US Banks: A (Joint) Venture Into A Changing Business Model

Prepping to release earnings earlier (which were moderately encouraging), J.P. Morgan (JPM) CEO Jamie Diamond came forward with a bleak statement regarding the economic and financial sector outlook.  Diamond’s comments focused on the continued deterioration of consumer-oriented businesses.  He expressed doubt that the “industry excesses in areas such as highly leveraged lending and securitization” would ever recover.  The conclusion seemed to be that the banks will have to largely shed their portfolios of mortgage-backed securities, credit cards, and consumer loans to focus on more traditional advisory and lending practices.

Diamond’s statement was very telling for a company built upon a similar business model.  Sandy Weill’s creation of a “one stop financial supermarket” appears to be unraveling.  The “excesses” referred to by Diamond have come to claim an over leveraged Citigroup (C) which failed to realize a turnaround upon the arrival of CEO Vikram Pandit.  Citi announced Monday plans for broad restructuring that could strip the company of one-third, or $700 million, of its assets.  While it appears the company will structure a “good bank-bad bank” to facilitate the reorganization, more details are set to be announced with Citi’s early release of earnings tomorrow.

Morgan Stanley Smith Barney

Morgan Stanley (MS) and Citigroup announced Tuesday a joint venture that will combine Morgan Stanley’s Global Wealth Management business with Citi’s Smith Barney brokerage.  The deal will create the largest U.S. retail brokerage (20k+ Financial Advisors, $1.5 trillion in assets).  While the deal is part of a broader restructuring for Citi, the question is, what is the effect on Morgan Stanley?

The move marks a strategic shift in Morgan Stanley’s Wealth Management business.  When James Gorman took over the GWMG business as COO in 2006, he slashed the bottom 15-20% of Morgan Stanley’s lowest grossing brokers.  Though lacking some of the technological capabilities of other firms, Gorman turned MS into one of the premier brokerage houses focusing on more affluent individuals.  MS was successful in luring away some of the highest grossing brokers from other firms (including Smith Barney) on a platform of more specialized services to a higher margin brokerage force.  Remaining smaller at 8000 FAs than rivals Merrill Lynch and Smith Barney marked a strategic decision to focus on higher margin business.  It will be interesting and I think very revealing to see if Gorman does the same this time around, cutting the bottom percentage of his combined 20,000 FAs.

Details of the Deal

Morgan Stanley agreed to pay Citi $2.7 billion in cash for a 51% majority in the Joint Venture.  Citi will maintain a 49% stake while giving MS the option for purchase of the remaining interest at fair market value beginning three years after the deal is closed.  The purchase will come from cash on Morgan Stanley’s balance sheet; it does not expect additional capital raising.  The acquisition is projected to lower their Tier I ratio by just a percentage point, from a healthy 18.3%.

On a pro forma basis for 2008, the combined entity would have pretax income of $2.8 billion.  Morgan will gross about $300 million in pretax annual income for their $2.7 billion one-time payment.  On top of the additional income, MS expects $1.1 billion in cost savings and synergies.  This represents 15% of expenses excluding broker compensation and by all accounts is reasonably achievable.  No deposits from either bank will be included in the joint venture.  Obviously a concern for the now bank holding company, this increases the incentive for MS to exercise their option to completely buyout Citi at a later date despite having to pay market value.  The final consideration for the deal will be broker retention payments, likely to total $2B to $3B over the next several years.

Diverging Paths

With the recent move, Morgan Stanley seems to be on a path of diversification and continued deleveraging of their balance sheet.  Nearly half of Morgan Stanley’s revenues will now come from their wealth and asset management businesses, up from 28%.  The other half of revenues will come from a scaled down, delevered investment bank.  Goldman Sachs (GS), on the other hand, seems to be biding its time.  Sitting on recent capital injections and FDIC insurance, Goldman continues to specialize in its core advisory and market making businesses.  This model seems difficult to sustain in a deleveraged environment.  That being said, as their competition moves out of these businesses, GS is poised to explode as the market rebounds.

Disclosure: The mutual fund the author is associated with is long JPM

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