Investment banks change up the game

NEW YORK -- The reorganization of Morgan Stanley and Goldman Sachs marks a historic end to a period of investment banks driving Wall Street. It leaves open what -- if anything -- will assume the role of taking the 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 the 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.

Investment banks provided an array 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 often were 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. Smaller, boutique companies -- including private equity firms and hedge funds -- are expected to take their place.

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

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 had only 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.

What's the next move?

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. He thinks JPMorgan Chase & Co. or Citigroup 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, 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 the year-ago period.

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.

Perhaps aware of these risks, government regulators moved quickly. The Office of the Comptroller of the Currency conditionally approved the application of Morgan Stanley Bank of Salt Lake City to convert to a national banking association. And the Fed waived its five-day review and allowed the banks immediately to tap the Fed's borrowing window.

Morgan Stanley shares surged more than 17 percent in early trading Monday before ceding the gains as the stock market tumbled. They finished the day down 0.4 percent, and Goldman Sachs shares fell almost 7 percent.