Goldman and Morgan's Crisis of Confidence

Goldman Sachs and Morgan Stanley are victims of declining confidence in investment banks in general.
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Updated from 12:27 p.m. EDT.

Goldman Sachs

(GS) - Get Report

and

Morgan Stanley

(MS) - Get Report

shares each were plummeting Wednesday, as the only two remaining independent major broker-dealers came in the crosshairs of the crisis of confidence gripping Wall Street.

Panic is dominating the markets, with a new major financial institution seemingly under threat of extinction every day. Following Tuesday's federal bailout of

AIG

(AIG) - Get Report

investors appear to be selling the shares of any institution that seems remotely vulnerable.

The problem for Morgan Stanley and Goldman Sachs -- both of which beat profit expectations Tuesday, but saw shares fall on Wednesday as much as 44% and 26%, respectively -- is that they depend heavily on the confidence of other institutions to stay open for business. Other financial institutions around the world are willing to take the opposite side of bets on loans and other trades, and because they trust Morgan Stanley and Goldman to pay them back.

In the current frenzied environment, however, that confidence could disappear in a few hours. One institution could call off its bet and ask for its money back, causing another to worry, creating a domino effect. This type of institutional bank run -- or the increasing likelihood of it occurring -- is precisely what helped drive Morgan Stanley's and Goldman's weaker and smaller competitors to sell themselves or file for bankruptcy.

"When the crisis in confidence unfolds against the institution, the confidence deteriorates to a point where no one is willing to provide it credit, and the scope, scale and leverage of these institutions just put them in a position where they are highly vulnerable to that crisis in confidence," says Steven Ricciuto, chief economist at Mizuho Securities USA.

Morgan Stanley CEO John Mack sent a message to firm employees Wednesday, blaming short sellers for driving down the stock.

"You should know that the management committee and I are taking every step possible to stop this irresponsible action in the market," Mack wrote. "We have talked to Secretary

Hank Paulson and the Treasury. We have talked to Chairman

Christopher Cox and the SEC. We also are communicating aggressively with our long-term shareholders, our counterparties and our clients. I would encourage all of you to communicate with your clients as well -- and make sure they know about our strong performance and strong capital position."

At the start of the year, there were five major U.S. investment banks. Now there are two.

Bear Stearns

was the first to go down, in a forced sale to

JPMorgan Chase

(JPM) - Get Report

in March.

Then came

Lehman Brothers'

(LEH)

bankruptcy filing early Monday. Almost simultaneously,

Merrill Lynch

(MER)

sold itself at a steep discount to its market value a year ago to

Bank of America

(BAC) - Get Report

.

When five giant investment banks worth hundreds of billions of dollars and which have been around for generations become four, and then whittled to two virtually overnight, it is only logical for investors to wonder about whether the ones left standing will meet the same fate. Because confidence is so important to investment banks, that mere wondering is enough to start a snowball rolling that -- in this fragile environment -- can quickly become an avalanche.

Commercial banks that take customer deposits are able to use those deposits as a second line of defense if large institutions are no longer willing to trade with them. They also have a third line of defense -- deposit insurance from the FDIC.

Goldman Sachs and Morgan Stanley

on Tuesday insisted they did not need or intend to seek merger partners at the present time.

However, according to a report on the

Wall Street Journal

Web site, Morgan Stanley CFO Colm Kelleher indicated in an interview with the paper Tuesday night that the firm's plans could change.

"We have to be adaptable," Kelleher said. "If the market fully decides that you need deposits, then it's decided."

Neither Kelleher nor a Morgan Stanley spokesman immediately responded to requests for comment.