With Goldman Sachs in the Rear-View Mirror, Morgan Stanley Chases Down Schwab

Back in 2008, at the depth of the global financial crisis, Morgan Stanley was on sale for a symbolic dollar. There were no takers.

Today the Wall Street firm long derisively known as the “smallest big bank” has roared past archrival investment bank Goldman Sachs in market valuation.

It has built a fee-gobbling, active asset management business as a viable alternative to the no-fee, exchange-traded fund managers that largely dominate the field. 

And now Morgan Stanley — a white-shoe firm traditionally linked to super-wealthy clients — has set its sights on overtaking Charles Schwab Corp., the discount brokerage and wealth management giant, as money manager for the mass affluent.

But according to James Gorman, who has presided over this turnaround as chairman and chief executive officer, Morgan Stanley is just getting started.

He describes his first 11 years at the helm as a period of fragility and recovery. Today, he says, the bank is at “an inflection point” — ready for even higher growth through a more vigorous pursuit of market share, an enlargement of its client base, and multibillion-dollar returns of excess capital to shareholders.

Within five or six years, Gorman predicts, Morgan Stanley will almost double its assets under management to a colossal $10 trillion. That would lift the firm to the stratospheric AUM levels of BlackRock and Vanguard.

“We have built a true juggernaut,” Gorman says in an exclusive interview with Institutional Investor. 

To be sure, Morgan Stanley faces some daunting challenges as it steamrolls ahead.

Foremost is whether it can entice its millions of new self-directed, mass affluent investors to upgrade to fee-paying products and financial advice. 

On the investment banking side, there is the risk management failure that led to the loss earlier this year of almost a billion dollars in loans to Archegos Capital Management, a family office.

Morgan Stanley’s exposure to China is a concern because of growing geopolitical tensions between Beijing and Washington.

Then there is the gender issue. For all his foresight and attention to detail in leading Morgan Stanley to unparalleled success, Gorman, 63, apparently didn’t plan ahead for diversity at the very top. In May, he disclosed a list of four possible candidates — all very capable white males — to succeed him in a few years. The absence of women stole the headlines.

But these negatives cannot obscure the accomplishments and further promise of the Gorman era.

Gorman has revved up organic growth with a combination of cost cutting, a focus on products and services where Morgan Stanley enjoys a competitive edge, and a relentless pursuit of increased fee margins while other firms struggle with fee compression.

At the same time, Gorman can lay claim to being the banking community’s supreme dealmaker after three transformational acquisitions. The earliest deal was the purchase of Smith Barney from Citigroup in two stages, beginning in 2009. It created one of the world’s largest wealth management platforms — and one aimed squarely at mass affluent clients instead of the high- and ultra-high-net-worth tier to which the bank had traditionally catered.  

Then in 2020, Morgan Stanley took another big step in expanding its wealth management business down market by acquiring E*Trade Financial Corp., a leading online brokerage. Also last year, Gorman closed a deal for Eaton Vance Corp., extending Morgan Stanley’s footprint into fast-growing asset management sectors like customized direct-indexing portfolios and ESG-dedicated investments.

Altogether an impressive performance by somebody who only became a banker well into middle age.

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A native Australian, Gorman began as a lawyer. He moved to New York and became a management consultant at McKinsey & Co., rising to senior partner. He then joined Merrill Lynch, where he was soon named head of its brokerage business.

Gorman finally launched his banking career in 2006, at age 47, when Morgan Stanley hired him away from Merrill to expand its wealth and asset management businesses. Three years later, he crafted the Smith Barney deal.

But in between, Morgan Stanley was on the verge of extinction because of missteps by its investment bank during the 2007-08 financial crisis. At one point, then-Treasury Secretary Hank Paulson offered Morgan Stanley to JPMorgan Chase & Co. CEO Jamie Dimon for a nominal dollar. Dimon turned him down. 

Gorman became CEO in 2010 and was named chairman as well two years later. His darkest moment as chief executive was Moody’s ratings downgrade of Morgan Stanley in 2012 to just three notches above junk status. Moody’s reasoned that Morgan Stanley — despite its new emphasis on wealth management as a reliable revenue stream — still had significant exposure to volatility and potentially high losses in its capital market activities. 

Gorman got the message: Since investment banking remained a major portion of Morgan Stanley’s business, he would have to further reduce risks on the balance sheet. Maybe profits wouldn’t be maximized on the up days, but neither would they get blown away on the down days.

In recent years, Morgan Stanley has ranked at or near the top of global players in investment banking and trading performance. In part, this is a reflection of a very reduced list of peers. Since the 2007-08 financial crisis, U.S. banks have collectively grabbed market share from the sputtering Europeans. Morgan Stanley, Goldman Sachs, and JPMorgan have been the standout beneficiaries.

