John Mack Returns, Big Trading Comes to Morgan Stanley

John Mack’s career paralleled the evolution of Wall Street. Mack joined Morgan Stanley in 1972 as a bond salesman. He rose through the ranks on the strength of his capital market savvy and deal making prowess. A protégé of MS Chairman Dick Fisher, Mack became firm President in 1993.⁴ Mack’s high regard for MS’ culture made him a Wall Street anomaly—a “one firm Banker.”

As a Morgan Stanley “lifer,” Mack absorbed certain lore about the firm’s culture. This began with J.P. Morgan’s appearance before the 1912 House Banking Committee’s Pujo hearings. Asked by the committee chairman whether he used money or property as the primary basis for lending, Morgan famously answered that “the first thing is character … because a man I do not trust could not get money from me on all the bonds in Christendom.”⁵ Another layer of firm DNA was laid down in 1933 at the Senate Banking Committee’s hearings into how Wall Street malfeasance contributed to the 1929 stock market crash. Jack Morgan, J.P.’s son, testified on behalf of the firm. In the end, committee counsel Ferdinand Pecora concluded:

“Mr. Morgan was undoubtedly wholly candid when he declared … I consider the private banker a national asset … any power which he has comes … from the confidence of the people in his character and credit … not financial credit, but that which comes from the respect and esteem of the community.’”⁶

A third component arose out of the Justice Department’s 1949 suit against MS and 16 other investment banks alleging “conspiracy and combination” in violation of antitrust laws. Harold Stanley, the firm’s senior partner, defended MS in the case. In 1952, Judge Harold R. Medina ruled against the Justice Department. In his ruling, Medina wrote of Stanley’s testimony as follows:

“Sensing from the outset the importance of his credibility as a witness, I followed with great care … his deposition testimony … I checked every statement … in search of discrepancies or possible equivocations or lack of frankness; and I submitted his statements, under oath and otherwise, to every one of those tests which an experienced judge applies in his every day search for the truth. As a result, I became convinced that his testimony could be relied upon … The fact that Stanley denied the existence of any such conspiracy as charged … is one of the significant features in the case …”⁷

The “Medina judgement” was regarded as so much an expression of the firm’s culture that well into the 1970s new employees were given a copy and instructed to read it.

However, investment banking changed during Mack’s career. Traditional franchises “commoditized,” meaning that margins and returns suffered due to intensifying competition. This was especially evident in capital market intermediation. Early in the 1970s, MS boasted the most envied list of relationship clients; it included Exxon, IBM, GM, GE, AT&T, and DuPont. These firms routinely hired MS to lead their capital market issuance. However, in the 1980s competitors, like Salomon Brothers and First Boston, convinced MS’ clients to competitively bid their stock and debt deals. Predictably, MS market share plummeted, along with the fees it used to earn.⁸

This evolution ushered in other changes. Investment bank relationships with clients became more “arm’s length.” Unsure whether it would be reciprocated with deals, MS became more cautious about volunteering free advice. The firm also embraced higher risk activities. MS became a public company in 1986, and soon boasted a multibillion-dollar balance sheet. It used this financial strength to take arbitrage positions in company takeovers and make bridge loans in M&A transactions. As trading rooms took ever bigger positions facilitating client deals, traders argued that there was money to be made risking the firm’s capital for its “own account.” This became known as “proprietary trading,” i.e., betting the firm’s capital on speculative investments.

By the 1990s all Wall Street houses embraced some version of this investment banking + trading business model. Firms like Salomon Brothers, Bankers Trust and Goldman Sachs became heavily weighted towards trading. By 1993, Goldman had 500 “prop traders” working off a $100 billion balance sheet that was leveraged 50:1. Some traders were accounting for annual profits of $100 million.⁹

Morgan Stanley produced average results in this era using a business model of traditional investment banking, strong international advisory, asset management, and a moderate amount of proprietary trading. Meanwhile, banking competitors continued to make moves. Credit Suisse formed a joint venture with First Boston and Primerica acquired Salomon Brothers. MS was under pressure to demonstrate some strategic initiative. In 1997, an opportunity materialized in the form of a chance to buy Dean Witter (DW). DW was a well-known, nationwide retail brokerage firm. MS saw in DW a chance to diversify, grow, and marry its still formidable capital markets business with channels selling securities and wealth management products.

