Colm Kelleher may have the toughest job on Wall Street.
On Monday, Mr. Kelleher was named the sole head of Morgan Stanley's securities arm. His main challenge lies in the firm's fixed-income division, where traders deal in bonds, derivatives, currencies and commodities. Fixed income is a big contributor to earnings at most Wall Street firms. But it is a fiercely competitive business that can sometimes lead to steep losses - and now it has the added difficulty of being subject to new regulations that have crimped profitability.
Such headwinds prompted UBS to scale back in fixed income, a plan that was announced last weekend. Investors actually liked the plan, believing in part that UBS would stop deploying capital in nonproductive ways, and the bank's shares jumped.
Fixed-income trading nearly blew up Morgan Stanley in the financial crisis, and since then it has been volatile. This year, a strong first quarter for fixed-income trading gave way to a terribl e second quarter.
When markets freak out, as they did about Europe earlier this year, clients seem more likely to pull back from Morgan Stanley than other large firms. Over the last two years, Goldman Sachs' fixed-income revenue has not only been much larger in dollar terms than at Morgan Stanley, it has also been more stable.
As the head of the trading businesses in the securities division since 2010, Mr. Kelleher is partly responsible for the patchy performance. Still, it's down to him to show that Morgan Stanley isn't UBS, and it can compete with the likes of Goldman and JPMorgan Chase in fixed income. His two main challenges are to bolster bond-trading revenue and get rid of the whiplash movements that can unnerve both clients and Morgan Stanley's shareholders.
One viewpoint posits that the odds are implacably stacked against Morgan Stanley.
By such thinking, the Wall Street firm is little more than a huge inventory of bonds, stocks and other asse ts. It then calculates a firm's profit as a percentage of its assets. At Morgan Stanley, that “return on assets†is lower than at peers, as it was before the financial crisis.
In the past, this didn't matter too much to shareholders. The firm could increase its borrowings, or lever up. This increased profits for shareholders, even though its assets still had meager returns. In accounting jargon, a firm with a low return on its assets could use leverage to bolster its return on shareholders' equity.
But since the crisis, regulators have essentially capped leverage. A firm with low-returning assets is effectively trapped. Without high leverage, the only way to strengthen profits for shareholders is to increase the profitability of the assets it holds.
This new constraint on Morgan Stanley's profits were outlined in a September research note from Richard Ramsden, a Goldman Sachs banking analyst. For Morgan Stanley to get close to hitting its return-on-equi ty targets, he estimated that the bank would have to increase its return on assets to 0.7 percent. That is close to what Morgan Stanley was making on its assets before the financial crisis, when markets were booming and banks held higher-yielding assets than they hold now.
How big a leap that is depends on where Morgan Stanley's return on assets is today. Over the 12 months through the end of September, it was just 0.23 percent, close to that of UBS, and well short of Goldman's 0.59 percent.
But stripping out a large charge in the fourth quarter of last year, Morgan Stanley's return on assets comes to 0.38 percent, significantly higher than 0.23 percent, but still well short of the 0.7 percent that Mr. Ramsden, the Goldman analyst, says that Morgan needs. His research says the key to improving Morgan Stanley's profits is to improve returns in its fixed income business.
Given the obstacles, how might Mr. Kelleher transform fixed income?
Some things mig ht be easier than others. Profitability should increase as the firm holds less of the riskier, less-liquid assets it acquired before the crisis. If the global economy avoids more large disruptions, client confidence in Morgan Stanley should increase.
Market stability could also allow Morgan Stanley to borrow more cheaply. Its own borrowing costs, higher than at some other banks, are a major determinant of profitability.
But there are harder tasks.
In its news release on Monday, Morgan Stanley's chief executive, James P. Gorman, said he wanted to align trading more closely with investment banking. The idea might be that the traders sell more fixed-income products to companies doing bond deals with Morgan Stanley. But this could backfire if companies feel they are being asked to do business that may not fit their exact needs.
Then there's the task of wringing more revenue out of Morgan Stanley's fixed-income inventory.
Broadly, fixed-income busine sses make money in two main ways. One is through the money they earn on the assets they hold, like interest payments on bonds. Another way is by earning the “spread,†which is buying bonds from clients and then selling them on at a higher price. Firms that excel in fixed income turn over their inventory more often, creating more opportunities to earn spread income. To do this, Wall Street firms need to show clients that they will consistently provide reliable prices for assets.
Morgan Stanley may have given clients confusing signals since the crisis by pulling back and then expanding in fixed income. Winning client trust may therefore take time. It also requires nimble inventory management, so the firm isn't stuck with too many fixed income assets when markets recoil.
The stakes are high. If Mr. Kelleher fails, the UBS's about-face will look very attractive to Morgan Stanley's shareholders.
