Monday, September 22, 2008

Why Goldman, Morgan Stanley Raced For The Fed

The Big Banks

Liz Moyer, 09.22.08, 5:10 PM ET

Goldman Sachs and Morgan Stanley sought and won bank holding company status from the Federal Reserve in an expedited weekend process that waived the rules in the interest of "unusual and exigent circumstances."

Hoping to avoid the fate of Lehman Brothers, Bear Stearns and Merrill Lynch, both agreed to trade weaker regulation by the Securities and Exchange Commission and near limitless freedom--as well as the high risks and multibillion-dollar paychecks that come along with it--for the stricter standards and accountability of Federal Reserve oversight. That would suggest the urgency of their appeal to the Fed.

"This is a high-cost move," says Brad Hintz, an analyst at Sanford Bernstein. "The SEC was a very light regulator. They have now chosen the most intrusive regulator."

The dramatic changes over the weekend and last week acknowledge the view that Wall Street's business model has broken down. That model included using a combination of unsecured and secured debt financing to fund activities like trading and corporate lending, rather than relying on stable bank deposits to fund some of those activities.

Leverage was the engine that fueled Goldman and Morgan Stanley , among other Wall Street firms, to record profits in the boom times. As of their last quarterly regulatory filings, in June, Goldman had $71 billion in short-term unsecured borrowings and $182 billion in long-term borrowings. Morgan Staley had $32 billion in short-term unsecured borrowings and $210 billion long term. Goldman and Morgan each had $1 trillion in assets, and shareholder equity of $45 billion and $34 billion, respectively.

Both Goldman and Morgan Stanley had been weighing the possibility of gaining bank holding company status since last March, when the Federal Reserve opened its emergency borrowing programs to primary dealers, a group of Wall Street firms that included them.

In March, the Fed sent in observers to each of the companies to keep closer tabs on their capital levels, funding and cash positions. The presence of the Fed in these companies already helped speed the approval process.

On Monday, a day after approving their applications, the Fed said the action could take effect immediately rather than wait through a customary 30-day comment and review period. In its order approving the applications, the Fed said that "emergency conditions exist that justify expeditious action on this proposal."

The two banks reported solid profits last Tuesday, Sept. 16, which is to say at least they didn't report losses like other banks. But that wasn't enough to stop the erosion of confidence in their survivability as independent companies.

By Friday, the spread on credit default swaps on Goldman had widened into the mid-500 basis-point range, and spreads for Morgan Stanley reached into the 900s, compared with more recent levels in the 100s to 200s. That shows the markets were alarmed after the collapse of Lehman Brothers just days earlier and the shotgun merger Merrill Lynch arranged with Bank of America.

Morgan Stanley filed its application on Saturday, according to a spokeswoman. Goldman filed Sunday night, a spokesman said.

In its announcement Sunday, the Fed added the London broker-dealer entities of Goldman, Morgan Stanley and Merrill Lynch to the list of banks eligible to borrow directly from it through its emergency borrowing programs. The London operations are separate units under the companies' holding companies and did not enjoy access to the Fed's emergency borrowing program for primary dealers, as their U.S. broker-dealer units have since March.

That means the Fed will stand behind the firms while they reduce leverage from the 24-to-1 level typical of a broker dealer to the 10-to-1 level more typical for a bank.

So far, the Fed's moves have not calmed the markets. Bank stocks tumbled Monday on uncertainty about the outcome of a proposed $700 billion financial system bailout by the Treasury Department.

Morgan Stanley had ended the week trying a number of strategies to see what would ultimately pan out. It was in talks with China Investment Corp. officials last in December. It was also in talks on a possible merger with Wachovia. And it was preparing to file the bank holding company application with the Fed, which it did Saturday.

On Monday, Morgan Stanley announced an agreement with Mitsubishi UFJ Financial Group,, Japan's biggest bank. Mitsubishi will buy up to 20% in Morgan Stanley, for an estimated $8.4 billion. The deal would help Morgan Stanley dramatically reduce leverage on its balance sheet and turn to plans to expand its deposit-taking commercial bank operations. The Wachovia talks have been sidelined.

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