If I can take you back the events of last year, what do you remember about the weekend running up to Lehman’s collapse?

I remember receiving a call from our CEO on Thursday.  I was told that Lehman was going to fail and that the major Wall Street firms were being asked to look at either a takeover of Lehman, or some form of collective bailout.  I also remember that after most of the firms had done some preliminary due diligence, it was pretty clear that the problems were far greater than even the most sceptical had assumed.

And can you remember your reaction on hearing that news?

It wasn’t a surprise that Lehman was in trouble, we’d assumed that after the Bear Stearns debacle, if not before.  But obviously the timing of it was a surprise.

Do you think the US regulators did the right thing letting Lehman Brothers go to the wall?

Obviously with the benefit of hindsight, letting Lehman fail was a mistake.  However, at the same time, none of the major securities firms in the US had major exposure to Lehman.  After Bear Stearns, most institutions had managed to reduce their exposure.  Therefore, wrongly of course, it was assumed that Lehman did not represent systemic risk.  There was increasing talk in Washington and in the UK about moral hazard. It was unclear whether secretary Paulson had enough political capital left to save Lehman.

At the height of the crisis Morgan Stanley received significant investment from Mitsubishi UFJ Financial Group.  What was the reasoning behind this decision?

Morgan Stanley had just reported our 3rd consecutive quarter of good profitability with an ROE [return on equity] of 16 per cent. We’d managed our balance sheet down from $1.3 trillion at the peak to about $900 billion, giving us one of the strongest balance sheets in the world of any major bank. We also had $175 billion of liquidity. Despite all this, the rumours started on the Monday morning, following the Lehman bankruptcy, to the effect that Wall Street was dead and Morgan Stanley and Goldman Sachs were next. We started to see problems immediately, with hedge funds withdrawing their prime brokerage accounts, our stock trading down wildly and our credit default swap spreads ballooning to unprecedented levels.  By Tuesday it looked like we might be out of cash by the end of the week, which is normally the deathknell for a financial institution.  I think we knew by the end of the week – and the regulators made sure we knew – that we and Goldman Sachs had to find new partners by the opening of business on Monday. After different conversations with Wachovia, with Citi and with JP Morgan, as well as the Chinese, we announced the deal with MFUJ, one of the strongest and largest commercial banks in the world.

There must have been a strong argument that eventually the rumours would correct themselves and adjust to the actual facts.  Was there a view that you should just wait it out?

We started the week with $175 billion of liquidity and it was pretty clear that we would be out of cash by the end of the week.  We tried very hard on the opening of Monday to quell the rumours – and Tuesday too – but it didn’t really work.  And the more people that withdrew funds, the more the news made its way to the marketplace, the more other people who didn’t think they had a problem with Morgan Stanley decided that maybe there was a problem and maybe we were more like Lehman.  The more the rumours spread, the clearer it became that the implications of making the wrong decision were too horrendous to deal with.  The fact of the matter is that we had no choice, and neither did Goldman Sachs. 

Morgan Stanley was also one of the major participants in the Troubled Asset Relief Program.  Can you explain what the main components of Tarp were? What were the downsides of government involvement that you had to weigh up?

Morgan Stanley was one of the nine systemically important banks that were summoned to the office of Secretary Paulson and asked to take $10bn of Tarp funds under the Capital Purchase Programme.  It has to be remembered that the financial crisis really began in August 2007 and the central banks and governments around the world were slow in dealing with it. They were also dealing with it in an uncoordinated fashion, one market at a time, one institution at a time.  I think they dramatically underestimated both the magnitude and the severity of the problem and the rapidity with which it was unfolding, indeed escalating and spreading globally, with pretty horrendous implications for not just the financial system, but the real economy as well.  I believe that Tarp represented a systemic solution to a systemic problem.  I view it as an act of enormous courage and faith that this would calm markets and stop the freefall in asset prices and finally instill confidence in major financial institutions and the financial system overall.  

You say that the problems were evident from August 2007 and the regulators let it slide.  What should they have done?

There were a number of institutions on the regulatory watchlist and a number that were already in trouble, such as Lehman.  Aside from a “systemic solution”, I believe the regulators could have moved earlier, either through moral persuasion or otherwise, to force these institutions to sell assets and/or raise capital, or merge with stronger institutions.  Failing that, they should have been nationalised or closed earlier, before the problems became insurmountable. 

How do you think it compared with the UK bail out?

The regulators both in the US and the UK, as well as the politicians, were working around the clock to come up with a systemic solution. I think it’s quite accidental that the US followed the UK by a day or two. Initially it looked like the UK bail out plan was quite punitive. For example, the dividend on the preferred shares in the UK was 12 per cent whereas the dividend on the preferred shares in the US was 5 per cent. There was also a provision in the UK which meant that the banks that took the preferred shares could not repay those shares or pay common dividends for five years. But then it’s also important to take into account that the US government had equity warrants for each and every bank that took the Tarp money. That means an option to buy stock in those companies. Morgan Stanley, for example, traded down to a low price of about $6 per share at the depth of the crisis.  Today the stock has been trading around $30 per share. The increase in the value of the shares enabled the US government to earn $950 million on their $10 billion investment in Morgan Stanley, simply through equity warrants. If you add the preferred stock dividends to that, you get a repayment by Morgan Stanley of $1.268 billion on a $10 billion investment by the government in less than a year, generating a 20% annualized return, not a bad result for taxpayers.