But internally, much of the credit for the investment bank’s turnaround goes to Ted Pick, 52, Morgan Stanley’s head of investment banking and trading. In May, Pick and Andy Saperstein, the head of wealth management, were named co-presidents, making them the favorites to succeed Gorman. 

Pick has spent his entire career at Morgan Stanley. He came up as a trader, with the elbows-high reflexes and raunchy repartee common to the profession.

Over the last dozen years, Pick has smoothed his rough edges while scoring notable successes in three key areas: equities trading; prime brokerage; and fixed income, currencies, and commodities, or FICC.

He began in 2009 with a mandate to restore the health of equities trading, which was walloped by the financial crisis. “We took the view that equities had long been one of our stronger businesses and that we wanted to reinvest in it,” recalls Pick. 

Morgan Stanley notched an early success in its comeback in equities by claiming a leading market share in the rise of quant trading. Over the last seven years, the firm has held the No. 1 position in the equities business overall.

Its top perch in equities filters through to other parts of its investment banking. When a firm knows that Morgan Stanley is trading its stock, it often gives the investment bank an edge in the underwriting business.

Prime brokerage was another historically strong business that rebounded quickly from the financial crisis, thanks to the bank’s longtime ties to hedge funds. “We had a unique track record in having identified new hedge funds when they were still working out of the proverbial garage,” says Pick.

The way Morgan Stanley handled its FICC business has also been a big plus for its investment bank. As a high-cost, high-capital-consumption business, FICC was a drag on Morgan Stanley’s bottom line. So five years ago, Pick downsized FICC, cutting both the headcount and capital expenditures by a quarter.

Surprisingly, Morgan Stanley didn’t lose FICC market share. At the same time, it recorded some of its best earnings quarters in that business by offering FICC services to selective parts of the market instead of trying to cover every possible client. “They basically showed everybody else that you can cut costs while staying committed to the business,” says an executive at a rival bank. 

Pursuing a decade-long strategy, Gorman and his team took Morgan Stanley out of the financial crisis, created a reliable income stream from wealth and asset management, and seemingly reduced risks in investment banking. 

Last year, the company earned $11.2 billion on $48.2 billion in revenues, up from $9.2 billion in net income and $41.4 billion in revenues in 2019. In the first half of this year, net profit rose by 55 percent over the same period in 2020 to a record $7.6 billion, while revenues jumped to $30.5 billion from $23.4 billion. The investment bank accounted for about half of those revenues and profits.

Then in January 2021, Moody’s upgraded Morgan Stanley to A1, its highest credit rating.

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All that good news was tarnished by the Archegos fiasco.

Archegos Capital Management, a family office owned by veteran investor Bill Hwang, borrowed billions of dollars from Wall Street and foreign banks to purchase outsize stakes in a small number of U.S. and Chinese companies. Hwang funneled some $10 billion into ViacomCBS shares alone, making Archegos the largest institutional investor in the shaky media giant.

In March, Viacom shares fell sharply. The banks demanded repayment of their loans. When Archegos was unable to pay, the lenders claimed its assets and sold them off. Some were quicker than others. Goldman Sachs and Wells Fargo & Co. exited with no losses. Worst hit with multibillion-dollar losses were Credit Suisse Group and Nomura Holdings.

Morgan Stanley lost $911 million, the only U.S. bank to suffer a major setback. As the leading prime brokerage, Morgan Stanley unsurprisingly made some of the largest loans to Archegos. But Morgan Stanley also was an underwriter for Viacom, which made it harder to off-load its position quickly. 

“They incurred losses, recognizing that from a reputational standpoint they had to do right by their client,” says Steven Chubak, a Wolfe Research analyst. “So they had to wait a little longer to get rid of those positions.”

Morgan Stanley’s two-day delay after Goldman and Wells Fargo unloaded Viacom proved to be the difference between zero losses and almost a billion dollars down the drain.

Even analysts who have long been bullish on Morgan Stanley don’t hide their disappointment with the bank’s risk management failure. “They simply screwed up,” says Richard Bove, a longtime bank analyst now at investment bank Odeon Capital Group. “What they did was inexcusable.”

In the aftermath of the Archegos affair, Morgan Stanley reviewed all its margin positions in prime brokerage and across its wealth management platforms. According to Jonathan Pruzan, 52, the chief operating officer and another possible successor to Gorman, the bank has reduced exposure in accounts deemed higher risks — or threatened to do so unless the clients increased their collateral.

But Pruzan concedes that until regulators insist on more transparency from family offices, they will pose a continuing problem. “I don’t think we will ever have perfect information from these clients unless something dramatically changes in terms of disclosure requirements,” he says.

