New world on Wall Street

Goldman Sachs and Morgan Stanley to face more oversight from the Federal Reserve. Change provides more funding and opens door to more mergers.

By Tami Luhby, CNNMoney.com senior writer
Last Updated: September 22, 2008: 7:19 AM EDT

NEW YORK (CNNMoney.com) — And then there were none.

Federal regulators converted Wall Street’s remaining stand-alone investment banks – Goldman Sachs (GS) and Morgan Stanley (MS) – into bank holding companies Sunday night.

The move allows Goldman and Morgan to scoop up retail banks and to streamline their borrowing from the Federal Reserve. The shift also is aimed at removing them as targets of nervous investors and customers, who brought down their former rivals Bear Stearns (BSC), Lehman Brothers (LEH) and Merrill Lynch (MER) this year.

But it also puts Goldman and Morgan under the Fed’s supervision, increasing the agency’s regulatory oversight and possibly forcing them to raise additional capital. As banks, Morgan and Goldman will be forced to take less risk, which will mean fewer profits.

And it brings to a close the era of the Wall Street investment bank, a storied institution that traded stocks and bonds, advised mergers and showered lavish bonuses on its executives.

“The separation of investment banking and commercial banking has come to an end,” said Bert Ely, an independent banking consultant.

The conversion is but the latest in a series of unprecedented events on Wall Street as it convulses through the global credit crisis. In the past eight days, the federal government announced a $700 billion plan to rescue the financial sector by buying up troubled mortgage assets and an $85 billion emergency loan to insurance titan American International Group (AIG). Also, Lehman filed for bankruptcy and Bank of America (BAC) took over Merrill Lynch.

Morgan and Goldman, whose shares plummeted last week before the $700 billion bailout was unveiled, will likely avoid those fates with the conversion, experts said.

“They were afraid they’d get killed if they didn’t [convert],” said Christopher Whalen, managing director of Institutional Risk Analytics. “The Fed is scrambling to take the remaining targets off the radar.”

Beefing up the retail banks

The duo is expected to quickly add to their tiny existing retail banking divisions, which will give them access to a cheaper and more stable source of funding – customer deposits – rather than the volatile short-term funding they rely on. The companies, which both requested the conversion, signaled as much in separate press releases Sunday.

They have plenty to pick from now that the credit crisis has devastated the banking sector.

Morgan, which has $36 billion in deposits, may already have a partner in mind. Rumors have flown on Wall Street in the past week that it would hook up with Wachovia (WB), a large but troubled bank. Sunday’s shift would make such a merger easier.

With $20 billion in deposits, Goldman said it plans to grow its deposit base through acquisitions and internally. It is also shifting assets from other divisions into its Goldman Sachs Bank USA, which will become one of the 10 largest banks in the United States with $150 billion in assets.
Access to the Fed funding

The action also solidifies their standing with the Fed. While the investment banks received emergency access to the Fed funding in the wake of Bear Stearns’ demise in March, Goldman and Morgan will now have all the same privileges at the Fed lending window as their banking peers.

As part of Sunday’s move, the Fed extended additional credit to Goldman and Morgan, as well as Merrill, allowing them to pledge a wider array of collateral.

The companies also hope the shift will end investors’ fears that the investment banks are not solid enough to survive.

“This new bank holding structure will ensure that Morgan Stanley is in the strongest possible position,” said John Mack, Morgan’s chief executive. “It also offers the marketplace certainty about the strength of our financial position and our access to funding.”

“We believe that Goldman Sachs, under Federal Reserve supervision, will be regarded as an even more secure institution with an exceptionally clean balance sheet and a greater diversity of funding sources,” said Lloyd C. Blankfein, Goldman’s chief executive
Turmoil on Wall Street

The Fed’s decision is just the latest in a dizzying series of events over the past week representing a dramatic reordering of the financial world.

All eyes now turn to the troubled traditional banks, such as Washington Mutual (WM, Fortune 500) and Wachovia, which are scrambling to shore up their books as lending has frozen up and investor confidence has sunk.

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