Morgan Stanley's Bank Shot

A possible combo with Wachovia could provide some relief, and offer a number of pitfalls

Anxious to avoid the cruel fate of onetime rival Lehman Brothers Holdings (LEH), Morgan Stanley (MS) and Goldman Sachs (GS), the only two independent investment banks still standing, have been looking for commercial banks with which to merge in order to stanch the bleeding in their shares. On Sept. 18, Morgan's shares were down 39.4% from their closing price of $37.23 on Sept. 12, before the Lehman failure, while Goldman's stock had lost almost 30% of its value.

The crisis of confidence in Wall Street financial institutions that made risky bets on mortgage-backed securities has all but immobilized efforts by investment banks to raise capital to bolster their balance sheets for inevitable further asset writedowns. That has prompted the teetering investment banks to seek protection in the comfort of cash deposits that constitute the relative strength and stability of commercial banks like Wachovia (WB). During the weekend of Sept. 13 and 14, Merrill Lynch (MER) watched Lehman's frantic efforts to find a white knight come to naught and, reading the tea leaves, quickly ran for cover by selling itself to Bank of America (BAC). However much less exposed they may be to toxic financial derivative products, Goldman and Morgan know they could be next amid investor concerns about their future access to capital.

The betrothal of investment and commercial banking under one roof isn't new. Chase Bank acquired JPMorgan in 2000 to form JPMorgan Chase (JPM). With the escalation of the financial crisis to a more frenzied pitch, however, it has started to look like a series of shotgun weddings.

Talking to China

Morgan has reportedly been discussing with China Investment Corp. the possibility of China's relatively new wealth fund increasing its stake in the New York investment bank from the $5.6 billion stake it took in Morgan in December.

But more advanced talks between Morgan and Wachovia, which is struggling with its own exposure to mortgage defaults, have caused some critics to scoff at the notion that the Charlotte (N.C.) bank has anything to offer Morgan in terms of shoring up either its access to capital or investor confidence. As of June 30, roughly $7 billion, or 5.78%, of Wachovia's $122 billion portfolio of option Adjustable Rate Mortgages was in default, says Kevin Fitzsimmons, an analyst who covers the bank for Sandler O'Neill & Partners in New York. Compared with its peers, that's a big percentage for overall mortgage defaults and it continues to grow, he adds.

Given Wachovia's focus on preserving the cash it has and generating new capital and Morgan Stanley's liquidity problems, Fitzsimmons says he doesn't see the logic of putting them together, especially in the current market environment. "[A merger] would definitely make them bigger, but I struggle to see how it would make them better," he says.

Nebulous Market Values

Bert Ely, a principal at Ely & Co. an Alexandria (Va.)-based consulting firm for financial institutions, agrees that the combination of two weak companies would create a more precarious situation. "In my opinion, [the merger] would have to be…conditioned on X billions of dollars of capital raise to get regulatory approval."

Under current accounting rules, if the investment bank were the acquisition target, it would have to write down all its assets to fair market value in order for the commercial bank to take those assets onto its balance sheet, says James Abbott, an analyst who covers regional banks for Friedman Billings Ramsey (FBR) in Arlington, Va. Given how illiquid the secondary market for financial derivative products is right now, there's a lot of debate about how accurate those market values are. But if they're correct, Abbott says he doesn't see much risk for the commercial banks other than not having enough capital to be able to afford the deal.

The guarantees that the Federal Deposit Insurance Corp. (FDIC) provides for all individual customer deposits of up to $100,000 would not be affected by a merger, whether the commercial bank ends up as the buyer, as in Morgan's case, or the seller, the more likely scenario in a Goldman deal. The resulting entity of a merger would have to be registered with the Federal Reserve as a financial holding company, which Morgan Stanley is not, says Ely.

And the Shareholders?

FDIC spokesman David Barr told BusinessWeek that Chairwoman Sheila Bair wasn't available to comment on whether or not the FDIC believes customers' deposits would be at additional risk from mergers between commercial and investment banks.

For his part, Ely doesn't believe Morgan or other investment banks would be giving up anything by submitting to the FDIC's regulatory authority since it would still be able to trade securities under a different subsidiary. "The question is what does it mean for their shareholders?" he says. "What we have seen here in all three cases" of investment bank collapses is that shareholders were wiped out. "That's the issue facing Morgan Stanley right now, and I guess, to a lesser extent, Goldman."

Over the long term, the bet is that shareholders in a merged investment bank will fare better than if that bank were to remain independent, says Ely. The combined companies will be stronger and more stable, with more diversified operations and a commercial banking base. "The problem in the investment banking business is that history has shown it's a relatively more volatile business," he says. "From an investor perspective, you're damping down volatility. It's a reasonable [assumption]."

From SEC to FDIC

Ely thinks that in order for Morgan to tap into Wachovia's deposits for its capital needs, "some of the securities trading activities permissible for a bank may be moved under an FDIC-insured bank" for the sake of funding efficiencies," If that were to occur, those trades would shift from being under the oversight of the U.S. Securities &Exchange Commission, which regulates broker-dealers, to the FDIC, he adds.

To the extent that trading activities get moved from the broker-dealer to a bank, the bank may decide it wants to attract more deposits, he says. That would increase the FDIC's obligations as a guarantor but the FDIC would also be able to boost the income it gets from the premiums it charges on its insurance, he adds.

If both Morgan and Goldman end up in combinations with commercial banks, it would in one sense be a coda to the Gramm-Leach-Bliley Financial Services Modernization Act signed into law by President Bill Clinton in November 1999. That legislation repealed provisions of the Glass-Steagall Act, a Depression-era law that prohibited a bank holding company from owning other financial companies, such as investment banks.

Greater Regulatory Scrutiny

More surprising, in Ely's view, is that it took as long as it did for the two banking models, which he sees as needlessly separated, to come together again. The reason for the delay: Investment banks didn't want to become financial holding companies under Fed oversight because they considered the Fed heavy-handed in its regulatory measures.

But the various steps the Fed has taken to mitigate the credit crisis—particularly opening its discount window to broker-dealers in March after the collapse of Bear Stearns&mdashhave been pulling investment banks closer to the central bank's orbit of authority, and if the mergers occur, they would be firmly in that orbit, says Ely.

So whether Morgan Stanley or Goldman completes a tie-up with a commercial bank, the Wall Street firms will have to get used to greater regulatory scrutiny as officials scramble to avoid a replay of the Crisis of 2008.

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