James Gorman: Market doesn't "understand' Smith Barney deal

Feb 12, 2012 @ 12:01 am

By Bloomberg News

James Gorman walked across the stage of the auditorium on the top floor of Morgan Stanley's Times Square headquarters.

It was late October, and he was in the midst of the second investor revolt that he has been through in three years, with the first one occurring during the financial upheaval of 2008.

Morgan Stanley's chief executive, a 53-year-old Australian, addressed employees a day after the company released its earnings. And he had just finished a media blitz to ward off persistent rumors that Morgan Stanley is heavily exposed to shaky European debt.

The whispers, which Morgan Stanley denied, helped drive its stock down almost 50% over the course of 10 weeks.

Mr. Gorman asked managing director Tom Wipf, a 25-year Morgan Stanley veteran who was in the audience, if he felt the strain as the firm's shares dropped below $12 a share. Mr. Wipf shook his head from side to side.

“That's right; you're battle-hardened,” Mr. Gorman said. “You've seen real stress.”

Mr. Gorman turned to the standing-room-only crowd.

“For those of us who lived through the last crisis, that was real stress,” he said.

That a 50% share price drop in a little more than two months didn't trigger real stress says a lot about the past few years for Morgan Stanley. The 77-year-old investment bank has proved that it can survive under the worst circumstances.

In 2008, Morgan Stanley, 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% of itself to Japan's Mitsubishi UFJ Financial Group Inc.

Now Mr. Gorman, who came to Morgan Stanley in 2006 as head of its brokerage unit after holding the same job at Merrill Lynch & Co. Inc., must show that the company 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 eurozone are shunning bank shares. Revenue and profits are down, and so is compensation, including Mr. Gorman's, which fell 25% last year, from 2010.

In December, he completed his second year as chief executive, and the board handed him the job of chairman Jan. 1 after Mr. Mack stepped down from a role that he had held since 2005.


To put five years of write-downs and government bailouts behind him, Mr. 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.

Mr. Gorman has reorganized the firm around three businesses: wealth management, investment banking and trading, and he has set as a target 15% return on equity, modest compared with the 23% that the bank earned in 2006. The bank's return on equity last year was 4%.

“We've been among the most aggressive in repositioning our firm,” Mr. Gorman said in an interview in December. “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.”

Mr. Gorman's most assertive move has been to turn back the clock 15 years and look for profit in his retail brokerage. He and Mr. Mack created a joint venture between the firm's old Dean Witter brokerage and Citigroup Inc.'s Smith Barney in June 2009 and took a controlling 51% stake in the unit, which Mr. Gorman ran before his promotion to chief executive.

With 17,000 financial advisers and $1.65 trillion under management, Morgan Stanley Smith Barney LLC is the world's largest retail brokerage, surpassing Bank of America Corp.'s Merrill Lynch Wealth Management, which boasts $1.5 trillion. Morgan Stanley last year generated 41% of its revenue from that unit, compared with 16% in 2006.

Mr. Gorman has set a target of 20% pretax profit for 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 Mr. Gorman hired in 2009.

At the end of last year, the brokerage firm was a long way from its goal, with a margin of 10% for the year.

The brokerage firm has been held back by delays in the integration of Dean Witter and Smith Barney technology, Mr. Gorman said, and will prove its worth in the long term.

“The market doesn't understand the potential of the Smith Barney acquisition,” he said. “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 were down last year by 44% to $2.28 trillion from their 2007 peak, while U.S. equity-trading volumes were down 20% from 2009, according to data compiled by Bloomberg.

The financial firms' response has been to take a hatchet to staff levels and compensation. Banks globally announced more than 230,000 job cuts last year, according to Bloomberg data.

For its part, Morgan Stanley said in December that it would cut 1,600 jobs, and in January, it reduced pay for senior bankers by 20% to 30%. Among those who took a hit was Mr. Gorman himself, whose compensation package last year totaled $10.5 million, according to people familiar with the decision, a 25% 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.


Mr. Gorman hasn't been able to look to the stock for support of his decisions. On Feb. 3, Morgan Stanley shares traded at $20.31, 25% below what they were worth when he took over. They fell 44% last year.

“We're stronger. We have $8 billion more capital,” Mr. Gorman said of the progress made last year.

“We have spun off a bunch of prop businesses, and we've gone down half in value because of that? Why?” Mr. Gorman said.

Morgan Stanley has rebounded so far this year.

Its stock was up about 34% through Feb. 3, as U.S. economic growth showed signs of accelerating and European leaders moved 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.

“There are signs the U.S. economy is doing a little better, unemployment ticking down,” Mr. Gorman said Jan. 25.

He 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. Mr. Gorman keeps supplies of Vegemite — a favorite Australian food that is made from yeast extract and loathed by most Americans — in the executive kitchen and eats it on toast.

The 6-foot-3-inch, 195-pound executive's favorite pastimes include reading John le Carré spy novels and taking weekly boxing lessons.

As he begins his third year as chief executive, Morgan Stanley's business mix and revenue breakdown look almost identical to the 2004 and 2005 versions at Merrill Lynch during Mr. Gorman's final years there.

His 15% return-on-equity target is about what Merrill Lynch produced in his last years there. Merrill Lynch, 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.

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. And in 2009, it scaled back on risk at a time when markets were recovering.

“The problems have really stretched back almost a decade, so a few quarters only represents early days of measuring their progress,” Mr. Mayo said. “It really comes down to two words: Show me.”

Mr. Gorman's overriding goal is to persuade employees and the markets that a Morgan Stanley turnaround is imminent.

“We were the last guys to get through the last crisis,” said Mr. 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,” he said. “The market will eventually catch up.”


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