(FORTUNE Magazine) - With all the ink spilled over Morgan Stanley's failed attempt this February to buy asset-management juggernaut BlackRock -- which instead linked arms with Merrill Lynch (Research) -- you'd think this was a make-or-break deal for Morgan. As Wall Street insiders were quick to point out, Morgan CEO John Mack not only had a longstanding personal relationship with BlackRock (Research) leader Larry Fink but also had several months' head start in negotiations. Was Morgan's unsuccessful effort a red flag about the firm's future?

More like a red herring. While Mack had plenty of good reasons for walking away (price and management control being the most important), the hubbub over the deal has actually served to distract from the real meta-issues facing Morgan: Does CEO Mack have the right strategy for his company? And if he does, will he be able to pull it off?

John Mack

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You may remember that when Mack swept into Morgan early last summer in a triumphant return to his old home, it was as though a cloud had lifted from the giant securities firm. There was Mack, having vanquished his nemesis, Phil Purcell, glad-handing on the trading floor (with CNBC's Maria Bartiromo in tow). Morgan Stanley (Research)'s stock moved up (though this was due as much to Purcell's departure as to Mack's arrival), and conventional wisdom had it that the old white-shoe investment bank was back in the game.

Since then the steady exodus of talent from the company has largely abated. Many of the horribly embarrassing legal issues that Morgan faced have been resolved. Investment banking has been firming up. And morale has improved.

"Like night and day" is how one Morgan banker describes the environment now vs. under Purcell. "We are allowed to speak. Brainpower wins. And every time I've asked John [Mack] to call a client, he has," says the banker. "Under Phil [Purcell], no one asked. Why bother? He never did."

But take a closer look at Morgan, and you'll see that despite darkness being turned to light, the firm remains in a tricky competitive position -- one that requires outsized strategic vision. And in certain corners of Wall Street there are those who wonder if Mack is the right man for the job. Morgan Stanley stock has trailed its peer group since he took over. Mack, after all, championed the 1997 Morgan Stanley/Dean Witter merger, which has never jelled (though Mack says this is a matter of failed execution). Then there was his tortured tenure running Credit Suisse First Boston, which ended partly because his Swiss bosses disagreed with his desire to expand that firm.

"I just don't see John as a strategic thinker," opines a top Wall Street competitor.

Says Guy Moszkowski, analyst at Merrill Lynch: "I think John Mack has a grip, but huge scope and size don't necessarily work. The firms working best now are focused: Bear Stearns, Goldman Sachs (Research), and Lehman Brothers. The more diversified model is tough."

It is that more diversified model to which Mack appears wedded.

"We have been in a period where the right strategy was to be a pure fixed-income house," says a person familiar with Mack's thinking. "But I'm not convinced that going forward holding a portfolio of businesses isn't a good strategy."

Wall Street right now can be broken down more or less into three camps. On one end you have Moszkowski's aforementioned focused firms. They often have strong bond businesses and have become expert at wagering their firm's own money in so-called proprietary trading or principal investing. They look to co-invest with clients and are tight with hedge funds and private-equity firms.

On the other side are universal banks like Citigroup (Research), J.P. Morgan, Bank of America (Research), and European players like Barclays. These mammoth institutions, which grew out of the old commercial banks, are often clunky but usually have strong retail cash cow franchises.

In the middle sits a third group: Merrill Lynch, CSFB, and Morgan Stanley. Neither sleek money machines nor behemoths, they are, some say, in financial no man's land.

Morgan's problems are clear to friends and foes. The firm's return on equity -- in essence, the rate of return to its shareholders -- trailed Goldman's in 2005 by three percentage points: 22% to 19%. That may not seem like much, but it translates into many hundreds of millions in profit.

Says one senior Goldman banker: "Our competition isn't necessarily Morgan Stanley. It's the hedge funds and private-equity funds. They have the best returns and take our best employees and best customers."

