Morgan Stanley: Trading Sideways - 'ZIFFPAGE TITLEThe Road to Perdition '

Mack has steadfastly rejected calls to sell the troubled brokerage unit, calling it a "tremendous asset" in the 2005 annual report issued in February of this year. Late last summer, he made a strong statement about his intention to fix retail by hiring a high-powered new boss for the business: James Gorman, who made his name with the successful revamping of Merrill Lynch & Co.'s huge brokerage operation.

The argument for owning a retail brokerage business at Morgan Stanley is the same now as it was in 1997, when the investment bank firm merged with Dean Witter to become a broad-based financial services company.

Investment banks like to have ready-made channels to distribute shares of companies they take public, as well as a steady source of revenue from the individual investor market. "The key reason you want a retail sales force is that it's a good distribution channel for the sale of investment banking product," says Richard Bove, a securities analyst with Punk, Ziegel & Co. "You make more money selling your own product than you do in anything else but trading."

But the marriage was troubled from the start, a clash of Wall Street and Main Street. Morgan Stanley has long been one of investment banking's elite firms, while Dean Witter was a mass-market stock brokerage; even its credit-card unit, Discover, had a down-market feel to it. Morgan Stanley executives spent a lot of time looking down their noses at their new colleagues. "They treated us like we were the Clampetts," one former Dean Witter executive told Fortune last year.

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Whatever political problems faced Purcell, a former McKinsey & Co. consultant, it was his own business decisions that ultimately led to his downfall.

"If you think about the problem at Morgan Stanley that caused Phil Purcell to be dislodged, it was a belief that after the market crash in 2001 markets would not come back rapidly, so he changed the strategy from revenue generation to profit maximization," Bove says. "He started thinking of ways to cut costs, and reduced cash allocation to each division. He eliminated people. It's not surprising if he didn't reinvest in technology—he didn't reinvest in a bunch of areas in the firm. Since the core philosophy was wrong—the markets and the businesses did come back strongly—Morgan Stanley started to lag its peers. It all relates back to the core issue, the decision to hunker down and increase margins."

This was especially true on the retail side. "They really haven't done a whole lot in retail in the last five years," says Jeffery Harte, an analyst in the Chicago office of Sandler O'Neill & Partners LP, referring to the business as a whole and not technology in particular. "Their retail brokerage was pretty good at selling mutual funds in the bubble years; once that changed they were slow to change in response."

Like everything else, technology was being starved, too. While Merrill Lynch has spent $1 billion or more on its new broker systems, "Morgan Stanley kept the wagons circled, at least from a tech perspective," says Forrester's Doyle. "With all the turmoil inside, things froze, action froze."

Mack has made fixing the brokerage's technology a public issue. "We will invest where we need to fix businesses, as in retail," he said at a conference in late 2005. "We have an investment to make in technology . ­. ­. that, for whatever reason, has not been made." Brokers, he said, "need technology," and he pledged to provide the "focus, investments and­ . ­. ­. leadership" to get the brokers what they need. Mack also spoke of the need for a "one-firm culture" and the imperative of rationalizing the company's "two technology platforms." Mack reiterated this position in the recently released 2005 annual report: "We are committed to addressing underinvestment" in retail, he said. The report went on to say, "We're going to upgrade our technology platforms and provide our financial advisors and investment representatives with a tool kit that is as competitive as that of our leading peers." A company spokesperson added: "Whether through technology investments in the branch system, or in new products or financial advisor tools, we are currently investing in technology that supports both our financial advisors and our clients."

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Morgan Stanley: Trading Sideways

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