Fed Pressure Factors into Morgan Stanley/Citigroup Venture

By , Contributing Writer, Money Morning •

By Don Miller
Contributing Writer
Money Morning

Morgan Stanley (MS) and Citigroup Inc. (C) are about to launch a joint venture of their brokerage units in a move that may be motivated as much by a desire to placate impatient government overseers as by financial imperatives.
 
The deal's no surprise to Wall Street, since Citigroup has chalked up $20 billion in losses in the last year and Morgan Stanley needs to leverage its brokerage business by increasing its scale. But recent pressures on both companies from the Treasury and Federal Reserve may also have led to pulling the trigger.

"There's been a lot of pressure for Citi to monetize some of their more valuable assets, and Smith Barney is certainly one," Michael Nix, a money manager at Greenwood Capital Associates, told Bloomberg News. "There's also been a lot of pressure for Morgan Stanley to look at how they can better lever their business units."

Morgan Stanley is set to pay $2-3 billion in cash for a majority stake in Citigroup's brokerage unit, Bloomberg reported. Morgan Stanley would also have the option to buy the remaining 49% of Smith Barney over the next three to five years.

But the deal could open Morgan Stanley to criticism that the bank is spending taxpayers' money on acquisitions rather than kickstarting the economy through lending.  Morgan Stanley and Citi were among several banks to receive large government investments.

As an ongoing Money Morning investigation has demonstrated, billions in U.S. bank rescue funds are financing buyouts worldwide - instead of lending at home. Some of those buyout deals are being done in markets as far away as China. Meanwhile, credit remains tight here in the U.S. market, a situation that could be alleviated if only the banks made the bailout money available to consumers in the form of loans.

But few believe the authorities will raise many objections since the move will serve to strengthen both Morgan Stanley and Citigroup's financial position, as well as increase their ability to pay back government loans in the future.

Although government officials have been badgering banks to use the federal funds to boost lending, they will probably back the deal since it gives Citi $2.7 billion in much needed capital while strengthening Morgan Stanley's balance sheet with billions in assets.

For its part, ceding control of Smith Barney in exchange for cash and a sizeable capital gain underlines Citi's need to bolster its balance sheet. Citi will record a capital gain of up to $6 billion on the difference between the valuation of Smith Barney on its books and the value of its share of the joint venture.

Putting Smith Barney in play represents a change of direction for Vikram Pandit, the bank's chief executive, only weeks after he pledged that Smith Barney would remain part of Citigroup.  And Pandit is under pressure from the Treasury  and Fed to sell assets and improve capital reserves, according to the Financial Times.

But selling the unit comes at a steep price to Citi's bottom line. Smith Barney will make $1 billion next year, according to a forecast by Barclays Capital. Citi's North American global wealth management division, which houses the brokerage, contributed 20% of Citi's net profit in 2007, up from 6% the previous year, showcasing its ability to perform even in tough times.

On the other hand, Morgan Stanley needs more brokers to turn its wealth management business into a bigger profit engine. The Citi deal would take care of that in one fell swoop, adding more than 15,500 brokers to its current base of 8,000. Brokerage businesses thrive on size as their technology costs can be spread over a larger number of brokers.

The move comes after Morgan Stanley's recent conversion from an investment bank to a bank holding company regulated by the Fed, limiting its ability to take leveraged bets in its trading businesses. But rather than providing checking accounts to ordinary bank customers, the company will be able to focus more on wealthier individuals, with portfolios of stocks and bonds.

Meanwhile, President-elect Barack Obama made clear that there will be strict controls on the second half of the $700 billion Troubled Asset Relief Program, the government bailout fund originally designed to purchase assets and equity from financial institutions in order to strengthen the financial sector.

"Let's lay out very specifically some of the things that we are going to do with the next $350 billion of money," Obama said on the ABC News program, "This Week." "And I think that we can regain the confidence of both Congress and the American people that this is not just money that is being given to banks without any strings attached and nobody knows what happens, but rather that it is targeted very specifically at getting credit flowing again to businesses and families."

News and Related Story Links: