In early 2011, Morgan Stanley Chief Executive James Gorman thought he had finally figured out how to rebuild the bank's depleted bond trading business without taking too much risk.
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He hired traders from rivals in areas where the bank was relatively weak, such as trading government debt, and exhorted his sales staff to gain new clients and win more trades from existing customers.
On Friday, after three years of spotty results, Gorman flipped the script, announcing a new strategy for fixing the operation: shrinking and taking less risk. It is at least the fourth time the bank has tried to retool the business since the financial crisis.
Rivals and some analysts are skeptical that Gorman has it right this time.
"Whether banks can really compete and be profitable on a smaller scale - that's the million dollar question," said Lisa Kwasnowski, an analyst at the bond ratings firm DBRS who is supportive of Gorman's plan.
Bond trading - including fixed income, currencies, and commodities - has historically been a profit driver for banks such as Morgan Stanley and Goldman Sachs Group Inc, but new capital and trading rules from regulators in the aftermath of the financial crisis have squeezed profits.
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Morgan Stanley saw its bond trading revenue fall 14 percent, excluding an accounting adjustment, in the fourth quarter. Revenue from the business also fell for Goldman and Citigroup Inc. Nearly every major global bank is examining what to do with their fixed income businesses in light of new regulations.
Bond trading has been critical for banks for more than a decade, both as a source of profits and as a way to win lucrative underwriting and merger advisory assignments.
If it is too small, those benefits can disappear fast. For example, a company looking to issue bonds may not be confident that the underwriting bank will continue to trade them after the deal is initially sold.
But Gorman has said he thinks that Morgan Stanley can continue to meet client needs even after it shrinks the business. His latest plan includes a new, more centralized management team, and "a particular focus on expenses, technology, capital, and balance sheet," he said on a conference call with analysts on Friday.
He is meeting some resistance from traders. Glenn Hadden, global head of interest-rates trading, was so vocal in his opposition to the changes that he was eventually asked to resign, said two people familiar with the matter.
Hadden declined to comment when reached on Friday.
Earlier this month, Hadden cited the new strategy as his reason for leaving. [ID: nL2N0KG1SZ]
Morgan Stanley hired Hadden, a former Goldman Sachs trader in March 2011, and told him to win new business. But soon after that, new regulations started to hurt bond trading. Morgan Stanley's debt ratings fell as well, making customers less willing to enter into lucrative longer-term derivatives contracts with the bank.
In May, Hadden's boss quit, to be replaced by Michael Heaney and Robert Rooney as co-heads of fixed-income sales and trading. The two executives sought to reduce risk and centralize management of the sprawling business.
One element of that centralization plan particularly irked senior traders: the co-heads now make decisions about how much money every individual trader can trade, according to the sources.
In the past, heads of fixed-income sales and trading would allocate capital to the desk, and let the desk determine how much money individual traders could use. Traders complained that the tighter controls limited their risk-taking and bonus potential, the sources said.
'THEY CUT AND CUT'
Limiting risk is critical to Gorman. He is keenly aware of Morgan Stanley's bad bets on subprime mortgages that in 2008 nearly capsized the company and forced it to take a government bailout. Coming out of the crisis, then-CEO John Mack took a much more cautious stance in fixed-income trading, slashing jobs and risk-taking.
His move made sense at the time but left Morgan Stanley unprepared for a bond trading boom in 2009 and 2010 that created the most profitable year ever for rivals, including Goldman Sachs.
Part of Gorman's strategy is to cut the bank's risk-weighted assets, a measure of assets that makes it easier for the bank to hold onto safer instruments like U.S. government bonds.
The bank is in the process of winding down a big pool of fixed-income assets by more than half to $180 billion by the end of 2015, on a risk-weighted basis. The bank has another $30 billion worth of assets to go, and on Friday accelerated the timeframe for the task to be completed.
Some rivals have argued that the bank cannot compete if it is too small, and say Morgan Stanley should go the way of UBS AG , which announced a decision to exit FICC trading almost entirely in October 2012.
"History has shown people don't give up businesses easily - they cut and cut, and make strategic changes before they finally throw in the towel," said an executive at a rival firm. "If you cut and are weak to begin with, it's hard to see how you get stronger."
Morgan Stanley officials say they do not want to be big just for the sake of it, preferring to be smaller but profitable.
They also say they are not shrinking the business so drastically that they won't be able to compete and that it is big enough to maintain a presence in most major bond and derivatives markets. The bank knows it needs a fixed income arm to serve its other clients.
"At a minimum, they need to accommodate clients in the wealth management and investment banking businesses," DBRS' Kwasnowski said. (Editing by Dan Wilchins and Paritosh Bansal)