Morgan Stanley Buying Smith Barney From Citibank. Why?

by | Jan 10, 2009 | Stock Market Comments

In this podcast, Tom Mullooly discusses several reasons why

Citibank would consider selling Smith Barney, to their competitor, Morgan Stanley.

There are several reasons why Citibank may be considering this transaction, including:

  • Citibank simply needs the money

  • Volume is down, and projected to stay down in stocks and products

  • Margins are down

  • The new product pipeline has dried up

  • Liabilities are increasing (including legal expenses and the cost of severance)

And finally, Tom discusses the “secret sauce” retail brokerages have employed for years, that may now be going away.

On Friday afternoon, January 9, 2009 Citibank announced that they were in talks with Morgan Stanley to discuss a possible sale of their Smith Barney brokerage unit to their competitor, Morgan Stanley.

What would a combined Morgan Stanley — Smith Barney firm look like?

A combined Morgan Stanley — Smith Barney sales force would total approximately 18,000 — before any cuts were made.  And I would expect many of the overlapping branches to be closed.

From the street level, there are many towns and cities across the United States where as Smith Barney branch sits directly across the street from a Morgan Stanley branch.  On a local level, there would be tremendous consolidation — and elimination.  It would be very clear to the lower end producer at both firms, that their days are numbered.

There simply wouldn’t be any room for the bottom 20% of the combined sales force any longer.

Why would Citibank be considering such a drastic move?  There are several reasons:

Citibank needs the cash. After receiving $45 billion in a capital infusion from the federal government, Citibank is now exploring every single possible way to raise money.  Clearly, they feel this franchise (Smith Barney) still carries a valuable price tag, but there has to be some doubt, collectively among Citibank board members that perhaps the future value of Smith Barney may not be as great as it is today.

Margins are down. This should not be a shock for most people: sometimes, buying 100 shares of stock at a retail brokerage firm can cost you between $50 and $100 in commission.  You can buy the same stock through a discount broker for $15 or less.  Additionally, the commission you are charged at a full service brokerage firm is often not shared with the broker.  In recent years, brokerage firms began policies that stopped paying brokers for transactions generating less then $25, soon it became “less then $50”, then it became “less than $75.”  The individual broker was getting squeezed out of his own business — his own firm would pocket the commission on small trades.  25 years ago, a brokers were often paid 50% of the transaction.  Meaning, if a client generated $1000 in commissions, the payout to the broker was $500.  While some of the highest revenue-generating brokers receive a 40% payout, more and more brokers are finding themselves receiving a payout somewhere between 25% and 30% of the gross commission.  This is pre-tax.

Volume is down. It’s no secret trading volume in stocks and bonds is down in the last 12 months.  Apparently, Citibank must feel this volume will not be returning anytime soon.  It’s also important to note that not only is trading volume down, but product volume is also down.  When a brokerage firm creates new products, their sales force raises the money for it — from the individual investors (their clients).  A mutual fund rollout, a new bond sale, a managed futures fund, synthetic preferred stocks and hybrid investments are all examples of new products brokerage firms have rolled out in recent years.  If you’ve been in the market a long time you may also recall that brokerage firms also were involved in the underwriting of investments like variable annuities, limited partnerships and tax shelters.  These new product creations always carried significant profit margins for the brokerage firms that created them.  That market has now dried up.

The new product pipeline has shut down. May 1, 1975 was the day commissions were deregulated on Wall Street.  Discount firms like Charles Schwab took advantage of these unregulated prices and began offering “discount brokerage.”  The difference between a full service brokerage firm and a discount firm was in research, products, advice and initial public offerings (IPOs).  One by one, all of these distinctions have become blurred.  There is no more proprietary research — minutes after a research opinion has been disseminated by a Wall Street firm, it’s freely available on Yahoo, and many other websites on the Internet.  One advantage full service brokerage firms offered in recent years was access to initial public offerings (IPOs).  Perhaps Citibank feels this market is now also disappearing.  It appears that way at the moment.

Liabilities are likely increasing. As is the case with any downturn in the market, complaints may be on the rise — with legal costs to follow.  Legal and settlement costs can be a tremendous drag to earnings in the future.  Perhaps this is something Citibank wants to simply avoid.

No more “secret sauce.” There is another area that may have eroded significantly over the past year, causing Citibank to reconsider whether they wish to remain in this business.  It’s an area of retail brokerage that many never discuss.  But one branch manager explained it to me as “the secret sauce” retail brokerages have employed for years.  If you ever walked into a local branch of a full service brokerage firm, you have probably thought “hey, this is pretty swanky!  I wonder who pays for all of this?” This particular branch manager was talking about margin interest and interest on free credit balances.  For the first 12 years I was a broker, I had no idea of the components that make up a profit and loss statement of a retail office of a brokerage firm.  Like many others, I simply thought the biggest producers were the people that carry the profitability of the branch.  This is not necessarily true.  The biggest “profit center” for most retail branches is not an employee — in fact, it’s not even a member of the sales force.  As it was explained to me, margin interest and interest earned on free credit balances works 24 hours a day, seven days a week, 365 days a year.  And interest charged on margin accounts, and the interest earned on free credit balances (that is, money that has been credited, but not yet swept into a money market account) can amount to nearly 50% of the profits in a retail branch.  Retail brokerage firms like debit balances in margin accounts!  Perhaps Citibank realize is that fewer people are buying and selling stocks, fewer people are carrying margin balances and investors in general are much more careful today about how (and where) their money is invested.

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