Nobody expects Morgan Stanley to turn its back on family offices or reduce its lucrative prime brokerage. But the Archegos affair does illustrate that Morgan Stanley — despite its burgeoning wealth and asset management business — remains beholden to its volatile investment bank and trading activities for much of its revenue and earnings.

Those results are reflected in its trailing price-earnings ratio of 12.81, which badly lags Schwab’s 24.39 trailing P/E.

Little wonder that Morgan Stanley emphasizes its dramatically improved price-to-book value instead. Gorman can take genuine pride in raising a stock that traded at only 70 percent of book value a decade ago to the current 1.8 times book.

He also points out that few competitors — either banks or wealth managers — are delivering such generous returns to investors. That claim was highlighted by the announcement last month that Morgan Stanley is doubling its common stock dividend to $0.70 per share later this year and will buy back up to $12 billion of its shares by mid-2022.  

This upbeat news followed the disclosure by the Federal Reserve a few days before that the major U.S. banks had passed their stress tests and could boost payouts to shareholders.

“We have always said that once the final rules were in place, we will return excess capital to our shareholders and still have room to grow,” says Sharon Yeshaya, the newly appointed chief financial officer.

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In recent years, Schwab has become Gorman’s white whale. And to lead the hunt against Schwab, he chose Saperstein as head of wealth management.

Saperstein, 54, was a Gorman colleague at Merrill Lynch and moved over to Morgan Stanley at the same time he did in 2006. Mirroring Pick’s success at the investment bank, Saperstein has built a wealth management powerhouse that makes him an equally credible choice to succeed Gorman.

Saperstein’s star will shine still brighter if he gains market share on Schwab.

For years, Morgan Stanley wanted to extend its wealth management business down market to younger, mass affluent clients who have flocked to Schwab. Developing an in-house operation was too difficult. Building an army of financial advisers to deal with clients holding $50,000 accounts wasn’t worth the expense. Those clients had to be reached on a digital basis. But Wall Street banks aren’t very good at technology, despite enormous expenditures and hype.

Morgan Stanley had been courting a reluctant E*Trade for almost a decade. It was the third largest online brokerage. But after No. 1 Schwab agreed to buy No. 2 TD Ameritrade in November 2019, E*Trade no longer had the scale to compete against the new behemoth. It quickly accepted a $13 billion all-stock offer from Morgan Stanley in February 2020.

The deal puts Morgan Stanley head to head with Schwab in competition for upwardly mobile retail clients. E*Trade brings 5.5 million of these self-directed investors with $880 billion in assets.

“We needed the E*Trade brand and its leading technology, which we could not have built ourselves,” says Saperstein. 

He envisions the progression of a self-directed E*Trade client to fee-paying financial advisory service client over the course of years.

Maybe so. But it often doesn’t work out that way for the simple reason that a self-directed client who started out with a $50,000 account in a discount brokerage and is now worth $2 million isn’t keen to turn over the nest egg to a Morgan Stanley financial adviser at a 100-basis-point annual fee.

Saperstein believes the key to a successful recruitment of new fee-paying clients lies with E*Trade’s industry-leading corporate stock plan franchise. The brokerage administers such plans for 40 percent of S&P 500 companies, including major health insurers and Facebook. It has 2 million corporate stock participants with $365 billion in total assets.

It might prove more efficient to engage a multitude of E*Trade clients at their place of employment in the hopes of persuading a fraction to sign up for financial advice than it is to chase after individual E*Trade customers outside the workplace.

“For Morgan Stanley, the corporate channel is a really great mousetrap,” says Chubak, the Wolfe analyst.

But that’s the long game. 

The biggest immediate benefit to Morgan Stanley from its acquisition of E*Trade is access to cheap money. Between trades, the brokerage’s account holders park as much as a quarter of their funds in cash deposits at little or no interest. These deposits totaled $80 billion at the end of 2020. By using E*Trade deposits to partially replace wholesale funding, Morgan Stanley will realize $250 million in cost savings annually.

The investment community woke up to the success of Gorman’s strategy only after Morgan Stanley acquired E*Trade and Eaton Vance, an asset manager.

Following the announcement last October of the $7 billion Eaton Vance deal, Morgan Stanley’s stock rose 96.5 percent through July 27. That compares to a 52.6 percent rise in the KBW Nasdaq Bank Index over the same period.

With a $179 billion market cap, Morgan Stanley has overtaken both traditional rival Goldman Sachs ($127 billion) and Citigroup ($140 billion) to become the fourth largest U.S. bank by market valuation. 

With the Eaton Vance acquisition, Morgan Stanley’s assets under management swelled by $500 billion for a current total of $1.5 trillion AUM.

Even before the Eaton Vance deal, Morgan Stanley’s asset management business was operating at full throttle. Revenues and AUM more than doubled over the previous five years. In an asset management world dominated by ETF-driven, passive-management mammoths, Morgan Stanley combined strong organic growth and lucrative fee income to emerge as the best-in-class active asset manager.

