...and then there were two

Of the five big stand-alone investment banks, only Goldman Sachs and Morgan Stanley remain. Even these folks have been hit, though. Goldman has shown a 70% drop in third quarter net income. Morgan is looking at Wachovia for a merger, who, interestingly enough, has hired Goldman to look for potential merger partners. How has Goldman done so well? A commentator noted how Goldman mentioned last year that they were net short, effectively shorting indexes of all of the bonds which they were selling. I had mentioned this concept only a few weeks ago, but cited it only as a general business strategy. The commentator in fact saw it as a "predatory" action, due to the fact that Goldman is selling to customers (the bond purchasers) products which they personally don't have faith in.

If we are going to see Morgan and Wachovia merging, and perhaps Goldman at some point down the road, this brief article does a good job at describing the nature of combining investment and commercial banks, as it pertains to risk and loans.

“There’s a prevailing sense that the business model of the free-standing, highly leveraged investment bank that funds itself in the wholesale financial markets is virtually kaput,” Willem H. Buiter, a professor at the London School of Economics, told the New York Times this week.

“The pure investment bank was an American specialty,” he added. “But we’ve now seen three major American investment banks go down, so this model looks like a weakness, not a strength in a down market.”

What is the advantage of a merger with a commercial bank? To cite this article, the large pools of capital that come from retail banking deposits - your and my money. Because there is so much stable money in retail banking, made safe by the FDIC's insurance, retail banks receive greater credit ratings, which makes it easier for them to raise capital. 

Goldman doesn't necessarily need these deposits:

That’s because a large amount of what Goldman Sachs invests in is considered riskier than the bread-and-butter loans that commercial banks make with deposits. If Goldman were to become part of a commercial bank, those deposits couldn’t be used to support the vast majority of its investments.

Meredith Whitney, an analyst from Oppenheimer, was quick to respond on the conference call, telling Mr. Viniar, “Obviously, you can’t fund capital market activities with deposits, but your overall credit rating as seen by the rating agencies would improve because of diversification. So there would be a benefit.”

Whether or not Goldman's shareholders will agree to this when a good purchase offer comes around is a different story.

And finally, this comment comes from Judey, and one which I'm sure we'll be hearing a lot more of, as the fallout of this market tends to lead towards more conservatism.

The Glass Stiegal was put in place during the Depression for a reason. Having banks which have access to low cost federally insured deposit funds is just another way to have a government subsidy for investment banking.Its repeal was dangerous. Merging with banks is another even more insidious way to to subsidize risk taking.We need to learn from history. We must stop and investigate and regulate market manipulation. We must put the brakes on short sellers. The bear raids must be stopped. The uptick rule must be restored in addition to stopping naked shorts. And the uptick should be at least .05.

Most people expect this crisis to take ages to finally erode away, but I have more faith than Judey in the after-shock. People will be looking for a solution, and I'm sure that is going to come from strict regulation changes. Most likely, as the US continues to switch to IFRS accounting standards (a topic that has obviously taken a back seat to the credit crunch and sub-prime write downs), I believe will see a more international standard of regulation as well.