Morgan Stanley deal redoubles pressure to improve

April 21, 2011

By Antony Currie
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Chalk one up for Morgan Stanley boss James Gorman. Persuading Mitsubishi UFJ Group to convert $7.8 billion of preferred stock into common shares early will save his bank almost $800 million a year in dividend payments and lift its common equity. It’s a smart and opportunistic move to offload the expensive capital that saved the Wall Street firm’s hide in the 2008 meltdown.

Of course, Morgan Stanley’s deal with its Japanese partner isn’t all good. Increasing the capital base makes the bank’s target of a mid-teens return on equity that much harder to reach, especially after achieving only about 6 percent in the first quarter. Not having to pay Mitsubishi dividends will only make up around half the extra earnings needed to post a 16.5 percent return with the extra capital — and to sustain it across the cycle.

That’s a distant prospect either way, even if Morgan Stanley is making progress. Its advisory and underwriting units are performing well and revenue from the equities sales and trading operation posted its best quarter since the crisis. But there’s a long way to go. At 10 percent, wealth management’s pre-tax margin is slightly better than what it posted for all of 2010, but it’s still half Gorman’s target.

Even the beleaguered fixed income trading unit looks better. Revenue more than doubled from the fourth quarter, after stripping out accounting dings on its own liabilities. But there’s still no tangible evidence Morgan Stanley is making sufficient headway to improve its market share from 6.5 percent among the top nine players to the 8 percent management wants to achieve within a year.

Gorman, who will be under growing pressure to improve the bank’s performance in his second year on the job, could decide to plow some of the additional equity into trading in hopes of increasing returns. Or he could lobby the Federal Reserve to allow his firm to buy back some of the extra capital. Neither step is a sure thing. For now, the Mitsubishi deal leaves the CEO’s recovery plan with less margin for error.

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