Issue of the week: Investment banks, RIP

And then there were none. When investment banks Goldman Sachs and Morgan Stanley converted to federally chartered commercial banks this week, said Joseph Weber in BusinessWeek, Wall Street as we know it came to an end. Following the Washington-driven takeover of Bear Stearns by JPMorgan Chase, the bankruptcy of Lehman Brothers, and Merrill Lynch’s flight “into the waiting arms of giant Bank of America,” Goldman and Morgan were the last two major independent investment banks left standing. Now they’ve junked their old business model, moving to replace the short-term loans that once funded their activities with long-term customer deposits. Their new structure is designed to reassure skittish investors, and it seems to have worked: A day after the announcement about Goldman’s and Morgan’s new status, Warren Buffett’s Berkshire Hathaway bought $5 billion of Goldman preferred shares. But the banks’ newfound stability comes at a high price. A demanding new regulator, the Federal Deposit Insurance Corp., will replace the hands-off Securities and Exchange Commission and force the banks to abandon their “swashbuckling, risk-taking, and financially ingenious” ways.

Wall Street’s self-styled “Masters of the Universe” may have brought this fate upon themselves, said David Leonhardt in The New York Times, but they had plenty of help from Washington. When dot-com stocks’ house of cards came crashing down in the late 1990s, Alan Greenspan’s Federal Reserve, in a bid to keep investors investing, slashed short-term interest rates to near zero—and kept them there. Further encouragement to borrow came from the SEC, which in 2003 allowed the investment banks to borrow up to 30 times their own capital, far more than their previous limit of 12 times capital. They sank that borrowed money into the housing boom, concocting exotic securities that “sliced mortgages into so many little pieces that they forgot what they were really trading: contracts based on increasingly shaky loans.” When home­owners stopped paying, the investment banks had no cash flow to repay their own debts.

Now we’ll see what emerges from “the most catastrophic shift among investment banks” since the Great Depression, said Philip Augar in the Financial Times. “In one sense, not much will change.” The firms will still trade securities for themselves and their customers, raise capital for clients, and advise on mergers and acquisitions. But they’ll have new competition from hedge funds and private-equity firms. And because the FDIC will rein in their speculative trading, the investment banks will likely return to their roots as financial advisors to corporations. The investment banks that once towered over the markets may be dead, “but I would be very surprised if we have seen the death of investment banking as an industry.”

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But we will see many small regional banks disappear, said Ambereen Choudhury in Bloomberg.com. Goldman and Morgan Stanley are rushing to build up their deposit bases “by going after retail and corporate banking customers.” The quickest way to acquire those customers is to buy commercial banks. Big banks aren’t likely to sell out, but “regional banks will probably become lunch” for Goldman and Morgan. Bon appétit.