Morgan Stanley Tries on a New Psyche

JAMES P. GORMAN, a 6-foot-2 Australian, recently took up boxing lessons, in keeping with some of the trappings of his Midtown Manhattan office. On one wall, opposite an inspirational poem by Rudyard Kipling (“The Thousandth Man”), hangs a photograph of Elvis Presley sparring with Muhammad Ali.

“I have a lot of respect for Ali,” says Mr. Gorman.

As the new chief executive of Morgan Stanley, an investment bank that narrowly escaped the financial smackdown that destroyed many of its competitors, Mr. Gorman may have to get ready for some fisticuffs.

He is tasked with overhauling a firm that put a primacy on high-risk trading under his predecessor, John J. Mack, and one that has spent the last several years often riven by factional disputes and internal debates over strategy.

Under Mr. Mack, Morgan Stanley made errant mortgage bets and commercial property gambles that cost it billions of dollars and almost destroyed it. The firm was saved by a $10 billion bailout from the federal government, since repaid, and by Asian investors who wrested a large stake in the firm in exchange for cash.

During Mr. Mack’s tenure, from 2005 to the end of last year, the stock price fell 32 percent. And the firm, which will celebrate its 75th anniversary this year, is expected to announce this week the first annual loss in its history.

“There is no question there have been rough spots,” Mr. Gorman said, in his first interview since becoming chief executive on Jan. 1. “We have had periods of management turmoil, misplaced trading positions. We have invested in real estate at the wrong end of the market. Clearly there were some mistakes made, but you can’t be in a complex global bank and not have mistakes.”

He added that the bank now had “a sense of clarity about what we want to be” — and that it wouldn’t be trading with large amounts of its own capital. “We are a very focused investment bank,” he said, “very client-centered.”

Mr. Gorman, 51, will have to prove that the steadier, more diversified bank he hopes to build — with less megatrading and more advisory work for clients — can still take on more aggressive Wall Street titans like Goldman Sachs or JPMorgan Chase, rivals that thus far have navigated the crisis more successfully.

Mr. Gorman says that Morgan will eventually begin taking bigger risks and wagering more money to do so, but that it will avoid big, concentrated bets on complex products that few people understand — and that have the potential to blow up an institution.

“We are still taking risks,” he says, but “we will not have the outsize risk positions that will endanger the firm.”

Still, some analysts remain tentative about Morgan Stanley’s prospects in a financial landscape littered with corporate wreckage and dominated by a handful of wily survivors. While the firm’s traditional investment banking franchise has emerged strongly from the crisis — topping JPMorgan and Goldman in some of its businesses — it has shrunk its fixed-income division and taken piles of money off the table in its broader institutional securities business.

Guy Moszkowski, an analyst at Bank of America Merrill Lynch, notes that Morgan Stanley has about $17 billion in capital committed to its institutional securities business, compared with his estimate of around $40 billion at Goldman and $33 billion at JPMorgan.

Over the last few years, “they seemed to hang back from risk-taking even at times when they could get paid richly,” Mr. Moszkowski says.

“Then they pushed themselves forward when the party was already ending,” he adds. “Morgan Stanley lagged again last year. The net result is they zigged when they should have zagged. There is an issue in that they have fallen behind their peers, though I believe they can resolve it.”

MR. GORMAN’S arrival at Morgan Stanley is, of course, heavily informed by Mr. Mack’s track record. Mr. Mack, who is staying on as chairman and will continue to occupy his old office, inspired fierce loyalty among his traders but ultimately drew mixed reviews as a manager.

Mr. Mack, 65, had spent most of his career at Morgan Stanley and was one of the architects of its 1997 merger with the brokerage firm Dean Witter. The chief executive of Dean Witter, Philip J. Purcell, outmaneuvered Mr. Mack for control of Morgan in the following years. Mr. Mack left in 2001, ushering in an era of pitched battles between Purcell supporters and Mack loyalists who remained.

After much to-and-fro, Mr. Purcell — who pushed for less risk-taking at the firm but delivered lackluster financial results — was forced out in 2005, and Mr. Mack made a triumphant return. And that is where the real debate on his performance begins, especially in light of the outsize losses Morgan Stanley absorbed.

