was taking from a smaller pool. Fixed-income revenue at the top nine global investment banks fell to $101 billion last year from a record $146 billion in 2009. It dropped 17 percent to $32.1 billion in the first quarter from a year earlier, according to Schorr and Swaffield.
Morgan Stanley’s attempts to gain share have been hindered by turnover, both at the top ranks and on the trading desks. Hiring was interrupted by a freeze in the second half of 2010.
Seven of the top interest-rate traders, including Moore, have left the firm over the past year. Six of them -- Richard Armes, Joeri Jacobs, Barry Piafsky, Vito Santoro, Colin Teichholtz and James Watson -- have landed at hedge funds. Armes, Watson and Santoro all joined Brevan Howard Asset Management LLP, one of Morgan Stanley’s biggest clients.
The firm hired Olivier Pariente and Julien Gaubert last year from BNP Paribas for the interest-rate swaps desk. The pair has improved the bank’s swaps technology and analytic systems and has been more aggressive in trading, according to one executive. Hadden has also increased Morgan Stanley’s presence in the interest-rate markets, three people said.
The bank is expecting its performance to improve as problems from the credit crisis recede. Those issues include clients viewing the firm as a weaker counterparty than competitors as well as the losses related to monoline insurers that have cost the company more than $1 billion since the beginning of 2010.
The conversion of Mitsubishi UFJ’s preferred stake to common shares will increase confidence in the firm as a counterparty, Porat said last month. Morgan Stanley also may benefit from the move of many derivatives to central clearinghouses, which would eliminate credit-risk differences between dealers because the clearinghouse would hold collateral against trades.
The opportunity for the firm’s shares to benefit from a successful turnaround is “tremendous” as it would help drive the stock price back to book value, said Roger Freeman, an analyst at Barclays Capital Inc. in New York. Still, the market is likely going to be skeptical until increased revenue and decreased revenue volatility is the norm, he said.
“We’d like to see three or four quarters of outperformance to really make a market-share case,” Freeman said. “You can outperform for one quarter or maybe a couple if you’ve deployed capital a little more aggressively or some of your principal positions went your way. The actual flow captured is going to be the more sustainable piece. We haven’t seen it yet.”
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