Welcome to the Morgan Stanley conference call. The following is a live broadcast by Morgan Stanley and is provided as a courtesy. Please note that this call is being broadcast on the Internet through the company's website at www.MorganStanley.com. A replay of the call and webcast will be available through the company's website and by phone for a period of seven days.
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At this time I would like to turn the program over to James Gorman for today's call.
Thank you. Good morning, everybody. I am delighted to be here. I wanted to join you for our first call under my watch as CEO. I am here with Colm Kelleher and Ruth Porat and the rest of the team. Before we review our financial results I would like to do a couple of things. I will review our accomplishments and provide a brief outlook.
Looking back, 2009 was a year of transition in which the firm achieved a number of milestones. We maintained a prudent balance sheet and held appropriate levels of capital and leverage while reducing our troubled exposures. We were among the first banks to repurchase TARP and the associated warrant. We raised $6.9 billion in common equity and sold our remaining interest MSCI enhancing our capital structure.
We issued a total of $13 billion in unguaranteed senior unsecured debt including a fourth quarter 1.5 billion Euro raise which was our first non-US dollar unguaranteed issuance of 2009. We made significant progress on our global hiring plan which is on track. The new hires are primarily in our sales and trading businesses further building out our footprint and expanding our client franchise. We closed the Morgan Stanley Smith Barney joint venture earlier than expected creating the industry leader with more than 18,000 financial advisors and over $1.5 trillion in client assets.
We made progress towards optimizing asset management. The sale of our retail asset management business to Invesco is on track to close mid-2010. This is an important accomplishment for asset management as we emphasize our core institutional strengths while establishing a stake in Invesco. We entered into a strategic outsourcing partnership with State Street for our loan only business which enables us to take advantage of their scale and ensures we will remain well positioned to deliver best in class service to our investment teams and to our clients.
The assets and liabilities related to Crescent that were the subject of approximately $2 billion of remaining third-party financing with a single lender were conveyed to that lender in November. In addition we have a number of new funds that are well positioned to invest opportunistically.
Turning next to our partnership with MUFG continues to gain strength. We announced an MOU to integrate our securities operation in Japan which is on track to be completed later this year. Morgan Stanley and Bank of Tokyo Mitsubishi UFJ in partnership now lend to over 900 corporations, elevating us to the five lenders in the Americas. Together we committed on an aggregated basis $3.2 billion to NBC Universal, the largest amount by any bank and critical to Comcast acquiring control.
Looking forward I believe 2010 will be a year of execution for Morgan Stanley. We have the best management team in place to execute the firm’s strategy to be number 1, 2 or 3 in all of our businesses. The team includes, as you know, Colm Kelleher and Paul Taubmann, Co-Presidents of Institutional Securities; Charlie Johnson as President of Morgan Stanley Smith Barney; Greg Flemming who is due to arrive here in early February as President of Morgan Stanley Investment Management; Wallid Chammah, Chairman and CEO of Morgan Stanley International. In addition Ruth Porat is joining us as CFO formerly from investment banking. Ken deRegt is Chief Risk Officer maintains that role. Tom Nides has become our Chief Operating Officer and Jim Rosenthal is the Chief Operating Officer of Morgan Stanley Smith Barney in addition to being Head of Corporate Strategy for the firm. Finally, Gary Lynch remains as General Counsel and Chief Legal Officer.
I am very pleased to have elevated several key executives and it is important that Charles, Ken and Gary who have proven track records continued in their roles. Together this extremely seasoned team has on average approximately 25 years of experience in the industry. The group has complementary skills and has been tested through one of the most difficult times for our industry.
I am bullish on Morgan Stanley as I believe we are well positioned to capitalize on the recovery in the global capital markets.
Now I will turn it over to Colm, my colleague, but before I do so I want just publicly thank Colm for his contributions as our CFO in an extraordinarily difficult environment. I think he has done an extraordinary job. On that note, let me turn it over to you for the financial results. I will be available with Colm for any Q&A that might be pertinent at the end of this meeting.
Thank you James. I am pleased to have my colleagues, Ruth Porat, here with me this morning. Ruth and I have been working closely together to ensure a smooth transition of the CFO function.
Beginning with our consolidate results on page 2 in our financial supplement, for the quarter ended December 31 Morgan Stanley generated net income of $770 million and diluted earnings per share from continuing operations of $0.14. Negative revenue of approximately $600 million from the narrowing of the firm’s debt related credit spreads lowered earnings per share by approximately $0.27.
