Morgan Stanley Getting Vegemite for New Wall Street’s 15% Bogey
James Gorman strides across the stage of the auditorium on the top floor of Morgan Stanley (MS)’s Times Square headquarters. It’s late October, and he’s in the midst of the second investor revolt he’s been through in three years -- the first one coming during the financial upheaval of 2008.
Morgan Stanley’s chief executive officer, a 53-year-old Australian, is addressing employees a day after the bank released its earnings. And he has just finished a media blitz to ward off persistent rumors that Morgan Stanley is heavily exposed to shaky European debt. The whispers, which the bank has denied, have helped drive its stock down almost 50 percent over the course of 10 weeks, Bloomberg Markets magazine reports in its March issue.
Gorman asks managing director Tom Wipf, a 25-year Morgan Stanley veteran who’s in the audience, if he felt the strain as the firm’s shares dropped below $12 a share. Wipf shakes his head from side to side.
“That’s right; you’re battle-hardened,” Gorman says. “You’ve seen real stress.” Gorman turns to the standing-room crowd. “For those of us who lived through the last crisis, that was real stress.”
That a 50 percent share-price drop in a little more than two months doesn’t trigger real stress says a lot about the past few years for Morgan Stanley. The 77-year-old investment bank has proved it can survive under the worst circumstances.
Warding Off Collapse
In 2008, the bank, then headed by John Mack, warded off collapse by taking more than $100 billion in Federal Reserve loans in the two weeks after Lehman Brothers Holdings Inc. failed -- and by selling more than 20 percent of itself to Japan’s Mitsubishi UFJ Financial Group Inc. (8306)
Now, Gorman, who came to Morgan Stanley in 2006 as head of its brokerage after holding the same job at Merrill Lynch & Co., must show that the bank can make money at a time when investment banks are constrained by roiled markets, sharply reduced trading and deal volume and new regulations that have banned most proprietary trading.
At the same time, investors frightened by the potential unraveling of the euro zone are shunning bank shares. Revenue and profits are down and so is compensation -- including Gorman’s, which fell 25 percent in 2011 from the previous year.
In December, Gorman completed his second year as CEO, and on Jan. 1 the board of directors handed him the job of chairman after Mack stepped down from a role he had held since 2005. To put five years of writedowns and government bailouts behind him, Gorman is unloading unprofitable investments and expanding in relatively low-risk areas such as currency trading. He has abolished the bank’s proprietary-trading operations, built up a $54 billion capital cushion and sharply reduced leverage.
Assets on the firm’s balance sheet have plunged to $750 billion at the end of 2011 from $1.2 trillion at their 2007 peak, as Mack and Gorman sold off assets, including the Van Kampen group of mutual funds and a stake in a hedge fund called FrontPoint.
Gorman has reorganized the firm around three businesses: wealth management, investment banking and trading, and he has set a target of 15 percent return on equity -- modest compared with the 23 percent the bank earned in 2006.
The bank’s ROE in 2011 was 4 percent.
“We’ve been among the most aggressive in repositioning our firm,” Gorman, wearing a gray suit with blue pinstripes, says in a conference room down the hall from his office on a rainy December morning. “All you can do against a backdrop of uncertainty is build the business as best you can for how you think the future environment is going to look -- and do so aggressively.”
Keeping a Checklist
Gorman keeps a handwritten checklist on his desk setting out tasks to be completed. One of the biggest items on it last year was closing out the firm’s money-losing exposure to insurer MBIA Inc. (MBI), which it did in December.
Gorman’s most aggressive move has been to turn back the clock 15 years and look for profit in his retail brokerage. He and Mack created a joint venture between the firm’s old Dean Witter brokerage and Citigroup Inc. (C)’s Smith Barney in June 2009 and took a controlling 51 percent stake in the unit, which Gorman ran before his promotion to CEO.
