Goldman and Morgan Stanley redefine investment banking

Now that the two US investment banks have become bank holding companies, the standalone investment banking model is forever changed.
Sunday night, when Morgan Stanley and Goldman Sachs announced that their applications to become bank holding companies were approved they made a decision to shore up their image in the market. The message was: our funding base is secure, donÆt worry about us.

Yesterday, Morgan Stanley took one more step in that direction. It announced that Mitsubishi UFJ Financial Group, JapanÆs largest banking group and the worldÆs second largest bank holding company with $1.1 trillion in bank deposits, will buy a stake of up to 20% in the American bank in order to establish a strategic partnership. MUFG said its maximum investment in Morgan Stanley will be Ñ900 billion ($8.4 billion). Upon closing of the deal, a representative of MUFG will join the Morgan Stanley board. The news sent Morgan Stanley's share price 13% higher in pre-opening trading but these gains were eroded when Wall Street took another tumble amid uncertainty about the details of the governmentÆs proposed $700 billion bailout package as well as concerns it may be delayed. The stock finished down 12 cents at $27.09.

In a press release, Morgan StanleyÆs chairman and CEO, John Mack, said: ôThis strategic alliance with Mitsubishi UFJ can put Morgan Stanley in an even stronger position as we look to realise the opportunities we see in the rapidly changing financial marketplace. As one of the largest commercial banks in the world, Mitsubishi UFJ would be a valuable partner as we transition to a bank holding company and build our bank services and deposit base. This alliance also would build on Morgan StanleyÆs deep ties and market leadership in Japan and throughout Asia, and help us to continue growing our business in this critically important region.ö

As for the Fed announcement, it quietly hammered the last nail in the coffin of the depression era Glass-Steagall Act, which in 1933 divided investment banks into one camp and retail banks into another. The first nails were pounded into that casket in 1999, when a law was enacted that repealed the Glass-Steagall Act, but Goldman Sachs and Morgan Stanley still remained as truly independent standalone investment banks, so the coffin wasnÆt fully sealed and buried.

On Sunday, when Morgan Stanley and Goldman announced that they would become financial holding companies under the Bank Holding Company Act, they gave up that status as independent standalones.

And now you can plant a flower at the grave.

Some bankers are arguing thatÆs not the case û that all theyÆve done is diversify their funding basis but the standalone bank remains. They point out that the investment banks will now have access to the Federal ReserveÆs discount window. The banks had been granted temporary access to such lending up until January 2009. This now becomes permanent and, so the reasoning goes, should bolster their images among investors and ratings agencies, as both should see the funding as assurance.

In the press release announcing the move, Morgan StanleyÆs Mack said: ôThis new bank holding structure will ensure that Morgan Stanley is in the strongest possible position û with the stability and flexibility to seize opportunities in the rapidly changing financial marketplace. It also offers the marketplace certainty about the strength of our financial position and our access to funding. As we evolve our business model and move quickly to seize these new opportunities, we remain intensely focused on continuing to provide world-class service and advice to our clients and deliver long-term value to our shareholders.ö

Similarly, Lloyd C Blankfein, chairman and CEO of Goldman Sachs, had this to say in a separate press release: ôWhen 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.ö

For sure, the move should bolster confidence. The Fed has sent out a message that it will not allow Goldman Sachs and Morgan Stanley to fail, an important message as both banks stocks plummeted last week after the bankruptcy of Lehman Brothers, the Bank of America acquisition of Merrill Lynch and the FedÆs $85 billion rescue loan to American International Group. One could also interpret the FedÆs actions as forestalling more potential buyouts of major US banks by sovereign wealth funds. Morgan Stanley was reportedly in talks last week with China Investment Corp, better known as CIC.

And from the FedÆs point of view, this new move is a good one. After all, the Fed does not organically regulate investment banks, except in a limited sense as they are primary dealers in government securities. But the Fed is increasingly being asked to supply liquidity. As the Fed regulates all bank holding companies (even though supervision of the banks is split among the Fed, the Comptroller of the Currency, the FDIC, the Office of Thrift Supervision, and the 50 states etcetera), the easiest way to get supervisory control without changing the law (and starting a territorial war with other regulators) is to help them to become bank holding companies.

Indeed, Morgan Stanley and Goldman will now be subject to the same increased regulation and scrutiny as commercial banks. That will mean that the amount of leverage these investment banks can take on in the future will be significantly less than what theyÆve done in recent years.

As the New York Times pointed out on Monday: ôWhen it collapsed, Lehman had about a 30:1 debt-to-equity ratio, meaning it had borrowed $30 for every dollar in capital it held. Morgan Stanley currently has a debt-to-equity ratio of 23.5:1, while Goldman Sachs has one of about 22:1.

"Bank of America, on the other hand, currently has about an 11:1 leverage ratio, while J.P. Morgan has about 13:1 and Citigroup about 15:1. Because they can borrow less, bank holding companies typically have lower earnings multiples.ö

Adjusting the amount of leverage investment banks take on surely will change the way they do business in the future. That indicates the business model û as we know it û of investment banking has permanently changed as well.

But thereÆs also another twist to this story. The tables have turned. By becoming bank holding companies, these banks can now consider going out and buying other banks on the cheap, a la BarclaysÆ savvy move of purchasing Lehman BrothersÆ core capital-markets business out of bankruptcy late last week or in the same manner as how J.P. Morgan acquired Bear Stearns this spring (albeit in a deal that was brokered by the Fed).

With Morgan Stanley's MUFG announcement, there's a strategic partnership that will help it grow. It will be interesting to see if Goldman Sachs plans any such partnerships or buys another bank. It's clear, though, that both banks are going to need more than their blue-ribbon reputations to win business in the future; theyÆll need something to replace leverage. And a nice solid deposit base is a good start.
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