Goldman, Morgan Rewrite Playbooks

Having come face-to-face with their own mortality, Wall Street rivals Goldman Sachs Group Inc. and Morgan Stanley are doing things they wouldn't have imagined just months ago.

They have diluted existing shareholders, pushed for rules that are an anathema to many free-market champions and rewritten their corporate charters to become commercial banks -- a business they had regarded as beneath their pedigrees. Morgan Stanley is even considering adding automated teller machines inside its brokerage locations, say people close to the firm.

But as a fuller picture emerges of the threat arising between Sept. 16 and Sept. 22, it is clear the banks had little choice but to defuse the danger through aggressive moves. Interviews with people inside the firms as well as others involved with the crisis reveal how unexpected market events forced the firms into drastic action.

As late as Tuesday, Sept. 16, both firms projected the image that they could weather the storm without any big changes.

The markets weren't listening. Despite reporting positive earnings on the 16th, both Goldman and Morgan Stanley saw their shares drop amid concerns about ripple effects emanating from insurer American International Group Inc.

The next day, as Morgan Stanley shares plummeted 24%, Chief Executive John Mack phoned Goldman CEO Lloyd Blankfein, legislators, regulators and Bush administration officials including Chief of Staff Joshua Bolten to underscore the hit to the firm's stock price. Goldman shares, which dropped 14%, were faring badly, too.

There was "real fear" inside Goldman, according to one executive there. While Goldman and Morgan Stanley have navigated the credit crunch better than many peers, they had seen others fall with increasing speed, even after they had taken steps like capital raises to address their problems. Investment banks' business models include making big trading bets with borrowed money and constantly revaluing inventories in volatile and sometimes illiquid markets.

When financial firms like Morgan Stanley and Goldman lose the market's confidence, they lose customers, trading partners and -- with surprising rapidity -- their ability to survive. In the week ended Sept. 19, for example, Morgan Stanley lost about a third of the assets in its prime-brokerage business, a person familiar with the matter said, as clients looked to move assets to bigger commercial banks that are perceived as safer.

During phone conversations, both CEOs said they needed new, emergency rules to prevent abuses in the market by investors betting on drops in Morgan Stanley and Goldman shares. The Securities and Exchange Commission had passed other rules to limit the bets, known as short sales, but hadn't taken the more radical step of temporarily banning short sales on financial stocks.

It was an ironic plea. Both Goldman and Morgan service scores of hedge funds, which depend heavily on the ability to short stocks. The two also lend out shares used by others to short. The firms knew that they would face some angry clients by calling for restrictions against a popular investment strategy, but they felt they needed to restrict abuses and protect themselves. The SEC on Friday, Sept. 19 enacted the temporary ban.

Meanwhile, Mr. Mack was trying to raise more capital from an outside investor, even though the firm says it doesn't need to raise new funds until mid-2009.

With Morgan Stanley shares declining sharply Wednesday, Sept. 17 and in the early part of Thursday, Sept. 18, investors were demanding action. A vote of confidence from an outside investor was one way to do it. Mr. Mack jumped into merger talks with Wachovia Corp., the Charlotte, N.C., bank that at the time still seemed stable enough to pull off a deal. Morgan Stanley also called China Investment Corp. to see if it would be interested in adding to its existing $5 billion investment.

CIC was a name that had also been floated in discussions held by Goldman executives as they considered their own options for raising capital. At Morgan, both options ran into problems. Friday, Sept. 19, bankers in Morgan Stanley's Tokyo office reached out to Mitsubishi UFJ Financial Group and Mizuho Financial Group to see whether they would want to make an investment and possibly offer a credit line to Morgan Stanley.

Phoning the Fed

Morgan Stanley had also just phoned the Federal Reserve Bank of New York to rush through an application for Morgan Stanley to become a commercial bank holding company. Morgan Stanley turned in the materials Saturday and achieved an approval Sunday night, a process that usually takes weeks or months. Mr. Mack had hoped to sign the papers quickly to restore confidence, which was still shaky despite the announcement of a possible U.S. bailout plan for the financial sector.

In the days before the approval, Mr. Mack and his senior team worked nearly nonstop, speaking with Federal Reserve Bank of New York President Timothy Geithner and Secretary of the Treasury Henry Paulson about details of the commercial-banking plan.

The plan would entail an ambitious expansion of Morgan Stanley's relatively small business for holding the deposits of banking customers. Currently an afterthought with only $36 billion in deposits, Morgan's bank would now hope to grow several times that large in an effort to increase the reliability of its funding base.

As Goldman's shares swooned during the week of Sept. 15, employees wondered aloud about the future of their company, long regarded as a peerless manager of market risks. Some discussed the idea of buying back Goldman shares in hopes of boosting its stock price, and many worried about their own employment and net worth if the company became the next domino to fall.

Amid the worries, Mr. Blankfein caucused with his brain trust -- Co-Presidents Gary Cohn and Jon Winkelried, Chief Financial Officer David Viniar and others -- about the holding-company application and the possibilities for raising capital.

Everything was on the table, say people familiar with the conversations, but one given was that no matter what, the firm and its competitors would soon find themselves under greater regulatory scrutiny by the Federal Reserve and others.

Over the weekend, Goldman submitted its application to become a bank-holding company. In discussions with both firms, say people familiar with the matter, Mr. Geithner had made one point particularly clear: If only one of the two firms were to seek bank-holding status, he feared for the safety and soundness of the one that didn't. It felt important, he argued, that both Goldman and Morgan move in tandem, these people add.

Morgan Stanley also pleaded with Mitsubishi UFJ officials that they needed to announce a deal by Monday. At first, the Japanese bank was reluctant to move quickly, but by Sunday, Sept. 21, talks had resumed with two banks agreeing to announce a deal the next day. The separate bank-holding-company move, approved Sunday night, made a credit line unnecessary, because it would allow Morgan Stanley to tap the Federal Reserve's lending facilities permanently.

The change into a commercial bank could have wide-ranging implications. It will subject both banks to tougher oversight by the Federal Reserve, which will set up permanent staff at the two banks. It will put more of both banks' client accounts under the protection of the Federal Deposit Insurance Corp., but potentially limit some lucrative, but riskier, strategies, such as borrowing heavily to make trades and operating real-estate assets.

Morgan Stanley ATMs?

For Morgan Stanley, it could mean adding banking services such as automated teller machines to its 500 retail-brokerage branch offices in the U.S. And, for both companies, it could mean buying up deposits from battered banks to get more stable funding sources than they have had in the past.

The stocks have recovered from their previous lows. But the firms aren't out of the woods yet. Morgan Stanley shares are down 10% since the initial announcement of the Mitsubishi UFJ deal, while Goldman's have risen about 8% since a $5 billion investment from Warren Buffett's Berkshire Hathaway Inc.

Default protection on Morgan Stanley debt has remained expensive, a sign that concerns about its future haven't dissipated. Both firms could benefit from passage of the bailout plan, as well as from continued restrictions against short-sellers.

Source: The Wall Street Journal