Firm wide revenues were $6.8 billion and non-interest expenses were $6.2 billion for the quarter. The full-year compensation ratio excluding the negative impact from the improvement in Morgan Stanley’s debt related credit spreads was 50%. This ratio reflects the inclusion of seven months of Morgan Stanley Smith Barney which carries with it an industry standard higher ratio.
We consider the impact of the U.K. bonus tax and 2009 compensation levels and since this legislation has not been finalized we see this largely as a 2010 event with probable timing being between the first and second quarter of this year. Having said that the cost of this tax will be shared significantly by employees globally.
While non-compensation expense has increased 17% sequentially, full-year non-compensation expenses declined 10% from a year ago illustrating the success of our cost saving initiatives. We exceeded our annual cost savings target of $800 million by over 30%. Excluding expenses related to Smith Barney auction rate securities and goodwill impairment from both years our recurring non-compensation expense and savings totaled over $1.1 billion. The effective tax rate for the quarter was a benefit of 11% reflective of the geographic mix of earnings, domestic tax credits and the utilization of state net operation losses.
Now if we turn to page three in the financial supplement. Total assets at December 31 increased slightly to $773 billion of which $163 billion is our liquidity pool. We continue to keep a significant portion of our balance sheet in cash and equivalents. Our capital ratios demonstrate the strength of our balance sheet. While we are still finalizing our calculations we believe under Basel 1 our Tier 1 ratio will be 15.4% and Tier 1 common ratio will be 8.2%. Risk weighted assets are expected to be approximately $301 billion at December 31. Level three assets were in the mid $40 billion range at December 31, representing approximately 6% of total assets.
Now if we turn specifically to the businesses. Starting with institutional securities detailed on page five of the supplement, revenues of $3.2 billion included approximately $600 million negative impact from tightening credit spreads as discussed earlier. Non-interest expenses were $2.8 billion in the fourth quarter of 2009, down 25% from the third quarter on lower compensation. Excluding the negative impact of the improvements in Morgan Stanley’s debt related credit spreads, the compensation ratio in this business was 39% for the quarter and 40% for the year. This business reported a pre-tax profit of $464 million.
Specifically turning to investment banking on page six, our franchise continued to deliver very strong performance for the quarter and the year despite volatile markets and economic uncertainty. We were number one in amounts of completed global M&A and we secured the top spot in both the Americas and Europe. In the quarter we led Comcast’s $14.4 billion joint venture with General Electric and for the year we advised in eight of the top 10 announced transactions, more than any other firm. We continue to act as a trusted advisor to the US and European governments and corporates with respect to important government sponsored reorganizations.
The capital markets remain very active and were up from third quarter levels and we continue to see a broadening across products, industries and regions. We led significant deals in the quarter including the IPO of China [inaudible] Electric and various Analytics and Warner Chilcott’s $3.2 billion leverage financing to acquire P&G’s drug unit.
Fourth quarter investment banking revenues of $1.5 billion were up 42% sequentially. Advisory revenues increased 90% up across all regions of completed M&A activity. While announced M&A volumes increased significantly in the fourth quarter of 2009 they do remain on par with 2004 levels. Equity underwriting revenues in the fourth quarter of 2009 were $627 million, our highest disclosed quarterly revenue. Activity was very strong across all regions with substantial increases in Asia and Europe. Fixed income underwriting revenues increased 7% from the third quarter on higher loan syndication fees and high yield bond activity.
Turning to equity sales and trading. Equity sales and trading revenues of $722 million were negatively impacted by $221 million from the narrowing of debt related credit spreads on firm issued structured noted. Morgan Stanley was named the top prime broker for funds with more than $1 billion in assets by Institutional Investor for 2009. Prime brokerage continues to recapture market share reflected by a 10% increase this quarter in average client balances.
However, a combination of seasonal and market factors including lower hedge fund activity resulted in lower revenues, down 20% sequentially. Derivatives reported lower revenues driven by lower activity in the second half of the quarter. Cash equity revenues were flat sequentially as higher commissions from increased client flow were offset by lower trading revenues.
Turning to fixed income and other sales and trading. Fixed income and other sales and trading revenues of $963 million included losses of $380 million from the narrowing of credit spreads on firm issued structured notes. As mentioned earlier we are positioning this business for growth through our global hiring plan, integrated analytics and new management and this will take time.