John Mack pushed hard for this deal, which closed in May 1997. As part of the merger, DW’s Philip J. Purcell became Morgan Stanley Dean Witter’s CEO. Mack was named President and Chief Operation Officer. He anticipated that Purcell would step down fairly soon, allowing Mack to move up to CEO. Purcell then made clear that he had no intentions of going anywhere. It was Mack who ended up leaving, moving to head CS First Boston in 2001.¹⁰

As the chart below shows, MS performance post-merger did not compare favorably with Goldman’s.

Sources: Morgan Stanley and Goldman Sachs 2005 10-Ks

Increasingly, MS faced skeptical stock analysts. They questioned not only the firm’s performance but also the contributions of mature franchises like brokerage and asset management. Attachment 2 shows the relative contributions of MS’ main business units during these years.

Purcell made clear that building up MSDW’s brokerage business remained his top priority. He also stacked the MSDW Board with Midwestern loyalists, dismissing heritage MS directors in the process. This did not sit well with many MS investment bankers. Internal dissension festered and led to the exit of prominent dealmakers. Noteworthy departures included not only Mack, but top bankers Vikram Pandit and Joseph Parella, John Havens (head of equities) and Stephan Newhouse (MS president).

Matters came to a head in spring 2005. A revolt among MS former leaders and current senior bankers led to a June showdown. On June 13, Purcell was forced out. After a brief pause, Mack was brought back to be CEO. He arrived at the end of June to a standing ovation on the trading floor.¹¹

Mack Guides Morgan Stanley into and Through the Financial Crisis

Upon returning, Mack initiated a thorough review of personnel, business performances and policies. He immediately reached out to the departed executives, some of whom returned. The asset management and retail brokerage businesses were deemed as having underperformed. Mack trimmed the footprint there, selling off Discover Card, a DW legacy business. Mack then revamped the compensation system. Believing it important to align employee interests with those of the firm, Mack raised to 65% the percentage of year-end bonuses paid in restricted company stock. Restricted grants would also be forfeited if an executive leaves before the stock time restriction expires. Mack saw talent retention as his #1 issue. Increased restricted stock would help staunch the Purcell-era bleeding. Mack himself took his entire MS bonus in restricted stock.¹²

Mack then moved MS’ strategic direction closer to the rest of the financial industry. Morgan Stanley followed GS deeper into proprietary trading. This included ramping up MS activities in securitizing subprime mortgages. Attachment 2 illustrates the growth in MS’ trading positions and leverage over 2004–06. Attachment 3 shows the firm’s performance during the same period. All seemed to be going well for a time. MS’ 2006 profits were the largest ever.

Like other Wall Street CEOs, Mack either failed to detect or felt he didn’t dare break with the herd regarding the momentous fraud building in the subprime securitization machine. Earlier in the decade, mortgage originators like AmeriQuest and Countrywide began offering “affordability” products that turned out to be “doomed to fail.” Firms like Citigroup and MS packaged the mortgages into debt-like instruments so complicated and opaque that neither the Rating Agencies nor the final buyers appreciated their “doomed to fail” quality. Whatever fiduciary responsibility the banks felt towards their customers was swamped by a “buyer beware” ethos and the vast profits and bonuses being generated.

The reckoning came in 2007. In July, S&P began downgrading subprime securities. Moody’s soon followed suit. By October the entire subprime sector was reeling. Morgan Stanley suffered with the rest. Attachment 3 details the falloff in performance in 2007-08 versus 2005–06. Late 2008 was especially bad. Markets went into panic mode when Fannie Mae went insolvent in August and Lehman Brothers declared bankruptcy in September. On Sunday, September 7, New York Federal Reserve President Tim Geithner was advised that without government intervention, Goldman and Morgan Stanley could be insolvent by Friday.

John Mack and his team performed some heroics during this period. Conversion to a bank holding company allowed MS to borrow from the Federal Reserve. More importantly, Mack spearheaded efforts to raise capital from sovereign wealth funds and foreign investors. The crowning achievement was Mitsubishi’s $9 billion equity infusion. Doubts about that deal were so pervasive that MS showed the NY Fed Mitsubishi’s physical check.¹³ These capital infusions probably saved MS from being swallowed by another firm. Now, MS would have a chance to consider what had gone wrong and chart a new course.

