How Morgan Stanley landed a sweeter deal than Goldman Sachs from Uncle Sam

    Goldman chose to store up political capital rather than push its luck when it came time to exit TARP.

    By William D. Cohan

    The decades-long rivalry between Goldman Sachs and Morgan Stanley is Wall Street's answer to Smokin' Joe Fraser vs. Muhammad Ali. And last week, Morgan Stanley won the bout over who could devise a more lucrative exit strategy from the TARP (Troubled Asset Relief Program) when the company was able to untangle itself from Uncle Sam for $150 million less than did Goldman Sachs. When Morgan Stanley and Goldman Sachs applied for TARP funds last fall, the two banks received the same deal -- $10 billion equity infusions. In exchange, Goldman and Morgan Stanley agreed to pay dividends and also granted the government free warrants to buy up to $1.5 billion worth of their respective stocks at set prices.

    The $150 million win was good news for Morgan Stanley (MS, Fortune 500), which lately had been looking like the big ugly bear compared to Goldman's (GS, Fortune 500) floating butterfly. While Goldman has been raking in the profits during the first six months of 2009 -- $5.1 billion to be exact, the best six-month stretch in the firm's history -- Morgan has been making losses of $345 million from continuing operations.

    True, Morgan Stanley has had its small victories. While Goldman's stock is up some 3.4 times, to around $164 per share, since its nadir of $49 per share last fall, Morgan Stanley's stock is up nearly five times, to $30 per share, from a scary low of $6.71 last October. Morgan Stanley also successfully pulled off the acquisition of Smith Barney, giving the firm the largest army of brokers in the world, and raised close to $7 billion in new capital.

    The value of the warrants

    The warrants the two banks granted the government last fall had value regardless of short-term fluctuations in stock prices since they remained valid for 10 years. The likelihood the warrants would be in the money -- that each firm's stock would increase above the exercise price -- during that ten-year period greatly effected the value of the warrants. And in fact, both the Goldman and the Morgan Stanley warrants were in the money as the banks began their negotiations with the government.

    This likelihood of being in the money is often referred to on Wall Street as the "volatility" of the underlying stocks, in this case Goldman Sachs and Morgan Stanley. The volatility is also an important component of the so-called Black-Scholes Model used to price such warrants. (Once upon a time, Fischer Black, the economist who helped to develop the option-pricing model, worked at Goldman Sachs.)

    In the last few weeks, both Goldman and Morgan have paid back to the U.S. Treasury the $10 billion each received from the TARP, plus dividends. Both firms have bought back the warrants, too: Goldman paid $1.1 billion for its warrants, which gave the government the right to buy 12.2 million Goldman shares by October 2018 at $122.90 each.

    Morgan Stanley paid $950 million for its warrants, which gave the government the right to buy as many as 65.25 million Morgan Stanley shares by October 2018 at an exercise price of $22.99 per share. (The exercise price for the warrants was set based upon a trailing 20-day trading average at the time they were issued last October 28.)

    So, We The Taxpayers received a 23% annualized return on our Goldman investment, and a 20% annualized return on our Morgan investment. "Our process to value the warrants has worked well to protect the taxpayers," said a Treasury Department spokesman of the negotiations, but declined to shed light on how the deals were struck.

    Sources have told FORTUNE that the Treasury Department used Black Scholes plus outside evaluations from three independent advisors -- Alliance Bernstein, FSI Group LLC and Piedmont Investment Advisors -- to come up with a price for the warrants.

    How Morgan Stanley did it

    So why was Morgan Stanley able to pay less? The answer lies not in the fact, as some have suggested, that Morgan Stanley was in a better bargaining position because it had lost money in the last year while Goldman was in a worse bargaining position because it has made so much money. Nor is the reason, as others have suggested, related to the fact that had Morgan Stanley raised additional equity, it could have eliminated some of the warrants. (Goldman could have done that as well.)

    The reason, sources close to both firms say, is that Morgan Stanley decided to negotiate with the government and its third-party advisors while Goldman started to haggle but then changed strategies. (Goldman's decision-making process may have been helped along by my colleague Allan Sloan's recent column in which he took Goldman to task for trying to make a fast buck off the taxpayers who bailed the firm out last fall.

    Before entering into the discussions with the Treasury about the warrants, Morgan Stanley and Goldman Sachs ran their own Black Scholes models and canvassed private equity firms, hedge funds and other investors who might potentially consider bidding for them. These bids put the price of buying the "volatility" in the "25 to 30" range, according to one source, but the Treasury wanted more.

    Political capital vs. market prices

    In the end, Goldman chose "to pay the full freight -- the government's asking price," which turned out to be a volatility of "45" and a purchase price of $1.1 billion. Goldman had initially offered $650 million for the warrants, then $900 million before settling on the final price. Goldman paid for "goodwill," according to one Wall Street executive, an idea that Goldman's statement seemed to acknowledge.

    "This return is reflective of the government's assistance, which benefited the financial system, our firm and our shareholders," Lloyd Blankfein, Goldman's CEO, said publicly. "We are grateful for the government efforts and are pleased that this additional money can be used by the government to revitalize the economy, a priority in which we all have a common stake."

    Morgan Stanley opted to negotiate harder but still paid a premium to the bids being received by its trading desk and settled on a volatility of "40" and a purchase price of $950 million. The lower settlement is all the more impressive considering that Morgan Stanley stock has historically had more volatility than Goldman Sachs stock, which means that the Black Scholes model would have ascribed a higher value to Morgan Stanley's warrants because Black Scholes rewards volatility.

    While this round went to Morgan Stanley, Goldman seems for the moment to have the edge when it comes to Wall Street's reason for being: Making money. Even though it has been rough going for Morgan Stanley on that front in the past year or so, don't count them out of that particular fight yet either.