BHC or Bust
The news that Goldman Sachs (GS) and Morgan Stanley (MS) are in the process of becoming Bank Holding Companies (BHCs) doesn't come as a complete surprise. If these firms were to remain independent, they had to radically reposition their balance sheets by bolstering capital and lengthening debt maturities. Further, the trend towards greater transparency is already afoot, so the kinds of disclosures required under the BHC Act were in the offing, anyway. Finally, by becoming a BHC you have access to the Fed window, access which is of some consequence given today's tumultuous market conditions. So by becoming a Bank (with a capital B) in the regulatory sense of the word, Goldman and Morgan Stanley are choosing life, with the chance of remaining independent. The question is - what kind of a life will it be?
One of the best things about being a Bank is the ability to take deposits. Few things are better in liability-land than core deposits, that sticky, low-cost source of financing that makes every other industry drool. Having deposits as part of the capital structure means that unless you screw things up pretty badly, you've got a stable, long-term source of funds to help support investment activities. But I have two questions when thinking about the former Houses of Goldman and Morgan Stanley becoming banks:
- Are they really going to take in core deposits and run branch networks?; and
- If so, is the FDIC (and, by extension, taxpayers) on the hook if the banking side of the house blows up?
Is the Glass (Steagall) Half Full or Half Empty?
In the topsy-turvy world of bailouts and rule changes, are the principles of Glass-Steagall gone forever? Is the FDIC effectively backstopping trading activities? If so, this is both wrong and terribly dangerous, yet another way of privatizing gains and socializing losses. If this is the path the Fed, Treasury and Congress want to take (by having former bulge-bracket firms become BHCs), then I'd recommend very clear fire-walls between the banking and trading and deposit-taking sides of the house. If stock and bond holders buy paper in the Bank, and if trading does badly, they should suffer - not the taxpayer. Otherwise, we'll just be perpetuating the asymmetry between private investors and the U.S. taxpayer (heads I win, tails you lose).
But what of the "new" Goldman and Morgan Stanley's business activities? The cost of capital just skyrocketed because of forced de-leveraging, and by now becoming BHCs this deleveraging is a permanent state of affairs. They need to be much more capital efficient and to focus on high-margin businesses. Asset Management. Private wealth management. M&A advisory. Restructuring advisory. Trading portfolios that are highly diversified with buckets of orthogonal risk. Otherwise, these firms will establish an entirely new - and lower - level of base-line Returns on Equity, and will begin to trade at multiples of book that are more bank-like. Question is, will this business mix restructuring lead to a place that is less attractive to top performers?
Will top traders want to live inside this kind of institution instead of hedge funds? Will advisory pros rather be at this kind of firm or at a Greenhill, Lazard, Evercore, or one of a scad of new vertically-focused boutiques? As noted previously, I believe we will have a small number of global capital markets behemoths that will run the capital formation process for the largest companies (as an oligopoly), and a large number of boutiques focusing on advisory services, private placements, alternative investment management and perhaps the high end of private wealth management.
Will Goldman and Morgan Stanley make the jump to behemoth (with a more stable, longer duration capital structure to support such a business) or pull back on focus more intensively on high fee-generating, less capital intensive businesses? I'm guessing they'll go for being a behemoth but it is not clear that this is ultimately best for shareholders.
Bailout 2.0 - Just Give me your Tired, Your Weary...
And what about the bailout plan? Without question, the pure 1980s RTC structure was easier to implement because the Government simply took over the assets and liabilities of failing firms and worked them out. But in a regime where this is not viewed as desirable from a regulatory perspective, complexity needs to be dealt with fairly and with an eye towards the ultimate goal: getting the wheels of the credit markets going again and enabling mortgage debtors who are able to pay a restructured obligation to stay in their homes. Mechanically, I see it happening as follows:
- The Government-sponsored bailout vehicle (Principal Loan Origination Program, or PLOP in my vernacular) sets parameters around pools of assets it is willing to purchase. This approach is similar to a bid sheet in a program trade - tell me the characteristics of the portfolio, and I will make you a price. This is an efficient way to get bids and offers on a hetergeneous pool of assets. This will likely include illiquid mortgage securities, leveraged lending commitments and derivatives held by troubled firms.
- PLOP collects offers, and either starts from the bottom and buys them up or sets a single clearing price that is paid to all parties. This will ensure transparency and fairness; the after-tax difference between the PLOP price and the carrying value will be a direct reduction of book value.
- The gap between post-sale book value and regulatory capital requirements will either be sourced privately or through the PLOP. If through the PLOP, it will be in the form of a convertible debt instrument or debt + warrants senior to both debt and equity holders. This reflects the fact that taxpayers are giving this firm life, and should benefit from its rebirth after being recapitalized.
- The PLOP will work out troubled assets over time, and will eventually float the equity participations it receives in the firms it has bridged.
One thing is for certain: the Wall Street of tomorrow will look very different than the Wall Street of today. A handful of global giants. A large number of profitable, focused specialty boutiques. Quite similar to the trend in the hedge fund industry. The barbell is the shape du jour. Very big and quite small. Both can and must exist. But the middle, once again, will get squeezed.
A more thorough and cogent take on the mortgage piece is provided by John Hussman. It is definitely worth a read.