January 9, 2014 7:51 pm
Banking rivalries: Risk on, risk off
Goldman Sachs is sticking to trading while Morgan Stanley bets on wealth management
Only two pure Wall Street investment banks survived the financial crisis intact. One came to be viewed as so powerful that it had become a problem for society. The other was considered lucky simply to have made it.
Since then, Goldman Sachs has defiantly hewed to the strategy that made it the most ruthlessly effective Wall Street bank, with risk-taking at the centre of its business. Long known as a “black box” for its opaque trading practices, the few public changes that Goldman Sachs has made have been in its ethics policies – an effort to fight the impression that, as an unfortunate internal email suggested, it deliberately punts “shitty deals” to customers.
Morgan Stanley, which barely emerged in one piece from the crisis, is engaged in a far more drastic transformation. It has bet hugely on wealth management, acquiring a network of advisers from Citigroup who sell financial products to well-off Americans. At the same time, it has shrunk its fixed income trading division.
James Gorman, Morgan Stanley’s chief executive, is not a trader at heart. A former McKinsey consultant and executive at Merrill Lynch, famous for its “thundering herd” of wealth managers, Mr Gorman, 55, has emphasised retail’s role in Morgan Stanley’s future.
Morgan Stanley has encountered severe turbulence. Rated as the most vulnerable US bank, its shares plumbed new lows during the successive summers of eurozone crises in 2011 and 2012. During the first episode, regulators even looked at potential acquirers for the company should it approach the point of failure, according to people familiar with the situation.
While Goldman’s return on equity has remained above 10 per cent for most of the post-crisis period, Morgan Stanley’s has exceeded that benchmark only fleetingly and has often been stuck below 5 per cent, well beneath its cost of capital.
But investors are beginning to view Morgan Stanley in a new light. Although it continues to trail Goldman’s profitability, investors no longer seem to care. Its valuation has narrowed the gap with Goldman on a measure of share price to book value of its assets.
Morgan Stanley’s prospects of failure, as measured by credit default swaps, have improved even more significantly. Since the start of 2008 Goldman’s credit spreads have been healthier more than 90 per cent of the time. But since their last quarterly earnings announcements in October, the two companies exchanged places and Morgan Stanley has maintained the advantage ever since. Goldman is now viewed as the riskier proposition.
In some areas the two banks compete closely. Goldman has been the world’s number one mergers and acquisitions adviser for a decade, according to Thomson Reuters rankings, apart from 2009 and 2010 when it was dislodged by Morgan Stanley.
Goldman and Morgan Stanley have been one or two in equity underwriting for three of the past four years, with Morgan Stanley winning the lead role on the Facebook initial public offering in 2012 and Goldman winning bragging rights on Twitter’s IPO last year. Last quarter, Morgan Stanley took the top spot in equity trading from Goldman.
But there are two defining differences in strategy, reflecting contrasting attitudes to risk-taking and the value of a retail business.
Morgan Stanley has been trying to free capital – with the intention of returning it to shareholders – by pulling out of capital-hungry areas of fixed income trading. Its physical commodities trading has been for sale for more than a year and it recently agreed to sell a slice of it to Rosneft, the Russian oil producer. As in so many other areas of trading, Goldman is not budging, saying it will not sell its commodities business. Some executives even talk of expanding it to benefit from its rivals’ capitulation.
He adds: “Every way you slice and dice it Goldman Sachs is the best trader.” But Mr Hintz cautions: “Since we have a much more intrusive regulator we are almost mathematically certain that the future premium performance of Goldman is going to be lower. The best trader won’t be that much better than the average trader.”
Judging the impact of trading regulations that are still being phased in poses a particular challenge for Goldman.
“It’s very hard to pre-emptively exit unless you really think that the regulatory landscape has made it unsustainable,” says a former senior Goldman executive. “In some ways it was easier for other firms. Harder for Goldman to let go, which may be a strength and a weakness.”
In November, Mr Blankfein noted that “weaker” investment banks might be embracing “larger strategic change” and “difficult operating environments might lead management teams to overreact. However, when you have a strong franchise and a record of superior returns, overreacting may be the most dangerous thing that you can do.”
Some of Morgan Stanley’s employees have been disillusioned by the emphasis on reducing risk. “It’s the fallacy of shrinking your way to prosperity: you lose diversification and most importantly you lose . . . let’s call it ‘cyclicality’,” says one former executive. This perfectly captures the Blankfein message: when the cycle turns you find you are no longer a player in businesses that are suddenly lucrative.
