Most investment banks spent another year under the hood fine-tuning their strategy and operations in the face of often confounding economic, business and regulatory changes. But one firm, having taken tough decisions to rebuild and remodel early, came into its own in 2014 and realised the gains of its endeavours with some glittering wins. Morgan Stanley is IFR’s 2014 Bank of the Year.
The makeover of Morgan Stanley has been nothing short of extraordinary. Standing on the brink of oblivion amid the rubble of the financial crisis, the bank embarked on years of tough, no-nonsense rebuilding, which culminated in 2014 with an outstanding performance that proved it had regained its spot as a world-class business. The new Morgan Stanley is leaner, returns-focused – and highly successful.
After the collapse of Lehman Brothers in 2008, Morgan Stanley was the next giant waiting to fall. Its share price had plummeted; credit and CDS spreads were in the stratosphere; and hedge funds were yanking tens of billions of dollars out of its prime services platform. Morgan Stanley was forced to convert to a bank holding company so it could borrow from the Fed’s emergency windows. As would later emerge, it used those facilities to the tune of US$137bn, more than any other bank.
It also needed a US$9bn cash infusion from Mitsubishi UFJ Financial Group (in return for a 22% equity stake). Morgan Stanley received a further US$10bn from the US Treasury’s Capital Purchase Program under TARP. Even with those lifelines, however, some daunting remedial work lay ahead.
The bank had to shrink its balance sheet – and did so in dramatic fashion, from US$1.326trn to US$626bn in just a matter of months. It also substantially improved asset quality, building a sizeable liquidity buffer, a solid funding profile that no longer relied on short-term borrowing, and a robust capital base. Its CET1 capital ratio was 14.4% at September 30, a 180bp increase from the same time in 2013.
In impressively short order, then, Morgan Stanley has transformed itself from a deeply troubled and highly leveraged trading house – with a heavy principal orientation and a fetish for complex risk – into a well-rounded, client-focused investment bank balanced against a best-in-class wealth and investment management franchise.
It is an impressive achievement. And while there is still more work ahead, the heavy lifting has been done. The firm has made all the major strategic decisions it’s going to make for the time being, said chairman and CEO James Gorman.
“For now, it’s less about dramatic change, although that doesn’t mean we can’t have dramatic performance improvement,” said Gorman, who is four years into his job. “We want fewer capital-intensive activities as we drive the new Morgan Stanley.”
Less is more
Since the firm’s near-death experience, a lot has happened. A thorough de-risking process, a dramatic reduction in the balance sheet, and a new strategic direction forged on the back of (and in anticipation of) the Dodd-Frank rules has seen Morgan Stanley rethink, rebuild and reform. As part of that process, it has exited a number of businesses.
Process Driven Trading, the legendary proprietary trading group, was spun out to its founder Peter Muller. Equity Trading Lab, the quantitative technology-driven prop business, became an in-house electronic client-trading platform. FrontPoint, the storied US$6.5bn in-house hedge fund, was sold to its management.
In addition, the troubled Crescent Real Estate Equities REIT went to Barclays, while TransMontaigne Partners, the terminal and transportation company, was bought by NGL Energy Partners. The physical oil merchanting unit is going to Rosneft.
In the process, the bank has returned to its roots. “What I’m really proud of is that this firm is now the Morgan Stanley it always was – except it’s stronger and more stable,” said Gorman.
“The things that have made Morgan Stanley great throughout the firm’s existence – our core advisory business, our equities franchise and part of the fixed-income business – are coming back to the levels for which they were respected for so long.”
The FICC RWA reduction and de-risking that were a crucial part of the revamp actually began before the worst days of the financial crisis. The process had already been started at the tail-end of 2007, after the firm was forced to recognise a US$9.4bn writedown, stemming mainly from a massive proprietary short in super-senior synthetic subprime CDOs that had gone monumentally wrong. That led to a 93% decline in FICC revenues between fiscal 2006 and 2007 – and proved to be a wake-up call for all concerned.
