Wall Street's New Realities

My anonymous colleagues here at Portfolio.com have a couple of questions:

With Bank of America's $44 billion acquisition of Merrill Lynch, only two independent Wall Street firms remain: Goldman Sachs and Morgan Stanley. Will they now feel pressure to merge with a big commercial bank? ...
With the deal, Bank of America leaps over Citigroup to become a behemoth in every niche of finance, from credit cards to derivatives. Is the financial supermarket back?

The simple answers are yes and yes.

But.

The first thing to note is that although there is undoubtedly pressure on Goldman and Morgan Stanley to be acquired by someone much larger, the chances are that they will resist that pressure. Megan Barnett has a good overview of the pressures facing the two last banks standing, not least the fact that their public-company status means constant pressure from shareholders to grow profits -- which, naturally, means taking more risk.

But the market doesn't seem to think either of them will be taken over any time soon: takeover targets tend to rise, but Goldman's down 8% today and Morgan Stanley's down over 9%. And neither of them is in remotely desperate enough straits to agree to a "takeunder".

Goldman, with a market cap of about $56 billion, trades on a price-to-book ratio of 1.46; Morgan Stanley is worth about $37 billion, or 1.24 times its book value. Are those book values realistic? Frankly, nobody knows -- but neither bank was nearly as aggressive in mortgages as Lehman and Merrill, so they might be.

Both banks, however, can afford to be extremely picky about whom, if anybody, buys them. They both consider themselves to be homes of a "special sauce" which could easily be curdled by insensitive management (ie, a boss who thinks it unconscionable that a twentysomething bond trader can be making more money than he is). I can imagine that's why Dick Fuld was (is?) so taken by the idea of selling to the Korea Development Bank -- they're the kind of passive owner who would probably interfere very little with current managment.

Similarly, no commercial bank wants to even try to buy Morgan Stanley or Goldman Sachs without the full assent and cooperation of the investment bank in question. The stars at these companies can and will walk if they're not happy with the new ownership -- which would defeat the purpose of buying the banks in the first place. So if either bank does enter into matrimony with a larger suitor, expect the marriage to come after a very long period of dating. No Vegas-style quicky marriages for these two, we'll leave that kind of thing to Merrill.

As for financial supermarkets, now there are three: Citigroup, Bank of America, and JP Morgan Chase. Citi is still a mess; JP Morgan seems much more coherent. And Bank of America is somewhere in the middle: think of Ken Lewis as a latter-day Sandy Weill, bringing together disparate franchises by sheer force of personality. Which isn't exactly auspicious, and maybe helps explain the fact that Bank of America's market capitalization fell today by $26 billion.

What's beyond a doubt is that all three supermarkets are, at this point, far too big to fail. That's something which should worry Hank Paulson, and all of his successors. If a Lehman bailout was too expensive to contemplate, just imagine what a BAC bailout might look like.