Morgan Vends PDT: Boon or Bane? - Analyst Blog

As part of its effort to comply with the financial regulations, Morgan Stanley (MS) is planning to spin off its proprietary trading business – Process Driven Trading (PDT) – by the end of 2012. Announcing the divesture on Monday, the company stated that the unit would be turned into an independent firm which will be known as PDT Advisers.

Morgan Stanley has entered into an agreement with the employees of PDT, whereby they will acquire certain assets from the company. All the 60 employees of PDT will join the new firm, which will be headed by Mr. Peter Muller, the present proprietary trading chief of the company.

Morgan Stanley is expected to purchase a stake in the firm. During the transition period, PDT Advisers will continue to manage the company's business and will also expand its own business with new clients.

Why the Spin Off?

According to the Dodd-Frank Act, which was signed into law by President Obama in July last year, banks will be restrained from proprietary trading and investing more than 3% of their capital in private equity or hedge funds in the long term. Morgan Stanley's latest decision to spin off its PDT business is a part of its compliance with the Dodd-Frank Act.  Many large U.S. banks including – Goldman Sachs Group Inc. (GS) and Citigroup Inc. (C) – are also closing down or selling off their proprietary trading businesses for the same reason.

For many years, the U.S. banks made substantial profits from their proprietary trading businesses. However, the business proved to be a bane for them when the financial crisis started, leading to the fall of large investment banks like Lehman Brothers and Bear Stearns in 2008. So, the compliance with the Dodd-Frank Act will probably help these mega banks avoid a collapse in the future.

Are Revenues at Stake?

The proprietary trading business is a very lucrative revenue generating source for the financial institutions and banks. Though the Act gives banks and financial institutions about five years to reorganize, many of them are keen to follow the law at the earliest. As a result, there will be an immediate impact on their revenues. However, over the long-term this will help them avoid dependence on risky revenue sources.

The proprietary trading business accounted for nearly 5% of Morgan Stanley's total revenues in 2009. So the company will have to brace for such revenue losses over the near- to medium-term.

The latest move by Morgan Stanley is the second major spin off for the company in order to comply with the Volcker Rule. In the mid 2010, the company had announced its plan to spin off FrontPoint Partners, a hedge fund business.

For the Goldman, the proprietary trading generated about 10% of its total revenue in 2009. The company shuttered its equity proprietary trading group, Goldman Sachs Principal Strategies, in September 2010 to comply with the Volcker rule.

Citigroup is also shifting its teams of proprietary traders to asset management division that manages clients' money.

Better or Bitter? 

Though the spin off of PDT is not good news for Morgan Stanley as it will lose significant revenue following the transaction, but its always better to have a stable revenue source in the long-run.

We believe that Morgan Stanley has the potential to realize full benefits of its strategic initiatives. Moreover, inorganic growth initiatives with a healthy balance sheet continue to be significant growth drivers. So the revenue loss related to the spin off is not expected to significantly impact the bottom line.

Morgan Stanley currently retains a Zacks #5 Rank, which translates into a short-term ‘Strong Sell' rating. However, considering the fundamentals, we are maintaining a long-term “Neutral” recommendation on the stock.

 
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