Under Dan Simkowitz, 56, head of asset management, there has been a strong focus on alpha investments such as private alternatives like real estate, mid-cap private equities, and private credit, where Morgan Stanley has decades of experience. “These are real growth areas where it’s hard to start from scratch,” says Simkowitz, who rounds out the list of four possible candidates to succeed Gorman.

The equities portion of asset management focuses mainly on portfolios concentrated with only 30 to 40 stocks. According to Simkowitz, the more usual 100-plus stock portfolios barely outperform the S&P 500 index. 

He describes the typical Morgan Stanley asset management portfolio as a barbell, with beta and fixed-income investments at one end and higher-risk, higher-yield stocks and alternatives at the other end. 

On the beta side, Morgan Stanley stays away from sectors with intense commoditization and fee compression, such as S&P 500–linked ETFs popularized by BlackRock and Vanguard. “The world doesn’t need another giant to do that,” Simkowitz says.

But the Eaton Vance deal brought other beta platforms that elicit his enthusiasm. They include two Eaton Vance–owned firms:  Parametric, the No. 1 purveyor of customized solutions, and Calvert Research and Management, a market leader in ESG investments.

Rising numbers of institutional and retail investors want accounts built to their specifications and values. Parametric can help customize ESG funds for clients who wish to steer clear of companies involved in such businesses as tobacco, gambling, weapons, and fossil fuels, among other products — or avoid firms mired in social and political controversies.

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China looms as another potential bonanza for Morgan Stanley and other U.S. financial services firms. Yet analysts can find no historical parallels to the current situation in which the world’s two largest and most intertwined economies are increasingly at political odds.

“We’re in uncharted waters,” says Michael Hirson, a China expert at Eurasia Group, a political risk consultancy. 

Glancing through Morgan Stanley’s website on its activities in China, there’s no hint of a cold war between Beijing and Washington. Instead, there is a compilation of the bank’s patient, steadily increasing presence in China over almost three decades.

“We would be foolish to withdraw from the second largest economy in the world because of the current political rhetoric,” says Gorman. 

Since opening offices on the mainland in 1993, Morgan Stanley’s strategy has been to build up a fully integrated financial services operation offering financing, restructuring, merger and acquisition advisory, research, fixed income, foreign exchange, private equity, and real estate funds.

Morgan Stanley does not disclose its exposure in China. But its net revenues in Asia expanded by 32 percent last year — the fastest growth for any region — and China was a leading driver. Asia accounted for $6.75 billion of Morgan Stanley’s $48.2 billion in total net revenues for 2020.

The bank has seemingly remained unperturbed by Beijing’s repression of the Uighur population in Xinjiang province, its moves to bring Hong Kong to heel, and its increasingly aggressive military posture toward Taiwan and its neighbors along the South China Sea.

Thus far, pressure from Washington hasn’t been great enough to make U.S. financial firms hold back on their expansion in China. “But it’s definitely becoming an issue,” says Hirson. “It’s probably the only bipartisan issue out there.”

Beijing, meanwhile, has been adroit at exploiting foreign bank fears of not being invited to the banquet. The underwriting potential is huge, with Chinese companies accounting for some of the largest IPOs over the last five or six years. And the prospect of managing just a fraction of the $18 trillion of Chinese private wealth leaves U.S. and European firms salivating.

As it opens its financial sector further, China courts foreign banks by playing them against each other. Last year, it gave regulatory approval to both Morgan Stanley and Goldman Sachs to take majority stakes in their China securities joint ventures. The permission came just as Beijing was clamping down on Hong Kong dissent and relations with Washington were worsening. But neither U.S. bank felt it could afford to let its rival forge ahead alone.

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For all the careful strategy to transform Morgan Stanley into a profitable, balanced firm with a global reach, Gorman somehow overlooked the gender gap at the pinnacle of the firm. 

With a woman at the helm at Citigroup and one of two women executives likely to become head of JPMorgan Chase, the absence of women among the four candidates to succeed Gorman is glaring.

“If you look at the women who are leading this firm in very senior roles, none of them are one step from being CEO at this point in time,” says Gorman. “But we have a phenomenal bench right behind them.”

True enough, there is no lack of women in higher executive posts at Morgan Stanley. A short list would include vice chair Shelley O’Connor; CFO Yeshaya; co-head of investment banking Susan Huang; CEO of China Wei Christianson; and head of Europe, the Middle East, and Africa Clare Woodman. 

But only Yeshaya, 41, is the right age to become a candidate to succeed Gorman’s successor — presumably a dozen or more years from now.

“We know we have more work to do,” says O’Connor.

Amen.