By Heather Landy
Special to The Washington Post
Thursday, September 18, 2008
NEW YORK, Sept. 17 -- The traditional model of investment banking came under renewed threat Wednesday as Morgan Stanley and Goldman Sachs, the two remaining giants of this beleaguered Wall Street industry, suffered stunning losses only one day after they reported quarterly earnings that exceeded analysts' expectations.
Morgan Stanley shares plunged 24 percent. Its bonds also declined, while derivatives meant to gauge the likelihood of a bond default by the firm suddenly signaled impending doom.
Goldman Sachs fared only slightly better, with a 14 percent drop in its shares and derivatives spreads that did not imply default but a much higher risk of one.
The turmoil at the two vaunted institutions -- which only a year ago had the company of three other major investment banks -- follows an unprecedented week in American finance that has rattled investors, reshaped the landscape of the investment-banking business and raised questions about the viability of stand-alone brokerages.
In years past, brokerages could depend on a steady stream of short-term financing to keep their ledgers balanced. But now that the credit crunch has made it prohibitively expensive, if not impossible, to unwind positions in unwanted securities, lenders have become more reluctant to extend financing.
Those were the dynamics that pushed Lehman Brothers Holdings into bankruptcy and Merrill Lynch into the arms of Bank of America on Monday, and they had investors questioning whether the remaining independent brokerages could maintain enough confidence among lenders to keep their massive trading portfolios going.
The pain rippling across Wall Street was magnified by the brokerage industry's reliance on leverage, a strategy that allowed them to put up little of their own capital and place huge bets on investments mostly with borrowed money. While neither Goldman Sachs nor Morgan Stanley was as entrenched as Lehman in the mortgage markets, they, too, built up their proprietary trading portfolios with liberal use of leverage.
Morgan Stanley, which had tried to get out ahead of investor anxiety by reporting its earnings a day early on Tuesday, was sucked down Wednesday by the relentless undertow of the markets.
"I don't think you can justifiably suggest that Morgan Stanley shouldn't be a going concern. But we've moved past the idea of rationalization to one of palpable market panic, and it's tough to say exactly what's going to break that cycle," said Scott Colbert, director of fixed-income investments at Commerce Bank in St. Louis.
Morgan Stanley chief executive John J. Mack blamed the steep drop in the company's stock on short sellers who would profit from a decline in the shares.
In a memo to employees, Mack said he and fellow executives had contacted major shareholders, clients and counterparties, along with Treasury Secretary Henry M. Paulson Jr. and Christopher Cox, chairman of the Securities and Exchange Commission.
"What's happening out there? It's very clear to me -- we're in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down," Mack said in the memo.
Morgan Stanley and Goldman Sachs got support from the California State Teachers' Retirement System, which decided late Wednesday to stop lending its shares of the two companies to short sellers, who borrow stock in hopes of repaying it after the price has dropped.
Chris Ailman, chief investment officer of the giant pension fund, which is known as CalSTRS, wants other state pension funds to follow suit.
"It won't end the short selling but will make it tougher," he said.
But Morgan Stanley may have more than short sellers to worry about. The 73-year-old firm, which on Tuesday posted better-than-expected results for the third quarter, still has out-of-favor assets on its books, including mortgage securities and leveraged loans.
"I think there probably are people making a lot of money watching the stock drop, but there also has to be some reason why people don't take the other position" and buy it on its way down, said Thomas Cooley, dean of New York University's Stern School of Business. "There's just sufficient uncertainty. We don't know what's in their portfolios."
Investment and commercial banks already have taken billions of dollars of write-downs on assets that turned toxic in the subprime mortgage meltdown. But investors remain concerned about whether the firms are accurately pricing the assets and how quickly they will be able to get them off their books.
Those concerns, unfounded or not, led to Monday's Chapter 11 filing by Lehman Brothers and have put pressure on Morgan Stanley and Goldman Sachs to consider merging with a retail bank, as Merrill Lynch on Monday announced it would.
Goldman Sachs and Morgan Stanley officials boasted this week about the strong credit ratings they carry. "Yet, the tectonic shifts in risk and return could even force the better firms to link up with a depository bank," David Hendler, a financial industry analyst at the independent research firm CreditSights, wrote in a note to clients.
Some analysts suggested this week that the firms merge with retail banks so they would have access to a stable base of deposits. Although bank deposits could not be tapped to fund most of the investment-banking activities at Morgan Stanley and Goldman Sachs, they could give investors -- and the credit-rating agencies that often set the tone for the firms' relationships with lenders and trading counterparties -- peace of mind just by sitting on the balance sheet.
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