What should that course be? John Mack thought about how MS and every firm on Wall Street had gotten things so wrong. Mistakes would have to be identified and measures taken to prevent them from happening again.

Mack Analyzes the Financial Crisis and Revamps MS Compensation

Reflecting on the Financial Crisis, Mack saw plenty of blame to go around. Some he apportioned to government, which pushed “Affordable Housing” for people who shouldn’t have qualified for a mortgage. Mack also saw Federal regulators as overmatched. Mack felt that there were authority issues within the U.S. regulatory community. It was unclear whether any government agency was supposed to intervene if investment banks like MS were threatened with insolvency. Morgan and Goldman had $ trillion balance sheets and relations with a universe of counterparties. They truly were “Too Big to Fail” but nobody was authorized to catch them if they did.¹⁴

Mack saw plenty of culpability within his own industry. For starters, all investment banks had used excessive leverage.¹⁵ In the critical year of 2008 it was not uncommon for major investment banks to sport debt levels 30–50 times their equity capital. Bear Stearns had debts over 40 times its equity when it failed. The banks reliance on overnight repo financing was another issue. That worked fine until lenders developed doubts about the borrower and its collateral. Then, financing dried up overnight, leaving cash-strapped banks with no alternative but to sell assets at fire-sale prices.

Why had doubts develop on collateral? In Mack’s view it happened because banks loaded their balance sheets with excessively risky assets. Mortgage departments left hard-to-sell portions of their subprime securities on the balance sheet. Other units thought they saw opportunities to reap profits by jumping into subprime instruments when prices fell below par. This combination made risk management hellaciously difficult. One side of the house might be trying to move out subprime inventory while another side is adding risk right back. When doubts on subprime developed, concern spread that nobody knew either the exposure levels at various firms or the quality of that exposure. This uncertainty led to fear, then paralysis, and the repo market shut down.

Mack had experienced all this firsthand. MS went into 2007 with a balance sheet bigger than $1 trillion but only about $30 billion in equity capital. This gave Morgan Stanley leverage of debts ~33 × equity. The subprime crisis then put a huge hole into this highly leveraged position. In 3Q’07, MS took a $9.4 billion write-down on subprime mortgage holdings. Subtracting that loss from firm equity meant that leverage ballooned to debt = ~50 × equity.¹⁶

Mack was still concerned about risky trading positions. Should there be new losses, they could wipe out MS’ now shrunken capital. Mack had learned the hard way that big positions in risky securities are two-way bets. Some $7.8 billion of the firm’s $9.4 billion 2Q’09 write-down related to one proprietary position. To limit further losses, Mack acted to reduce MS’ risk profile. By the end of 2008, Mack had raised $24.7 billion in new equity; he also shrank MS’ balance sheet, from over $1 trillion to $650 billion. Together, these measures lowered MS’ leverage ratio to debt only 11 × equity at year-end 2008.¹⁷ To limit excessive risk-taking, Mack made other changes. He beefed up MS’ risk management, named a new Chief Risk Officer and added more than 100 people to compliance activities.¹⁸

The final change, a big one, had to do with compensation. There is a saying on Wall Street—”the assets walk out the door at 5 pm.” Large bonuses for strong performance had become the standard means of retaining talent. However, this compensation model easily led to a “heads I win, tails you lose” mentality among traders. Make a risky bet, have it pay off, earn $20 million—and you are set for life. If a bet goes bad, it’s the firm that takes the loss. You may get fired, but you keep all past bonuses. Memories are also short on Wall Street. Fired traders often resurface at other firms after a year or two. This mentality proved corrosive to any sort of firm ethical culture. For one thing, it promoted “agency behavior.” Traders with huge incentives to look after their own interests cared little or not at all about the firm’s success. Second, the compensation model promotes short-termism. Traders focus intensely on gen-erating performance to boost their annual bonus. Whether their deals go south down the road is a lesser concern. Finally, the stakes are so high and the compen-sation levels so huge that there is an almost irresistible temptation to cut corners. If rules have to be bent to garner information not publicly available, so be it. If your trades are underwater, why let risk limits get in the way of doubling down to recover?

