Thundering herds on trail of Morgan merger

In the face of the Wall Street cry for even greater consolidation, City investment banks look vulnerable, writes Peter Rodgers

The event feared by much of London and Wall Street happened last week. The Western world's biggest securities firm was created when Morgan Stanley, one of the most successful investment banks in the US and Britain, announced a $23bn (pounds 14bn) merger with Dean Witter, Discovery. It will form a giant half as big again as Merrill Lynch, the "thundering herd" of Wall Street legend.

For London, the immediate threat seemed minor, since there is little overlap between the 2,000 staff employed by Morgan Stanley in Canary Wharf in Docklands, and the small Dean Witter office four miles away near Liverpool Street Station.

The impact should be very different from Morgan Stanley's stalled takeover of SG Warburg in 1994, which if it had succeeded would have led to extensive rationalisation of the two firms' large London offices.

Although many investment bankers and analysts in the City were dismissive of the short-term impact, the risk London faces is that the Morgan Stanley and Dean Witter merger will be the catalyst for a renewed worldwide rush to consolidation in the investment banking industry.

This is not a new idea. Most people in the industry think that within five years investment banking could revolve around as few as five and certainly less than 10 giant firms. The latest development suggests that the process may indeed be accelerating.

Dick Fisher, the chairman of Morgan Stanley, spoke for much of the industry when he said he expected consolidation would produce a small group of increasingly powerful market leaders.

There is, of course, a risk that the next merger in the industry will involve two firms that do have large overlapping operations in the City of London, leading to the scale of sackings that appear to have been avoided in the Morgan Stanley merger.

But the more significant threat is to the position of British-owned investment banks, of which rather few of any consequence are left. Merchant banks such as Schroders and Flemings are successful in their own way, but they are not in the same league as the New York giants.

Banks like Flemings are also finding themselves pitted more frequently against US investment banks, which are invading the domestic corporate finance niches they thought they had to themselves.

The fact is that NatWest Markets and BZW, which is part of Barclays Bank, are the only two British investment banks that have parents with the financial clout to leave the first and second divisions and join the new super league headed by Morgan Stanley.

Sadly, most analysts think these two banks are in serious danger of missing the boat as the pace of consolidation in investment banking accelerates.

Their most serious problem is that while the successful New York firms such as Goldman Sachs, Salomon Brothers, Morgan Stanley and Merrill Lynch have large operations on both sides of the Atlantic, it has proved tough for British firms to do more than gain a foothold in New York.

Yet without the ability to win US clients and distribute securities to US investors, British firms are competing at a disadvantage with the new giants.

This analysis explains why there were repeated rumours last year that NatWest was in talks with a large US investment bank, though eventually it spent its cash pile on a number of smaller deals.

Last week the market was buzzing with rumours that BZW was about to buy Lehman Brothers, a New York securities firm that also has offices in London, but the rumours were dismissed.

Indeed, NatWest and BZW may be forced, whether they like it or not, to stick to their present policy of gradual growth in New York through hirings and modest acquisitions.

The mergers that Wall Street expects to follow the Morgan Stanley and Dean Witter get-together may leave them with few potential partners unless they move fast. Wall Street, which arranged a record $1.14 trillion in mergers last year, is now taking aim at itself.

The announcement of the merger boosted shares in both companies and triggered a rally in other investment firms - all of whom may now acquire or be acquired to keep up with their rivals.

Securities firms are "thinking they have to do something in response to Dean Witter's announcement", said Bruce Wasserstein, head of investment bank Wasserstein Perella, which advised Dean Witter on the Morgan Stanley transaction. "You have insurance companies, securities firms and banks, and they're going to come in like the Oklahoma Land Rush."

Merrill Lynch, Lehman Brothers, Bear Stearns and Donaldson, Lufkin & Jenrette shares all rose, while Paine Webber Group fell only because of a big run-up in previous days on speculation that it was about to be taken over.

With fashion a powerful force on Wall Street, analysts expect more mergers between investment banks and retail brokers. Until now, only Merrill Lynch has been a leader in both lines of business.

