The End of an Era on Wall Street

An era came to an end last night, as Goldman Sachs and Morgan Stanley threw in their towels and asked the Federal Reserve to recognize them as banks. The investment bank boom on Wall Street that was led by Bear Sterns, Merrill Lynch, Lehman Brothers, Goldman Sachs and Morgan Stanley has come to an abrupt end.

Bear Stearns was rescued, while Lehman closed its doors. Merrill Lynch was bought out by Bank of America; Goldman Sachs and Morgan Stanley will become regular banks (unless someone buys them out, too).

What’s the difference between an investment bank and regular bank? An investment bank takes borrowed capital and uses it for its investing activities with very little regulation between what it borrows and what it invests. For example, Morgan Stanley held $20.00 in assets for every $1.00 of shareholder equity.

Banks are highly regulated (compared to investment banks) by the Fed and can only lend out a percentage of the deposits they have on hand from customers. Goldman and Morgan Stanley will now need to build their deposit base so they can rely on their deposits from customers instead of using borrowed money.

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Goldman and Morgan Stanley are basically going to deposit banking (using regulated deposits of customers) from investment banking (using borrowed money to invest). Goldman and Morgan Stanley already had more than $20.0 billion each in customer deposits at the end of the second quarter.

What does this all mean for investors like you and me?

Firstly, investment banks are wiped out…gone. And so are the big bonuses on Wall Street. Jobs will be lost. The 25,000 job losses at Lehman were just the beginning. Expect to see 100,000 white collar jobs gone from Wall Street. And all those real estate gurus (including Donald Trump) who told us New York real estate was immune to a slump are in for a rude awakening.

The days of the highly leveraged buyouts, financed by investment banks, are gone…which is a good thing for investors. Maybe we can all start investing again in companies that actually produce a product or sell a service. Personally, I believe the withdrawal of the investment banks makes it safer for investors…somewhat of a regression to the mean.

As for the stock market, it likes what the Fed and Secretary of the Treasury are doing for investors. I was around in the days of the Resolution Trust Corporation (it was set up for the assets of the savings and loans crisis) and it was a great idea. The Fed is basically doing the same thing again, only this time with troubled loans.

The stock market continues to be very resilient. As soon as the Dow Jones Industrial Average got down below its July low, it rallied a good 700 points. Trading over the next few days and weeks will be very important for overall direction. I’ll keep you posted.