Mack decided this model had to change. Earlier he had boosted the percentage of bonuses employees received in restricted stock. Now he added two new features. The first was a “clawback.” This feature gave MS the option to recall or cancel a bonus if an employee’s behavior proved detrimental to the firm. Detrimental behavior was defined as conduct which produced a significant accounting restatement, financial loss or reputational harm. The clawback applied to the three years after the bonus grant. Clawbacks work great with restricted stock, as there is no need for the firm to force employees to return cash—the restricted stock is simply cancelled. Second, Mack converted some of a bonus’ cash portion to deferred cash, i.e., cash that would only be paid if and when MS achieved certain performance targets; e.g., a stated level of earnings per share or return on equity.¹⁹

These moves greatly increased the percentage of compensation both deferred and subject to clawback. Mack felt this would go far towards disrupting the “heads I win, tails you lose” mentality on the trading desks. To drive the point home, Mack made sure that MS’ most senior executives retained 75% of their restricted stock so long as they remained active. Attachment 4 details MS’ new model as conveyed in Mack’s letter to employees of December, 2007.

Mack was less clear on whether Morgan Stanley had a strong business model going forward. It was one thing to rein in a trading-heavy organization. It was another to tell shareholders to live with a low return business. And what about MS’ bankers and traders—would the stars stick around for MS’ more risk-averse culture and new compensation’ model or bolt to greener pastures?

Before going to Washington, Mack decided to clarify his business vision. Could he return MS to a double digit ROE? Could this be done without compromising his efforts to repair MS’ ethical culture?

Mack Weights Strategic Alternatives for Morgan Stanley

Morgan Stanley’s second quarter results did little to make Mack’s strategizing easier. The firm lost $159 M. Mack could blame some of it on “accounting noise.” For example, MS had incurred an $810 M charge as it repaid its Federal Government debt and a $744 M write-down of firm-owned real estate. None of this detail was comforting to Mack. Wall Street media were drawing unfavorable contrasts with Goldman Sachs. Goldman had reported stellar profits, highlighted by revenues of $6.8 billion in trading. MS generated trading revenues of only $973 M.²⁰

Like it or not, MS was always going to be compared with GS. Yet, they were two very different firms. GS showed no signs of backing off on Big Trading. MS was much more committed to its historic investment banking role, working with clients as an adviser, taking their securities to market and executing their trades. It also had a Wealth Management business with a huge retail brokerage component. Attachment 5 provides MS’ description of its current businesses, including its Asset Management business. MS proprietary trading was lodged inside Institutional Securities while its merchant banking investments, real estate and private equity, resided in Asset Management.

Mack felt very conflicted about the MS trading function. He knew trading could generate huge profits. Yet, it also could yield big losses, as had materialized over the last two years. Trading also consumed big amounts of capital. The table below illustrates how MS allocated equity capital among its businesses during 2005–07:

Average common equity (dollars in billions)(4):

Source: Morgan Stanley 2007 10-K

Beyond trading’s voracious capital appetite lay something else—its penchant for creating risk. When discussing the Financial Crisis, Mack referred to this as “excessive risk taking.” This description was certainly apt but there was something more. Mack felt that Big Trading might also be a cultural cancer. Traders had scant regard for clients. To traders, they were just counterparties at the other end of a phone—if you “ripped out their throat” on a trade, hooray for you. That’s how $20 M bonuses are made. Mack suspected that this culture marginalized customer relations, entrenched conflicts of interest, and made ethical and legal compliance difficult to sustain.

The problem was whether investment banking, with Big Trading de-emphasized, remained an attractive business? MS’ shareholders no doubt favored the firm having an ethical culture, but they probably didn’t want one with a 3% ROE or no growth.

Mack had created an alternative path, one consistent with a lower risk profile. The deal with Citigroup was almost complete. MS and Citi would combine retail brokerage outfits into Morgan Stanley Smith Barney (MSSB). MS would own 51% and have operating control. Once the deal was completed, MS would manage a U.S. brokerage operation on a scale competitive with Merrill Lynch.