“John really did do most of the things that the shareholders and some of the retired employees were hoping he would do,” says Robert G. Scott, a former senior executive at the firm who was among those who successfully agitated for Mr. Mack’s return. “The C.E.O. is critical, but the people who are executing the strategy in various business units have a tremendous responsibility for the results, and the seeds for that underperformance were sown before John took over.”

Others, however, have a harsher view.

“What’s the legacy of John Mack?” asks William D. Cohan, a former investment banker and the author of “House of Cards,” a best seller about the financial crisis. “He nearly lost the firm by taking big risks. In the Mack era, a dirty little secret is that had they stuck to Purcell, they would not almost have gone out of business in 2008.”

Mr. Mack acknowledges some regrets about the course of his career — that he never consummated a proposed merger of Morgan Stanley’s asset management business with BlackRock, which has become one of the world’s largest money managers, and that he never flushed out more senior managers when he returned in 2005.

“There were things you just didn’t know until you asked specific questions,” he says. “Certain positions were a lot older than anyone ever told me. When you come into an organization, you need fresh eyes. You don’t need anyone who can defend what’s been in place in the past.”

But on his legacy he is clear, he says: he changed the firm for the better.

Passionate, emotional, intuitive and a former bond trader, Mr. Mack worked hard to restore swagger and confidence to traders and others who believed that Morgan Stanley lost its way under Mr. Purcell.

After returning, Mr. Mack boasted of his renewed appetite for risk and pushed the firm into fashionable areas like subprime mortgages, commercial real estate and leveraged lending. To emulate other banks like Goldman, he advocated using the firm’s own capital to pursue bigger, hairier trades.

That strategy worked at first — 2006 was a record year — but Morgan Stanley’s swashbuckling wasn’t backed up by adequate risk controls, a reality embodied by the biggest trading loss in its history and an event that more than any other may mark the Mack era.

The loss came at a specialized trading shop housed inside the firm and run by a man named Howie Hubler, then in his mid-30s. Mr. Hubler’s 50-person team correctly wagered $1.4 billion that the subprime mortgage market was weak and would become progressively worse, insight that paid off in 2006 and into early 2007.

But to protect itself against possible losses on that trade, the team bought contracts that would enable it to profit if the subprime sector stabilized. Those latter bets proved extremely vulnerable, and as the mortgage market imploded — setting off one of the worst economic crises in American history — Morgan Stanley was trapped. The firm ended up losing $10 billion on the wagers.

A person familiar with the trade, who requested anonymity because of contractual obligations that prevent him from speaking about the firm, said the unit was never a rogue operation and that many of Morgan Stanley’s leaders were aware of its activities and approved of them, including the group’s proposals to wind down the position.

At the same time, the firm was slammed by losses on direct commercial property investments, like Crescent Real Estate, a $6.5 billion portfolio of urban office properties that it bought at the peak of the boom in 2007. Last November, facing defaults on borrowing tied to the portfolio, Morgan Stanley surrendered it to Barclays Capital. For the first three quarters of 2009, Morgan Stanley booked real estate losses of $2.1 billion.

Mr. Mack says the firm took on such risks because everyone else on Wall Street was doing it, too. “Did I have too much leverage?” he says. “Yes. But the whole industry did.”

He says that some of the trading positions were put on the books in the Purcell years and that Morgan Stanley’s chief risk officer didn’t report directly to him, which prevented crucial information from reaching his office.

Mr. Mack responded to the trading debacle by ousting his protégé, Zoe Cruz, the firm’s co-president, who was in charge of the institutional securities group.

In an unusual gesture on Wall Street, Mr. Mack has taken some responsibility for his mistakes by forgoing a bonus for the last three years. In Congressional testimony last week, he said he was an advocate of greater regulation because of the threats to the financial system that he saw during the crisis.

He also shuttered all but one of Morgan Stanley’s proprietary trading desks and ousted some senior executives in its real estate businesses. And, rather than bowing to regulatory demands that he sell the firm, Mr. Mack strengthened Morgan Stanley’s balance sheet by selling a chunk of the firm to the Asian investors. That move, as well as taxpayer largess in the form of federal bailout money, kept it from collapsing.