“2007 was a shock to the management of Morgan Stanley, and we finally realised the misstep we’d made with sub-prime,” said Colm Kelleher, the bank’s CFO at the time and now president of the institutional securities group.
“We realised we had moved away from our true alpha – our client business. We knew we had to reshape the business pre-September 2008. Post-that just amplified our thoughts.”
For his part, Gorman said that management had quickly come to the view that the regulatory environment had changed permanently, and that the way banks operated – with thin capital bases and outsized levels of leverage – would no longer be tolerated.
“So we started adjusting our business model,” he said. “Part of our thinking reflected the fact that risk-weighted assets were very expensive, so you wanted higher-returning RWAs – and you wanted them in businesses where you had natural competitive advantages. Strategically, it was fairly straightforward, although the teams have worked hard over three to four years to make it happen.”
Many happy returns
As part of the FICC RWA reduction, Morgan Stanley shut its massive correlation book, while also working some huge uncollateralised derivatives positions off its balance sheet.
Operating under a drastically slimmer RWA stack, the bank’s platform is now centred on the higher return areas of credit and securitised products, while rates and FX have been scaled back.
“We’ve done a lot to optimise our fixed-income franchise over the past few years, and in 2014 we began to see the fruits of that labour, with greater consistency of results and an improvement in return on capital,” said Robert Rooney, global co-head of fixed income.
Morgan Stanley’s return on average CET1 capital in the first nine months of 2014 was 11%, a heady jump from the 4% realised in full-year 2013.
In Q3 2014, FICC posted net revenues of US$1.13bn – just one dollar in eight of firm-wide revenues. In 2006, the zenith of the pre-crisis era, FICC was making two dollars of every seven Morgan Stanley made.
“With most of our RWA reductions and the right-sizing of our rates business now behind us, we feel the fixed-income division is well-positioned to achieve returns above its cost of capital by capturing a greater share of market opportunities,” said Michael Heaney, the other global co-head of fixed income.
“[We are] growing in areas where we feel we have a competitive advantage, such as municipal securities and securitised products, and continuing to improve the velocity of our balance sheet.”
Gorman said FICC was now close to its desired state.
“We’ve refocused the business around client activities and we feel very comfortable with where we are on size,” he said.
“It’s a much smaller part of Morgan Stanley. Some people criticise us for being small. I don’t understand that. You want to be in businesses you perform well in. Size isn’t relevant; it doesn’t buy you advantage. The focus now is on getting the returns up. Part of that will be rolling off legacy assets – which will happen over the next year or so.”
Even if FICC is in a funk across the industry, Gorman and Kelleher are comfortable having a presence but letting their former problem-child play second fiddle to the world-beating equities and investment banking franchises.
“We need to have a relevantly sized fixed-income business for our client base,” Kelleher said. “It can’t be so small that it’s irrelevant, but it can’t be so big that it outgrows our clients. We’ve basically taken 60% of the capital out of the business, but we’re now at the scale we want. The focus is on optimising deployed capital.”
And the wider industry has noticed.
“Morgan Stanley has been a clear outperformer across all of its trading businesses in the past year,” said an analyst at a research and analytics firm. “And it’s not trying to pretend to be what it’s not.”
Another central change in the new Morgan Stanley was the ingestion of the Smith Barney retail platform into the Morgan Stanley wealth management business, which Gorman described as a game-changer.
“It took what was a great recovery story post-crisis on our institutional businesses and the strength in asset management, and added a dramatic new dimension to the new Morgan Stanley,” he said.
Management knew before September 2008 that it needed to bulk up wealth management in order to have a more balanced business. With the benefits of guaranteed revenue plus control over costs, it sensed it could get ROE up; at the same time it would provide a smoothing of the volatility of investment banking. But to make it work, the bank had to go all-in.
