Goldman, Morgan prepare for long battle

Goldman announced deals that will raise 15 billion from Warren Buffett8217;s Berkshire Hathaway and public investors. Morgan Stanley plans to sell as much as a 20 per cent stake for roughly 8.5 billion to Japan8217;s Mitsubishi UFJ Financial Group, one of the world8217;s largest banks.

The moves staved off the pressure that brought down Bear Stearns and Lehman Brothers and will let Goldman and Morgan Stanley acquire deposits. But the stability comes at the cost of stricter regulation and slimmer returns.

8220;They8217;re both saying it will be easier, and they8217;ll see more opportunities, with more capital,8221; said Gary Townsend, a veteran analyst who now runs hedge fund Hill-Townsend Capital. 8220;But commercial banking is not easy and the level of leverage allowed is quite a bit different from what they8217;re used to.8221;

Two companies who said they had plenty of capital and the right business model are now raising piles of cash and changing the way they do business.

Analysts cautioned that the two newly minted banks will be forced to rein in risk and use less leverage 8212; the very tools that made Wall Street so enormously profitable.

8220;We8217;ll see high- to mid-teens returns on equities. The days of 30 per cent ROEs are behind us,8221; said Sanford C. Bernstein analyst Brad Hintz.

Goldman8217;s equity sales reduced leverage on the balance sheet to where each dollar of capital supports less than 20 of assets 8212; down from more than 30 last year 8212; and boosted shareholders8217; equity by a third to 61 billion.

The sales dilute per-share earnings by about 16 per cent, and have Goldman paying Buffett a princely 10 per cent coupon.

8220;For Goldman Sachs, the blue chip of financials, the terms of this deal seem exorbitantly expensive and provide insight into how truly challenging current market conditions are,8221; Oppenheimer 038; Co analyst Meredith Whitney wrote.

Basking in the glow of its Buffett endorsement, Goldman shares rose more than 6 per cent on Wednesday.

TOUGH TIMES AHEAD

Even so, the tough times for banks are far from over.

The Treasury Department8217;s proposal to soak up hard-to-sell debts from ailing banks is still subject to debate in Congress. And the conditions that hurt Wall Street firms in the first place 8212; a slowing economy, too few deals and illiquid debt markets 8212; have not improved.

Despite all the positive developments this week, the cost of insuring against a default in Morgan Stanley debt rose Wednesday. Its shares fell 11.5 per cent.

8220;The willingness to raise a lot of capital at a modest premium to book value could suggest that Goldman8217;s management has a bleak outlook on the environment,8221; Sandler O8217;Neill analyst Jeff Harte said in a note. 8220;We remain cautious on the outlook for the near-term operating environment.8221;

The two firms also face Fed demands for greater disclosure about their trades and investments.

8220;We8217;re certainly at the end of an era. The higher risk, high reward strategies that the investment banks utilized are certainly going to be tamed,8221; said John Challenger, head of Challenger Gray 038; Christmas, who tracks job and salary trends.

Embracing the bank model also opens the door to some new opportunities.

The fourth-largest US bank with 1.1 trillion in assets, Goldman intends to snap up assets and deposits from distressed banks seized by the Federal Deposit Insurance Corp or federal bailout plan. Goldman does not intend to acquire large banks.

By comparison, Morgan Stanley already has a significant retail financial business through its 8,500 brokers and 3 million wealth management clients. The No. 5 US bank with 989 billion of total assets has said it will expand its retail banking business. It expects an alliance with Mitsubishi, the world8217;s second largest bank by deposits, will give it a real boost.

The MUFG talks, and its new bank status, means Morgan can pursue a whole new set of options. Talks that commenced last week with Wachovia Corp now dead, people familiar with the matter said.

For now, even the newly empowered and capital-rich Wall Street firms are holding back from buying banks.

8220;Given the difficulties in valuing potential targets due to rising credit problems and significant mark-to-market accounting issues,8221; RBC Capital Markets analysts wrote, 8220;we believe strategic buyers such as Goldman and Morgan will probably remain on the sidelines for now.8221;