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Mark Lennihan/AP
Stock tickers light up Morgan Stanley headquarters Monday, Sept. 22, 2008 in New York.

Morgan Stanley, Goldman Sachs Say There’s No Such Thing as an Investment Bank

September 22, 2008 05:56 PM
by Anne Szustek
The two major remaining investment banks in the U.S., Morgan Stanley and Goldman Sachs, petitioned the Fed to change their status to holding companies, allowing them to take deposits.

Morgan Stanley, Goldman Sachs, Were Last I-Banks Standing

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Out of fears for their survival, Goldman Sachs and Morgan Stanley requested on Sunday that they no longer be classified as investment banks. What were the two remaining Wall Street stalwarts are now technically “holding companies,” which means they can accept deposits from everyday customers—potentially a more reliable source of capital—as well as get emergency short-term loans directly from the Federal Reserve.

The move will not officially take effect until after a legally required five-day waiting period. Once the change is formally promulgated, Morgan Stanley and Goldman are to come under the direct supervision of the Fed—and its tougher rules. As investment banks, the two companies’ main governmental oversight body was the Securities and Exchange Commission, which will continue to monitor the companies’ trading.

The switch in organizational format situates Goldman Sachs and Morgan Stanley more easily to merge and takeover smaller companies that have deposits protected by the FDIC (Federal Deposit Insurance Corp). As the FDIC would be backing consumer savings, that organization would become another oversight body to Morgan Stanley and Goldman Sachs, in addition to the Fed.

“By becoming a bank holding company and being regulated by the Federal Reserve, we have directly addressed issues that have become of mounting concern to market participants in recent weeks,” a Goldman Sachs spokesperson told The Wall Street Journal.

Plus, as holding companies, the two banks may no longer have to calculate their finances using “mark-to-market accounting,” which requires that the company’s holdings be valued at the current price fetched on the capital markets.

Background: Merrill Lynch, Lehman and Bear Stearns bite the dust

Last week Merrill Lynch and Lehman Brothers became the second and third major investment banks to fall by the financial wayside. Bank of America bought Merrill for $50 billion—considered a steep bargain—and Lehman Brothers, once the fourth-largest investment bank in the United States, filed for Chapter 11 bankruptcy, reporting more than $613 billion in debts.

British bank Barclays was considered a top contender to inject critically needed capital into Lehman on Sept. 13; however it pulled out of talks on Sept. 14 after it announced it couldn’t obtain financial backing from Wall Street firms or the U.S. government to hedge against Lehman’s losses. But two days later, the same day that Lehman entered formal bankruptcy proceedings in a Manhattan court, Barclays president Robert E. Diamond Jr. announced that the British bank plans to take over Lehman’s capital markets and investment divisions, keeping the Lehman name.

In March, another erstwhile investment banking titan, Bear Stearns, was rolled into JPMorgan after its stock collapsed. Rather than a question of funds, as was the case with Lehman and Merrill, many believe Bear Stearns’ downfall was at the hands of short-sellers betting on a bearish outlook on the bank. Bear Stearns’ share price plummeted.

An anonymous investment bank executive told Vanity Fair magazine, “I don’t know of any firm …  that could have withstood that kind of bombardment by the shorts. This was not about capital. It was about people losing confidence, spurred on by rumors fueled by people who had an interest in the fall of Bear Stearns.”

Historical Context: Glass-Steagal Act of 1933; Financial Modernization Act of 1999

As in the current credit crunch, rumors over creditworthiness and lenient lending practices factored into the stock market crash of 1929, which in turn brought on the Great Depression. One legal result was the Glass Steagal Act of 1933, which, by stipulating that only 10 percent of a bank’s capital could be open to an affiliate business, effectively split investment banks from commercial banks. The law also intended to stave off conflicts of interest in securities trading, and established the FDIC.

Interpretation of the law began to grow increasingly lax starting in the 1960s and ’70s, starting with brokerage firms offering money-market debit and checking accounts as well as credit cards. In December 1986, the Fed ruled that commercial banks could earn up to 5 percent of revenue from short-term, unsecured credit transactions, known in the industry as “commercial paper.”
A few months later, in 1987, the board of the Federal Reserve voted 3-2 to further lessen Glass-Steagal regulations, despite opposition from then Fed chief Paul Volcker. PBS Frontline writes that he made clear “his fear that lenders will recklessly lower loan standards in pursuit of lucrative securities offerings and market bad loans to the public.” Speaking on behalf of banks, Citicorp Vice Chair Thomas Theobald argued that the SEC, credit-ratings agencies and informed investors could keep any sort of corporate malfeasance in check.

A number of other steps were taken to loosen Glass-Steagal in the coming years. These paved the way for the $70 billion merger of Citicorp and Travelers Group, the parent company of what was then known as Solomon Smith Barney, on April 6, 1998, establishing Citigroup. Under the law at the time, Citigroup would have to dissociate the insurance division of Travelers Group. Sandy Weill, the head of Travelers and later the head of Citigroup, then spearheaded a $200 million lobbying effort to have Glass-Steagal repealed.

In May 1998, Congress passed legislation by a 214-213 vote allowing for insurance and securities firms, as well as banks to form large conglomerates. On Nov. 4, 1999, parts of the Glass-Steagal Act were replaced by the Financial Modernization Act, signed into law on Nov. 4, 1999, removing the last hurdle for banks to offer both brokerage services and debit accounts.
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