Can Morgan Stanley and Goldman Sachs Go It Alone?

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Spencer Platt / Getty

A trader works on of the floor of the New York Stock Exchange on the worst single day loss since 9/11

When a company's stock gets beaten down in the market, its CEO often clamors about how short sellers and unjustifiably negative market sentiment are to blame. That's not always the case, but on Sept. 17, John Mack may have had a point.

Morgan Stanley, which Mack heads, and Goldman Sachs — the only stand-alone U.S. investment banks left after the collapse of Lehman Brothers and the sale of Merrill Lynch — saw their shares plunge by 24% and 14%, respectively. Morgan Stanley and Goldman haven't been without their problems, but they are viewed as the two most conservatively run investment banks — ones that have largely avoided the souring mortgage-related assets that have seized up the global financial system. Both firms reported better-than-expected, but by no means stellar, earnings just the night before.

And yet in the wake of the government's unprecedented take-over of insurance giant AIG, the shares were punished. Mack got in touch with the chairman of the Securities and Exchange Commission and the Treasury Secretary, and then sent out an e-mail to employees: "It's very clear to me," he wrote, "we're in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down."

Sept. 17 was a fearful day, that's for sure. The $85 billion lifeline the government threw to AIG may have prevented a total meltdown, but the Dow industrials still finished 449 off points for the day. The price of gold shot up by about $80 an ounce and the yield on the three-month Treasury bill maturing Dec. 18 dropped to 0.04% — from 0.68% the day before. "It's a total flight to quality, which points to the sheer panic that's out there," says S&P Equity Research strategist Alec Young.

In an attempt to bring some stability to markets, the SEC announced a ban on naked short selling, the aggressive practice of betting on a stock's fall without first borrowing shares. But that did nothing to quell widespread speculation about which struggling financial institution would be the next to disappear. British bank Lloyds was in talks to buy beleaguered U.K. mortgage lender HBOS. Washington Mutual, the U.S.'s largest thrift, put itself up for auction, and Wells Fargo and Citigroup might be interested, according to reports. Morgan Stanley appeared to be on the table too. There were murmurs the investment bank was holding conversations with Charlotte-based bank Wachovia. Chinese conglomerate Citic Group, owner of China Citic Bank, was also said to be sniffing around.

That Morgan Stanley might be up for sale had an element of surprise to it. Analysts were generally pleased with what executives at Morgan Stanley — and Goldman Sachs for that matter — had to say in recent conference calls. Glenn Schorr, a banking analyst at UBS, wrote that both firms have strong capital and liquidity positions, and they have reduced their exposure to problem assets and "priced remaining exposures at what we think are reasonable levels" and "don't have the same concentrations risk issues that the others had."

But some industry experts say the stand-alone investment-bank model is no longer working. Investment banks made buckets of money for many years by tapping capital markets and leveraging to the hilt. But with credit drying up, financing activities with deposits — like commercial banks do — appears to be a better strategy. Commercial banks like Wachovia also have fairly conservative caps on the amount of leverage they use, which affords them greater flexibility during periods of financial-system stress.

There are, of course, defenders of the stand-alone model. On Goldman's conference call, CFO David Viniar dismissed the notion that Goldman would be better off with a deposit base, saying that because of regulatory constraints, only a "small portion" of Goldman's business could be funded that way. "We think it's not about the model. It is about the performance of the company," he said.

But Marc Martos-Vila, a professor of finance at UCLA's Anderson School of Management, says it might also be about the state of financial markets. Mergers and buyouts, he notes, often come in waves. "The first merger tells the market something, and then other companies, to be competitive, try to make a move," he says. First Lehman, then Merrill, then ... But does this mean the stand-alone investment bank is no longer viable? "In the short term, it doesn't seem like it is," Martos-Vila says. "But when confidence is restored in the market and they move to another type of risk, who knows?"

(See the winners and losers of the Wall Street mess here.)