Whichever way you spin it, it appears that Japan's premier commercial bank has taken its pound of flesh in return for the historic $9 billion capital injection into Morgan Stanley in November 2008 -- if, that is, the memorandum of understanding (MOU) signed on Thursday becomes reality.
The announcement of the planned merger between Morgan Stanley's operations in Japan and the securities unit of Mitsubishi UFJ Financial Group signals a coup for the Japanese bank, which over the past year has been growing with an emphasis on improving its return on equity (ROE). Among other things, it has made Union Bank of California and Mitsubishi UFJ Securities into 100% subsidiaries and in 2006 it formed a private banking joint venture with Merrill Lynch.
"But MUFG needs to improve its profitability, which is why it wants to absorb the high ROE of Morgan Stanley," says a rival banker
MUFG, along with the rest of the global banks, has seen its net income drop in the past year. In the first nine months of its current fiscal year to March 2009 (referred to as fiscal 2008) it posted a net loss of ¥42 billion ($429 million), compared to ¥636 billion gain for the fiscal 2007 as a whole. It also has a high expense ratio (63.2% in H1 FY2008) and a low return on asset (ROA) compared to its global peers.
Two of the five board members of the joint venture (which will be 60% held by MUFG) will come from Morgan Stanley: the chairman and the head of the institutional business. The latter will reportedly be from Morgan Stanley in perpetuity, according to one Morgan Stanley source. Morgan Stanley bankers see this appointment as a guarantee of their operational independence.
Still, the average Morgan Stanley banker may be unhappy about combining with Mitsubishi UFJ Securities, one of the weaker securities houses in Japan (third in all ECM and all DCM and fourth in all M&A for 2008, according to Dealogic). And he may be even more disgruntled on seeing Goldman Sachs, still independent thanks to the investment by Warren Buffett (and US taxpayers), continue to make its characteristic private-equity transactions, as it did last week with the investment into Universal Studios Japan.
One of the rumours doing the rounds in Tokyo is that the agreed JV was a condition for MUFG's investment late last year. Recall that Morgan Stanley's stock price was in freefall after the Lehman Brothers collapse. The original deal, whereby MUFG contributed $3 billion of equity, had to be renegotiated over a weekend to 100% convertible shares, on which MS pays $900 million in dividends annually. MUFG also has one banker on the MS board.
However, a Morgan Stanley banker says the deal was entirely mutual. "It should be obvious that access to the local market (via the tie-up) will be beneficial to Morgan Stanley. We have the investment banking capacity and MUFG has the blue-chip corporate clients and the essential retail distribution." Morgan Stanley will also be able to help MUFG with its international distribution.
On the downside, Morgan Stanley can wave goodbye to its FIG (financial institutions group) clients in Japan (apart from MUFG itself) since other Japanese banks will not give business to a domestic rival.
The deal has some interesting points. It's not clear what will keep Morgan Stanley bankers with the JV, given that (so far) there is no guaranteed bonus like the one Nomura promised Lehman Brothers' employees following its takeover of the US investment bank's Asian operations last year. A second rival banker estimates that "80% of the MS bankers there now will be gone in the next two years".
Secondly, it's interesting that MUFG's first serious foray into international investment banking should take place inside Japan, rather than outside.
Thirdly, in Japanese banks, the crème de la crème of bankers go into the commercial banks, not the securities houses. Therefore, it's unlikely that MUFJ Securities is driving the merger, or that it will be able to provide much assistance in dealing with the famously conservative commercial banks.
Finally, the ROE boost must be taken with a pinch of salt. The Japanese market is small compared to the global investment banking market (representing roughly around 5% of the global investment banking fee pool), and it's been getting thinner over the past two to three years. The amount of equity raised halved in 2008 from the previous year, which itself halved from 2006. The securitisation and real estate markets, which MS specialised in, have virtually gone, at least for the time being. In addition, MUFJ Securities has its own institutional bankers, who (unless they get redeployed) will likely dilute the JV's profitability per head, which is something that US banks excel at. The long-awaited crumbling of Chinese walls between different parts of the bank will also likely be put on hold, say bankers, given the regulatory problems apparent in the US.
But if everything does works out, and the markets recover, the new unit could increase its market share at the expense of its over-stretched rivals in Japan (RBS, Merrill Lynch, UBS and Credit Suisse are all constrained in Japan in view of developments in their home countries). Affiliated to a large local bank, the joint venture should be able to challenge Nomura and Daiwa SMBC Securities for access to local blue-chips. The unit will be able to keep that portion of the fees which it previously would have had to hand over to the houses with extensive local distribution. And it will likely become the underwriter of choice for global offerings by Mitsubishi-affiliated companies. The JV may be hard for the Morgan Stanley bankers to swallow, but maybe better profits will sweeten the pill.