Interest rate credit and currency combined revenues were down significantly from last quarter. Revenues were lower across all products due to seasonality, lack of market volatility and tighter spreads. On a full year basis IRCC revenues rebounded from 2008 driven by a strong performance in interest rates and credit trading. Commodities revenues were lower from the third quarter of 2009 driven by range of prices and lower volatility. Other revenues of $277 million include spread tightening and valuation gains in our corporate lending business.
Turning to value at risk. Total average trading and non-trading VAR increased to $187 million from $168 million primarily reflecting a modest increase in fixed income and equity trading. However, methodologies must be examined when comparing VAR measures across the industry as they are not standardized. Morgan Stanley uses a four-year market data series. Therefore our VAR has a tendency to maintain higher volatility assumptions with a modestly increasing trend under current market conditions.
If you now turn to page eight in the supplement on our global wealth management business. This quarter marked the second full quarter of consolidated Morgan Stanley Smith Barney results. Revenues were up 4% sequentially to $3.1 billion on higher fee based revenues and were in line with the overall retail environment. Non-interest expenses were $2.9 billion and included $146 million of integration costs. Full year Morgan Stanley Smith Barney integration costs were $280 million. For 2010 we expect integration costs of approximately $450 million mostly relating to the rationalization of real estate and IT. Full year closing costs related to the joint venture were $221 million and mostly related to FA replacement awards.
The business reported a pre-tax profit of $231 million and pre-tax margin of 7%. If we exclude the JV related integration costs in the quarter PVT would have been $377 million and PVT margin would have been 12%.
On page nine you can see the core three productivity metrics for the business. Total client assets increased 2% to $1.6 trillion on higher market levels. The number of FAs remain relatively unchanged at 18,135. FA turnover within our top two quintiles remained at historic lows of under 1%. Attrition primarily within the lower quintiles has substantially declined since the closing of the joint venture. Net new asset outflows of $4.7 billion continue to reflect the lag effect of financial advisors that left Smith Barney prior to the JV closing. This magnitude of outflows has declined substantially and we expect this trend to continue.
Total firm wide deposits at quarter end were $62 billion. Deposits in our bank deposit program increased to $112 billion of which $54 billion is held by Morgan Stanley banks.
If you now turn to page 10 of the supplement on asset management. The financial results related to Crescent subsequent to the date of consolidation and the retail asset management business being sold to Invesco have been reclassified to discontinued operations in all periods presented.
In the fourth quarter discontinued operations also included an accounting gain related to the present conveyance. The continuing operations of asset management recorded a pre-tax loss of $55 million as profits from the core business were more than offset by losses in merchant banking. This is the fourth consecutive profitable quarter for the core business. Core asset management revenues of $357 million declined 15% sequentially on lower net gains on alternative investments as well as performance fees which were partially offset by higher asset management fees.
Merchant banking revenues of $153 million were up from the third quarter 2009 driven by gains on principle investments. Asset management non-interest expense of $565 million declined slightly from the third quarter of 2009 on lower compensation expenses.
If you turn to page 11 of the supplement you can see the assets under management and asset flow data. This data has been restated and excludes assets that will be transferred to Invesco on the deal close. As such, total assets under management are $283 billion up 6% sequentially on asset inflows and continued positive momentum in the equity markets.
Total net inflows were $10.3 billion and the core business generated positive flows for the first time since the second quarter of 2008. Inflows are mostly directed to money market funds. Fixed income flows were positive for the second consecutive quarter. Equity flows were slightly negative. However, we did see some significant mandate wins and performance continued to improve with 77% of equity strategies in the continued business performing above the Morning Star peer median for the three year time period.
If you turn to page 14 of the financial supplement to look at our firm wide real estate exposures. Our real estate gross asset exposure as reflected on the Statement of Financial Condition was $2.2 billion at the end of the quarter, down from $4.4 billion at the end of September. Including $1.5 billion of contractual commitments and other arrangements with respect to our real estate investments, our total exposure will be $3.7 billion down from $6 billion at the end of September. This exposure excludes assets and investments for the benefit of certain deferred employee compensation of co-investment plans.
Now finally a few words on the outlook. Global economic conditions are improving and the financial markets are healing. The global economy likely troughed in 2009 and is recovering. We expect short-term rates to remain low for the time being and expect a tightening of monetary conditions thereafter. Global equity markets are reasonably healthy and open across industries and geographies. Public credit markets are functioning normally although bank lending remains slow. Global M&A activity is improving as funding becomes available and corporate confidence recovers.
