Morgan Stanley's "Subsidiary Strategy"

Investment bankers have never been famous for their nonconformist ways. But Morgan Stanley is increasingly beginning to look like a very different species to its industry rivals.

At the front of the news this week was the clear divergence between Morgan Stanley’s earnings and those of its U.S. rivals such as Citigroup. While the others posted gains for the quarter — albeit controversially — Morgan Stanley said that it made a $177 million loss. As if domestic competition wasn’t enough, Bloomberg reported today that Deutsche Bank may report record trading revenue at its securities division in the first quarter as credit markets stabilized.

What’s most eye-opening about this earnings season is that while Deutsche, JP Morgan, Goldman Sachs and Citigroup all made money on trading profits, Morgan Stanley lagged behind. Part of the reason for that, of course, is that it didn’t bet against its own creditworthiness in the same way some of the others did. But there appear to be deeper rumblings in the chambers of the House of Morgan.

Today, it was rumored on dealing desks on Wall Street that Morgan Stanley may be about transform its biggest proprietary trading desk into a hedge fund as a way to sidestep new government restrictions on pay and hiring.

Breaking Views finds the idea compelling, if inevitable:

The notion of spinning off a piece of its proprietary trading business is hardly a new idea at Morgan Stanley. The Wall Street firm was debating the issue more than 18 months ago, when breakingviews.com broke the story. Of course, the credit crisis shifted priorities, putting the idea on the backburner. But the crunch only increases the rationale of such a move.

The plans are fresh on the back of the departure of Morgan’s top trader Fabrizio Gallo, who ran the firm’s prop trading desk. Officially Gallo claimed he wanted to “spend more time with his family,” though most on Wall Street suspect the departure to be yet another incident of an unmotivated senior banker leaving a government-besieged U.S. bank. That theory was given further play when Gallo announced he was leaving the U.S. altogether to start a new life across the pond in London.

Furthermore, Morgan Stanley has been cosying up to megabank Mitsubishi UFJ, at exactly the time when most of its competitors are trying to escape the Japanese securities business.  At about the same time Morgan Stanley merged its Japanese securities business with its largest shareholder’s operations there, Citigroup sold its stake in Mitsubishi rival Nikko Cordial, and Bank of America folded former Merrill Lynch Japan into the much-reduced BofA Japan.

The takeaway cannot be missed. No banks want to live with government ownership. They are losing their best talent while having to spend most of their time answering to the taxpayer instead of driving business.

Most banks appear to be using accounting tricks so that they can get rid of the TARP funds faster — that much is clear. But by entering into offshore deals in Tokyo, and unregulated ones in the guise of setting up hedge funds, Morgan Stanley seems to have other ideas as to how it can circumvent Treasury Department oversight. Effectively, Morgan Stanley is divesting all its core businesses into subsidiary entities that don’t legally fall under government scrutiny.