Published September 23, 2008

Morgan Stanley, Goldman Sachs reinvent for risk-averse world

Both opt to become commercial banks as Wall Street dumps high risk, reward model

By ANDREW MARKS
NEW YORK CORRESPONDENT
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IN what could be the final transformative act of the fundamental re-shaping of the US financial sector and Wall Street itself, the Federal Reserve late Sunday approved a request from both Goldman Sachs and Morgan Stanley, the country's last two major independent investment banks, to change their status to bank holding companies.

Morgan Stanley's change cut even deeper as, in a separate development, it was announced that Japanese megabank Mitsubishi UFJ Financial Group would take a 20 per cent stake in the ailing US giant in a deal that could be worth up to US$8.5 billion.

That, however, paled in comparison with the more basic shift in the banking landscape. The change in status will subject both Goldman Sachs and Morgan Stanley to far greater regulation and oversight. But the move allowing them to create commercial banks that will be able to take deposits, is an acknowledgement that banks involved in trading and investing alone can no longer survive in the new, risk-averse world of high finance.

The new era has evolved in a period of time measured in weeks, replacing a way of doing business that had been Wall Street's mainstay for more than 75 years, since the banking and financial crisis of the 1920s that produced the Glass-Steagall Act, which separated investment banking from commercial banking.

'It's the end of an era on Wall Street. What we've done is reverted to the pre-1929 model of the bank. There're security laws and the Bank Holding Act to provide regulation now, but this move is like the coup de grace for the Wall Street we've known since the mid-1980s,' said Charles Geisst, a Wall Street historian and professor of finance at Manhattan College.

The move comes despite the US$700 billion government rescue of financial firms being engineered by Congress and the Bush administration, and will require the two former investment banks to greatly reduce their leverage, and in the future, their returns.

Typically, investment banks have debt to capital ratios - known as leverage - of more than double that of commercial banks, which are required by law to keep capital reserves at certain levels. Recently, firms such as the now-defunct Bear Stearns and Lehman Brothers had leverage ratios of as high as 40-to-1, compared to commercial banks such as Bank of America, the new owner of Merrill Lynch, which has a leverage ratio of less than 12-to-1.

Both companies will now have access to the full array of the Federal Reserve's lending facilities, which will allow them to avoid the fate that befell Lehman Brothers a week ago, and likely drove the investment banks to request the change in status from the Fed.

The Fed's simultaneous announcements for both Goldman Sachs and Morgan Stanley appear to be a deliberate one, aimed at completely transforming Wall Street from the highly leveraged, high-risk and high-profit business model investors have known for the last 80 years.

'The Fed is essentially saying the financial system that was in place as of three weeks ago cannot cope with the mounting problems that it has brought upon itself, beginning with the sub-prime mortgage crisis, and it has to be forever and fundamentally changed,' said Prof Geisst, the author of Wall Street: A History and Undue Influence: How the Wall Street Elite Put the Financial System at Risk.

Investors reacted warily to the latest details of the US government's mortgage bailout plan for financial companies and the news about Goldman Sachs and Morgan Stanley in the early going yesterday. The Dow Jones Industrials was falling by 86 points, or 0.76 per cent, to 11,302 shortly after the opening bell on the New York Stock Exchange.

Morgan Stanley, however, was bucking the overall negative trend yesterday morning, after Tokyo-based Mitsubishi UFJ Financial Group announced plans to buy between 10 per cent and 20 per cent of Morgan Stanley common stock, boosting the firm's capital position. Shares in Morgan Stanley were trading up by 14 per cent.

What does this latest move mean for the future of finance in the US? From here on, Wall Street will likely have to go back to its traditional model of devising mergers and acquisitions and underwriting securities transactions that it had before this trading and high-risk, high-leverage derivatives boom began 25 years ago.

If that's the case, Wall Street will become a much smaller place both literally, in terms of the number of firms operating and people employed in high finance in New York, and figuratively, as its influence will be greatly diminished along with its high-roller status.

The hedge funds, too, will likely diminish in importance, and analysts expect the government to take moves to increase regulation of their investments and transactions.

'It's hard to take in everything that's happened in such a short time, but this move effectively means that Wall Street firms will now look more like commercial banks, with more disclosure and oversight, higher capital reserves and less risk-taking,' said Prof Geisst.