IPO activity has returned to a more normalized level and the momentum of completed offerings and file backlogs are encouraging for 2010. We do believe that real estate markets continue to be challenged and rising foreclosures may threaten prices and the availability of credit. We expect the industry’s cyclical and structural changes to continue for some time. This industry is on the path to re-regulation and we expect significantly higher capital and liquidity requirements. We are well positioned for this although concerned about the apparent lack of international coordination.
Industry consolidation, better pricing of risk and stronger growth in emerging markets present opportunities to gain market share and maintain spreads globally. We at Morgan Stanley remain focused on long-term secular growth opportunities in the capital markets and we are leveraging our global brand and client franchise to grow our share of the markets.
With that I would like to thank you and invite you to ask questions.
Question and Answer Session
(Operator Instructions) The first question comes from the line of Mike Carrier – Deutsche Bank.
Mike Carrier – Deutsche Bank
First a question on the trading side of the business. You had some CBA. You had some other benefits last quarter from some spreads tightening from some derivative business and PIK. Just curious on the current PIK results were there any reversals in this quarter or was it just a weakness across the board on both the client side and lower volatility across products?
A CBA itself is really not much of an issue at all this quarter. Our spreads have normalized. Also I am somewhat skeptical about trying to force CBA out of the business because I don’t believe you can run a derivatives business without CBA being an integrated part although we do disclose it in the Q. Broadly the story was one of subdued activity for us this quarter. As you know spreads didn’t do too much during the quarter itself and I think the larger the footprint you have the more you will benefit. I think what you saw there was reduced client activity in our case. There was no one story I can point to other than reduced activity.
Mike Carrier – Deutsche Bank
On the comp side you gave the adjusted numbers on the institutional business, 39% for the quarter and 40% for the year. While I understand with more equity investment over time that ratio could trend lower at least for the next 1-2 years before we get to a full run rate. I guess when we are looking out for 2010 and 2011 not just for Morgan Stanley but what you are seeing for the industry is 40% comp ratio going to be more like the new norm? Obviously it depends on activity levels and the competitive environment but it is obviously down significantly from the 50% we are used to.
Generally I have said on a number of occasions I think comp generally will come down in the industry but we are in an environment where forecasting compensation is difficult for a number of reasons including market pressures and regulatory oversight. Having said that, we have to pay our people competitively to not only retain them but also attract the top talent. The market is still competitive itself but obviously the structure of compensation is changing and on that measure Morgan Stanley was the first to introduce [claw] back. We strengthened those positions. We give a high degree of deferred compensation to all our employees. The operating committee specifically getting a very high level of 75% and I think that is a trend you will see continue.
Mike Carrier – Deutsche Bank
Given the updated Basel guidance, and taking into consideration we are not there yet on Basel 2, some of the banks have been giving some estimates in terms of the potential impact to the regulatory capital ratios. Just curious about your take on that. Probably more importantly when do you expect…is it still a first half 2010 to get guidance from the U.S. regulators on capital requirements for the US firms?
I think Chairman Bernanke said it best that Basel was a journey not a destination. What you have seen is proposals come forward that are now subject to the impact of QIF studies. We have been very clear in the past about expecting and forecasting what we consider to be a big risk which is the regulatory changes coming forward and increased capital. We are looking at all the alternatives and modeling those appropriately. We believe that we have positioned this firm with our capital ratios and the way we have changed our balance sheet to be able to adapt to those. Nothing that I saw on December 17th surprised me that came out of the BCBS suggestions but obviously the QIF impact of those needs to be worked through. You can have quite significant bookends in the way you interpret that. It will take some time to work through this.
The next question comes from the line of Howard Chen - Credit Suisse.
Howard Chen - Credit Suisse
We have heard a lot about the long-term goals for institutional securities and global wealth management but I am wondering if you could share some of your thoughts for plans for the asset management business and maybe long-term timeline for getting there.
There is a 5-6 point plan that we are working on. The first one is to integrate our fund to funds business which we did by merging Greystone and AIP which is about a $16 billion business which we expect can be very significantly larger than that given our distribution capability. The second was to sell our retail asset management businesses to keep an equity stake option which we did with the Invesco transaction. The third is to restructure our institutional asset management business which we are doing with the outsourcing with State Street. Now hiring portfolio managers and generally focusing our attention on the institutional liquidity space. The fourth is to look at all of the hedge fund stakes that we have and that is something Greg Flemming is now coming in to run.
