Wall St capitulation marks end of an era

By Stephen Foley in New York
Tuesday, 23 September 2008

Goldman Sachs and Morgan Stanley have ripped up the traditional business model of investment banking and – in a desperate bid to survive – submitted themselves to new regulations and restrictions that put an end to the excesses of swashbuckling trading on Wall Street.

Their decision to convert into traditional bank holding companies, under the supervision of myriad US regulators, sparked a furious debate yesterday about the future of the finance industry when it emerges from its worst crisis since the Great Depression.

And in the short term it frees up the two firms, until Sunday night the last independent major investment banks left standing, to acquire retail banks and the stable deposit base that has enabled them better to weather the financial storm.

Morgan Stanley's chief executive John Mack mothballed emergency talks about being the possibility of being taken over by Wachovia, one of the biggest high-street banks in the country, and instead began a search for an acquisition. The company also, yesterday morning, announced that the Japanese bank Mitsubishi UFJ would provide around $8.5bn in new financing in return for a stake of up to 20 per cent in Morgan Stanley.

The panic of last week had threatened to destroy both Goldman Sachs and Morgan Stanley as their shares plunged, the cost of financing their operations in the credit markets ballooned, and their most nervous clients began to pull business from the firms.

At the root of their problems has been the enormous leverage put on the businesses as they expanded their highly-profitable proprietary trading desks in the years before the credit crisis broke. Through leverage, Goldman Sachs has been trading assets with a value some 22 times that of its underlying capital; Morgan Stanley's leverage reached 30 times. These allowed them to juice profits on their investments during the boom, recording record earnings for shareholders and handing giant bonuses to their most aggressive traders, but it also made the companies inherently unstable.

Lehman Brothers and Bear Stearns, two of the other big five investment banks, collapsed when their riskiest mortgage investments went sour; Merrill Lynch sold itself to Bank of America a week ago to avoid the same fate.

"This is a major realignment on Wall Street and we are going back to the days of the merchant banking of the 1800s," said Bob Ellis, senior vice president of the wealth management group at Celent, a Boston-based financial research and consulting firm.

"The universal bank model that has proved so successful in Europe and Asia and was not even permissible in the US until recently, had become the winning business model in the US, too. These companies will have a strong retail bank, a strong retail brokerage and a reasonably strong investment bank and each of these companies supports the other."

The existence of a strong deposit base should reduce the cost of funding the overall business, according to proponents of the universal banking model, since the whole is less risky. It also provides firms with greater access to lending facilities from the Federal Reserve.

Lloyd Blankfein, the chief executive of Goldman Sachs, said: "When Goldman Sachs was a private partnership, we made the decision to become a public company, recognising the need for permanent capital to meet the demands of scale.

"While accelerated by market sentiment, our decision to be regulated by the Federal Reserve is based on the recognition that such regulation provides its members with full prudential supervision and access to permanent liquidity and funding.

"We believe that Goldman Sachs, under Federal Reserve supervision, will be regarded as an even more secure institution with an exceptionally clean balance sheet and a greater diversity of funding sources."

The greater security, however, comes with greater scrutiny and much tougher restrictions on the amount of leverage that will be appropriate in the future. Typical commercial banks have leverage ratios below about 12 times. Since the credit crisis began, all the investment banks were engaged in a frantic effort to reduce leverage, and that will continue under the transition to bank holding company.

Some hedge fund managers said they expected to be able to poach some of the most successful traders from the investment banks' proprietary trading desks, which may now have to be significantly slimmed down at Goldman Sachs and Morgan Stanley – although both companies expressed the hope that they will gain market share in trading. Analysts said profitability is sure to be crimped by the reduced leverage, however, making outsize bonuses less likely.

Goldman Sachs shares fell 7 per cent in New York. Morgan Stanley fell less than 1 per cent. Financial terms of its deal with Mitsubishi are subject to scrutiny of its businesses and assets by the Japanese bank. MUFG has entered into a non-binding letter of intent for an investment that "would eventually reach 20 per cent" of its equity, Morgan Stanley said in a statement.