Investment banks reorganize

NEW YORK – The reorganization of Morgan Stanley and Goldman Sachs marks a historic end to a period of investment banks driving Wall Street and leaves open what – if anything – will assume the role of taking big risks that have powered the market’s booms and busts.

The move to convert to a commercial bank structure will help the two companies avoid the fates of Bear Stearns, Lehman Brothers and Merrill Lynch by giving them broader access to borrow federal money and the ability to build a stable base of deposits.

But it also likely means an end to sky-high profits that were topped by few other companies. The strict rules set by the Federal Reserve will limit opportunities for big payoffs from bets on the price of oil and other investments usually funded with borrowed money.

“The Fed is a much more intrusive regulator,” said Brad Hintz, an analyst with Sanford C. Bernstein and a former chief financial officer at Lehman Brothers.

Investment banks provided a wide variety of services, from managing initial public offerings to repackaging and selling various forms of debt to trading of stocks and bonds.

They profited from deals completed with borrowed money and took risks that commercial banks either opted not to or were unable to because of regulations.

The absence of stand-alone investment banks will leave a void in proprietary trading, which is when a financial company uses its own money or borrowings instead of clients’ cash to complete trades. Those units – which were often responsible for making billions or losing billions – placed big bets on interest rate changes and commodities prices.

The investment banks had been the biggest players in such trading. Now, experts expect smaller companies – including private equity firms and hedge funds – to take their place.

Boutique investment banks, which are similar to Morgan Stanley and Goldman but on a much smaller scale, could step in to take up some of the action, said Dave Ellison, the president and fund manager of FBR Funds – a unit of Friedman, Billings, Ramsey Group Inc.

“The smaller companies are winners a little bit,” Ellison said.

Those companies include Keefe, Bruyette & Woods Inc., Stifel Nicolaus Corp. and Friedman, Billings, Ramsey Group, he said.

Spreading the risk among smaller players and increasing competition for business could help the financial sector.

But, with tighter regulations that will help reshape Wall Street, Goldman and Morgan Stanley will also now have access to more federal money to shore up their global operations. Previously, they only had temporary access to borrow from the Fed for U.S. operations, Hintz said. Now, as bank holding companies, they can help support their entire global operations with Fed funding.

The pair can also now build up deposit bases, but analysts predict Goldman and Morgan Stanley are unlikely to make a splashy purchase of a large retail banking institution anytime soon.

Banking industry consultant Bert Ely doubts either will pursue embattled Washington Mutual Inc. He thinks JPMorgan Chase & Co. or Citigroup Inc. are more likely buyers.

In a bid to shore up its balance sheet and further restore investor confidence, Morgan Stanley on Monday agreed to sell a 20 percent stake in itself to Japan’s biggest bank for about $8 billion.

The investment by Mitsubishi UFJ Financial Group Inc., which has $1.1 trillion in deposits, is the first step in this process of strengthening its balance sheet. Morgan Stanley’s profit fell 41 percent during the nine months ended Aug. 31, compared with a year ago.

Most recently, the investment banks have come under pressure because of the collapse of the real estate market. Investment banks made money by purchasing pools of mortgages, combining them into larger securities and selling them in slices to investors.

Since the housing bust, the financial services industry has lost more than $500 billion.

The housing bust and ensuing credit crisis forced Bear Stearns Cos. into a sale to JPMorgan Chase & Co. at a steep discount in March. Lehman Brothers Holdings Inc. declared bankruptcy last week. And Bank of America Corp. announced it was buying Merrill Lynch & Co.

Shares of both Morgan Stanley and Goldman Sachs had slumped in recent weeks as fears grew that hedge funds and other large clients would pull out their money. Those worries intensified after Lehman’s bankruptcy left some hedge funds unable to access their money.

As credit problems hastened in recent weeks, it was increasingly difficult for investment banks to fund their operations, especially internationally, Hintz said.

“The natural response for dealers is to be conservative and pull back,” Hintz said.