With 17,000 advisers and $1.65 trillion under management, Morgan Stanley Smith Barney is now the world’s largest retail brokerage, surpassing Bank of America Corp. (BAC)’s Merrill Lynch, which boasts $1.5 trillion. Morgan Stanley in 2011 generated 41 percent of its revenue from that unit compared with 16 percent in 2006.
Specter of Purcell
The realignment is a belated victory of sorts for Philip Purcell, the Dean Witter, Discover & Co. CEO who ran Morgan Stanley for eight years after the two firms merged in 1997. Mack, who was president under Purcell and headed the investment bank, resigned in 2001 after he and Purcell clashed.
Mack’s departure was followed by a struggle between shareholders and management that ended with Purcell’s 2005 ouster and Mack’s triumphant return.
Gorman says he and Mack agreed that bolstering the brokerage would provide much-needed stability in the wake of events that brought the bank to its knees. He says it makes even more sense now, as U.S. and global regulatory agencies impose new rules and capital requirements that limit banks’ ability to use leverage to invest billions of their own dollars in securities such as the risky mortgage-backed debt that drove profit in the decade prior to 2008.
“We have a balanced model of a client-focused, less-capital-intensive institutional securities business with a global wealth-management and asset-management business that uses little capital and carries little risk,” Gorman says. “Over time, a firm with that mix should trade at a higher multiple than a traditional bank or a traditional institutional securities business.”
Gorman has set a target of 20 percent pretax profit on Morgan Stanley Smith Barney, which is the bulk of the bank’s wealth-management division. The unit is run by Greg Fleming, a Merrill Lynch veteran whom Gorman hired in 2009.
At the end of 2011, the brokerage was a long way from its goal. Morgan Stanley reported in January that the brokerage’s profit margin fell to 8 percent in the fourth quarter, down from 12 percent a year earlier. The margin for all of 2011 was 10 percent. Morgan Stanley received $665 million in profit from the unit in 2011, only 16 percent of the firm’s total.
The brokerage has been held back by delays in the integration of Dean Witter and Smith Barney technology, Gorman says, and will prove its worth in the long term.
“The market doesn’t understand the potential of the Smith Barney acquisition,” he says. “Instead, they’re focused on what our margins have been in the last financial crisis and during all the integration.”
It was a dismal fourth quarter for big banks, capping off a year in which Europe’s debt woes and a slowing global economy drove down deal volumes and trading activity. Mergers and acquisitions, as measured by deal volume, were down last year by 44 percent, to $2.28 trillion, from their 2007 peak, while U.S. equity-trading volumes were down 20 percent from 2009, according to data compiled by Bloomberg.
Goldman Sachs Group Inc. (GS), Morgan Stanley’s main rival, was hit hard, reporting a third-quarter loss, only its second since it became a public company in 1999. In January, two of the four heads of its trading business, Edward Eisler and David Heller, retired.
Citigroup last year posted two consecutive quarters in which it earned less than $300 million in equity-trading revenue, after regularly generating more than $1 billion before 2008.
Even JPMorgan Chase & Co. (JPM), the most profitable of the big banks since 2008, has fallen back; earnings for the fourth quarter dropped 23 percent, to $3.73 billion, due to a sharp fall in income from investment banking and trading.
Revenues from those businesses have slipped just as dramatically at European banks. Credit Suisse Group AG (CSGN)’s fixed-income trading fell by more than a third in the third quarter and Deutsche Bank AG (DBK)’s equities trading dropped by 38 percent in the fourth quarter.
The financial firms’ response has been to take a hatchet to staff and compensation. Banks globally announced more than 230,000 job cuts last year, according to Bloomberg data. Credit Suisse is likely to suspend its practice, the industry norm, of automatically boosting pay for junior bankers and traders, according to people briefed on the plans.
For its part, Morgan Stanley said in December it would cut 1,600 jobs, and in January it reduced pay for senior bankers by 20 percent to 30 percent. Among those who took a hit: Gorman himself, whose compensation package for 2011 totaled $10.5 million, according to people familiar with the decision, a 25 percent drop from the $14 million he was awarded in 2010. He won’t receive a cash bonus, while 2011 cash bonuses for other employees were capped at $125,000.
