New York | In this issue of The Institutional Risk Analyst, we compare Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS). We have a negative risk assessment on GS that has been in place since 2019. Of interest, Moody’s has put the senior unsecured debt ratings of GS (A3) and MS (A2) on review for possible upgrades.
When we look at these two $1 trillion asset bank holding companies (BHCs), it is tempting for analysts and investors to see their business models as similar. After all, both are in the business of investments and securities, right? But this is not the case. Other than the fact that the two BHCs are primarily focused on securities dealing and investment advisory services, and are roughly the same size, the similarities between GS and MS are outweighed by the differences.
GS and MS are two of the oldest financial firms in the US. The legacy of Goldman is that of a 19th Century commercial paper discount house that became known as a trusted investment banker after WWI and then evolved into a global trading and investment advisory firm until 2008. In the case of MS, the firm split off from the predecessor of JPMorgan (NYSE:JPM) after the passage of the Glass-Stegall law in 1933 separating banking and securities.
In the dark days after the great financial crisis, GS, MS and other near-bank securities firms often owned nonbank depositories in UT and other venues. GS and MS became full-blown commercial banks after 2008 in order to gain access liquidity from the Fed. MS acquired the Smith Barney brokerage business from Citigroup (NYSE:C), while GS has chosen to grow its banking and asset management business organically. Today both firms own federally insured depository institutions, but have core deposit and loan portfolios a fraction of the size of JPM and other money center banks.
Quantitative Factors
The comparable public companies used for our analysis are shown below at the close on Friday, October 30, 2020. We also use the averages for Peer Group 1, which includes the 127 largest US banks by assets. First let's look at GS and MS as banks on a consolidated basis and then discuss their nonbank operations.
Source: Bloomberg (10/30/20)
The first metric to consider is the composition of the assets of the two firms. While GS is slightly larger than MS in terms of its balance sheet, MS has a bigger loan book and bigger deposit franchise. MS had almost $175 billion in core deposits at the end of June 2020 vs $128 billion for GS.
More important, MS had just $330 billion in noncore funding vs over $500 billion for GS at the end of June 2020. Overall, interest expense at GS exceeded 1% of total average assets vs. 0.62% for MS and 0.61% for Peer Group 1. As shown in the chart below, GS has a higher cost of funds than Citi and is just under American Express (NYSE:AXP) in this regard. MS, on the other hand, tracks Peer Group 1 in terms of funding cost.
Source: FFIEC
The next thing to consider after funding is how the bank prices its loan portfolio, an important measure that captures both the bank’s competitive position and also its ability to generate revenue given its chosen internal default rate targets. When it comes to the pricing of its larger loan book, MS seemingly is below GS and the other comparables, but its returns net of credit costs are actually higher.
Source: FFIEC
As the chart above illustrates, GS has the best gross loan yield in the group after Citi and AXP. Indeed, AXP has managed to increase its gross loan spread even as other banks have been forced to give ground, a remarkable performance for the smaller AXP. Notice that MS has seen its consistently mediocre gross loan yield fall in recent quarters, but GS has seen the worst erosion of economics on its loan book of the group.
After we consider funding costs and the gross yield on the loan book, the next analytical point is the cost of credit. For this purpose, we compare the net loan loss rate as a percentage of total loans. While GS is close to the top of Peer Group 1, MS is in the bottom decile of the peer group and, indeed, tracks well below the group average for loan losses. At the end of June 2020, GS reported net losses equal to 76bp vs 28bp for Peer Group 1 and just 3bp for MS. Indeed, as shown in the chart below, MS basically has reported the lowest losses of any of the banks in the group.
Source: FFIEC
As you will note in the chart, AXP has the highest loss rate of the group, followed by Citi and GS. Indeed, GS has just seen its net loan losses rise above that of JPM after basically tacking Peer Group 1 for the past five years. This suggests that GS is taking more risk with its loan book. Meanwhile, MS has seen its net loan loss rate actually falling in recent quarters to near-zero levels.
Once we assess the bank’s funding costs, loan pricing and net credit losses, we begin to understand the components of income. Since both MS and GS depend upon non-interest fee income for the majority of their profits, the net income of the BHCs reflects both the assets of the group and the intangible relationships with customers that define the franchise of any investment bank. But the fact of the matter is that MS looks a lot better as a commercial bank than does GS.
The chart below shows net income as a percentage of average assets. Aside from illustrating the superior performance of AXP, which is the best performing large bank in the US, the chart illustrates how MS manages to outperform both GS and Citi in terms of asset returns. Indeed, in recent quarters MS has outperformed both GS and Citi by a wide margin.
Source: FFIEC
As noted above, GS and MS generate roughly the same net operating income, but MS makes more money on its lending operations because of the relatively low cost of the funds and also the extremely low net credit losses. Indeed, while GS generates slightly more revenue in terms of gross interest income than MS, the more efficient MS manages to take almost twice as much net interest income to the bottom line.
At GS, roughly 85% of net operating income comes equally from trading, and investment banking and commissions. At MS, less than a third of the firm’s operating income comes from trading while more than 50% comes from investment banking. The striking thing to note comparing the two firms is that these relationships are quite stable at MS going back years, while GS evidences significant volatility in the share of net operating income that comes from these two key areas.
In terms of operating expenses as a percentage of average assets, the two securities and investment firms are relatively close to each other, with MS at 3.41% and GS at 3.12%, but far above the average for most large banks in Peer Group 1 at 2.63% of average assets. MS has slightly higher overhead expenses in dollar terms, but the superior profitability and credit performance of MS more than allows for this difference. Indeed, as of Q2 2020, GS reported an efficiency ratio of 78% to the Federal Reserve Board vs 70% for MS. The lowest efficiency ratio for the top banks is 49% for Citi.