The least Wall Street-y of Morgan's four businesses, the Discover card, is a downmarket retail operation that has seen outstanding balances shrink for three straight years, according to Banc of America Securities' Michael Hecht.

Says Merrill's Moszkowski: "I'd unlock value by spinning it off into the market as a standalone company."

During Purcell's waning days he announced he would consider setting Discover free -- but Mack pulled the plug on the idea. Why? Discover generated $921 million in high-margin profits in 2005, which the credit-rating agencies look upon kindly.

Morgan's second unit, asset management, is hardly running on all cylinders. Assets there grew only 1.7% last year, to $431 billion, and Hecht expects no revenue growth in 2006. Goldman Sachs, in comparison, chalked up an 18% gain in assets under management last year, to $532 billion.

In addition, the rationale for merging money management and brokerage in one firm -- to have a distribution channel through which to push in-house investment products -- has lost its allure as regulators question whether such preferential practices are in the best interest of investors. Targeted companies like T. Rowe Price, Legg Mason, and BlackRock are now seen as better homes for asset management, and Citibank and Merrill Lynch both recently offloaded their operations (to Legg and BlackRock, respectively).

Yet Mack still wants to build Morgan's asset unit. "This is a business that can smooth out the cyclicality of the securities business," says a high-level Morgan Stanley source.

Morgan's third leg, brokerage Dean Witter, has long lagged behind Merrill and Smith Barney in nearly every metric. Mack just installed James Gorman, who turned around Merrill Lynch's broker arm, in hopes of getting Merrill-like results: "Dean Witter's pretax margins are subpar," says Moszkowski. "Gorman will try to move the needle, eventually up to 20%, which is where others are."

Gorman will likely seek to shift customers with $100,000 or less to call centers, much as he did at Merrill, and to get rid of nonproductive brokers.

"This won't be as easy as at Merrill," asserts a competitor. "It'll take four years. You have to retrain, fix compensation, change the technology." Mack supporters say it will take only 18 months to show progress.

Finally, there's Morgan's institutional securities arm. There are two sides to this business: the agency model and the principal model. Investment banking, mergers and acquisitions, and securities underwriting are the agency side (or acting as an agent). It is a huge global franchise for Morgan Stanley that's in no danger of expiring, but gradually this old school is becoming less profitable on Wall Street. UBS analyst Glenn Schorr writes of Morgan Stanley, "It's the institutional securities segment that has been one of the main driving forces behind the company's subpar ROE."

There is now a push at Morgan to expand the principal business (or acting as a principal in a transaction). The risks here are obvious: Do it right, you become Goldman; do it wrong, and you're in deep yogurt.

Controversial co-president Zoe Cruz ("There's nothing subtle about her," says one insider) and others like rising star Neal Shear, co-head of institutional sales and trading, are putting more of the firm's capital to work and ratcheting up its risk-reward profile. "The greater risk is not doing it," is how Mack puts it.

Folks in Mack's camp say he is committed to keeping all these businesses, and it's possible that his "diversified portfolio" will shine once he's buffed it up. "Why should we [sell off] an asset if it's not perfectly run, and part with something at 30 cents on the dollar?" asks the Morgan banker.

On the other hand, for a guy who says he's dancing with the gals he came with, Mack has been busy talking deals all over town -- not just to BlackRock but also to buyout king Tom Lee and various hedge fund groups. (Ultimately, some say, Mack will sell the whole firm to a J.P. Morgan or HSBC.)

When asked why Morgan's stock has lagged its peers during Mack's tenure, his backers can still get away with saying, "Give the man a break -- he's barely got his saddle warm yet!" And that's certainly true. (As a fixer-upper, there may be more upside to MS shares than, say, Goldman's.)

Yet Mack's situation may be best summed up by a money manager involved in the fray surrounding the removal of Purcell last spring: "Nobody would give [Mack] an A+, but no one would give him a D, because no one hates him, and everyone knows he has a lot of work to do." The clock is ticking.

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