The federal government's $10 billion equity investments in both Morgan Stanley ( MS) and Goldman Sachs ( GS) seem to have eased nagging doubts about the firms' liquidity positions, but the long-term outlook for both businesses remains far from clear. The investments in Morgan Stanley and Goldman Sachs are part of a $250 billion capital injection unveiled by the government Tuesday to bolster the U.S. banking system. Combined with Mitsubishi UFJ Financial Group's ( MUFG) $9 billion investment in Morgan Stanley and Berkshire Hathaway's ( BRK-A) $5 billion investment and concurrent $5 billion public equity offering by Goldman, the government's backing adds to already strong capital bases for the two companies. The Federal Reserve considers a bank with a 6% Tier-1 capital ratio well-capitalized. Before the government's investment, Morgan Stanley boasted a Tier-1 capital ratio of more than 15.5% on a pro-forma basis as of Aug. 31. Goldman Sachs said in its third-quarter financial report that it ended the period with an 11.6% Tier-1 ratio. Even as the major indices hovered in neutral territory, shares of Morgan Stanley were up 20.8% $21.86 Tuesday afternoon, while Goldman stock was up 11.7% to $124.02. The cost of insuring $10 million of Morgan Stanley's debt dropped from more than $1 million on Monday to $375,000 -- a level approaching some semblance of normalcy. Insurance on $10 million of Goldman's debt -- the price of which has been far more stable -- cost $210,000 mid-Tuesday morning. Morgan Stanley spokesman Mark Lake notes that the company's bonds also have risen from 62 cents on the dollar Monday into the high 80s Tuesday afternoon. He said he expects they are headed higher because it takes time for the market to process all of the information the government released Tuesday.
"The market is saying the risks inherent in Morgan Stanley's debt and Goldman's debt are significantly lower
due to the government moves to the point where they can access markets," Lake says. Still, the success of these Wall Street institutions has historically been based on helping other companies raise capital and, more recently, on trading profits. But large companies no longer rely as heavily on investment banks as they did throughout most of the last century in order to raise money. And now that Morgan Stanley and Goldman have become bank holding companies, their ability to take risks looks to be sharply diminished. Sandler O'Neill analyst Jeff Harte published a report Tuesday that rated Morgan Stanley a hold with a price target of $20, writing that the firm "appears in a much stronger capital position." But he also strikes a cautious note. "We think conservatism is appropriate because the operating environment is shaping up to be one of the most difficult in decades," Harte writes. Citigroup analyst Prashant Bhatia was more optimistic, upgrading both Morgan Stanley and Goldman to buy on Tuesday in light of the government's moves. "The new government plan involving both a capital infusion and the guarantee of debt are meaningful positives to both firms, as it takes solvency issues off the table," Bhatia writes. Still, Bhatia is setting relatively modest price targets of $30 for Morgan Stanley and $150 for Goldman Sachs, arguing that though their earnings fundamentals would imply prices of $48 and $210, respectively, they may trade closer to book value, as brokers have tended to do amid "the current macro environment and market turmoil."
There remains a great deal of uncertainty about the new environment of tighter regulation in which Goldman and Morgan Stanley will operate, according to Derrick Wulf, a fixed income portfolio manager at Dwight Asset Management, a $73 billion asset manager in Burlington, Vt. While Wulf is encouraged by the U.S. government decision to inject capital into Morgan Stanley and Goldman Sachs, the firms' access to the long and medium-term debt markets has still to be tested. "Morgan Stanley and Goldman require leverage, and if counterparties are unwilling to provide the financing for them to lever themselves then the business model breaks down," Wulf says. Spokespeople for the firms did not immediately respond to email messages seeking comment. But the companies have demonstrated that they have been reducing their leverage in response to the current crisis. Morgan Stanley said Monday that the MUFG investment reduces its leverage ratio to just under 20 times and its adjusted leverage ratio to just over 10 times on a pro-forma basis at Aug. 31. In addition, Morgan Stanley has reduced its total assets to under $900 billion, down from $987 billion over the same time. Goldman's leverage ratio could not immediately be learned. By comparison, Lehman Brothers was levered 31 times last year when the mortgage market collapsed, according to Bloomberg. At the same time, Morgan Stanley was levered 32 times and Goldman was levered 22 times. Lake says Morgan Stanley is now focusing on retail and asset management, which require less leverage than the investment banking model.
"The world has changed: we acknowledge that. It's not going to be a leveraged model," he says.