In 2006, cash bonuses for the firm’s top traders and investment bankers were as high as $12 million.
Gorman has little patience for those who might complain about the pay cuts.
“You’re naive, read the newspaper, No. 1,” he said he would tell them, in a January interview with Bloomberg Television. “No. 2, if you put your compensation in a one-year context to define your overall level of happiness, you have a problem much bigger than the job. And No. 3, if you’re really unhappy, just leave. I mean, life’s too short.”
Gorman hasn’t been able to look to the stock for support of his decisions. Morgan Stanley shares dropped 44 percent in 2011.
“We’re stronger,” he says of progress made in that year. “We have $8 billion more capital. We have spun off a bunch of prop businesses. And we’ve gone down half in value because of that? Why?”
The stock has rebounded so far in 2012. It’s up 34 percent through Feb. 3, to $20.31, as U.S. economic growth shows signs of accelerating and European leaders move closer to a solution on the region’s debt crisis.
The firm’s shares also got a boost from news that Morgan Stanley would lead the underwriting of Facebook Inc.’s initial public offering. The bank’s $20 share price is still well below its tangible book value of $27.95.
“There’s a little bit of relief,” Gorman said on Jan. 25. “Europe did not completely collapse. The talks are ongoing. There seems to be some progress emerging, albeit slowly. There are signs the U.S. economy is doing a little better, unemployment ticking down.”
Big bank stocks across the landscape had a dreadful 2011. Bank of America’s shares fell 58 percent; Goldman Sachs’s, 46 percent; Citigroup’s, 44 percent; UBS AG (UBSN)’s, 27 percent; and JPMorgan’s, 22 percent.
Gorman doesn’t fit the image of a Wall Street titan. Notwithstanding his $10.5 million pay package, he shows up at black-tie events in a rumpled tuxedo he bought as a business-school student in the 1980s. He keeps supplies of Vegemite -- a favorite Australian food that’s made from yeast extract -- in the executive kitchen and eats it on toast.
He often walks home from his Times Square office to his Upper East Side townhouse and was spotted on one weekend in a track suit and sneakers waiting in line at the post office. The 6-foot-3-inch (1.9-meter), 195-pound (88-kilogram) Gorman’s favorite pastimes include reading John le Carre spy novels and taking boxing lessons weekly at his gym.
Who’s James Gordon?
Compared with Mack, the Australian was relatively unknown on Wall Street when he assumed the CEO role. When, a month before the handoff, Mack took his anointed successor to a meeting with William Dudley, head of the Federal Reserve Bank of New York, Gorman was listed on the calendar as James Gordon.
Gorman is the sixth of 10 children born to Melbourne engineer Kevin Gorman. His father, now 90, was home-schooled until age 14 because he lived in the Australian outback, far from any town. Kevin Gorman once had each of his children take an IQ test, James says. He posted the results in the family’s living room, with each child’s score and expected occupation.
James, whose sister is now a judge on the Supreme Court of Victoria, came in fifth -- a result that relegated him to an expected job of “midlevel bureaucrat or manager,” he recalls.
“I think I succeeded in that,” Gorman quipped in a November speech as honoree of the American Australian Association.
Retired Chairman Mack, a more-extroverted manager whom Gorman describes as “larger than life,” told employees shortly after Gorman was selected as his successor in September 2009 that the breadth of Gorman’s experience in banking -- with stints running marketing and leading research at Merrill Lynch and as head of strategy at Morgan Stanley -- made him the right choice.
“He understands people, and he understands the business,” he said. “I trust him with the franchise.”
That franchise has undergone head-spinning changes since Gorman’s arrival in 2006. In the U.S., the Dodd-Frank law, enacted in July 2010, bans most proprietary trading and moves many derivatives onto central clearinghouses. Globally, the Basel III accord raises the amount of equity capital banks have to hold against illiquid trading assets. For Morgan Stanley, that amount is likely to rise to 8.5 percent by 2018.