Another aspect of the quantitative analysis is the investment management arm of GS and MS. While the former has a larger pool of assets under management (AUM), MS manages to generate more revenue per dollar. With the purchase of Eaton Vance (NYSE:EV) and its $500 billion in AUM, MS has now topped $1 trillion in client assets but still does not figure in the top 10 global asset managers. Note that most of the top managers are neither investment nor commercial banks and thus tend to trade at higher equity valuations than either GS or MS. And not all AUM is the same.
(Ranking as of year end 2019)
Looking at the most recent results for Q3 2020, MS earns far more from its smaller investment and wealth management businesses than does the larger GS. The table below shows the three main business lines that are disclosed by both firms. In both cases, the footings attributable to the commercial bank operations are shown as part of wealth management
Source: EDGAR
Again, not all AUM is created equal. Even though GS claims to have twice the AUM of MS (pre-Eaton Vance acquisition), it makes less than half the revenue per dollar of client assets. Along with the disparity in the performance of the insured depository, the chief quantitative differences between GS and MS have to do with the performance of the investment and wealth management businesses. Also, the markets and investment banking lines of MS have displayed superior stability in recent years while the comparable business lines of GS evidence substantial operational risk, as discussed below.
Qualitative Factors
The chief qualitative issue facing both GS and MS is the sufficiency of internal controls to manage the manifold risks that come along with the investment banking business. As we noted above, the banks and broker-dealers among global financial institutions tend to trade at lower equity market valuations than do the pure asset managers. This discount arises, at least in part, due to the perceived risk of doing business with a financial institution that engages in banking and/or securities dealing activities.
As the major banks of Europe, Asia and the United States seek to derisk and grow their investment management business, the natural question is when and how will this perceived gap in terms of risk and market value be eliminated? The short answer to the question is that such an improvement is unlikely to occur because the business of investment banking and capital markets dealing is intensely competitive, which tends to generate outsized risk.
Whether one talks about the 1MDB affair, a Goldman Sachs-backed Malaysian fund that turned into one of the biggest scandals in financial history, or other events in the past of GS such as Abacus (2011), American International Group (NYSE:AIG) (2008), Blue Ridge and Ticonderoga (1929) and other regulatory and legal violations, the prominence of operational risk in the firm’s business model is unmistakable. Firms such as Bear, Stearns & Co and Lehman Brothers also took outsized risks and are no longer with us.
A guilty plea and partial settlement of the 1MDB scandal cost GS two quarters worth of earnings. Since 1998, fines and settlements have cost GS shareholders over $10 billion, not including the $2.5 billion in the 1MDB settlement with Malaysia earlier this year.
MS does not have a similar tale of woe when it comes to legal and regulatory matters, events which ultimately are a cost to shareholders in terms of cash losses and also reputation damage. The reason very simply is that MS as a firm manages risk and encourages bankers to hit singles and doubles, and pays well for performance. GS as a firm has needed to go for more risky business in terms of sourcing opportunities.
To boil down the question of comparing MS and GS to each other to its essence, the question is this: Would MS CEO James Gorman ever have agreed to meet with the architect of the 1MDB fraud, Jho Low, much less accept him as an investment banking client? Probably not. MS is a far more conservative firm as an investment bank than GS, in ways that few on Wall Street understand.
Culture matters. MS went through an existential event in 2008, a near death experience that management determined not to repeat. After years of cost cutting and restructuring under Gorman, MS emerged stronger and with one of the toughest risk management cultures on the Street. The firm ran its own internal stress assessments years before the Fed began its annual testing circus. And a decade later, Gorman has one of the most stable operating teams in the business.
Another important qualitative risk factor is the company’s business strategy and execution, a metric that is partly described by quantitative measures such as efficiency as discussed above. MS has an eight-point advantage in terms of operating efficiency over GS, but is well above peer compared with other banks. Both GS and MS need to get efficiency into the 60s long term.
MS has also been far more aggressive in building its business via opportunistic acquisitions. The acquisition of E*Trade in February of 2020 and more recently Eaton Vance illustrate that Gorman is serious about not only derisking the traditional MS business of investment banking and program trading, but building a successful portfolio of investment management businesses to compliment the traditional brokerage/wealth management lines. Both the E*Trade and Eaton Vance deals, of note, brought new deposits for the MS banks.
Conclusion
As we’ve noted in our past profiles of GS, we believe that CEO David Solomon and his board need to be more aggressive about acquisitions or risk being left behind in the global competition for banking clients and investment assets. Gorman, on the other hand, seems to understand that getting big is an expensive process in today’s market, but one that will ultimately ensure his firm’s future. And he is acting from strength in executing his strategy.
We believe that at some point in the future, GS will again stumble, face another outsized operational risk event such as 1MDB and be compelled to seek a combination with another bank. The firm’s stock valuation and credit spreads are a function of this quarter’s investment banking and trading results, while the wealth management and banking lines are still too small to matter in the grand scheme.
In the meantime, we expect to see MS continue to grow even if it means paying substantial multiples to book that GS could never afford to pay. Gorman has cash, but his currency in terms of MS share price is still a disappointment given the firm's impressive financial performance. By rights MS should trade above book and closer to JPM, but the dependence on investment revenue still makes investors shy. The numbers tell the story.
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