Goldman Sachs, Morgan Stanley: Playing It Safer

From now on, the chastened investment banks will act more like conventional big banks, prudent and risk-averse

by Joseph Weber

With their historic moves to become commercial banks, Goldman Sachs Group (GS) and Morgan Stanley (MS) have ducked the financial disaster that befell bankrupt Lehman Brothers (LEH) and led to panic sales for Bear Stearns (JPM) and Merrill Lynch (MER), but the firms will never be the same. The swashbuckling, risk-taking, and financially ingenious investment banks that produced stellar returns for years—and turned Wall Street into a stunningly lucrative place for even the most junior staffers—are fast becoming distant memories. Instead, Wall Street observers say, these firms will now operate like conventional big banks whose bywords will be prudence, far more careful risk management. and less of the financial inventiveness that spawned the subprime crisis and its myriad toxic offspring.

"It's the end of an era of extraordinary leverage," says Sherry Cooper, global economist strategist for Toronto's BMO Financial Group. "The U.S. financial system is deleveraging, and the 25-to-1 or 30-to-1 leverage ratios at those institutions are just not tolerated any longer by the financial markets. Now, under traditional banking regulation, they have to have more capital and less leverage. So their proprietary trading desks won't be nearly as active or taking as much risk as before."

Way Less Rewarding

The conversion of the two firms into traditional bank holding companies, agreed to on Sept. 21 by the banks and the Federal Reserve, could mean big staff changes as high-powered investment bankers and damn-the-torpedoes traders may find them less rewarding places to work. Shareholders may also have to adjust to far lower gains. Analyst Michael Hecht of Bank of America (BAC) predicts "a reduction in risk appetite (and hence, also lower returns)." Annual returns on equity, which have averaged a stunning 22.1% at Goldman and 19.5% at Morgan since 1999, may drop to as little as 13%, closer to those of conventional bank holding companies, Hecht warns.

Despite the change, Goldman officials are sticking by their high expectations. The firm intends to average 20% returns on equity over five years or so and can do so because "leverage is only one element of profits," says Goldman spokesman Lucas van Praag. The firm, he adds, will gain the ability to borrow from the Federal Reserve, the lender of last resort, which should shore up confidence among the insurance companies, pension funds, and other lenders it deals with regularly to fund its operations. Its business strategy—advising clients on financing and managing investments—will proceed unchanged, he argues. Even Goldman's commodities trading operations will continue, since the firm won a special exemption from restrictions that preclude commercial banks from much of that business.