Stock Market

In defence of diversification

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Good morning. In the streaming wars, news from the front. Last night Disney announced a restructuring, including a $5.5bn costs savings target and 7,000 planned job cuts (about 3 per cent of its workforce).

Bob Iger, called back from retirement for a second stint as chief executive, said: “Our creative teams will determine what content we’re making, how it is distributed and monetised and how it gets marketed. Managing costs, maximising revenue and driving growth from the content being produced will be their responsibility.” Giving business unit leaders direct responsibility for functions such as marketing and distribution, rather than managing those functions centrally, is called “de-matrixing”. Unhedged recently discussed this process with an executive at Trian, the activist investor with a stake in Disney.

Were Iger’s de-matrixing comments a mere verbal sop to the activists, or something more? We will be following closely. In the meantime, email us: robert.armstrong and ethan.wu

Goldman, Morgan Stanley and bank diversification, redux

Earlier this week we wrote about the big valuation gap between Goldman Sachs and Morgan Stanley. The argument was that while investors will pay a premium for diversified banks like Morgan Stanley, that was not necessarily a good reason for Goldman to pursue its own diversification strategy. Diversification will not magically make Goldman’s volatile and capital-intensive core business more valuable, and the synergies between different finance businesses (retail banking, wealth management, capital markets) are often elusive. Better for investors to pursue the benefits of diversification at the stock portfolio level, rather than have banks pursue it with a risky merger.

I asked one bank expert why, given all this, investors pay up for diversified banks. He replied that diversification . . . 

. . . provides the perception of a big stable funding base. After all a lot of this is a confidence game, and if debt holders don’t feel like they’re the only ones holding the bag then that provides a layer of stability.

This was too much for one reader, a bank resolution expert at a large European bank. He wrote, with “a pang of anguish”:

The US GIBS [global systemically important banks], of which GS is one, all have clean holdco structures for resolution purposes . . . debt holders of these holdco entities (buyers of total loss absorbing capital, or TLAC, in the jargon) are literally the only ones holding the bag. All other group liabilities are structurally protected from loss by being located in subsidiary entities, including, most importantly, those (retail) depositors (as well as the operating liabilities of their US broker/dealer subs). I sincerely hope that the people who actually buy TLAC understand this.

He has a point: if Morgan Stanley or any other diversified financial institution were to fall into crisis, it could not plug holes in its balance sheet with depositor capital from its retail bank or wealth management subsidiaries. In a resolution, unsecured debt holders would be bailed in (becoming equity holders, quite possibly of valueless equity) first.

But that is not quite the whole story, according to Steven Kelly, a senior research fellow at the Yale Program on Financial Stability. He argues that when a crisis strikes — but before a bank reaches the point of being resolved by the authorities — diversified institutions have several advantages. First, they “have a wider capital base which can be reallocated”. A company that had excess capital at the holding group level could inject it into, say, a broker/dealer or prime broker subsidiary that is facing acute market pressure, and otherwise might not be able to meet its obligations. This capital would not be deposits, but “buffer” equity capital in a subsidiary that is not under stress.

Kelly points out that it might not actually be necessary to move any money in this situation, so long as the market and the authorities knew the capital was somewhere under the holding company umbrella. This knowledge will make counterparties less likely to run and central banks more likely to help. In a crisis “funding is not the crucial thing. You can get a subsidiary funded by the Fed . . . we have the pipes. In March 2020 we had a primary dealer funding facility at the Fed . . . but if counterparties are running, the Fed will hesitate to support failing businesses.”

In short, if an aggregate balance sheet of a diversified business looks solvent, counterparties and regulators will extend more trust, even when one subsidiary is in bad trouble. This keeps the resolution process and bail-ins at bay.

There is another piece, too. In a crisis, good assets go on sale. Institutions that have stable cash flow businesses will have the means to take advantage of the bargains. Certainly, Bank of America and JPMorgan Chase did so last time round.

All this makes sense to me, though I remember Goldman coming through the mess of 2008 in relatively good shape. But I wonder how much value investors put on this sort of resilience, 14 years on. I wonder if the Morgan Stanley premium arises instead from investors’ misunderstandings about how diversification does and does not work. I guess we will find out in the next recession, if the Goldman-Morgan Stanley valuation spread widens even further.

One further point about the risks involved in pursuing diversification, again from a reader. Morgan Stanley seems to have nailed its diversification strategy in this cycle. It was not so easy last time. In 1997, the bank merged with Dean Witter, Discover & Co, a retail brokerage/credit card group. How did it go? Our reader, an investment banker, recalls:

[The deal] would [in theory] broaden MS from very corporate investment banking and trading into retail land of the average Joe living his regular life and saving for retirement. Think of all those baby boomers who had not properly prepared yet for retirement and were going to have to catch up!

Well, MS had the . . . problem of lots of new expenses for the DW branches in shopping malls across the country and those synergies AGAIN failed to materialise. [CEO Philip] Purcell was pushed out, the Dean Witter name disappeared and the branches were closed as fast as possible (I think at a cost greater than the “bargain” price paid for it — although over several years). Discover was spun off as a stand alone public company — MS may have eventually made money on this part.

John Mack, who led Morgan Stanley at the time of the Dean Witter merger and later returned, remembers the deal as “painful” but says it was worth it. He would say that, of course; it was his deal. Even accepting that the deal made strategic sense, though, it is important to remember that the costs incurred in mergers are often larger than expected, and the synergies smaller. Diversification is expensive.

One good read

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