Gorman has responded to the new strictures by shrinking some of Morgan Stanley’s derivatives businesses and its structured-finance units, which create, buy and sell bundles of debt such as collateralized debt obligations.
Spinning Off PDT
He will also spin off, by the end of 2012, the bank’s Process Driven Trading group, a proprietary-trading business run by Peter Muller.
Under the so-called Volcker rule, banks must abolish most proprietary trading and can’t invest more than 3 percent of their capital in hedge funds. From its launch in 1993 through 2010, PDT, which invests only Morgan Stanley money, has returned an estimated annual average of more than 20 percent, according to a person close to the group.
Gorman has also been getting rid of the clutter the bank accumulated in the 1990s and 2000s. Gone are some of the toxic investments made during the real estate bubble -- everything from a mortgage-servicing company to a half-built Atlantic City casino.
In December, the bank discarded another piece of old baggage when it announced a settlement with bond insurer MBIA. The deal, which ended lawsuits between the two firms, canceled credit-default swaps Morgan Stanley bought from MBIA before the crisis. In the fourth quarter, the bank took a pretax charge for its losses on the deal of $1.7 billion.
The bank has simplified its income statement by converting investments made by Mitsubishi UFJ and Beijing-based China Investment Corp. from preferred to common stock. Mitsubishi’s $9 billion in preferred shares were supposed to convert at a price Morgan Stanley’s shares never reached, so, last year, the two negotiated a conversion that gives Mitsubishi a 22 percent stake in the American bank. CIC’s preferred Morgan Stanley shares, bought in 2007, automatically converted to common stock in August 2010. The sovereign-wealth fund now owns an 8 percent stake.
As Gorman begins his third year as CEO, Morgan Stanley’s business mix and revenue breakdown look almost identical to the 2004 and 2005 versions at Merrill Lynch during Gorman’s final years there. Like Merrill of that time, Morgan Stanley gets a little more than half of its revenue from investment banking and trading, more than 40 percent from the retail brokerage and less than 10 percent from asset management, which includes mutual funds, private equity, hedge funds and real estate.
Gorman’s 15 percent ROE target is roughly what Merrill produced in his last years there. Merrill, however, did it with much higher leverage -- which can be used to multiply gains -- while under the Basel III rules, Morgan Stanley and other big banks will have to keep leverage down in order to maintain reserve capital at required levels.
“Mid-teens ROE is going to be tough: You’re going to need a pretty darn strong market environment,” says Glenn Schorr, a bank analyst at Nomura Holdings Inc. “And, unfortunately, they have a tough backdrop to execute against.”
That backdrop includes a global economy that has whipsawed stocks and bonds. The Chicago Board Options Exchange Volatility Index, or VIX (VIX), rose 32 percent in 2011 to 23.40, the highest year-end level since 2008.
“We can now focus on a client business, but for that to work, you need stable markets,” says Colm Kelleher, who as co-president of Morgan Stanley’s Institutional Securities Group is chief of trading. “Volatility scares clients.”
Revenue from trading and investment banking at Morgan Stanley and seven other large global firms likely dropped more than 15 percent each of the past two years and will remain below 2010 levels through 2013, says Kian Abouhossein, an analyst at JPMorgan Chase.
“I hope I’m wrong, but at this point, it feels like a slow recovery,” says Morgan Stanley Chief Financial Officer Ruth Porat.
Even if the new mix of revenue sources is the right one, Michael Mayo, a bank analyst at CLSA Ltd., wonders whether the firm will be any better at executing than it was in the past. In 2007, Morgan Stanley lost more than $9 billion trading mortgage-related securities for its own account. At the same time, it was loading up on what turned out to be toxic commercial real estate, which cost it more than $4 billion in writedowns. And in 2009, it scaled back on risk at a time when markets were recovering.
Outplayed by Goldman
Goldman Sachs took advantage of the upturn, racking up record profits of $13.4 billion, while Morgan Stanley posted its first per-share annual loss of 77 cents.