Ruth Porat, Morgan Stanley’s chief financial officer, has succeeded in the painstaking job of rebuilding trust in the bank’s ability to withstand a shock. Together with Mr Gorman, she now finds part of her role rebutting the idea that Morgan Stanley has stopped taking risk.
“For 76 years we’ve been an institutional securities business,” she says. “Fixed income is an important part of our suite of businesses within institutional securities. But we’ve also made clear how much capital we’re going to allocate.”
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Yet there is an even bigger difference in the two banks’ attitudes towards retail distribution. Goldman’s clients are concentrated among corporations, hedge funds and a handful of ultra-wealthy individuals. In addition to those same sorts of clients, Morgan Stanley now has 16,500 financial advisers catering to a much broader swath of American investors, who might have $200,000 to invest rather than $200m.
It bought Smith Barney from Citigroup last year. The two had battled over the price and the ultimate valuation – $13.5bn – is now seen as a steal for Morgan Stanley as margins have quickly improved after the deal closed.
Now rebranded as Morgan Stanley Wealth Management, the business has more than one purpose. Customers pay fees for the advice and products sold by the brokers. And they also bring deposits.
During the crisis, Goldman and Morgan Stanley lacked the comfort blanket of cheap sticky funding presented by ordinary customers’ leaving money in the bank that rivals such as JPMorgan benefited from. Now Morgan Stanley’s deposits make it the 10th largest bank in the country.
Morgan Stanley’s investment bankers wooing companies for equity and debt offerings can also tout it as a distribution network. This feature even brought Mr Blankfein to Morgan Stanley recently as he used his rival’s platform to sell a Goldman mutual fund to investors.
A few weeks ago, to mark the occasion and explain the fund, Mr Blankfein met Morgan Stanley bankers and brokers over lunch. He was asked by one adviser whether Goldman wanted a retail platform of its own. According to several people familiar with the conversation, he said Goldman had made its decision years ago to stick to being an institutional firm and it was too late to change now.
People at Morgan Stanley can detect a wistful air to those sorts of comments, believing their great rival would love a retail distribution channel. People at Goldman detect nothing of the sort, noting that the business of retail brokerage has its downsides – not least of which is the prospect of regulatory trouble because of advisers’ temptation to push unsuitable products that swell their bonuses. And the costs of the industry are structurally high: advisers’ bonuses, as a percentage of revenue, dwarf even those of Goldman’s investment bankers.
In their charitable moments, Goldman and Morgan Stanley bankers can see a world where both strategies prosper. But most of the time they can see more opportunities for the other to come unstuck.
The market’s reappraisal of Morgan Stanley is a recent phenomenon. If regulators at the Federal Reserve stand in the way of Morgan Stanley increasing its dividend or making share buybacks – or if there is an operational problem – the rewards from this renewed faith will be elusive. In a fresh crisis, Morgan Stanley could still be seen as more vulnerable than Goldman despite a new source of strength: a partnership with Mitsubishi UFJ Financial Group, the Japanese bank that is Morgan Stanley’s largest shareholder.
Morgan Stanley’s wealth management division has been plagued with technology problems and the $135bn of deposits collected from customers are great as long as you can find a profitable use for them. Many banks have found meagre investment returns because of ultra-low interest rates and, if Morgan Stanley chooses to invest the funds as loans, it could make bad decisions and suffer big credit losses.
Its fixed income division has been winnowed down and, though the whole sector is going through lean times, Morgan Stanley could find itself deprived of a revenue boost when a recovery happens. Clients who find a company less willing to extend liquidity or provide a full range of products might look elsewhere.
Goldman could still find that the new regulatory climate is too tough for some of its businesses to thrive. The Basel III capital rules make risky assets less profitable. The Volcker rule prohibits proprietary trading.
Goldman will face persistent questions from regulators and politicians about whether its risk-taking is indeed on behalf of clients or whether the firm is managing – as it traditionally has – to bet its own funds.
The issue of conflict-of-interest management at Goldman is also a continuing regulatory, legal and political threat. During much of the post-crisis period Goldman has had to fend off questions about whether it exploits conflicts of interest.
Congressional hearings investigated whether Goldman deliberately sold mortgage products while betting the firm’s own money against the housing market. A judge rebuked Goldman in 2012 for multiple conflicts on an energy deal, including advising one side while having a stake in the other.
As to who wins in the end, there will be an opportunity to gauge the progress in the battle next week when both Morgan Stanley and Goldman report earnings. The rivalry, however, between the two investment banks – the last of their kind – will continue as fiercely as ever.
Additional reporting by Arash Massoudi
Copyright The Financial Times Limited 2014.
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