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The End of Investment Banks

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On this day in economic and business history …

Goldman Sachs Group, Inc. (NYSE:GS) and Morgan Stanley (NYSE:MS) announced their intent to become bank holding companies on Sept. 21, 2008, in a last-ditch effort to draw on Federal Reserve funds and avoid financial oblivion.

The two venerable investment banks were the last of their kind left standing by this point in the financial crisis. Bear Stearns had foundered six months earlier and had been sold to JPMorgan Chase & Co. (NYSE:JPM). Lehman Brothers and Merrill Lynch had both failed a week before the Goldman and Morgan Stanley conversion, but Merrill had also been bought at fire-sale prices. Lehman’s collapse had left a sucking vortex in the middle of Manhattan that now threatened to pull in all counterparties. The options seemed bleak: Accept liquidity (tied to stricter regulation), or accept death.

Goldman Sachs Group Inc (NYSE:GS)

Many financial writers called the move a symbolic end to Glass-Steagall, which had technically been repealed nine years earlier. That legislation had placed a firewall between investment banking and commercial banking — and had prompted Morgan Stanley’s creation in the first place — but once the two remaining investment banks returned to commercial-banking regulatory regimes, there would be no remaining legacy of Glass-Steagall’s firewall against risky big-bank investment bets. Andrew Ross Sorkin and Vikas Bajaj of The New York Times wrote on the impact of this unprecedented move:

It also is a turning point for the high-rolling culture of Wall Street, with its seven-figure bonuses and lavish perks for even midlevel executives. It effectively returns Wall Street to the way it was structured before Congress passed a law during the Great Depression separating investment banking from commercial banking, known as the Glass-Steagall Act.

By becoming bank holding companies, the firms are agreeing to significantly tighter regulations and much closer supervision by bank examiners from several government agencies rather than only the Securities and Exchange Commission. Now, the firms will look more like commercial banks, with more disclosure, higher capital reserves and less risk-taking.

For decades, firms like Morgan Stanley and Goldman Sachs thrived by taking bold bets with their own money, often using enormous amounts of debt to increase their profits, with little outside oversight.

They were the envy of Wall Street, dominating the industry’s most lucrative businesses, landing headline-grabbing deals and advising companies and governments around the world on mergers, stock offerings and restructurings.

But that brash model was torn apart over the last several weeks as investors lost confidence in the way they made those bets during the recent credit boom, when investment banks expanded with aplomb into esoteric securities, the risks of which were not easily understood.

Over several harrowing days, clients started pulling their money, share prices plunged and these banks’ entire enterprises were brought to the brink.

Lehman’s leverage had done it in, but Goldman and Morgan Stanley teetered on the same ledge. Morgan Stanley’s 30-to-1 leverage ratio actually matched Lehman’s pre-bankruptcy level, and Goldman’s 22-to-1 leverage ratio was not far behind. In the months that followed, the two banks borrowed heavily from the Fed — Goldman tapped $69 billion in government liquidity by the end of 2008, and Morgan Stanley drew on as much as $107 billion in federal funds in the days after its conversion. Each bank also received $10 billion apiece  from federal bailout programs, which has since been repaid.

The deal didn’t necessarily help Morgan Stanley rebound from a weak post-dot-com era of tighter IPO regulations, but it appears to have been good for Goldman. Five years after the conversion, Morgan Stanley’s net income remains 80% lower than it was when it made the shift, but Goldman’s is now more than 250% higher. Both banks have begun to agitate for a return to investment-bank status in response to the proposed Volcker Rule, although they have yet to take that leap.

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