A reported joint venture between Citigroup and Morgan Stanley prompts worrying questions.
Economist StaffJanuary 12, 2009

On his appointment as Citigroup’s chief executive, just over 12 months ago, Vikram Pandit set great store by taking a systematic route to working through the bank’s problems. The results have not been hugely successful. Citi’s share price stood at a measly $6.75 on Friday January 9th, a drop of more than 75% over the past 12 months. To judge by widespread reports, conspicuously undenied, of a planned merger between the brokerage arms of Citi and Morgan Stanley, Mr. Pandit now appears to have ditched the methodical approach. Spinning out Smith Barney, the bank’s brokerage arm, would constitute an abrupt swerve.

As recently as November, Mr. Pandit heaped praise on the brokerage arm and told staff that he did not want to sell the business. Smith Barney is hardly one of the “legacy assets” he identified as being ripe for offloading when he took over. (Nor, for that matter, is Banamex, a Mexican bank that was, until the downturn, a profit machine, which Citi is also said to be thinking about selling.) The brokerage accounted for a sixth of group revenue in the first nine months of 2008 and is a relatively stable source of income in an environment of unprecedented volatility.

A joint venture would mean that Citi could retain some of that precious revenue. But the proposed deal, which would reportedly give Morgan Stanley an initial 51% stake, would also apparently give the investment bank an option to acquire the rest of the business over time. If the universal model, which Mr. Pandit still professes to believe in, has life in it, then the mixture of brokerage and private and retail banking is one of its more logical combinations. Assuming the reports are true, why turn his back on it?

The obvious answer is that Citi badly needs more cash. Weighed down first by huge write-downs in its trading book and now by mounting loan losses, the bank is set to announce a fifth consecutive quarter of losses on January 22nd. There are whispers of an operating loss that could exceed $10 billion, far bigger than most analysts have been anticipating. Concern is growing that Citi’s dramatic rescue of a few weeks ago, when the government injected more capital and agreed to backstop more than $300 billion of assets, did not after all put the bank on a firm footing.

If reports of negotiations between the two banks are to be believed, Morgan Stanley would pay Citi up to $3 billion for its stake in the new venture, in recognition of the greater number of advisers and assets that Smith Barney would bring to the table. That may not sound much—on Thursday, for instance, Citi announced that it would suffer a $1.4 billion loss on its exposure to a single, floundering chemicals firm—but it is doubtless more than Citi could get for other bits of its fraying empire. Low prices are better than no prices (and the fact that the government has invested money in both firms suggests that a deal is being pushed from above).

Even if less worrying forces are at work, an agreement would still represent a significant moment for both firms. For Citi, a spin-out of Smith Barney would move the firm more dramatically away from its financial-supermarket model than any of the other recent divestments it has undertaken. The news on Friday that Robert Rubin, a powerful voice in favour of the universal model and widely blamed for Citi’s woes, is to quit the board further symbolises a shift away from the one-stop-shop. (The position of Sir Win Bischoff, the bank’s chairman, is also reportedly under discussion). What’s emerging instead is a new firm with three core businesses: consumer credit (credit cards, retail banking and consumer finance); large-scale corporate banking; and payment systems and processing, another stable business that Citi’s managers have grown to love.

For Morgan Stanley, meanwhile, a deal with Citi would emphasise its consumer businesses at the expense of institutional activities such as underwriting and merger advice. A joint venture would create the industry’s biggest brokerage, with 22,000 advisers. The reason why a spin-out of Smith Barney seems odd for Citi is also why it makes sense for Morgan Stanley. The investment bank may also see a beefed-up brokerage as the best way (eventually) to strengthen its deposit-gathering operations and reduce its reliance on wholesale markets.

Huge question marks would still hang over Morgan Stanley. The scale of the venture signals many of the same integration challenges that apparently dog the merger between Bank of America and Merrill Lynch, for instance. But these are nothing compared to the concerns still weighing on Mr. Pandit, who won a lukewarm endorsement on Sunday from Richard Parsons, Citi’s leading independent director. Citi never sleeps? Nor would you.

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