There were several things Mack liked about the deal. First, it would provide revenue growth without requiring large amounts of new capital. Second, brokerage was unlikely to have really bad years like trading. Third, Mack suspected there would be an opportunity to buy out Citi. That would provide a second growth step. All of this could help compensate for giving up some of the revenue and profits associated with trading.²¹

Mack’s concern was whether doubling down in brokerage just directed MS deeper into commodity financial businesses. Would investment banking, brokerage and asset management prove to be low return businesses subject to ever-increasing competition? Did Morgan Stanley have any competitive advantages in these businesses to deliver the performance its shareholders expected? Finally, how would they fare under a more intensively regulated environment? Attachment 5 provides more information on MS’ historic business lines and their performance before and after the Financial Crisis.

The regulatory question intrigued Mack. The era prior to 2008 had been one of steadily increasing competition. Everyone got into investment banking—U.S. commercial banks, European and Japanese universal banks, even foreign merchant banks. Meanwhile, pieces of investment banking turf had broken off and gone private—the so-called shadow banks of private equity, hedge funds and “dark pools.” With new legislation in the works, would this continue or reverse? Should MS plan for ever-increasing competition or would banking consolidate into fewer players focused on distinct markets?

Mack worried and wondered whether MS was fated to shrink in this new environment. If he curtailed Big Trading, did that mean revenue shrinkage that would swamp whatever new brokerage might contribute? The two business lines were apples and oranges as regards both the capital required and the revenues generated. With trading curtailed, MSSB might be a success and MS shareholders could still see a diminished firm with lower earnings per share. Assuming Goldman stuck to Big Trading, that outcome might make the inevitable comparisons among the banks acutely embarrassing.

To clarify his thinking, Mack outlined the complete set of business model options he’d consider and put down pros/cons next to each (See Attachment 6).

Two points remained fundamental for Mack. He was fully committed to his changed Compensation Policy. Restricted stock, deferred compensation and clawbacks would define MS’ approach going forward. Second, he believed that a recommitment to clients and customers was essential both to restoring faith in Wall Street and to sustaining a sound ethical culture within the firm.

Could he now find a way to reconcile those givens with a viable business strategy?

Attachment 1

(Historical Recreation)

April 15, 2009

To:	Morgan Stanley Management Committee
From:	The Washington Office
Subject:	Pending Dodd-Frank Legislation – An Outline

While it is still “early days” in a legislative sense, we are able to provide an outline of legislation likely to be taken up by the House Financial Services Committee and the Senate Banking Committee. We believe some form of this legislation is likely to pass Congress and be signed into law given the Democratic majorities in both Houses and President Obama’s occupancy of the White House.

This legislative content is actually taking shape in the Executive Branch and is expected to be sent to the relevant committee chairmen shortly. At present, the salient features of the proposed legislation are:

1. The consolidation of regulatory agencies, elimination of the national thrift regulator, and new oversight council to evaluate systemic risk;
2. Comprehensive regulation of financial markets, including increased transparency of derivatives (bringing them onto exchanges);
3. Consumer protection reforms, including a new consumer protection agency and uniform standards for “plain vanilla” products as well as strengthened investor protection;
4. Tools for financial crises, including a “resolution regime” complementing the existing Federal Deposit Insurance Corporation (FDIC) authority to allow for orderly winding down of bankrupt firms, and including a proposal that the Federal Reserve (the “Fed”) receive authorization from the Treasury for extensions of credit in “unusual or exigent circumstances”;
5. Various measures aimed at increasing international standards and cooperation, including proposals related to improved accounting and tightened regulation of credit rating agencies.

Other possibilities under discussion include substantial increases in bank capital requirements and the application of “stress tests” as a constraint on risk taking and shareholder distributions. There is also talk about differentiating “Systemically Important” financial institutions. These firms would be deemed to pose potential risks to the banking system, and therefore be subject to additional capital requirements. Finally, there is talk in congressional circles of reintroducing something like Glass-Steagall’s separation between investment and commercial banking. A less drastic version of this reform would be some limitation of bank’s betting their own capital, i.e., proprietary trading.

At a minimum, Morgan Stanley should prepare for a lower leverage business model and anticipate that much more trading will be conducted on electronic exchanges rather than “over the counter.”

Author’s Note

This case is a companion piece to the three Goldman Sachs cases that span 1995–2011. During that period Morgan Stanley struggled with the same challenges affecting investment banking. Morgan Stanley, however, is a different firm with different DNA. Can it devise a different answer?