Yet, for all of this, Mr. Mack arguably made another mistake after the worst of the crisis’s initial stages had passed — by dialing back risk-taking too far. Rivals like Goldman Sachs took advantage of the reduced number of competitors to ring up record trading profits last year, windfalls that Morgan Stanley missed out on.

“We were probably too conservative,” concedes Mr. Mack. “But we had not built out enough of a platform in sales and trading.”

Waiting in the wings as all of these financial dramas played out was Mr. Gorman, a former lawyer from Melbourne who was one of Mr. Mack’s first major hires when he returned to the firm in 2005.

CEREBRAL, circumspect and analytical, Mr. Gorman’s style contrasts with Mr. Mack’s brasher, more intuitive approach — a telling reminder of just how much the financial crisis has traumatized Morgan Stanley and the extent to which the bank’s board, and Mr. Mack himself, recognize the need for a calm, risk-conscious hand at the tiller.

In 1987, after receiving an M.B.A. from Columbia’s Graduate School of Business, Mr. Gorman joined the consulting giant McKinsey, where, among other things, he was a member of the financial services practice. In 1999, David H. Komansky, then the chief executive of Merrill Lynch, recruited Mr. Gorman as its marketing chief. Mr. Gorman describes Mr. Komansky — who, not unlike Mr. Mack, is a larger-than-life figure — as his first mentor.

"He told me: One, stay grounded; two, don’t underestimate the importance of personal relationships inside and outside the firm,” Mr. Gorman says of Mr. Komansky. “And three, if someone is doing the wrong thing, no matter how big a producer they are, they are out.”

MR. GORMAN eventually oversaw Merrill’s global private client business and made many changes he would later employ at Morgan Stanley — segmenting the market and focusing on wealthier clients. A former Merrill colleague described him as a quick study and unafraid of internal battles with Mr. Komansky’s successor, E. Stanley O’Neal.

“He was not always focused on the political ramifications of something,” says this person, who requested anonymity because of contractual obligations that prevent him from speaking about Merrill. “I watched him in a tug of war with O’Neal and not let it go. If he thinks something is right, he is going to dig in. This is a good thing.”

Friction with Mr. O’Neal primed Mr. Gorman to accept Mr. Mack’s invitation in 2005, a call that came partially at the recommendation of Laurence D. Fink, the chief executive of BlackRock.

“He understands how to bring culture to an organization,” says Mr. Fink. “He can talk about the high-level strategy and understands the details of the business.”

At Morgan Stanley, Mr. Gorman led the global wealth management division and tied up a number of loose ends from the Dean Witter merger: replacing 27 of the top 30 managers, removing the 2,000 least productive financial advisers, unifying all of the firm’s retail business under one name, streamlining technology systems, overhauling marketing and focusing on wealthier clients.

Mr. Gorman worked from Morgan Stanley’s offices in Purchase, N.Y. Once a week, Mr. Mack, who lives nearby in Rye, would go to the gym and then stop by for an 8:30 a.m. meeting with Mr. Gorman.

In addition to having valuable face time with Mr. Mack, Mr. Gorman also lavished praise on his boss: in Mr. Mack’s office hangs a printed, signed and framed e-mail message from Mr. Gorman, richly complimenting Mr. Mack for his leadership during the financial crisis.

Such overt gestures haven’t given Mr. Gorman the reputation of being a toady. Many around the office describe him as “nice” and “decent.” Or, as one of his senior colleagues puts it, Mr. Gorman is “definitely not a slimeball.”

After the trading losses in 2007, Mr. Gorman became co-president. The firm also put him in charge of thinking about long-term strategy with its chief financial officer. During the crisis, Mr. Gorman argued forcefully for a big strategic shift, with an emphasis on cutting complex products and expanding retail brokerage services.

To that end, Mr. Gorman pushed Morgan Stanley to pay $2.75 billion last year to acquire a 51 percent stake in Smith Barney, the big brokerage firm owned by Citigroup, another struggling financial behemoth. Morgan Stanley hopes to take full control of Smith Barney by 2014. The takeover gives it about 18,000 financial advisers and one of the biggest wealth management businesses in the world.

