Greed is no longer good on Wall Street
Goldman Sachs and Morgan Stanley are unlikely to do away with the investment banking model. But they will probably become smaller, safer and less sexy.
NEW YORK (CNNMoney.com) -- These are certainly strange times for Wall Street. Government regulation threatens to give the industry a massive overhaul and job losses continue to mount.
Lehman Brothers seemed invulnerable just a year ago before vanishing virtually overnight last month. Merrill Lynch (MER, Fortune 500) leapt into bed with Bank of America (BAC, Fortune 500) in order to live another day.
That's right. These blue-blood investment banks are now relying on the pedestrian business of attracting deposits to raise cash.
But can you blame them? Much of the business that came to define these two Wall Street fixtures has dried up in recent months. Not a single U.S. company has gone public since mid-August and other than a flurry of deals in the financial services sector, merger activity has been moving at a snail's pace.
Investors have certainly recognized this -- shares of Goldman and Morgan have fallen 44% and 61% respectively just since Labor Day.
"People's concerns are still focused on the business model," said Mark Lane, equity research analyst for William Blair & Co.
The recent conversion by Goldman and Morgan to bank holding companies suggests that both firms will make the transition to some sort-of financial services "supermarket" model like Citigroup (C, Fortune 500) and JPMorgan Chase (JPM, Fortune 500).
Just this week, Morgan Stanley revealed that such plans were well underway, as it had raised $3 billion in certificates of deposit (CDs) in the last four weeks. The New York City-based firm added that it would market other savings account products to its financial advisory clients next year.
Goldman Sachs appears to not have enacted similar measures, although that could happen soon enough.
There has also been speculation that either firm could soon scoop up one of the growing number of troubled traditional banks.
Both companies certainly have the financial wherewithal to do so.
Earlier this month, Japanese financial firm Mitsubishi UFJ finalized a deal to take a 21% stake in Morgan Stanley for $9 billion. Warren Buffett's Berkshire Hathaway announced last month it was investing $5 billion in Goldman Sachs.
And the government injected $10 billion into each company earlier this month as part of its broader rescue package.
Purchasing a bank would help put to rest some concerns surrounding Goldman and Morgan about funding. Unlike traditional commercial banks which rely on deposits, securities firms depend on short-term funding sources, which essentially stopped flowing after Lehman collapsed in September.
But industry experts have largely downplayed the idea that American consumers will soon be writing checks emblazoned with a Goldman Sachs or Morgan Stanley logo. For one thing, Goldman and Morgan would have a difficult time absorbing a branch network.
"There's not a lot of benefit," said Richard Staite, a London-based banking analyst with Atlantic Equities who tracks Goldman Sachs. "You would end up with two very separate businesses."
There have also been rumors, however, that Goldman or Morgan could merge with Citigroup. And there has even been chatter about a marriage between Goldman and Morgan.
But given all the steps the government has taken since then to keep both firms alive, a combination of the two seems pretty unlikely, according to industry trackers.
Still, analysts are cautious about the prospects for both firms in the next few months as well as the long-term.
Goldman and Morgan are expected to remain profitable in the coming quarters. But neither firm is likely to deliver the same record-setting numbers they did in recent years at least through 2010, according to analysts' estimates.
Both companies should enjoy a flood of new business once capital markets activity picks back up again. But the risk of additional writedowns in the next quarter and in early 2009 remains.
For this reason, the firms are probably going to emphasize some of their more stable, albeit less exciting, businesses.
David Killian, portfolio manager at Valley Forge Advisors in Malvern, Penn., which oversees about $600 million in assets and owns shares of Morgan and Goldman, expects both firms to look to businesses outside of investment banking or sales and trading to pick up the slack.
That includes asset management, which is highly profitable and doesn't require a lot of capital. But it may not yield the type of eye-popping returns that investors grew used to seeing from the two firms.
"They are going to have to run their business with an eye towards generating the types of profits their shareholders have become accustomed to with lower levels of risk and leverage," said Killian. "That is quite a challenge."