This case is situated in 2Q 2009. CEO John J. Mack has already made changes to MS’ balance sheet and most strikingly to its compensation system. Mack’s actions made him a leader on Wall Street in attempting to correct some homegrown causes of the Financial Crisis. The question he now confronts is whether those changes, meant to rein in risk and restore an ethical culture, can be reconciled with a satisfactory return business model.

The case poses the dilemma of whether Wall Street investment banks can achieve an ethical culture and a high growth, high return business. Have the “commoditization of banking” and the onslaught of post-Crisis regulation forced banks to choose one or the other? Students examining this case should look at the evolution of Morgan Stanley’s business from 2004–08. They should then review the likely regulatory changes taking shape in Congress. Finally, they should consider the strategic options Mack outlines in Attachment 6. The fundamental ethics issues are several: 1) are Mack’s changes, especially in compensation, a valid antidote to the ethical corrosion suffered at Morgan Stanley; 2) where should MS place its future bets in pursuit of a sustainable, high return business model; and 3) is that business model compatible with Mack’s changes? If not, what has to give?

The case stipulates that Morgan Stanley had a renowned ethical culture that eroded going into the financial crisis. Prior to the crisis, the firm had occasional hiccups that resulted in relatively small settlements or fines. However, the Financial Crisis produced a sea change here. In 2015, MS agreed to pay $2.6 billion to settle subprime mortgage litigation brought by the U.S. Department of Justice. The prior year it agreed to pay $1.25 billion to the Federal Housing Financial Authority to settle claims that it sold fraudulent loans to Fannie Mae and Freddie Mac. These are still “small” amounts compared to the sums paid by J.P. Morgan, Citigroup or Bank of America. They are, however, large in absolute terms and bigger than anything ever before paid by MS. Clearly John Mack had a basis for worrying about the firm’s culture as he considered his course of action in 2008–09.

The case provides MS business line data to help students grapple with the business model issues. The data contains an aspect to be highlighted. Only some of MS’ risky bets are contained in its Institutional Securities business. The rest, real estate, hedge funds and private equity, are combined with Asset Management. This accounts for Asset Management’s dismal performance in 2008, when one would otherwise expect some positive result from a fee-based service business.

There is no public evidence that John Mack explicitly linked his compensation changes to restoring Morgan Stanley’s ethical culture. However, he did tie it to curbing excessive risk taking. He also talked in terms of better aligning of individual interests with those of the firm. This means he was trying to correct what is known as Agency Behavior. Given this and MS’ longstanding self-image of operating “in a first class way,” it is reasonable to infer that Mack made the connection between changing the compensation system and restoring the firm’s ethical culture.

A primary source for the material covering Morgan Stanley’s history and John Mack’s return to the firm is Blue Blood and Mutiny: The Fight for the Soul of Morgan Stanley, by Patricia Beard. Numerous financial press articles also covered the story. Mack’s analysis of the Financial Crisis is based upon the prepared testimony he gave to Congress in July 2009. Attachment 4 is Mack’s actual letter to firm employees announcing the changes to the compensation system. Attachment 1 is a Historical Recreation that draws upon published summaries of what the White House sent to Congress for what eventually became the Dodd-Frank Law. There is no public document from a MS Washington office that provides this summary. Attachment 6 is a Historical Recreation summarizing the strategic options available to Mack in 2009. No such public document exists. The Historical Recreation attempts to capture the options available to Mack by reflecting the different strategies major banks have since adopted, e.g., Goldman retaining Big Trading, J.P. Morgan pursuing the universal bank model, and various other institutions adopting variants in between.

Recent Wall Street performance suggests the dilemmas facing Mack have yet to be resolved. Virtually all Wall Street firms are generating single-digit ROEs. Though nothing like the subprime frauds has occurred, the post-Crisis period has been punctuated with other scandals, e.g., commodity and LIBOR price fixing. Massive amounts of new regulation and revived enforcement are, for the moment, supporting firms’ internal efforts to upgrade ethics and compliance. For how long will this balance last? Cries that innovation is stifled and animal spirits need to be released can already be heard. John Mack’s successors continue to search for answers to the questions he faced—is there a high growth, high return business model left in banking, can it be reconciled with an ethical culture, and if not, what gives way?