Morgan Stanley's Crown Jewel Is No Longer Investment Banking

When Morgan Stanley CEO James Gorman took the reins of the bank 2010, one of his first moves as he began to absorb the acquisition of Smith Barney from Citigroup was to install hundreds of lending specialists at its wealth management offices around the country. The bet? Over time, Morgan Stanley wouldn't just manage the assets of the ultrarich, the firm would also become their go-to banker.

With each passing quarter, this decision is paying off for Gorman and his shareholders. Morgan Stanley's wealth management division, now the crown jewel of the storied investment bank, continues to be one of the great growth businesses on Wall Street. Net revenues in the unit rose 9% year-over-year to $4.2 billion and profits surged 28% to $1.1 billion, fueled by the impact of Gorman's lending push.

Morgan Stanley now holds $26.2 billion in real estate loans with its clients and a further $40.1 billion in securities-based loans and other debt that is collateralized by everything from art collections to stakes in private equity partnerships and jets. Overall, the unit holds some $78 billion in client liabilities and these assets, taken with client deposits, generated some $1 billion in net interest income in the third quarter alone. Net interest income is $3 billion in 2017, up $500 million from last year, and a huge reason overall wealth management profits have surged by more than a quarter to $2 billion while pre-tax margins now stand at 26.5%.

How important is Gorman's big lending bet for investors? Banking the ultrarich could soon consistently become a bigger driver of Morgan Stanley's top line than its vaunted investment banking unit.

Edward Jones banking analyst James Shanahan told Forbes he expects Morgan Stanley's wealth management net interest income will hit $1.5 billion a quarter by the second half of 2019. That would be a threefold increase from the beginning of 2014 and it would put the unit on track to firmly eclipse investment banking as a moneymaker for Morgan Stanley. Since the crisis investment banking revenues at Morgan Stanley have topped out at about $1.5 billion a quarter at times when mega-mergers closed, large corporations were refinancing their debt, or IPO markets opened up to powerhouses like Facebook , Alibaba and the portfolio companies of big private equity funds.

Shareholders may welcome this development, according to Edward Jones's Shanahan. Investors are keen to value recurring income streams like interest income, particularly in a rising rate environment. Moreover, it gives Morgan Stanley better earnings visibility. Institutional businesses seesaw with changing market conditions, therefore the boring coupon clipping of wealth loans can be a big stabilizer, especially at a $4 billion annualized run rate.

Since wealth lending has become more prominent on Wall Street -- in 2015 Forbes calculated there were over $500 billion in wealth loans within big brokerage houses -- there are new concerns about risk. Will wealth managers overdo it, pitching risky debt onto unsuspecting clients who then get financially over their skis?

In April, Morgan Stanley paid a $1 million fine to resolve a Massachusetts investigation into alleged high pressure sales contests to originate wealth loans. Furthermore with real estate, stocks, 20th century art, and other valuable assets at record prices, many wonder if a market pullback would effectively put a margin call on the ultrarich. The Wall Street Journal found a well-reported anecdote of just that scenario, involving an oilman and a 217-foot luxury yacht, which the bank tried to repossess.

Is a more widespread margin call really coming? To date, despite shocks in the oil patch, Brexit, and episodic turmoil in emerging markets like China and Brazil, firms like Morgan Stanley, Goldman, Bank of America , UBS , Credit Suisse and JPMorgan have not reported alarming defaults in their wealth book, or some surprising contraction of assets. To hear bank chieftans like Gorman explain the business, they see it as meeting their own customer demands and offering a product well within their underwriting capability.

Here's how Gorman explained it to investors and analysts on Tuesday morning (transcript from FactSet):

The lending side [of the wealth management business] provides a lot of stickiness with relationships. So I was on a phone call with a client yesterday. He's adviser left a competitive firm, a multi-hundred million dollar relationship. We have a significant loan out to that client, and the client has no interest in moving because they like the loan that we have.

They like the funding they're getting from that. In fact, after the call he said they were likely to increase their assets here. So that stickiness for the high end is a big deal. These markets go in cycles, as we all know, and people want access to credit. They have large, illiquid positions. So concentrated stock and businesses they founded. And they don't necessarily want to liquidate that, and we're in a position where we're dealing with a lot of very, very wealthy people.

I think 2% of our assets are with clients with less than $100,000 with us. So the vast majority have significant wealth, and it's a real competitive advantage now to be able to compete with the banks and offer these lending products.

Edward Jones analyst Shanahan does warn that there are risks for Morgan Stanley's overall wealth franchise. Client assets are now $2.3 trillion at Morgan Stanley and record $1 trillion of those are fee-based assets. Were markets to significantly correct, declining client assets could cut into the operating leverage that the business is now reporting (wealth management profits are currently growing three times faster than revenues) and which has shareholders so bullish.

Overall, Morgan Stanley reported $9.2 billion in net revenues and 93-cents a share in profits, exceeding analyst forecasts. Those earnings amounted to a 3% rise in the top-line and 11% increase in profitability. Investors responded by continuing to bid up Morgan Stanley, particularly against its Wall Street competitor Goldman Sachs. Morgan Stanley shares briefly touched new post-crisis highs above $50 on Tuesday, adding to a 17% year-to-date stock surge and a near doubling in the stock over the past 18-months. By contrast, Goldman shares are slightly lower for 2017, lagging the broader market.

With results strengthening, Morgan Stanley continues to focus on returning capital to investors. In the third quarter, it bought back 27 million shares for approximately $1.25 billion. This summer, the bank said the Federal Reserve did not object to its plan to buy back $5 billion in stock over four quarters and increasing its dividend to 25-cents a share, or $1 annualized.