Core asset management and immersion banking we will be looking at and it includes stakes across how we are managing front point in that various stakes and [avenue] tracks us. Finally to work with our merchant banking side both in rolling out more funds across private equity. We have some we have just raised. We are looking at distressed funds and potentially commodities. Then on the real estate side we have [measure of seven] which is over a $5 billion fund waiting to invest.
Obviously we have had a traumatic couple of years in terms of initially fund performance and then in terms of actual investments in the merchant bank and problems in our portfolio. We believe the vast majority of that is behind us with Crescent being sort of an important chapter close. We are looking forward to Greg’s arrival and executing that strategy.
Howard Chen - Credit Suisse
A few on the numbers. On the trading businesses, clearly as you spoke to a very muted fourth quarter activity levels but there is also a few moving parts with the human capital installation and the allocation of unallocated capital into the business. As we try to just gauge a bit of a run rate or proper support on getting to this top 1-3 player in 2010, a year of execution, can we get an update on early thoughts on how the year has begun? Are you seeing the same seasonal uplift as you saw seasonal downdrafts in the fourth quarter?
It is early days but we have had a pretty buoyant January so far in the same way as we had a very depressed December. I would hope it would last like that but I suspect it won’t. We feel pretty good about that. In terms of getting to 1 or 3 I think what we have to do is I am not going to give you guidance on numbers but you have to look at what our gap to leader is across our competitors and [inaudible] with our aspirations of being to plot that.
Thirdly you keep talking about our allocated capital. Not you specifically but everybody. This is part of what we call buffer capital these days because our expectation is that capital will be absorbed in light of what is happening with regulatory change.
Howard Chen - Credit Suisse
On the new client activity some of the more transaction driven expense line items that I would think like brokerage and clearing appeared to be a bit higher in the year-end quarter. Am I wrong to think that and if not what is driving that?
No it is up slightly. We definitely had some activity going up there. Clearly when we look at our non-comp expenses the way we have been managing them. The one variable you can’t control too much is brokerage and clearing because that is dependent upon client activity and so on. My view is if that goes up that is probably because we have seen a pickup in activity in client revenues so actually it nets itself out. Away from that we made significant inroads in getting the non-comps down.
Howard Chen - Credit Suisse
Could you provide a bit more color on the accounting write up you mentioned related to Crescent this quarter? Post the conveyance what remains to be resolved for Crescent if anything?
It is a relatively small write off. If you look at page 12 of the financial supplement you will see a $200 million line and that was the bulk of that. If you remember we took an impairment charge as we moved the portfolio across to the bank who will provide the secured finance. Of course on the financing we were able to write that back. In terms of what we have got left it is relatively small. It is one very small property, two very small properties which we have taken impairment charges on. They are not material. In addition to that we do have a keyhole agreement, more of a guarantee than a line of credit. It is meant to cover losses of certain defined obligations. It is on our exposure format although still operationally we don’t believe there is a lot of risk in that.
The next question comes from the line of Guy Moszkowski - BAS-ML.
Guy Moszkowski - BAS-ML
I wanted to try and follow-up a bit on the unallocated capital issue. Given what we know so far about Basel 3, shouldn’t we expect that some of that will be allocated back into some of the lines of business? Especially institutional. You are small in terms of your allocated capital relative to some of your peers and obviously you are rebuilding the footprint there.
First of all we are one of only a few institutions that actually show our economic capital model in all fairness. So given that we do that I am not sure we are comparing like to like. Yes, I totally agree with you the bulk of our capital will be absorbed in the institutional securities business in light of the BCBS recommendations we saw on December 17th. That is why I refer to it as buffer capital. There is no doubt that we could not operate a business with $17 billion dedicated to ISG unless people thought there was a significant amount of capital behind that. I think the regulatory changes will force that issue.
Guy Moszkowski - BAS-ML
Do you think that we should expect some of that capital to roll into the business over the course of this year or is that really still in advance until you know more about BIS?
I think it is a function of what is happening. As you know there are a number of initiatives going on. The securitization framework which is now law. There was the Basel 2 and Basel 1 conversion for us and the other firms which will become active as well. Then rolling forward you have the Basel 1 to Basel 2 conversion and what you are referring to as Basel 3. I think there are a number of initiatives in here that will actually start soaking up that buffer capital.