"If you don't have significant access to the individual investor, right now, you'll want it,'' said Hardwick Simmons, president of Prudential Securities. That was apparent in Salomon's alliance with Fidelity Investments' discount broker last month, he said.

Among many possible combinations, firms such as Goldman Sachs, Salomon and Lehman Brothers, which concentrate on selling stocks and bonds to institutional investors, might acquire Paine Webber, Prudential Securities or AG Edwards, each of which has more than 5,000 brokers selling to individuals.

Merrill Lynch executives told employees on Wednesday in an internal memo that "we've been predicting an increase in industry consolidation and we expect the trend to continue."

Some industry watchers pointed to the risks for buyers of broking firms. "The retail brokerage business is at a peak now," said John Keefe, an independent analyst in New York. "Is this the right time in the cycle to be doing such a large merger?"

Nevertheless, a merger between Salomon and Paine Webber "would make sense", said Michael Holland, who runs his own New York-based money management firm.

Big commercial banks such as Chase Manhattan, Citicorp and Bankers Trust New York might also be interested in Paine Webber, said Ken Fisher, chief executive of Fisher Investments in California and a shareholder of Paine Webber.

In December the Federal Reserve Board approved a proposal to allow banks to derive more of their revenue from underwriting and trading stocks and bonds, which had already set off a round of speculation on Wall Street about just which broking firms are potential takeover targets.

One of the main functions of investment banks is to raise money for their corporate clients. The surest way to achieve that is to own a network selling to potential buyers of the shares and bonds issued by those clients. The investment banks' drive for greater size is based on this pressing need for distribution power.

The network the new merged company will control will be impressive. Morgan Stanley is a traditional investment bank dealing mainly with large companies, selling shares and bonds to professional investors.

It was set up in 1935 when several partners of JP Morgan, the blue-chip bank, left to set up on their own because the Glass-Steagall Act of 1933 had prevented the bank dealing in securities. Morgan Stanley is still bound by an agreement with JP Morgan to keep the name Stanley in its title to distinguish it from the bank.

In fact, JP Morgan is nowadays a powerful rival of Morgan Stanley in many areas of investment banking. One reason securities firms such as Morgan Stanley say they need size to compete these days is that the US government is allowing commercial banks to encroach more and more on their business, as the restrictions of Glass-Steagall have been eaten away.

Dean Witter is a very different animal. It was spun off from Sears, the retailer, in 1993, and does not have the upmarket investment banking reputation of Morgan Stanley.

It does, however, have one of the US's biggest networks of retail stockbrokers, with more than 9,000 agents working their phones to sell shares to doctors, dentists and grocers. This is a type of business that has hardly got off the ground in Europe.

The two together will have the largest collection of investment funds under management by any securities firm, including a powerful stable of mutual funds - the US equivalent of unit trusts. Dean Witter also owns the Discovery credit card, which is top of the tree in the US according to the total number of cards issued.

Strictly speaking, the merger is a takeover of Morgan Stanley by Dean Witter, Discovery. But both sides were sensitive about the control issue. The executive board will be made up of an equal number of representatives from each side.

John Mack from Morgan Stanley and Philip Purcell from Dean Witter, the executives who will run the merged business, said they would work together as a friendly double act, though Wall Street is taking that claim with a pinch of salt.

If this merger founders, it could be because Dean Witter and Morgan Stanley are so different. People are the key to any business, and egos on Wall Street can be large; managing directors will complain about paltry million- dollar bonuses. Can the brokers and the mergers specialists get along?

"Clashes of corporate culture are a risk whenever two distinct financial institutions merge," said Standard & Poor's, which rates corporate debt. S&P added, however, that the differences will be overcome. One help on this score is that the two firms have little overlap, so there will not be hordes of people competing for the same jobs.

Morgan Stanley's chief executive, John Mack, who will be president and chief operating officer of the new firm, said that as long as the top managers get along, the rest of the employees will follow.

But Wall Street has a short memory. Merrill Lynch is a highly successful combination of retail broking and investment banking, the example the merged group is trying to copy. But American Express's attempt to pull off the same trick lost it $4bn, and it recently disposed of Shearson and Lehman, its costly broking and securities subsidiaries.