Mayo says it’s too early to know whether Gorman is the man to right Morgan Stanley’s ship.
“The problems have really stretched back almost a decade, so a few quarters only represents early days of measuring their progress,” Mayo says. “It really comes down to two words: Show me.”
Gorman insists that the troubles at his bank are short-term and solvable. He has been declaring Morgan Stanley stock a bargain since he became CEO, to little visible effect until recently. He told employees in December 2010, when the stock was about $27, that the shares were “meaningfully undervalued” and he expected a “huge inflection point.”
In August 2011, he bought $2.1 million of stock for his personal account at $20.62, according to government filings. By the end of 2011, the shares had fallen to $15.13, saddling him with a paper loss of $549,000.
Investor fears that Morgan Stanley may be hard hit by international financial instability have played a role in the stock swoon. Faced with potentially lethal rumors about the bank’s European debt exposure, Gorman says he was pressed by some investors to report third-quarter earnings early to defuse the speculation.
The CEO, who takes pride in remaining calm under pressure, refused. Instead, when the firm reported its earnings, it added a page of disclosures to show that, after hedges, it had $2.1 billion of exposure to five troubled European countries -- Greece, Ireland, Italy, Portugal and Spain -- an amount that represented just 3.6 percent of its common equity.
“The advantage we have is that the facts are on our side,” Gorman says. “In 2008, the facts weren’t on our side. We had a liquidity run. We knew it, the market knew it, and we talked about it, but we thought we could survive through it. This was different.”
$107 Billion Loan
The firm’s survival in 2008 depended largely on the government’s help. At one point in late September, Morgan Stanley had a loan balance with the Fed of $107.3 billion, the most of any bank, according to data compiled by Bloomberg News from Federal Reserve records obtained through a Freedom of Information Act request.
In October, it absorbed another $10 billion through the Troubled Asset Relief Program, or TARP.
By mid-2009, the bank had paid back all of the government money.
The stock stabilized after Gorman laid out the European risks. Yet not all investors are convinced that its exposure is insignificant, says Kenneth Crawford, a senior portfolio manager at Argent Capital Management LLC, which has about $1.2 billion under management and doesn’t own Morgan Stanley shares. During 2011, the bank’s stock closely tracked that of the most-troubled European lenders, and Crawford says that risk is the top concern at his investment committee meetings.
‘Kind of Doomed’
“It’s the first question, and the third, and the 15th and the 27th,” he says. “So as long as Europe becomes a headline on a daily basis, and people have in their minds ‘bad Europe equals bad Morgan Stanley,’ then maybe they are kind of doomed.”
Gorman says he and his deputies tried to maintain calm during the 2011 panic. He sent out a memo to employees urging them to stay focused on clients and stop watching the stock. Still, his frustration seeps through. He says he was particularly angered by one September report.
“There was a rumor about our real estate exposure in China,” he says. “It’s ludicrous. We have absolutely inconsequential real estate exposure in China.”
The bank’s critics are relentless, Gorman says.
“It would appear that after multiple attempts to try to find some great problem, it hasn’t been found -- just possibly because it doesn’t exist,” he says. “Just possibly.”
Below Book Value
Morgan Stanley stockholders share Gorman’s pain. The stock traded below the firm’s book value for more than 400 straight days from May 2010 to mid-January. Gorman elicited cheers when he told a gathering of former managing directors in November that the company is doing much better than its stock.
Gorman is depending on his former Merrill colleague Fleming, 48, to charge up earnings at the brokerage and drive up the stock. Fleming had cut 887 brokers as of mid-January, and he wants to more than double assets, to $1 trillion, in managed accounts.
Those accounts assess fees as a percentage of assets, generally 1 percent to 2 percent, rather than charging commissions on trades, and are more lucrative for the bank. Fleming also wants to sell brokerage clients banking services, from jumbo mortgages to consumer loans.
