Morgan Stanley Smith Barney and the Future of Citigroup

The short story is that Citigroup (C) and Morgan Stanley (MS) are allegedly combining the retail brokerage operations into a standalone entity with enough financial advisors to top the merged Bank of America (BAC) Merrill Lynch herd. Morgan Stanley is reported to be paying Citigroup an extra $2B to $3B for at least 51% controlling interest. Currently Citigroup’s Smith Barney has substantially more financial advisors than Morgan Stanley. Morgan Stanley is said to have the option of buying out Citigroup’s interest in the joint venture within 5 years.

I believe that this is the first step in splitting the current Citigroup into Citigroup Domestic and Citigroup International, with Citigroup Domestic eventually merged into Morgan Stanley. The current shareholders will probably be left with only Citigroup International. This appears to be happening with not only government blessings, but with the government’s prodding. The government has already created a special facility to quarantine substantial portions of Citigroup’s most toxic mortgage securities to facilitate such a merger. And worry exists that Citigroup could become American International Group 2 (AIG). Remember that the Treasury did not really kick up the volume until Morgan Stanley and Goldman Sachs (GS) were targeted for implosion. Morgan Stanley is clearly on the most favored list while Citigroup is just a big problem.

How does each side benefit? Citigroup gets cash and the ability to write up its investment in Smith Barney. Some have reported a non-cash gain of up to $10B, though Citigroup will lose a portion of Smith Barney’s steady earnings with its reduced interest. Morgan Stanley will gain economies of scale and a potential upgrade in the average net worth of its retail clients. The Smith Barney clientele is most likely wealthier than the legacy Dean Witter clientele that Morgan Stanley acquired. That said, I don’t doubt that Morgan Stanley has plenty of high net worth retail customers.

As a Citigroup stockholder, I favor the joint venture. I don’t believe that dependable profits from the likes of Smith Barney and Merrill Lynch retail operations will continue. History argues that retail customers always return to full service brokers after each financial blowup. After all, didn’t investors need a feeling of security and hand-holding following the dot-com blowup? These firms were there to offer high margin, can’t-lose products for their tattered customers. Demand was so great that these firms were able weed out their lower net worth unprofitable customers.

Now that the trend is toward simpler, more understandable investing, will their customers still seek the shelter of full service brokers? I think they will, but the customers will be less likely to purchase the high margin products that led to a large portion of these firms’ profits. Asset based fees have already come under scrutiny, as have pushing difficult to understand products like auction rate securities on retail customers. The firms will still be able to market some simpler new corporate and municipal debt, and maybe even a few IPOs to retail customers. But the demand for the highest margin structured products targeted at retail customers should be waning.

Full service retail firms have been most profitable when they can give their customers the illusion of risk free investing. Products, such as indexed link securities, promised to at least return your total investment when held to maturity. Originally these products were conceived as a combination of treasuries, futures contracts and a hefty profit margin for the house. Next came retail structured products that customers actually could lose money on at maturity, but the brokers must have convinced their clients it was unlikely. Then the last cycle culminated with high fee retirement date targeted mutual funds that shifted investments from stocks to more conservative bonds as customers aged. Trouble was everything lost value. Even opening the door to the prestigious world of alternative investments like hedge funds and private equity has lost the allure for retail customers.

In a simpler world, profits at the imagined Morgan Stanley Smith Barney could be steady but at a lower level. Full service brokering will become a utility, just like the rest of banking. And with my imagined Citigroup Domestic, Morgan Stanley will become a real bank.

Disclosure: Author is long BAC and C.