Guy Moszkowski - BAS-ML
If I can turn the conversation to the global wealth management Smith Barney integration can you give us an update on time period here and estimates of when we might expect to see those further integration costs realized and what we should be thinking of in terms of timing of the IT and real estate integration?
I will address that. We are obviously in the middle of a very complex integration program. The first, most immediate concern is getting the management structure right, harmonizing the compensation programs and harmonizing the pricing differences. All of that is now in place. We have essentially made our technology decisions and we are now planning the rollout of the new technology integration in addition to closing some of the excess real estate that we have. So we have said for some time these items will all come to a head full year 2011 and some of the charges expense through 2012. So it is kind of a 2-3 year program essentially from when we closed. We are confident, as we have said, of achieving 20% pre-tax margin targets up from obviously where we are today.
Guy Moszkowski - BAS-ML
A final question on GWM can you help us reconcile the minority interest expense for the joint venture to the net profit shown above that line? It sure seems like a lot more than 51% or rather a lot more than 49%.
It is because there are a lot of reconciling items going back and forth in terms of the normalization. It is the costs allocating more than anything else. We can give you specific details later. The severance cost is there which is probably what is skewing it. But that is really what is happening.
Guy Moszkowski - BAS-ML
Going forward as we model is it fair to think of a 51/49 split or is there still the potential for a lot of those items?
I think it is pretty fair to think of it as a 51/49 split. You won’t get much noise after this.
The next question comes from the line of Glenn Schorr – UBS.
Glenn Schorr - UBS
A quick follow-up on the non-comp first. Part of the pickup in the quarter was the merger related charges I am sure but I hear you loud and clear on the uncontrollable brokerage and clearing but all of the line items were up for one and two the brokerage and clearing was up a lot but the revenues weren’t and activity was down. I am being nitpicky but I am trying to set the stage for what I think the company can earn going forward. I just want to understand the mechanics of it.
We had some occupancy write offs in GWM. There was $146 million in JV integration costs. There is some higher professional service fees there. However, we reduced our recurring non-comp expenses by approximately $1.1 billion for the year. So if you actually take out the normalization and adjust 2008 for auction rate securities and all the goodwill impairments and so on and compare like for like what you have as a true rate is $1.1 billion out.
Glenn Schorr - UBS
But in your mind the true rate in the quarter is the  less the merger and integration?
Glenn Schorr - UBS
I don’t think you disclose this but I will take a shot. Headcount year end for the institutional business this year versus last?
No we don’t disclose it.
Glenn Schorr - UBS
In wealth management you have made the comment about the lowest turnover in a long time overall in the top two quintiles. Just for a little color how much of it do you think is seasonal? How much of it do you think is the fact that everybody except one of the big guys had lock ups? Then maybe anything on expectations on keeping the flow?
We went through a frenetic period as an industry over the last couple of years in terms of deals and dislocation. Then ultimately mergers so some of it is exactly as you described it; lock up and people sitting on previous deals. I truly believe the industry is moving towards a more rational recruiting model. There is relatively low recruiting activity. Probably the lowest I have seen in my career of 10 years of overseeing these kinds of businesses. The lower turnover I believe is for real. I can’t predict five years out from now but I think for the next couple of years it will stay low and relatively stable.
Glenn Schorr - UBS
That will be a breath of fresh air. On the “rebuild” I think we have a pretty clear and some visibility on what you have done and what is going on in equities and prime brokerage on the banking side. I could use a little more color on the fixed side. Maybe, and I am not looking for head for head, I am looking for more where do you think the largest market share potential because you mentioned gap to leader and basically I am looking for a re-definition of what you do and don’t want to be because I feel like the whole industry got in trouble from gap to leader now. I know that is not what is driving the rebuild because I think there are some real constraints and thought process around [rock] and stuff like that.
We know we don’t want to do a full proprietary trading and you know that. So what else to be about is having a business where trading and sales work together to optimize the footprint. So if we look specifically at fixed income which is what you wanted to know about we actually have a business where we believe we are in the top three which is the credit trading business. The revenues there are very sound and have significant improvement over last year.
The interesting thing is the clients by and large are the same clients we have the businesses where we underperform. So what we have to do is sort of join those dots up. Interest rates while it is head to head and we have very productive salesmen and traders, we just don’t have the footprint from a client point of view and the salesmen and traders themselves. That is what we are working on and that is what is part of this hiring spree. The same is true for foreign exchange as well. So we have productivity per employee but we don’t actually have the footprint and frankly the breadth of talent for various reasons that were there. It’s now that we are going to work on it.
Now let’s talk specifically about commodities. I actually think commodities is one of the two best businesses around. It is a very good business. We don’t think that business is in any way impaired. It is doing well but that business needs volatility and client transactions to support it and as you know for various reasons the commodities market is somewhat subdued from a client point of view for the last few quarters. You tend to get bumper quarters every now and then because of extreme volatility in price that draws them in.
So what you need to look at really is within our fixed income business I am very focused or will be going forward on our interest rate and foreign exchange businesses and the sub-parts thereof. If that helps.
Glenn Schorr - UBS
On the rebuild, I think you brought it up perfectly, the same clients are participating that you have this top three credit business but a lot of times it is a different person in each asset at the client. So you do need to hire on the sales and distribution side. I guess tying into my earlier question on comp is can you rebuild, have a lower absolute and relative comp ratio and manage that process all at once?
I think the answer to that is you can because Morgan Stanley is clearly a winner here in terms of being an integrated global bank providing a range of services. There is a huge amount of [inaudible] from clients who want to have Morgan Stanley as a credible counter-party. What they want to see is those dots joined up by delivering the firm to the client. You correctly state that the credit portfolio manager in a long only fund may be different from a rate manager and so on. So what we have to have is a lot more discipline in the way we approach it. Remember there was a time when we were dominant in these markets with our client coverage. By the way, you and I can think of two firms that not that long ago had slipped quite significantly in their coverage of clients and they have made it back up. I think the quality of the Morgan Stanley brand name and the quality of people we have will allow us to attract people to deal with us.
The next question comes from the line of Roger Freeman - Barclays Capital.
Roger Freeman - Barclays Capital
I will start out with specifically in commodities there are a couple of questions there. One is can you talk a little bit more about the market conditions? I know you said volatility was down [range bound]. As I understand it one business that’s important for you is sort of the physical business given that you are I think the largest owner of storage outside of commercial and I am wondering how the economics of that had sort of progressed over the course of the year. I also noticed there was an impairment of an alternative energy business that was actually in discontinued ops. I wonder if there was anything tied in there.
Then a second sort of related question is what do you think about the impact of the new CFDC rules proposed last week with respect to dealer hedge exemptions and how much an impact that might have on your client business in commodities?
There are four questions there. The write down impairment had no standing or influence whatsoever. Fourth quarter 2009 revenues were down significantly from last quarter. The overhang of inventory and the late cold snap basically created an oversupply in inventory that reduced volatility and dampened opportunities. As you know to a large extent commodities can be weather or event related right? So the market itself remained range bound for most of the quarter and as a result the flow was subdued. I think it is that. You do need that volatility or event to happen to drive it.
In terms of the regulations coming forward it is just too early to say. I cannot handicap those. We are looking at them very closely. I see a whole range of interpretations from analysts and I just really wouldn’t want to comment on it at this stage.
Roger Freeman - Barclays Capital
With respect to headcount I think you mentioned in a quote this morning from an interview that you have hired like 350 of the 400 folks in institutional securities. I guess my question is what percentage of those people have actually started and completed their [garden lanes].
Quite a lot have started or are about to start now so I think what you should be thinking about is that certainly by the first quarter of 2010 we are going to be pretty much up to speed on most of those people.
Roger Freeman - Barclays Capital
Following up on Basel 3. Obviously a lot of moving pieces there. The broad question from my perspective would be how do you see these proposals which in my opinion look pretty draconian. How do you see them pushing out any capital plans that you might have with respect to your general over capitalization, i.e. is it fair to say this pushes back any thinking about stock buybacks or anything down the road?
I think without upsetting my regulators I would like to make sure we get full feedback from what the QIS studies will be and I do think we are probably going to end up in a different place. I do think it is going to take some time to work this out. You and I have spoken a lot about what I thought the regulatory changes would be and I think on a relative basis we are well positioned. So I think this is less a Morgan Stanley issue than an industry issue and I think that is what the regulators are looking at.
Roger Freeman - Barclays Capital
Not to nitpick around Crescent but can you explain how you are actually able to get a $200 million gain? Were you having to accrue for the difference between the equity value and value of the loan?