Brokerage profits will rise as the firm proceeds with its plan to buy the remaining 49 percent of Morgan Stanley Smith Barney. Under the contract with Citigroup, another 14 percent of the brokerage will become available to Morgan Stanley in May, and Gorman says it’s “more probable than not” that Morgan Stanley will buy it immediately.
The full purchase, while a key part of Gorman’s strategy, will take two and a half years and will cost the equivalent of all Morgan Stanley’s earnings over that period, Schorr estimates.
On the investment-banking side, Gorman says, he wants to make fixed-income trading a major profit driver. Morgan Stanley is trying to build up its so-called flow trading -- the high-volume area of executing customer orders to buy such products as bonds and interest-rate swaps. That effort is threatened by competition from other banks driven to the flow business by new capital rules, under which it’s considered lower risk than structured finance.
“It’s easier to maintain an established franchise when volumes are under pressure than it is to build a new one,” Schorr says. “They’re going through some of those growing pains now.”
After fixed income fell short of the bank’s expectations in 2010, Gorman placed former Chief Risk Officer Ken deRegt in charge in January 2011, the third leadership change for the group in less than two years. In 2011, Morgan Stanley raised its share of the fixed-income market among the nine largest global investment banks to about 7 percent from 6 percent in 2010. Yet even as the bank rose in the rankings, revenue continued falling, down 6 percent in 2011 as the industry faced a steeper decline.
Morgan Stanley is holding its own in other areas. Under Paul J. Taubman, co-president of the Institutional Securities Group who oversees investment banking, the firm claimed the top spot among equity underwriters and was in the top three of M&A advisers each of the past two years. Under Kelleher and Ted Pick, head of equities, the firm posted the largest equity-trading revenue increase among major U.S. firms in 2011. Still, lagging performance in fixed-income trading has led to lower earnings than rivals.
Goldman Sachs earned 45 percent more profit for the two years ended in 2011 than Morgan Stanley’s $8.81 billion.
The firm is trying to close that gap partly through its partnership with Mitsubishi UFJ. The two banks have a global agreement in which Morgan Stanley offers its investment-banking clients Mitsubishi’s commercial-banking services in M&A financing, foreign exchange and cash management. That has helped both banks find deals they wouldn’t have otherwise, says Masaaki Tanaka, CEO for the Americas at Bank of Tokyo-Mitsubishi UFJ.
“In many respects, having the benefits of a virtual merger and not a real merger works better,” CFO Porat says. “The strength of it is that we’re a strong, independent organization, but Mitsubishi’s $1.6 trillion of deposits in search of assets makes it a great partner.”
The downside of the partnership was highlighted in March 2011, when Morgan Stanley took a $655 million charge due to trading losses in a Mitsubishi-controlled Japanese joint venture.
Gorman’s plan to improve the investment bank’s performance has been based on partnerships and steady contact with clients rather than trading stars and higher risk. The firm has lost some top traders, including commercial-mortgage-trading head Ahsim Khan and equity derivatives trader Glenn Koh, by refusing to match the pay packages offered by rivals, according to people who worked with them.
Gorman says he has never liked the star culture of Wall Street’s trading desks, which he says has led to excessive risk taking by overconfident traders whose pay is based on short-term gains.
“Through the financial crisis and my career, I’ve met with most of the leading people in the industry, and there’s a fair number of the senior folks who actually believe they are uniquely qualified on all issues relating to finance,” he said at an industry conference in 2010. “And as we saw, it’s just not true.”
Gorman’s overriding goal is to convince employees, and the markets, that a Morgan Stanley turnaround is imminent.
“We were the last guys to get through the last crisis,” says Gorman, whose firm posted per-share losses through the second quarter of 2009. “Now, we are in much stronger shape than we were -- and than we are perceived to be. But that’s OK. The market will eventually catch up.”
Since he took over, Gorman’s checklist has been full of headaches from earlier years. In January, he told investors on a conference call that it now features a different kind of challenge: getting back to business and improving profits.
“For the first time in two years,” he said, “our to-do list is not our problem list.”
To contact the reporter on this story: Michael J. Moore in New York at firstname.lastname@example.org