Has your broker helped or hurt your portfolio? Join the discussion at Stockpickr Answers. Updated from 3:31 p.m. EST Morgan Stanley ( MS - Get Report) shares spiked nearly 10% early Monday as the company closed in on a deal to take a majority stake in Citigroup's ( C - Get Report) Smith Barney brokerage, but there are some potential pitfalls to the firm's strategy. The potential deal has been heralded as a chance for a combined Morgan Stanley-Smith Barney to compete with the newly merged Bank of America ( BAC - Get Report)- Merrill Lynch, as Morgan continues to redefine its business model in the wake of last fall's collapse of the investment banking industry. Days after Lehman Brothers filed for bankruptcy, Morgan and rival Goldman Sachs ( GS - Get Report) won approval to convert themselves to bank holding companies. But emphasizing the retail business in the current environment is dangerous, Sanford Bernstein analyst Brad Hintz says in a report he released Monday. He argues that a retail recovery will lag a recovery in the broader economy, while institutional businesses such as M&A and IPOs will anticipate it. "Unfortunately, the achievement of merger synergies in joint ventures is never as easy as the pro forma numbers would imply," Hintz writes. "Turnover of brokers is always a challenge in a combination and the integration challenges that Wachovia faced in its Prudential and AG Edwards rollups make Bernstein question the ability of Morgan management to quickly achieve the theoretical margin improvements from this combination, given the continuing weaknesses of the 'Dean Witter' franchise." Still, the move further distinguishes Morgan Stanley from Goldman, as those arch-rivals try to articulate their strategies. Goldman appears far less eager to make acquisitions or announce a shift in its business model.
To Hintz's point about defections, BofA already has shown signs of trouble in retaining key Merrill Lynch talent, just days after the deal closed. Robert McCann, the head of Merrill's retail business, resigned last week, followed shortly thereafter by Gregory Fleming, who had been the No. 2 executive at Merrill. The Merrill acquisition made BofA the nation's largest retail broker, but a combined Morgan Stanley-Smith Barney would eclipse it in terms of the number of advisors. Cutbacks and post-merger defections, however, will presumably shrink everyone's staffing levels considerably. Standard &Poor's equity analyst Matt Albrecht says annual revenues for a combined Morgan Stanley-Smith Barney would be $19 billion, compared to $14 billion for the joined Bank of America-Merrill Lynch, projecting fourth quarter 2007 figures over a full year. He also thinks Morgan Stanley would see fewer defections than he expects for BofA because he believes the culture is better aligned with Smith Barney than BofA's is with Merrill. Aside from a slowing business, one other concern brokers may have in the market downturn is backlash from angry clients. Investors have lost lots of money over the past year and are more likely to be suing their brokers than sending new business their way. Tom Brown, head of financial services hedge fund Second Curve Capital, says the brokerage business should improve as the economy does. "The fact is that there are a lot of unhappy investors in the world today that will come back and be investors in the future," he says. Brown likes the deal because he assumes Citigroup will be making major concessions due to its dire financial condition. "I like when companies are selling out of desperation," Brown says. Second Curve owns Morgan Stanley shares and has no position in Citigroup. It could not be determined whether Morgan Stanley might be on the hook for future lawsuits against brokers at Smith Barney, if the unconfirmed deal happens. A call to a Morgan Stanley spokesman was not returned and a Citigroup spokesman declined to comment. Morgan Stanley shares soared nearly 10% to $20.95 early on Monday, but closed down 1.4% to $18.79 amid a wider market selloff.