The acquisition of Smith Barney immediately created scale.
“In wealth management we have record client assets exceeding US$2trn and are meeting our profitability targets,” said Greg Fleming, president of wealth and investment management.
“Investment management is attracting new money through strong performance and is set to surpass US$400bn in assets under management. These two businesses, which make up half of Morgan Stanley, are providing stable, predictable and growing returns for shareholders.”
The creation of Morgan Stanley Wealth Management has rendered the firm an essential counterparty with a unique value proposition – a world-class investment bank allied with the largest retail distribution capability in the world.
“We’ve started cross-selling through the retail networks and have generated huge incremental revenue,” Kelleher said. “The connectivity between wealth management and ISG is very strong.”
Meanwhile, Morgan Stanley’s equity trading sits at the apex of the industry. Among many other things, its prime brokerage platform excels in providing services to the most demanding of high-frequency quantitative hedge funds. The firm is number one in US cash equities; it has a 40% share of the DMA swap market; and it has been making rapid headway in areas such as exotic equity derivatives.
“We are in the business of consistently servicing our clients across the ‘nine boxes’ – cash equities, prime brokerage and derivatives in the Americas, Europe and Asia,” said Ted Pick, global head of equities. “Trust and consistency are what our clients most value.”
Back on top
The sweeping rebuilding effort resulted in a remarkable roster of successes in 2014. The firm was in on many of the year’s transformational and complex event-driven transactions, which demanded superior intellectual technology, a solutions orientation, internal collaboration, first-rate structuring, and the ability to capture the benefits of deep and diversified distribution channels. It offered all of this in spades, meaning clients tapped Morgan Stanley time and time again for their most important trades.
To take just one example, compare the largest 25 M&A deals of 2014 with Morgan Stanley’s top 25 assignments – they’re identical. The firm scored a 100% hit-rate, the only investment bank to do so. And in a year that saw an 81% pick-up in IPO volumes, Morgan Stanley garnered the biggest underwriting market share worldwide. In so many instances, advisory and financing worked hand-in-hand to create optimal client solutions.
“Our investment over the long term in our clients and in our talent, together with our global reach and scale, allowed us to build a true competitive edge in 2014,” said Franck Petitgas, global co-head of investment banking.
“We sought, as always, to leverage our global footprint and to draw on the best thinking from across our firm to deliver new solutions for our clients around the world.”
Indeed, Morgan Stanley completed numerous complex deals that required multiple financing products as well as canny market advice.
Acquisition deals for Dynegy (for coal and gas generation assets from Duke Energy and Energy Capital Partners), Tyson Foods (Hillshire Brands), Alcoa (Firth Rixson), Zebra (Motorola Solutions’ Enterprise Business) and Forest Laboratories (Aptalis Holdings) were all complex multi-part advisory and financing assignments – and spoke to the way the new firm operates.
Other notable deals were for Blackstone around its Hilton stake (the largest-ever margin loan in the US) and the complex NYSE IPO for Israel Chemicals, which was partly structured as a Prepaid Variable Forward sale.
And on the stand-out ECM deal of the year for Alibaba – the largest IPO in history – Morgan Stanley was not only joint global co-ordinator and joint bookrunner, it was also lock-up release agent with Credit Suisse. The firm also led a US$3bn credit facility for Alibaba in August that became effective at the time of the IPO.
Morgan Stanley also got itself on to the underwriting dockets of most of the year’s biggest and transformational investment-grade, crossover and high-yield offerings, with debt IPOs one specialty and subordinated and preferred structures another. In high-yield, the firm had roles on most of the year’s largest trades, many of which were acquisition-related or involved corporate finance angles that created genuine and lasting benefits for clients.
“We were previously much more focused on product, so we sold M&A, we sold IPOs and bonds, but we didn’t sell clients,” said Kelleher.
“That’s what we’re doing now. We have some way to go around this, but it’s a good philosophy.”
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