Remember we weren’t fair value on Crescent. We were consolidating it. So after reflecting all the write downs and impairments from prior periods the carrying value of Crescent was less than the amount of the remaining finance outstanding. As such, the conveyance of those assets in full satisfaction of the financing resulted in that gain.
The next question comes from the line of Mike Mayo – CLSA.
Mike Mayo - CLSA
A follow-up for the 350-400 employees you hired. How will you know if you are getting your return on investment and whether you hired too many or if you should be hiring more. How are you going to measure that investment?
We have a number of measures and metrics. We have done this before. In the 90’s we had a hiring plan and we were able to measure the effectiveness of those employees through a number of measures whether it is just revenue per employee which is one crude measure. You clearly look at return on assets. You ought to look at the velocity of balance sheet and so on. I think we will be able to work that out and we have internal metrics that will allow us to do that.
Mike Mayo - CLSA
In wealth management you continue to have outflows and you look for $50 billion of inflows this year or so. How do we get from outflows to inflows?
As you have probably seen the business at Smith Barney in particular in the first half of this year had very large outflows relating to their turnover from the end of 2008 and early 2009 and that continued through the year. We anticipated or projected expected outflows of between 0 and $10 billion. We thought it would be around 5. We must be pretty good forecasters because it was negative 4.7. I expect this quarter it will be closer to flat. It is just a function of the run off of the assets which take about six months after a financial advisor leaves. That is netted against the inflows.
We have a target of $50 billion for 2011, not for 2010. I expect it to be positive in 2010 and it will grow through the course of the year. The good news is the very significant outflows for the first half of this year which we predicted would decline dramatically did decline dramatically and we are back to now sort of rounding territory and obviously we expect to grow from here.
Mike Mayo - CLSA
A big picture question as you take over the firm, what sort of risk appetite do you want to set for Morgan Stanley? At times risk was taken up and taken down. How do you view risk taking at Morgan Stanley over the next say 3-5 years?
First let’s just step back a little bit. A lot of people have asked me this question and it is presented as a binary answer. We either take risk or we don’t take risk which is obviously absurd. We are in the risk taking business. We have a balance sheet now over $800 billion and we are currently leveraged around 15-17 times. At our peak we were leveraged at 35 times. We had a balance sheet of $1.2 trillion at our trough for about $600 billion and leverage of about 11 or 12 times. So we are a leveraged institution. We take risk across currencies, emerging markets, credits, equity trading. We take risk in commodities. We take risk in our structured products group and we take risk in rate. So we take a lot of risks. We take positional risk and we take trading risk around the inventory that we carry. We take risk in our various capital investments in our merchant bank. We are clearly in the risk business. This is all about turning the dial and it is about not taking out-sized risks for particularly and complex, illiquid products with little ability for ourselves to get out of these positions.
So for example, we will not be making investments in our merchant bank for mature funds on bridges we give to Crescent. That is clearly the kind of risk where we are basically open to turning the market environment in real estate. We have closed down most of our proprietary trading positions and are working off a number of those trading desks with a couple of exceptions. We have two stand out businesses we have. We monitor the risk across all the businesses. My view is we are in a risk taking industry. We take risks professionally. We apply our capital and get the leverage on it. The question is what out-sized risks are we going to be taking which could jeopardize our financial health going forward and the answer is none.
Mike Mayo - CLSA
So tell me if I am paraphrasing correctly. So less illiquid investments. Less complex. Less proprietary trading. Less leverage.
And less out-sized. Go back to the sub-prime trade, we will not be having a $10 billion net exposure on one trade for one group.
The next question comes from the line of Michael Hecht - JMP Securities.
Michael Hecht - JMP Securities
Capital management and balance sheet from here, any expectation in kind of further accelerating your growth in deposits or even reducing gross leverage particularly given the concerns around Obama’s proposed tax levy proposal?
Let’s talk about that for a second. We give pretty clear guidance on where we think leverage ratio should be which is 5-7%, 14 to 20 times. We think that operates for us and makes sense. In terms of the guidelines that come from Obama we really have nothing to add at this stage. I think the balance sheet itself and the leverage is fine as it stands and it is a workable proposition. We centered the balance sheet around a certain size. We are obviously carrying a significant amount of liquidity. I think that is all we have to say about that.
Thank you very much everybody.
Thank you for participating in today’s conference call. You may now disconnect.
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