Goldman, Morgan Switch To Bank-Holding Firms

The Federal Reserve late Sunday approved a request from the country's last two major investment banks — Goldman Sachs and Morgan Stanley — to change their status to bank holding companies.

The change in status will allow them to create commercial banks that will be able to take deposits, bolstering the resources of both institutions. This means a future of stricter regulation, less leverage and probably lower returns.

But it also means a more stable financing future that will put the Federal Reserve and its balance sheet directly behind the two banks.

Extraordinary actions by the Federal Reserve Sunday evening to allow the two banks full access to the emergency discount window open to commercial banks, along with that of the London broker-dealers of Morgan and Goldman (and including Merrill Lynch) was meant to send an unambiguous message that the Fed was not going to let these institutions fail while they made the transition to becoming commercial banks.

Morgan and Goldman will continue to have investment banks, very much the way JP Morgan and Bank of America do. The big difference is that the investment bank in such a situation, has access to unsecured lending (subject to certain regulations) from the commercial bank and will be more strictly regulated by the Fed. If the two banks can grow their deposit base quickly, it will mean a "sticky" or reliable source of financing not available to investment banks.

The new configuration likely means lower profitability for both investment banks, but at least it allows for their survival.

Both Goldman Sachs and Morgan Stanley went to the Federal Reserve this weekend to make a formal request to become bank holding companies, culminating intense discussion that began the week that Lehman declared bankruptcy. In fact, both banks had been considering the alternative at least since the demise of Bear Stearns, if not earlier, but the recent punishment of their stock prices and concerns that they could not raise capital accelerated the process.

The Federal Reserve Board of Governors approved the request unanimously at a meeting that began at 9 p.m. Sunday evening. They waived the normal 30-day waiting period for such applications. The transition to bank holding doesn’t formally take place until after a five-day anti-trust review.

Both the Fed and the banks describe this as reacting to a clear signal from the market that being an investment bank no longer had any value. Specifically, with market values equal to their book values, there was seen to be no "franchise" value attributed by the market to being an investment bank. In other words, they had values that were no larger than the value of the assets on their books and that threatened to go lower.

Both Goldman and Morgan own industrial loan companies based in Utah that will become banks. Morgan's bank has $36 billion in assets and is the 36th largest bank in America.

Goldman has two banks with combined assets of $20 billion. It will move assets from its investment bank into the combined bank to be called GS Bank USA.  The combined assets of the two is worth $150 billion.

But it’s likely both companies will now seek to buy other banks. A Morgan Stanley executive said the company continued talks to raise additional capital. It likely ends talks by Morgan to merge with Wachovia Bank .

The Fed will now regulate both bank holding companies, a choice investment banks usually shunned because the Fed tends to be tougher and more intrusive. Significantly, Morgan Stanley’s current 23.5 to one leverage ratio will now have to decline substantially. Morgan’s bank (as opposed to its bank holding company) will eventually become a nationally chartered bank regulated by the Federal Deposit Insurance Corp. Goldman’s bank will be a state-chartered bank.

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