At the beginning of this year, Citigroup and Morgan Stanley combined their brokerages to form Morgan Stanley Smith Barney.  Why?

There are five or six major brokerage operations in the US.  Because of the nature of the business, it has always benefited from economies of scale, with the industry leader achieving margins in excess of 20 per cent.  For years and years Merrill Lynch had been far and away the industry leader. Morgan Stanley was fourth or fifth, and if you’re fourth or fifth the margins in this business are more like 15 per cent.  So this merger between Morgan Stanley and Smith Barney created the number one wealth manager in the US, with 18,500 financial advisors, a global platform, a vast array of products and services and $1.1bn of annual costs savings, about 15 per cent of the expense base. From both a strategic and financial standpoint, it really is a winning combination.

We’ve seen a lot of consolidation in the financial industry over the last year as a result of the crisis.  Do you think there’s more to come, and is this move towards fewer players necessarily a good thing?

Let me take the second question first.  I think it’s fair to say that the financial services industry is the most fragmented industry of any industry in the world.  It also happens to be the largest industry in the world if you look at it by size of revenues.  It’s fragmented by product, by country, by region – and there are very few global players.  So I don’t see it as a negative thing: my view is that there will still be plenty of competition in financial services, even if there is massive consolidation.  I think that if you look at the transactions over the past year to year and a half, what you’ll see is most of those transactions were done on a distressed basis. We saw mostly weakened or failing institutions being sold, either of their own accord or because of regulatory pressure, to the stronger players in the States.  Over the next year or two I do not think we’ll see many large transactions, because there is still considerable uncertainty out there, relating to asset quality, balance sheet strength and earnings power.  In an environment like this I’d expect to continue to see mostly smaller transactions as people reevaluate their franchises and their portfolios.  

In August, Morgan Stanley bought back warrants from the Treasury.  What extra freedom does it now have, is it completely exited from Tarp, and was the intervention a success?  

I think you have to say that the intervention was a success.  We bought back the warrants in August, we repaid the Tarp funds in June and we’re now completely free of any government ownership.  Having said that, we are obviously regulated by the government: we’ve always been regulated.  As a result of the transactions going back to last October, we are now a bank holding company and we are also regulated by the Federal Reserve Bank. 

How do you think the next financial crisis will be different; what lessons do you think might have been learned?

There are many lessons to be learned, too many to enumerate in this conversation, but at a very high level there are a few key takeaways. If you step back, the crisis was created by inadequate risk assessment and risk management, particularly surrounding subprime mortgages and commercial real estate, combined with excessive leverage and inadequate regulatory oversight. I’ve been in this business for 34 years. I have lived through 11 banking crises in the past 22 years alone. There are more than that if you go back 34 years. We’ve had the oil crisis, we’ve had the Asian banking crisis, the Russian banking crisis, we’ve had the Latin American debt crisis, we’ve had crises caused by excessive concentrations in commercial real estate; each crisis really is different, but they share similarities. Those similarities go back to inadequate capital, inadequate funding strategies, and inadequate risk management. It’s very difficult to predict where and when the next crisis will come from. It will be different but it will also share some similarities.

Last week the DOW Jones climbed above the 10,000 point mark for the first time in a year.  How do you assess what’s happening in the markets at the moment, especially in relation to what’s happening in the real economy? 

I think that we have averted financial armageddon, which might also have led to economic armageddon. The financial crisis is over. I don’t know if I want to say that we are now facing an economic crisis, but we’ve had a very difficult economic period. When I first joined Morgan Stanley 34 years ago, I would never have thought I’d live to see another 1929 style financial panic, but that is exactly what we have lived through. The response to the crisis has been unprecedented.  It’s difficult to predict how the central banks and governments around the world are going to get some of this excess liquidity out of the system.  We’re in unchartered territory. The road to recovery will be bumpy. People talk about green shoots but I think it’s difficult to see a lot of them. The market is discounting a fair amount of good news. We are in a fairly benign environment, but the key question is how fast the global economy will recover.

What’s next for Morgan Stanley, in Europe in particular?

Being one of the very few global investment banks to have survived this crisis, I think we have an unprecedented opportunity over the next five to ten years, particularly over the next 3 years. In the last year and a half we’ve done a huge amount. We’ve dramatically reduced our balance sheet, we’d sold off Discover, the credit card company, before the credit crisis began. We have raised enormous amounts of equity capital and recapitalised our balance sheet so that we now have a tier one ratio, which is probably the strongest of any bank in the world. We still have an enormous amount of liquidity and we have two very large shareholders, one in Japan and one in China. So I view this as a unique opportunity to become the preeminent global securities firm.