According to Howard Chen, an analyst at Credit Suisse, history may decide that Morgan Stanley bought Smith Barney “for a song.” The deal was certainly transformative. The retail business now makes up 35 percent of Morgan Stanley’s total revenue (compared with 57 percent for its traditional institutional business), up from about a quarter share before the deal.

WHATEVER its long-term merits, the deal did little to reverse Morgan Stanley’s sagging fortunes. Around the middle of last year, with the share price lagging, Mr. Mack confirmed previous plans to step down. Mr. Gorman won the race to succeed him, in part because the firm’s board, which voted unanimously for him, was impressed by his strategic abilities and work he had done turning around the retail business.

The board liked that Mr. Gorman wanted to strengthen Morgan Stanley’s institutional securities group and reduce risk-taking, says Robert Kidder, a director.

“We concluded that James was decisive, strategic and had knowledge of a range of the firm’s activities,” says Mr. Kidder. “We believed he was the kind of person who would build a strong and strategic team over time.”

According to another person familiar with the board’s thinking, who requested anonymity because the deliberations were confidential, Mr. Gorman’s calm demeanor offered a marked and welcome break from Mr. Mack’s more volatile temperament.

Despite his embrace of plain-vanilla retail enterprises, Mr. Gorman says that the firm’s core business remains its investment banking and institutional sales and trading — and that the company’s recovery won’t be complete until those businesses are nursed back to health. To buttress its risk management capabilities, Morgan Stanley has started what it calls Project Phoenix, which will measure and monitor proper risk-return ratios across the company.

Some analysts still have concerns. Institutional Risk Analytics, a research firm, recently gave Morgan Stanley’s shares a negative rating “because of the bank’s poor financial performance, low levels of tangible common equity and failure to make any significant disclosure regarding off-balance-sheet exposures.”

Morgan Stanley says that it has healthy levels of common equity and that it discloses details of its off-balance-sheet exposures. It points out that three other analysts upgraded their ratings of the firm this month.

Some analysts wonder whether Mr. Gorman has the investment banking and trading chops to rally the bank’s core institutional troops, or whether his resemblance to Mr. Purcell — who also began his career at McKinsey and rose to prominence in retail brokerage — may be too limiting.

“I no more or less resemble Phil Purcell than any 5,000 people here,” says Mr. Gorman. “And a lot of people ran brokerages — Sandy Weill, Jamie Dimon, David Komansky.”

The money manager Barton Biggs, who spent 30 years at Morgan Stanley before leaving in 2003 to run his own company, says he thinks the mood at Morgan is upbeat. “People respect Gorman as being a different person than John,” he says. “He is not a mingler. He is not going to walk the trading floor, slapping backs. But he is a first-rate intellect and he impresses with his organization and his thoughtfulness."

STANDING in his office recently, Mr. Gorman flips through sheets of corporate contacts he has made since his McKinsey days. He describes the back-to-back breakfasts, coffees and dinners he will be having with hedge fund managers and corporate titans over the next few weeks.

“This is a period of time when you are dealing with a lot of complicated constituencies — regulators, shareholders, legislators, politicians, the media,” he says. “There are a lot of things in flux and you have to feel comfortable dealing with a lot of complexity, which I do.”

As Mr. Gorman continues to get his stride, he will have Mr. Mack peering over his shoulder as chairman for at least the next two years. Mr. Mack says he’s looking forward to spending more time at his Tuscan vineyard and shows off a picture of himself standing beside Cher backstage in Las Vegas, as well as other mementos from a 40-year career. “I really like my new role,” he says. “I didn’t come to work until 9:30 today!”

But some analysts wonder that if things turn sour, will Mr. Gorman find himself isolated in an institution where Mr. Mack’s constituency is still powerful?

“Listen, this would not work if I wasn’t his man,” says Mr. Gorman. “We have a terrific relationship.”

On a recent afternoon, the two men posed in Mr. Gorman’s doorway, arms around each other’s shoulders, demonstrating their camaraderie.

“We do this every day,” says Mr. Gorman, joking, while Mr. Mack smiles beside him.

Mr. Gorman acknowledges, however, that the alternative — fighting with Mr. Mack — would be a terrifying prospect.

“I would not box John,” he says. “He has big shoulders.”